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1993 ITEM 1. BUSINESS INTRODUCTION The Newhall Land and Farming Company (a California Limited Partnership) ("the Company" or "the Partnership") is engaged in the development of residential, industrial and commercial real estate and in agriculture and is one of California's largest land resource companies. The interests in the Company (other than those held by the general partners) are represented by transferable Depositary Units listed on the New York and Pacific Stock Exchanges under the ticker symbol NHL. The Company was reorganized from a corporation to a limited partnership on January 8, 1985. The predecessor corporation was established in 1883 by the family of Henry Mayo Newhall and the shares of the corporation were listed on the New York Stock Exchange in 1970. The Company's primary business is developing master-planned communities. Since 1965, the Company has been concentrating its resources on developing the new town of Valencia on 10,000 acres of the 37,500-acre Newhall Ranch in accordance with a master plan designed to enhance the value of developed and undeveloped land. Preliminary planning is underway for another master-planned community on the 12,000 acres of the Newhall Ranch remaining in Los Angeles County. In 1993, the Company exercised an option on approximately 700 acres and purchased 160 acres in Scottsdale, Arizona, for a third master-planned community, with options remaining on an additional 1,400 acres. The master plan and zoning for the new planned community, McDowell Mountain Ranch, was approved by the Scottsdale City Council for development of over 4,000 homes and 70 acres of commercial property on a 3,200-acre site. Approximately 900 acres have been dedicated to the City of Scottsdale for open space. Valencia, one of the nation's most valuable landholdings, is located in the Santa Clarita Valley, approximately 30 miles north of downtown Los Angeles and within 10 miles of the San Fernando Valley which has a population of over 1.3 million people. The Company's Newhall Ranch landholdings are bisected by Interstate 5, California's principal north-south freeway, and four major freeways intersect Interstate 5 within ten minutes of Valencia. During the 1960s and 1970s, residential development dominated the activity in Valencia. In the 1980s, industrial development expanded eight-fold and the Santa Clarita Valley was the fastest growing area of unincorporated Los Angeles County. In the 1990s, Valencia is emerging from a residential and industrial suburb of Los Angeles to become the regional center for North Los Angeles County. Regional centers generate long-term increases in land values with the more intensive development of industrial and commercial business parks and shopping centers, along with a broader range of single-family and multi-family residential projects. The Valencia Town Center regional shopping mall, a joint venture with JMB/Urban Valencia Limited Partnership, celebrated its first anniversary in September, 1993. The mall's first phase development includes three department stores, space for 110 mall shops, a food court, two sit-down restaurants and a 10-screen theater complex in 790,000 square feet of space. In future years, it is expected that the shopping center will be expanded to a total of 1.4 million square feet to include six department stores and additional mall space. Valencia Town Center, with no competitive regional shopping center within 20 miles, has become the primary shopping and business hub for the entire Santa Clarita Valley and draws shoppers from the Antelope Valley, eastern Ventura County and northern San Fernando Valley. The Valencia Town Center trade area is estimated to include 350,000 people with an average household income 60% above the national average. A commuter rail line linking the Santa Clarita Valley, home of Valencia, with downtown Los Angeles began operations in October, 1992. The commuter station and parking lot are located about two miles from Valencia Town Center, and within a ten-minute drive for all Valencia residents. Also, the bus system within the Santa Clarita Valley has been expanded, with an entirely new fleet of buses placed in service. Major damage to freeways from the earthquake which struck the San Fernando Valley on January 17, 1994 is restricting traffic between Greater Los Angeles and the Santa Clarita Valley where Valencia is located. Reconstruction is underway and CalTrans has announced it intends to have the Interstate 5 freeway fully repaired by mid-June. For additional discussion, see the "Impact of Earthquake" section of Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations. In the late 1980s, the Company adopted the strategy of selling farm properties with little or no potential for development and redeploying the proceeds into real estate operations. As of December 31, 1993, more than 17,000 acres of non-strategic farm land have been sold. The Company plans to market for sale its remaining 14,800 acres of non-strategic farm land during 1994. The Company intends to retain the 37,500-acre Newhall Ranch where development is continuing and the 38,800-acre Suey Ranch where development will be considered in the future. Also, the 14,000-acre New Columbia Ranch will be retained for its substantial surface and underground water supplies. Financial information concerning the Company's business segments appears in Note 11 of the Notes to Consolidated Financial Statements in this Annual Report. At December 31, 1993, the Company employed 263 persons including 18 classified as seasonal/temporary. COMPETITION The sale and leasing of industrial, residential and commercial real estate is highly competitive, with competition from numerous and varied sources. The degree of competition is affected by such factors as the supply of real estate available comparable to that sold and leased by the Company and the level of demand for such real estate. In turn, the level of demand is affected by interest rates and general economic conditions. The Company is not dependent upon any one customer for a significant portion of its revenues. GOVERNMENTAL REGULATION AND ENVIRONMENT The governmental review process through which landholdings must go before real estate projects are approved and can be built by the Company is referred to as the entitlement process. This process has become increasingly complex and projects often require several years to pass through the requirements of various governmental agencies. In developing its projects, the Company must obtain the approval of numerous governmental authorities regulating such matters as permitted land uses, levels of population, density and traffic, and the provision of utility services such as electricity, water and waste disposal. In addition, the Company is also subject to a variety of federal, state and local laws and regulations concerning protection of health and the environment. This governmental regulation affects the types of projects which can be pursued by the Company and increases the cost of development and ownership. The Company devotes substantial financial and managerial resources to complying with these requirements and dealing with this process. To varying degrees, certain permits and approvals will be required to complete the developments currently being undertaken, or planned, by the Company. In addition, the continued effectiveness of permits already granted is subject to factors such as changes in policies, rules and regulations and their interpretation and application. The ability of the Company to obtain necessary approvals and permits for its projects is often beyond the Company's control and could restrict or prevent development of otherwise desirable properties. (See also Item 1 - Community Development) APPRAISAL OF REAL PROPERTY ASSETS Annually, the Company obtains appraisals of substantially all of its real property assets. The independent firm of Buss-Shelger Associates, MAI real estate appraisers, appraised the market value of the Company's real property assets to be $897,100,000 at December 31, 1993. The appraised assets had an aggregate net book value of $242,571,000 at December 31, 1993 and did not include oil and gas assets, water supply systems, cash and cash equivalents and certain other assets. For the purpose of the appraisals, market value was defined as the most probable price in terms of money which a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently, knowledgeably and assuming the price is not affected by undue stimulus. A significant portion of the appraised real property assets is located on the Newhall Ranch and currently is undeveloped. The appraised value of undeveloped assets reflects the discount or developer's profit necessary to provide a third-party buyer with the incentive to purchase and undertake the risks inherent in the development process. The Company believes that its strategy of selling primarily finished parcels on which the development process is substantially complete, or retaining land for development of building improvements, has enabled the Company to realize the fullest value from its various assets. The Company intends to continue the development of Valencia and the surrounding area. Entitlements and the continuing development of Valencia enhance the appraised value of the Company's land assets. Although raw land increases in value as development opportunities arise, the most significant increases occur when necessary land use entitlements, including zoning and mapping approvals are obtained from city and county governments. The appraised values of the Company's land and income-producing properties in the Valencia master-planned community have increased from $222 million in 1984, the first year independent property appraisals were obtained, to $745 million in 1993, despite declines in recent years. On a per unit basis, the Company's net appraised value has increased from $11.74 to $21.04 over the same period. A summary of appraised values of properties owned for each of the last five years as of December 31 follows (the appraisals were performed by independent appraisers except as noted): Appraised values are judgments. Land and property appraisals are an estimate of value based on the sale of comparably located and zoned real estate or on the present value of income anticipated from commercial properties. There is no assurance that the appraised value of property would be received if any of the assets were sold. Refer to the "Impact of Earthquake" section of Item 7 in this Annual Report for a discussion of the impact of the earthquake which occurred subsequent to the 1993 appraisal. Certain reclassifications within categories have been made to prior periods' amounts to conform to the 1993 presentation, however, prior periods' amounts have not been restated to reflect land sale activity. REAL ESTATE The Company is developing the community of Valencia on the Newhall Ranch in Los Angeles County, California. Valencia's development is based on a master plan with residential and industrial developments forming the basic community structure supported by shopping centers, schools, colleges, hospital and medical facilities, golf courses, professional offices and a range of recreational amenities. A system of landscaped and lighted pedestrian walkways, known as paseos, provide most residents with access to schools, retail, parks and recreation centers avoiding automobile traffic. Since 1967, over 10,000 homes and apartments have been built in Valencia by the Company and others. At the end of 1993, the population of Valencia was estimated to exceed 30,000. The Company also develops and operates a growing portfolio of commercial properties and provides building-ready sites for sale to industrial and commercial developers and users. RESIDENTIAL DEVELOPMENT AND LAND SALES The transition from the Company's internal home construction to the sale of ready-to-build lots to merchant builders was completed in 1993. During the year, a total of 30 of the Company's own homes closed escrow and merchant builders closed escrow on 137 homes. In 1993, the sale of 62 residential lots was completed. At December 31, 1993, four major home builders were constructing homes in Valencia on land purchased from the Company. They include Pardee, a division of Weyerhaeuser; M.J. Brock, a division of Ryland Homes; Warmington and Bramalea. Also completed in 1993, was the sale of 220 acres at the Cowell Ranch to the City of Walnut Creek. The Company has begun to engage national and regional builders in the construction and sale of single and multi-family homes through a variety of joint-venture arrangements. These development partnerships, initiated in 1993, are designed to provide additional profit participation, more rapid residential development, entry into more affordable housing markets and enable innovative builders to obtain financing in today's tight real estate lending environment. The Company's first residential joint venture is with EPAC Communities, Inc., for 65 homes, of which 21 closed escrow in 1993. At December 31, 1993, a total of 83 residential lots in Valencia Northpark, the Company's newest residential community, were in escrow to a merchant builder. The Company's ability to make additional lot sales in 1994 will be dependent upon market conditions, absorption of lots previously sold to builders and completion of necessary land development and infrastructure improvements. There is substantial interest by merchant builders and the Company is negotiating sales contracts for residential lots and superpads in the Company's newest planned community, McDowell Mountain Ranch, in Scottsdale, Arizona. The Company's ability to complete these initial sales is dependent upon finalizing public financings with the City of Scottsdale and completing necessary land and infrastructure improvements. INDUSTRIAL DEVELOPMENT AND LAND SALES The Company develops the infrastructure and provides building-ready sites to developers and users. Valencia's location just 30 minutes from downtown Los Angeles on Interstate 5, California's major north-south freeway, provides an attractive environment for industrial, commercial, service, distribution and entertainment businesses. The Company's first business park, Valencia Industrial Center, is currently home to over 500 companies and employs more than 14,000 people. At December 31, 1993, the Company had over 650 acres entitled industrial land, primarily in the Company's new business park, Valencia Commerce Center. With no competitive large land parcels available in Los Angeles County, these entitlements place the Company in a favorable position as the economy and real estate markets improve. The California real estate recession and the inability of developers to obtain financing continued to inhibit the sale of industrial and commercial land during 1993. Some improvement was seen in the fourth quarter, however, when five parcels closed escrow bringing the total closings to seven for the year. Escrow closings included two parcels in Valencia Auto Center totaling 8.2 acres, two church sites totaling 10.5 acres, a .7-acre commercial lot, 8.5 acres for a distribution center and a 2-acre parcel to the California Department of Transportation. Future industrial land sales will be concentrated in the 1,600-acre Valencia Commerce Center and expansion of the nearly completed Valencia Industrial Center. With Los Angeles County's northward expansion into the Santa Clarita Valley and beyond, the U.S. Postal Service chose Valencia Commerce Center for its new distribution center. The postal center, currently under construction, will bring 1,500 jobs to Valencia and is expected to make the Center particularly attractive to companies involved in mailing operations. At December 31, 1993, no industrial or commercial land sales were in escrow. COMMUNITY DEVELOPMENT The Company has continued to focus financial and management resources on planning and entitlements during the recession in order to ensure an adequate supply of entitled land as the California economy and real estate markets improve. The Company's success in obtaining entitlements in prior years contributed to a 21% decrease in entitlement expenses in 1993. The Company is committed to continuing its entitlements efforts in the future and does not anticipate a further reduction in entitlement expenses in 1994. For additional discussion of community development and the entitlement process, see Item 1 - Governmental Regulation and Environment. Approvals were granted in 1993 for 192 multi-family homes and 22 acres of commercial development in Valencia. At December 31, 1993, the Company had over 5,600 residential lots approved in the Valencia area including 1,600 lots with general plan land use approval. In March, 1993, the master plan and zoning for a new planned community, McDowell Mountain Ranch, were approved by the Scottsdale City Council for development of over 4,000 homes and 70 acres of commercial property. Final plans and environmental factors are subject to review by government agencies before development can proceed. Significant land development and infrastructure improvements remain to be completed before the Company can deliver the majority of approved lots for sale. COMMERCIAL REAL ESTATE DEVELOPMENT The Company develops and operates commercial properties in the Valencia area for the production of income. The Company's growing and diversified commercial portfolio is expected to continue to provide a stable source of income and cash flow throughout economic cycles as well as appreciation in property value. Valencia Town Center regional shopping mall, the Company's largest income property, celebrated its first anniversary in September, 1993. The Center includes over 100 mall shops, three department stores, a food court, a 10-screen theater and two sit-down restaurants in over 790,000 square feet of space. At the end of 1993, tenant space in the center was 94% leased or committed. Castaic Village, the Company's newest neighborhood shopping center which opened in November, 1992, added PayLess Drugstores, the second anchor tenant, and a Burger King in 1993. Construction is complete on 12,800 square feet of retail space in the 130,000-square-foot shopping center and leasing is underway. During 1993, the Company opened a 30,000-square-foot telecommuting center in Valencia Industrial Center. The facility, wired with fiber optic and traditional cabling for voice, video and data transmission, is the largest telecommuting center in California and reflects a number of trends taking place in the work environment. A new program for developing build-to-suit industrial and commercial facilities was launched in 1993 with the signing of an agreement with ITT Corporation to construct a 175,000-square-foot facility on approximately 10 acres in Valencia Commerce Center. ITT will move its Aerospace Controls and Neo-Dyn Operations with 400 employees from their current San Fernando Valley locations. Earlier in the year, the Company entered into a long-term lease agreement to construct a 7,000-square-foot facility for Trader Joe's, a popular specialty food retailer with stores throughout Southern California. Both of these build-to-suit properties are scheduled to be completed in 1994. Valencia Marketplace, a high-volume retail complex or "power center" to be built adjacent to Interstate 5, is in the entitlement process. The 850,000-square-foot facility, a joint venture with Riley/Pearlman/Mitchell, is expected to break ground in 1994 with completion in 1995. Additional future plans include community shopping centers, apartment projects, restaurants, commercial recreational facilities, office buildings and, eventually, additional hotels. The timing for development of future projects will be dictated by market conditions. For a description of the commercial properties, see Item 2 ITEM 2. PROPERTIES LAND Listed below is the location and acreage of properties owned by the Company at December 31, 1993: (1) An additional 1,430 acres are under long-term option. PLANTS AND BUILDINGS Agriculture - Various buildings located on five farming operations in California and office and maintenance buildings located in Dixon, California. Commercial Real Estate - Listed below is the location, square footage and anchor tenants of commercial properties owned by the Company at December 31, 1993. Other commercial properties not shown in the table include various commercial, industrial and restaurant buildings. The commercial properties are leased to 206 tenants, not including apartment complexes. Valencia Water Company - 14 distribution reservoirs, 14 booster pumping stations, approximately 200 miles of pipeline and other utility facilities. All of the commercial real estate properties and the properties of Valencia Water Company are located in and around Valencia, California. All water utility plant and buildings are owned by the Company. A $60 million mortgage is secured by the Portofino, Northglen and Stonecreek apartment complexes, River Oaks and Bouquet community shopping centers, and the Company's headquarters building. For additional information concerning encumbrances against Company properties, refer to Note 8 of the Notes to Consolidated Financial Statements in this Annual Report. For a discussion of the impact of the January 17, 1994 earthquake on the Company's properties, see the "Impact of Earthquake" section of Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company is involved in litigation and various claims, including those arising from its ordinary conduct of business. Management is of the opinion that the ultimate liability from this litigation will not materially affect the Company's consolidated financial condition. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. PART II Item 5. Item 5. MARKET FOR THE REGISTRANT'S DEPOSITARY UNITS AND RELATED SECURITY HOLDER MATTERS MARKET PRICE AND DISTRIBUTION DATA The Company's partnership units are traded on the New York and Pacific Stock Exchanges under the ticker symbol NHL and, at December 31, 1993, the Company had approximately 1,800 unitholders of record. The Company has paid uninterrupted quarterly cash distributions since 1936. The declaration of any distribution, and the amount declared, is determined by the Board of Directors, taking into account the Company's earnings, cash requirements, financial condition and prospects. Item 6. Item 6. SELECTED FINANCIAL DATA See notes to consolidated financial statements ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Years ended December 31, 1993, 1992 and 1991 LIQUIDITY AND CAPITAL RESOURCES The Company ended 1993 with $39.6 million in cash and cash equivalents, an increase of $28.8 million for the year. Contributing to the Company's strong cash position was a $30 million seven-year unsecured loan at 6.9% obtained from a major insurance company in December, 1993 and positive cash flow generated by operations. Also during the year, the Company expanded its lines of credit by $31 million to $69 million at December 31, 1993, providing the Company with over $100 million in credit and cash available to fund future operations. No debt was incurred against raw land or land under development in Valencia. Cash flow in 1993 was adequate to maintain quarterly distributions of 10 cents per partnership unit, fund on-going development projects, and end 1993 with no short-term borrowings outstanding. The Company believes its operations and available credit are sufficient to provide the cash required to finance future operations and enable it to take advantage of new development opportunities. There are no material commitments for capital expenditures other than in the ordinary course of business. The Company plans to spend approximately $30 million for capital additions in 1994 primarily for construction of commercial income properties subject to supportive economic and market conditions. Also, the Company is actively searching for additional large landholdings with development potential. At December 31, 1993, no specific land parcels had been identified. OPERATING ACTIVITIES: Cash provided from operating activities during 1993 included the sale of 3,900 acres of farm land and the sale of 220 acres at the Cowell Ranch. These sales were for $12.9 million cash and $2.5 million in notes receivable secured by the properties sold. An increase in inventory expenditures in 1993 was related primarily to land development and infrastructure expenditures for pending and future land sales in the Valencia area. Also, in 1993, approximately 900 acres of land were purchased with long-term seller financing for McDowell Mountain Ranch, a new master-planned community in Scottsdale, Arizona. The Company anticipates an increase in land development and infrastructure activity in 1994 for new Valencia area and McDowell Mountain Ranch residential projects. The Company has been providing financing for residential and other property sales in Valencia due to the difficulty buyers have been encountering in obtaining bank loans. Contracts generally provide that Newhall receive at least 25 percent in cash upon close of escrow, with the balance represented by a note receivable secured by the property sold and due within one year. In 1993, the Company accepted $8.9 million in notes receivable and collected notes receivable of $22.2 million relating to prior land sales. In 1992, the Company accepted $29 million and collected $10.7 million in notes receivable. Deferred revenues of $11.2 million were recognized in 1993 from land sales in prior years. At December 31, 1993, $1.7 million in deferred revenues remained to be recognized in future periods as the Company completes required site development, landscape and amenity work. In 1992, $8.0 million in deferred revenues were recognized from land sales in prior years and, at the end of 1992, $11.6 million remained to be recognized. Recognition of deferred revenues has no impact on the Company's cash position. INVESTING ACTIVITIES: Capital expenditures totaled $9.5 million in 1993 and included $4.6 million of construction costs for Castaic Village, a 130,000-square-foot neighborhood shopping center being developed just north of Valencia. Additional capital expenditures included water utility construction, land preparation for a 175,000-square-foot build-to-suit for ITT Corporation in Valencia Commerce Center, and various improvements to commercial properties. In 1992, capital expenditures totaled $60 million of which $50.4 million were for construction costs and infrastructure improvements for Valencia Town Center, the Company's regional shopping center which opened in September, 1992. Other capital expenditures in 1992, included $3.8 million for the first phase of Castaic Village, and the purchase of the 433-acre Isola Ranch for $2.7 million. In 1991, capital expenditures totaled $29.3 million and included initial construction costs of $13.6 million for Valencia Town Center, purchase of a 50,000-square-foot office building for $6.8 million, purchase of a 15-acre commercial parcel for $3 million, initial land development costs for Castaic Village and purchase of 79 acres of land adjacent to Valencia Commerce Center. FINANCING ACTIVITIES: Four quarterly distributions totaling $14.7 million, or 40 cents per partnership unit, were paid in 1993. In July, 1992, the Board of Directors reduced the quarterly cash distribution to 10 cents per unit from the 20 cents per unit which had been paid since 1989. The Board found it advisable to reduce the cash distribution when it became apparent that cash flow would be inadequate to cover the distribution paid previously and at the same time fund major projects under development, to obtain entitlements for promising new projects, and to continue the planned buildup of the Company's income properties. The declaration of any distribution, and the amount declared, is determined by the Board of Directors, taking into account the Company's earnings, cash requirements, financial condition and prospects. At December 31, 1993, mortgage and other debt totaled $174.2 million, compared to $131.8 million at year-end 1992 and $78.6 million at year-end 1991. The increase in 1993 primarily was from a $30 million unsecured loan from a major insurance company, $13.4 million of land acquisition notes in connection with McDowell Mountain Ranch in Scottsdale, Arizona and $9.5 million additional reimbursement from tax-exempt community facilities bonds relating to Valencia Town Center. In 1992, the increase in mortgage and other debt consisted principally of draws totaling $35.3 million against a $40 million construction loan and $6.1 million reimbursement from tax-exempt community facilities bonds for Valencia Town Center. Upon receipt of the $30 million unsecured loan in December, 1993, $10.5 million of outstanding advances against a revolving-to-term credit line for the Company's wholly-owned public water utility were retired. The Company expects to replace this revolving credit line with a long-term financing during 1994, subject to approval by the California Public Utilities Commission. In 1994, the Company intends to complete additional public financings to assist in funding major infrastructure and land development projects in Valencia and for McDowell Mountain Ranch. RESULTS OF OPERATIONS Revenues and earnings were depressed in 1993 as a result of the lingering recession in Southern California and continuing weakness in real estate markets. The Company's 1993 total earnings were lower principally because results for 1992 included the sale of farm land which contributed $14.5 million, or 39 cents per unit, to earnings. In 1993, the sale of farm land contributed $5.2 million, or 14 cents per unit, to earnings. Also, the sale of 399 residential lots in 1992 impacted the Company's ability to sell additional lots in 1993. Mitigating this decline, the Company's commercial operations posted a 24% improvement in operating income over the prior year and several moderately-sized land parcels closed escrow in 1993. The sale of land to government agencies, which added $39 million to revenues and $16 million to earnings in 1991, did not have a significant impact on results in either 1993 or 1992. A five-year summary of revenues and operating income for each of the Company's major business segments follows: FIVE YEAR SUMMARY RESIDENTIAL HOME AND LAND SALES Transition from the Company's internal home construction to the sale of ready-to-build lots to merchant builders was completed in 1993. A total of 30 of the Company's own homes closed escrow in 1993, compared with 88 in 1992 and 136 in 1991. Because of the impact of the recession and a larger than normal supply of lots in builders' inventories during the past few years, the Company lowered the price of its lots in 1992 to remain competitive. Profit margins in the past two years, as a result, were lower than in prior years. The sale of 62 residential lots to Pardee, a division of Weyerhaeuser, was completed in 1993. A total of 399 residential lots were sold in 1992 to merchant builders and 97 lots in 1991. The 62-lot sale contributed $4.6 million to current year revenues and $541,000 to income under percentage of completion accounting. Lot sales in 1992 and 1991 contributed $32.7 million and $9.0 million to revenues and $3.7 million and $2.2 million to income, respectively, under percentage of completion accounting. Also included in 1993 results is the sale of 220 acres at the Cowell Ranch for $6.0 million which contributed $5.3 million to income. Under percentage of completion accounting, the Company recognized $6.9 million of deferred revenues and $1.2 million of income in 1993 from prior residential lot sales. This compares with deferred revenues of $6.1 million and $995,000, and income of $5.5 million and $774,000 recognized in 1992 and 1991, respectively, as a result of the sale of higher margin residential lots in prior years. During 1993, cash received from prior residential land sale profit participation agreements added $100,000 to revenues and income. This compares to $733,000 received in 1992 and $1.0 million in 1991. The Company does not expect to receive any profit participation related to recent lot sales because of the more competitive market and lower margins being realized by home building companies. The Company is engaging a number of quality builders in the construction and sale of single and multi-family homes in Valencia through various joint venture arrangements. These ventures are intended to increase momentum in the residential segment, maximize land values and enable innovative builders to obtain financing in today's tight real estate lending environment. The Company's financial exposure is managed through strict controls with new starts directly tied to sales performance. These development partnerships are anticipated to provide the Company with several innovative products in the second half of 1994 to meet the demand for affordable housing in Valencia. The Company's first residential joint venture is with EPAC Communities, Inc. for 65 homes. As of December 31, 1993, 21 homes had closed escrow contributing $6.7 million to revenues and $1.0 million to income. Four major home builders are constructing homes in Valencia on land purchased from the Company. They include Pardee, a division of Weyerhaeuser; M.J. Brock, a division of Ryland Homes; Warmington and Bramalea. Merchant builders closed escrow on 137 homes in Valencia in 1993. At December 31, 1993, a total of 83 residential lots in Valencia Northpark, the Company's newest residential community, were in escrow to a merchant builder with closing expected in the first quarter of 1994. In addition, the Company is currently negotiating sales contracts for residential lots and superpads in its McDowell Mountain Ranch project in Scottsdale, Arizona. The Company's ability to make additional lot sales in 1994 will be dependent upon market conditions, absorption of lots previously sold to builders and the completion of necessary land development and infrastructure improvements. INDUSTRIAL AND OTHER SALES The California real estate recession and the inability of developers to obtain financing continued to inhibit the sale of industrial and commercial land during 1993. Some improvement was seen in the fourth quarter, however, when five parcels closed escrow bringing the total closings to seven for the year. During 1993, escrow closings included two parcels in Valencia Auto Center to Magic Ford totaling 8.2 acres, a 6.9-acre site for a church, a 3.6-acre parcel in Northpark for another church site, and a .7 acre commercial lot. Additionally, Weyerhaeuser purchased 8.5 acres for a distribution center, and early in 1993, escrow closed on a 2-acre parcel to the California Department of Transportation. These 1993 sales contributed $10.9 million to revenues and $5.2 million to income. The 1993 results include $4.3 million in revenues and $2.3 million in income recognized under percentage of completion accounting from prior land sales, including the final income recognition on the U.S. Postal Service site. In 1992, two sales of commercial land totaling 4.5 acres closed escrow and contributed $1.3 million to revenues and $940,000 to income under percentage of completion accounting. In addition, $2.0 million in revenues and $1.6 million in income were recognized in 1992 under percentage of completion accounting from the 1990 sale of 62.4 acres in Valencia Commerce Center to the U.S. Postal Service and the 1991 sale of a 5-acre parcel in Valencia Corporate Center to Kaiser Permanente. In 1991, the Postal Service sale contributed $22.8 million to revenues and $9.2 million to income under percentage of completion. Also, in 1991, 44.6 acres were sold to a local high school district for $14.4 million which contributed $5.5 million to income, and the sale of a 4.5- acre site to an elementary school district added $2.0 million to revenues and $1.2 million to income. At December 31, 1993, industrial land inventories totaled over 650 entitled acres. Of course, final plans always are subject to review by governmental agencies before development can proceed, but these entitlements, and the fact that few competitive large land parcels are available in Los Angeles County, place the Company in a favorable position as the economy and real estate markets improve. At December 31, 1993, no industrial or commercial land sales were in escrow. COMMUNITY DEVELOPMENT In March, 1993, the master plan and zoning for a new planned community, McDowell Mountain Ranch, were approved by the Scottsdale City Council for development of over 4,000 homes and 70 acres of commercial property. The Company exercised its first option on approximately 700 acres in November 1993, with options remaining on an additional 1,400 acres. Earlier in 1993, a 160-acre parcel within the project was purchased from the State of Arizona. The balance of the 3,200 acres has been dedicated to the City of Scottsdale for open space. There is substantial interest from merchant builders for the purchase of residential lots. Contract negotiations are on-going and initial sales are anticipated in late 1994. Arizona entered the recession before California and now is experiencing a good recovery and strong market for new homes. Governmental approvals for 192 multi-family homes and 22 acres of commercial development in Valencia were granted in 1993. At December 31, 1993, the Company had over 5,600 residential lots approved in the Valencia area including 1,600 lots with general plan land use approval. Governmental approvals granted in 1992 included 3,300 homes, three community shopping centers and two elementary school sites. In 1991, the County of Los Angeles granted master plan and zoning approvals for the 1,600-acre Valencia Commerce Center as well as subdivision approvals for 340 acres in the center and 100 acres in Valencia Industrial Center. Included in 1992 approvals was final approval from the Los Angeles County Board of Supervisors for the 1,800-home Westridge Golf Course Community. However, following approval, two environmental groups filed a lawsuit challenging the County's approval, their main contention being that the County had improperly permitted a golf course and highway within a significant ecological area. Numerous other environmental deficiencies were also alleged. In September 1993, the trial court ruled that the County had acted properly in regard to the significant ecological area. However, the trial court rescinded all entitlements for the 1,800 homes until such time as the County has demonstrated full compliance with the California Environmental Quality Act and its Development Monitoring System with respect to air quality, schools and libraries. The Company believes that the deficiencies will be cleared in about one year. Final plans and environmental factors are subject to review by governmental agencies before development can proceed. Significant land development work and infrastructure improvements remain to be completed before the Company can deliver the majority of approved lots for sale. Expenses associated with Community Development activities totaled $6.1 million in 1993, a 21% decrease from 1992, primarily as a result of the Company's success in obtaining entitlements during 1992 and prior years. The decline is partially offset by planning and entitlement expenses relating to McDowell Mountain Ranch. In 1992, Community Development expenses totaled $7.8 million, a 26% increase from 1991 expenses of $6.2 million, due to the Company's intensified efforts in obtaining entitlements. The Company is committed to continuing its entitlement efforts in the future and does not anticipate a further reduction in entitlement expenses in 1994. COMMERCIAL OPERATIONS Commercial operations include the Company's portfolio of income- producing properties and the Natural Resources division, consisting of Valencia Water Company, a wholly-owned public water utility, and the Company's energy operations. The primary contributors to increases of 27% in revenues and 24% in income over 1992 results are Valencia Town Center, the Company's regional shopping center which celebrated its first anniversary in September, 1993, and Valencia Water Company, which received approval for a water rate increase of approximately 20% and a drought recovery surcharge from the California Public Utilities Commission. Also contributing to the increases were Valencia Hilton Garden Inn and the new Castaic Village neighborhood shopping center. Tenant space in Valencia Town Center was 94 percent leased or committed at the end of 1993. The Center's first sit-down restaurant, TGI Friday's, opened in October 1993, and the second restaurant, Sisley Italian Kitchen, opened in December. Eddie Bauer, a national sportswear clothing chain, is scheduled to open in February, 1994 and a letter of intent has been received from the Disney Store. The three department stores and most mall shops report sales above expectations. This first phase development consists of 790,000 square feet of space and includes Robinsons-May, JC Penney and Sears department stores, over 100 mall shops, a 10-screen theater and food court, and the two restaurants. Future plans include expanding the shopping center to 1.4 million square feet with three more department stores and additional mall space. Valencia Hilton Garden Inn, a 152-room joint venture hotel, is in its second year of operation and enjoying excellent occupancy rates at almost 80 percent. Castaic Village, the Company's newest neighborhood shopping center located just north of Valencia, opened in November 1992 with Ralphs supermarket as its first tenant. In 1993, Burger King opened in May and PayLess Drugstores, the second anchor tenant, opened in November. Construction is complete on 12,800 square feet of retail space in the 130,000-square-foot center and leasing is currently underway. Revenues and income from the Company's three apartment complexes and River Oaks and Bouquet Center neighborhood shopping centers were slightly higher in 1993 than in 1992 and 1991. At December 31, 1993, Bouquet Center was 100% leased, River Oaks had a vacancy rate of just 1% and vacancies at the apartment complexes averaged 4%. At year-end 1992, vacancies in the apartment complexes averaged 4% and the two neighborhood shopping centers averaged 1%. These vacancy rates were the same at the end of 1991. During 1993, the Company opened a 30,000-square-foot telecommuting center in Valencia Industrial Center. The facility, wired with fiber optic and traditional cabling for voice, video and data transmission, is the largest telecommuting center in California and reflects a number of business trends taking place in the work environment. CareAmerica Health Plans, the building's first tenant, has leased over 5,000 square feet to accommodate its employees who live 25 miles or more from the health insurer's office in Chatsworth, California. Subsequent to the earthquake the facility has been fully leased. Newhall Land has been negotiating with several major companies to develop industrial and commercial real estate projects on a build-to-suit basis. In December 1993, an agreement was signed with ITT Corporation to construct a 175,000-square-foot facility on approximately 10 acres in Valencia Commerce Center. ITT will move its Aerospace Controls and Neo-Dyn Operations with 400 employees from their current San Fernando Valley locations to this new $14 million facility. Earlier in the year, the Company entered into a long-term lease agreement to construct a 7,000-square-foot facility for Trader Joe's, a popular specialty food retailer with stores throughout Southern California. AGRICULTURAL OPERATIONS In 1993, sales of farm land, partially offset by improved citrus prices and higher prices and yields for grapes, resulted in net decreases of 10% in revenues and 16% in income from the prior year. In 1992, agricultural earnings were 32% below the prior year because of the sale of farm properties and a sharp decline in the price of oranges and lemons. Agricultural operations will continue to provide returns from the 37,000-acre Newhall Ranch where development is continuing and the 39,000-acre Suey Ranch where development will be considered in the future. Also, the New Columbia Ranch, which is being retained for its substantial surface and underground water supplies, will continue to be leased to tenants and contribute to agricultural operations. RANCH SALES A total of 3,900 acres of farm land at the Capay/Wheatland, Merced and Meridian ranches was sold in 1993, contributing $9.9 million to revenues and $5.2 million to income. In 1992, the sale of 6,750 acres of farm land at the Wilson, Merced and Meridian ranches contributed $21.7 million to revenues and $14.5 million to income. Sales of 2,989 acres at the Merced Ranch in 1991 added revenues of $3.9 million and income of $2.8 million. The Company plans to market for sale its remaining 14,840 acres of non-strategic farm land during 1994. While these properties had an appraised value of $23.5 million at December 31, 1993, there is no assurance that sales prices will approximate appraised values. At December 1, 1993, no agricultural parcels were in escrow. GENERAL AND ADMINISTRATIVE EXPENSE Reductions in staff and overhead expenditures resulted in a 3% decrease in total general and administrative expenses in 1993, 5% in 1992 and 16% in 1991. Prior year expenses have been reclassified to reflect consolidation of administrative departments in 1993. UNIT OPTIONS FOR MANAGEMENT Fluctuations in the market price of partnership units in connection with appreciation rights of the Company's outstanding non-qualified options accounted for expenses of $250,000 in 1993 and $650,000 in 1991 and an expense recovery of $900,000 in 1992. INTEREST AND OTHER Interest expense increased in 1993 from the prior year due to a construction loan and community facilities bonds for the Valencia Town Center regional mall, and a ranch mortgage obtained in December 1992. Interest income recognized on notes receivable from land sales reduced the overall increase to 5%. The increase in interest expense in 1992 principally was due to construction financing for the regional mall after completion of the project in September 1992, short-term borrowings during the year and bank financing for the Company's wholly-owned water utility. Also, interest income decreased with the repayment of land sale notes. In 1991, a mortgage obtained on a 50,000-square-foot office building and financing for the Company's wholly-owned water utility contributed to a net increase in interest expense. INFLATION AND RELATED FACTORS The Company's business, like most others, is affected by general economic conditions and is impacted significantly by conditions in its real estate markets. Also, fluctuations in interest rates and the availability of financing to land purchases have an important impact on Company performance. The Company believes it is well positioned against any effects of inflation. Historically, during periods of inflation, the Company has been able to increase selling prices of properties to offset rising costs of land development and construction. However, in the past few years, with declining land values in California and a lingering recession, sales prices of Company properties as well as costs have decreased. The commercial income portfolio is substantially protected from inflation since percentage rent clauses in the Company's leases tend to adjust rental receipts for inflation, and the underlying value of commercial properties over the long-term has tended to rise. IMPACT OF EARTHQUAKE The Company's Valencia properties came out of the San Fernando Valley earthquake in good shape. Valencia Town Center, the Company's regional shopping mall, had only minor damage. Other income properties, except for a four-story office building which incurred some structural damage, experienced only minor damage and virtually all were operational the day following the earthquake. While Valencia Water Company lost three of its 14 storage tanks and incurred extensive damage to main lines, service to most of its customers was restored within one week. The Company does carry earthquake insurance which will limit property losses, but it will be some time before a final determination of these losses is made. It is too early to assess the impact this will have on sales of residential, commercial and industrial land by the Company or on appraised values in Valencia. The most important issue facing the Company and community will be the restoration of full access between the Santa Clarita Valley and greater Los Angeles. Caltrans announced it intends to have the Interstate 5 freeway fully repaired by mid-June and all freeways restored by year-end. Metrolink commuter rail service between the Santa Clarita Valley and Los Angeles remained operational following the earthquake, and capacity and usage have been significantly increased on the Santa Clarita line. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEPENDENT AUDITORS' REPORT The Board of Directors of Newhall Management Corporation and Partners of The Newhall Land and Farming Company: We have audited the consolidated financial statements of The Newhall Land and Farming Company and subsidiaries as listed in the accompanying index. In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedules as listed in the accompanying index. These consolidated financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules 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 The Newhall Land and Farming Company and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1993, in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. KPMG PEAT MARWICK Los Angeles, California January 19, 1994 CONSOLIDATED STATEMENTS OF INCOME See notes to consolidated financial statements CONSOLIDATED BALANCE SHEETS See notes to consolidated financial statements CONSOLIDATED STATEMENTS OF CASH FLOWS See notes to consolidated financial statements CONSOLIDATED STATEMENTS OF CHANGES IN PARTNER'S CAPITAL See notes to consolidated financial statements NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 1993 NOTE 1. ORGANIZATION The Newhall Land and Farming Company, a California Limited Partnership ("the Company" or "the Partnership"), was reorganized from a corporation to a limited partnership on January 8, 1985. The general partners of the Company are Newhall Management Limited Partnership, the Managing General Partner, and Newhall General Partnership. Two executive officers and the Managing General Partner are the general partners of Newhall General Partnership. NOTE 2. INDUSTRY SEGMENTS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The Company operates in two reportable industry segments: Real Estate - residential land sales and home building, commercial and industrial land sales, and development and operation of commercial property; Agriculture - primarily farming. Information as to identifiable assets, capital expenditures and depreciation for these segments is summarized in Note 11. In 1993, the Company adopted an unclassified balance sheet to better reflect the current and future activities of the Company. Significant accounting policies related to the Company's segments are: REAL ESTATE/RESIDENTIAL HOME BUILDING: Sales of single and multi-family homes are generally for cash and therefore are recognized at the close of escrow. Home buyers are provided with warranties against certain building defects. Estimated warranty cost is provided for in the period in which the sale is recorded. REAL ESTATE/LAND SALES: Sales are recorded at the time escrow is closed provided that: (1) there has been a minimum down payment, ranging from 20% to 25% depending upon the type of property sold, (2) the buyer has met adequate continuing investment criteria, and (3) the Company, as the seller, has no continuing involvement in the property. Where the Company has an obligation to complete certain future development, revenue is deferred in the ratio of the cost of development to be completed to the total cost of the property being sold under percentage of completion accounting. REAL ESTATE/DEVELOPMENT AND OPERATION OF COMMERCIAL PROPERTIES: The Company owns and leases apartments, commercial and industrial buildings, shopping centers and land to tenants. Except for apartments, rents are typically based on the greater of a percentage of the lessee's gross revenues or a minimum rent. Most lease agreements require that the lessee pay all taxes, maintenance, insurance and certain other operating expenses applicable to leased properties. Apartments are rented on a six-month lease and continue on a month-to-month basis thereafter. Valencia Water Company (a California corporation), a wholly-owned subsidiary, is a public water utility subject to regulation by the California Public Utilities Commission. Water utility revenues include amounts billed monthly to customers and an estimated amount of unbilled revenues. Income taxes accounted for under the provisions of SFAS No. 109 are included in operating expenses. In addition to income, funds advanced or contributed to the utility are subject to federal and state income taxes. Accordingly, deferred income taxes are reflected in the consolidated financial statements. REAL ESTATE/COMMUNITY DEVELOPMENT: Preliminary planning and entitlement costs are charged to expense when incurred. After tentative map approval, expenditures for map recordation are charged to the identified project. AGRICULTURE/OPERATIONS: Revenue is recognized as crops are delivered to farm cooperatives and other purchasers. Crops delivered to farm cooperatives are marketed throughout the year after harvest. At the time of delivery, the Company estimates the proceeds to be received from the cooperatives and records these amounts as unbilled receivables. During the year following harvest, the Company records any adjustments of such estimated amounts arising from changing market conditions. Net income for the years ended December 31, 1993, 1992, and 1991 increased approximately $1,075,000, $1,177,000, and $1,253,000, respectively, as a result of such adjustments. Costs incurred during the development stage of orchard and vineyard crops (ranging from three to ten years) are capitalized and amortized over the productive life of the trees or vines. Farming costs which cannot be readily identified with a specific harvested crop or other revenue producing activity are expensed as incurred. Farming inventories include crops in process and harvested crops and are valued at the lower of cost or market, determined on the first-in, first-out method. AGRICULTURE/RANCH SALES: Sales of non-developable farm land occur irregularly and are recognized upon close of escrow provided the criteria as described for real estate land sales are met. OTHER GENERAL ACCOUNTING POLICIES ARE: BASIS OF CONSOLIDATION: The consolidated financial statements include the accounts of the Company and its subsidiaries, all of which are wholly-owned. All significant intercompany transactions are eliminated. Certain reclassifications have been made to prior periods' amounts to conform to the current year presentation. CASH AND CASH EQUIVALENTS: The Company considers all highly liquid investments with original maturity dates of 90 days or less to be cash equivalents. JOINT VENTURE: The Company uses the equity method to account for an investment in a joint venture which is less than 50% controlled. PROPERTY AND EQUIPMENT: Property is stated at cost, less proceeds from sales of easements and rights of way. Depreciation of property and equipment is provided on a straight-line basis over the estimated useful lives of the various assets without regard to salvage value. Lives used for calculating depreciation are as follows: buildings - 25 to 40 years; equipment - 3 to 10 years; water supply systems, orchards and other - 5 to 75 years. ENVIRONMENTAL MATTERS: Environmental clean-up costs are charged to expense or established reserves and are not capitalized. Generally, reserves are recorded for environmental clean-up costs when remediation efforts are probable and can be reasonably estimated. To date, environmental clean-up costs have not been material. INCOME TAXES: The Company, as a partnership, is not a taxable entity; accordingly, no provision for income taxes has been made in the consolidated financial statements. Partners are taxed on their allocable share of the Company's earnings. Partners' distributive share of the income, gain, loss, deduction and credit of the Company is reportable on their income tax returns. The Revenue Act of 1987 contained provisions which, in some cases, taxes publicly traded partnerships as corporations. Since the Company was in existence on December 17, 1987, it will continue to be treated as a partnership for the 1987 through 1997 taxable years; and, subject to certain qualification requirements, will continue to be treated as a partnership indefinitely thereafter. AMOUNTS PER PARTNERSHIP UNIT: Net income per unit is computed by dividing net income by the weighted average number of units and common unit equivalents (dilutive options) outstanding during the year. The number of units for the computation was 36,790,000, 36,796,000, and 36,831,000, for the years ended December 31, 1993, 1992, and 1991, respectively. NOTE 3. FEDERAL INCOME TAX RESULTS OF THE PARTNERSHIP The Partnership has elected under Section 754 of the Internal Revenue Code to adjust the basis of property upon the purchase of units by investors. For investors who purchase units, this election provides for the reflection of the investor's price of the units in the tax basis of the Partnership's properties. The excess of the purchase price over the monetary assets and liabilities is allocated to real estate assets and results in a new basis which is used to calculate operating expenses for tax purposes. As required by SFAS No. 109, at December 31, 1993, the net tax basis of the Company's assets and liabilities exceeded the Company's financial statement basis of its assets and liabilities by $212,956,000. This excess amount does not reflect the step-up in asset basis allocated to individual partners upon purchase of units subsequent to the formation of the Partnership. The Partnership's tax returns are subject to examination by federal and state taxing authorities. Because many types of transactions are susceptible to varying interpretations under federal and state income tax laws and regulations, the tax basis amounts may be subject to change at a later date upon final determination by the taxing authorities. NOTE 4. DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS The estimated fair values of the Company's financial instruments are as follows: The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value: CASH AND CASH EQUIVALENTS The carrying amounts approximate the fair values of these instruments due to their short-term nature. NOTES RECEIVABLE FROM LAND SALES The carrying amounts of notes receivable approximate fair value. Generally, these notes have maturities of less than one year from close of escrow and, if applicable, the carrying amount reflects imputed interest to reduce the note receivable to its present value. MORTGAGE AND OTHER DEBT The carrying amount of the Company's debt reflects fair value based on current interest rates available to the Company for comparable debt. See Note 8 for interest rates on outstanding debt. ADVANCES FROM DEVELOPERS FOR UTILITY CONSTRUCTION Generally, advances are refundable to the developer without interest at the rate of 2.5% per year over 40 years. The fair value is estimated as the discounted value (12%) of the future cash flows to be paid on the advances. NOTE 5. COMPOSITION OF CERTAIN FINANCIAL STATEMENT CAPTIONS NOTE 6. COMMERCIAL LEASING OPERATIONS A summary of the historical cost of properties held for lease, which are included in property and equipment, follows: Minimum lease payments to be received under non-cancellable operating leases as of December 31, 1993 are as follows: * This amount does not include contingent rentals which may be received under certain leases based on lessee sales or apartment rentals. Contingent rentals received for the years ended December 31, 1993, 1992, and 1991 were $8,119, $10,927, and $9,256, respectively. NOTE 7. LINES OF CREDIT No borrowings were outstanding against lines of credit at December 31, 1993 or 1992. At December 31, 1993, the Company had available lines of credit totaling $69 million. Revolving lines of credit for general corporate purposes include a $30 million line of credit with Wells Fargo Bank, a $20 million line of credit with Societe Generale, and a $4 million line of credit with Bank of America. Commitment fees range from .125% to .25% per annum of the unused portion. In addition, in 1993 the Company obtained a $15 million revolving credit facility from Morgan Guaranty Trust Company of New York which is restricted to financing development costs of various types of commercial income projects in Valencia. Letters of credit outstanding against available lines of credit totaled $4.2 million and $4.8 million respectively, at December 31, 1993 and 1992. NOTE 8. MORTGAGE AND OTHER DEBT The $60 million financing from Prudential is secured by six of the Company's commercial properties. The terms of the note require monthly payments of interest only through February, 1995 and monthly principal and interest payments of $501,000 thereafter until maturity on March 1, 1999 when a principal balance of approximately $57 million is due. In December 1992, the Company obtained a non-recourse mortgage financing from Prudential for $12 million secured by the 14,000-acre New Columbia Ranch property. The terms of the note call for interest payments on each May 1 and November 1 and annual principal payments of $240,000 until maturity on November 1, 2003. The commercial mortgage was obtained from Bank of America in January 1991 in conjunction with the purchase of a 50,000-square-foot office building in the vicinity of Valencia Town Center. A $1.6 million principal repayment was made on September 1, 1993 in return for a 2.05% rate reduction. The revised terms call for monthly principal and interest payments of $26,000 and a balloon payment of approximately $3.1 million at maturity on February 1, 2001. The Company obtained a $40 million construction loan from Bank of America for the Valencia Town Center regional mall. Terms of the agreement call for interest only payments until maturity on December 30, 1996. Borrowings bear interest as follows, at the election of the borrower: LIBOR plus 1.75% or the bank's reference rate plus .5%. In October 1992, tax-exempt community facilities bonds were issued to finance a portion of the costs of certain public infrastructure improvements located within or in the vicinity of Valencia Town Center, the Company's regional shopping mall which opened in September 1992. The bonds will be repaid over 20 years from special taxes levied on the mall property. The land acquisition notes include a $2 million, 8.75% mortgage payable in annual principal and interest installments of $201,000 until maturity on March 3, 2018, and a $1.3 million, 8% note payable May 31, 1994. Also included, is a $10.1 million note with interest at 8% and semi-annual installments commencing November 30, 1994 until maturity on May 31, 1998. In December 1993, the Company completed a $30 million seven-year unsecured financing. The terms of the notes call for interest payments payable semi-annually and principal payments in equal annual installments commencing upon the third anniversary of the notes. Upon completion of the $30 million financing in December 1993, $10.5 million of outstanding advances against a revolving-to-term credit line for Valencia Water Company were retired. Annual maturities of long-term debt are approximately $3,319,000 in 1994, $9,877,000 in 1995, $50,032,000 in 1996, $10,093,000 in 1997, $7,997,000 in 1998, and $92,839,000 thereafter. CAPITALIZED INTEREST: During 1993, 1992, and 1991, total interest expense incurred amounted to $10,348,000, $7,555,000, and $5,776,000, net of $535,000, $1,100,000, and $695,000, which was capitalized, respectively. NOTE 9. EMPLOYEE BENEFIT PLANS INCENTIVE COMPENSATION PLAN: Under the terms of the Company's Executive Incentive Plan, the Board of Directors may authorize incentive compensation awards to key management personnel of up to five percent of each year's income. The Board of Directors authorized awards of $307,000, $455,000, and $902,000, for the years ended December 31, 1993, 1992, and 1991, respectively. OPTION AND APPRECIATION RIGHTS PLAN: Under the terms of the Company's Option, Appreciation Rights and Restricted Units Plan, non- qualified options or restricted units may be granted at the market price at date of grant. The plan also allows for the granting of tandem appreciation rights or bonus appreciation rights in connection with non-qualified options, which entitle the holder to receive cash or partnership units, or a combination thereof, at a value equal to the excess of the fair market value on the date of exercise over the option price. The following options were granted: 1993 -- 226,200 non-qualified options without appreciation rights; 1992 -- 123,800 non-qualified options without appreciation rights; and 1991 -- 176,600 non-qualified options with appreciation rights. No restricted units were granted in 1993, 1992, or 1991. Fluctuations in the market price of partnership units in connection with appreciation rights on outstanding non-qualified options accounted for an expense recovery of $900,000 in 1992 and a charge to expense of $250,000 and $650,000 in 1993 and 1991, respectively. A summary of changes under the plans follows: At December 31, 1993, 467,150 options were exercisable and 145,300 options were available for future grants. RETIREMENT PLANS: The Retirement Plan is Company funded and is qualified under ERISA. Generally, all employees of the Company and subsidiaries of the Company are eligible for membership in the Retirement Plan after one year of employment and attainment of age 21. Participants' benefits are calculated as 40.5% of the highest average annual earnings up to Social Security covered compensation, plus 60% of average annual earnings in excess of covered compensation, reduced pro rata for years of service less than 30. The Company's contribution to the Retirement Plan is determined by consulting actuaries on the basis of customary actuarial considerations, including total covered payroll of participants, benefits paid, earnings and appreciation in the Retirement Plan funds. The Board of Directors has adopted a Pension Restoration Plan, pursuant to which the Company will pay any difference between the maximum amount payable under ERISA and the amount otherwise payable under the Plan. The Company's funding policy is to contribute no more than the maximum tax deductible amount. Plan assets are invested primarily in equity and fixed income funds. The weighted-average discount rate and rate of increase in future compensation levels used in determining the actuarial present value of the projected benefit obligations were 7 and 5 percent in 1993, and 8 and 6 percent in 1992 and 1991, respectively. The expected long-term rate of return on assets was 9 percent for each of the three years. The Company also has a Supplemental Executive Retirement Plan and a Retirement Plan for Directors. The additional pension cost for these plans was $184,000 in 1993, $208,000 in 1992, and $164,000 in 1991. The following table sets forth the plans' funded status and amounts recognized in the Company's financial statements for the Retirement and the Pension Restoration Plans: EMPLOYEE SAVINGS PLAN: The Company has an Employee Savings Plan which is available to all eligible employees. Certain employee contributions may be supplemented by Company contributions. Company contributions approximated $245,000 during 1993, $298,000 during 1992, and $292,000 during 1991. DEFERRED CASH BONUS PLAN: In February 1991, the Compensation Committee of the Board of Directors awarded deferred bonuses payable January 15, 1999. The amount to be paid is based upon the relative percentage return on the market value of the Company's depositary units compared to the percentage return on the Standard and Poor's 500 Index over a nine-year period. No deferred cash bonuses were earned in 1993, 1992, or 1991, and accordingly, no expense was recorded. OTHER BENEFITS: The Company does not provide postretirement or postemployment benefits other than those plans described above and, as such, there is no unrecorded obligation to be recognized under SFAS Nos. 106 and 112. NOTE 10. COMMITMENTS AND CONTINGENCIES The Company is involved in litigation and various claims, including those arising from its ordinary conduct of business. Management is of the opinion that the ultimate liability from this litigation will not materially affect the Company's consolidated financial condition. The Company believes it has acquired adequate insurance to protect itself against any future material property and casualty losses. In the ordinary course of business, and as part of the entitlement and development process, the Company is required to provide performance bonds to the County of Los Angeles and the City of Santa Clarita to assure completion of certain public facilities. At December 31, 1993, the Company had performance bonds outstanding totaling approximately $124 million. As a significant landowner, developer and holder of commercial properties, there exists the possibility that environmental contamination conditions may exist that would require the Company to take corrective action. The amount of such future latent cost cannot be determined. However, the Company believes such costs will not materially affect the Company's consolidated financial condition. NOTE 11. INDUSTRY SEGMENT INFORMATION NOTE 12. SELECTED QUARTERLY FINANCIAL DATA (Unaudited) The following is a summary of selected quarterly financial data for 1993 and 1992: NOTE 13. SUBSEQUENT EVENT On January 17, 1994, a major earthquake struck the San Fernando Valley area in close proximity to Valencia where many of the Company's properties are located. While none of the Company's properties sustained major damage, a final determination of the cost to repair the damage cannot be made at this time. The Company carries earthquake insurance which will limit losses and management of the Company believes that uninsured losses will not have a material adverse effect on the financial statements of the Company taken as a whole. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The Registrant was reorganized from a corporation to a California limited partnership on January 8, 1985. The general partners of the Partnership are Newhall Management Limited Partnership (the Managing General Partner) and Newhall General Partnership. Two executive officers and the Managing General Partner are the general partners of Newhall General Partnership. Newhall Management Corporation and Newhall General Partnership are the general partners of the Managing General Partner. The Managing General Partner, Newhall Management Limited Partnership, has exclusive management and control of the affairs of the Partnership and shares in Partnership income and losses on the basis of the number of Partnership units owned by it. The Managing General Partner of Newhall Management Limited Partnership, Newhall Management Corporation, will make all decisions and take all action deemed by it necessary or appropriate to conduct the business and affairs of Newhall Management Limited Partnership and, therefore, of the Partnership. The duties and responsibilities of directors are carried out by the Board of Directors of the Managing General Partner of the Managing General Partner, Newhall Management Corporation. Each voting shareholder of Newhall Management Corporation is also a director of Newhall Management Corporation and only voting shareholders may be directors of that corporation. Every voting shareholder and director has a number of votes in all matters equal to the number of votes of every other voting shareholder and director. Upon ceasing to be a director, a shareholder may be a nonvoting shareholder for a period of time prior to the repurchase of his or her shares by the Corporation. See further discussion of the shareholders' agreement and voting trust agreement below. The shareholder-directors of Newhall Management Corporation ("Corporation") are as follows: Thomas L. Lee, age 51, was appointed Chairman and Chief Executive Officer of the Corporation upon its formation in November, 1990 and of the former Managing General Partner in 1989. He served as President and Chief Executive Officer of the former Managing General Partner from 1987 to 1989, and as President and Chief Operating Officer from 1985 to 1987. Mr. Lee joined the predecessor corporation in 1970 and has served in various executive capacities. Mr. Lee was elected as a director in 1985. He is a director of First Interstate Bank of California and CalMat, Inc. and Chairman of the Los Angeles Area Chamber of Commerce. James F. Dickason, age 71, was elected as a director of the Corporation upon its formation in November, 1990 and of the former Managing General Partner upon its formation in 1985. He currently serves as Chairman of the Executive Committee. Mr. Dickason served as a director of the predecessor corporation from 1963 to 1985, as Chairman of the Board of Directors and Chief Executive Officer of the former Managing General Partner from 1985 to 1987 and held the same position with the predecessor corporation from 1979 to 1985. Mr. Dickason also served as President of the predecessor corporation from 1971 until 1985. He was the managing partner of Newhall Resources' managing general partner and the managing partner of Newhall Investment Properties' managing general partner from 1983 until their liquidation in 1989 and 1988, respectively. He is also a director of Pacific Enterprises, Southern California Gas Company and the Automobile Club of Southern California. Mr. Dickason is a Trustee of the Southwest Museum and a director of the California Museum of Science and Industry. George C. Dillon, age 71, has served as a director of the Corporation, the former Managing General Partner and the predecessor corporation, respectively, since 1973. He was Chairman of the Board of Directors of Manville Corporation from 1986 until 1990 and Chairman of the Executive Committee from 1990 to 1991. Previously he was Chairman and Chief Executive Officer of Butler Manufacturing Company, where he had served in various executive capacities since 1951. Mr. Dillon is a director of Phelps-Dodge Corporation and Astec Industries, Inc. Peter McBean, age 83, is a rancher and has served as a director of the Corporation, the former Managing General Partner and the predecessor corporation, respectively, since 1940. Mr. McBean is Trustee Emeritus of the San Francisco Fine Arts Museum, a Life Trustee of the Cate School of Santa Barbara and Grace Cathedral in San Francisco, and an Honorary Trustee of The California Academy of Sciences. He is also a director and President of the McBean Family Foundation and a Trustee of the Alletta Morris McBean Charitable Trust. Paul A. Miller, age 69, has served as a director of the Corporation, the former Managing General Partner and the predecessor corporation, respectively, since 1979. Mr. Miller is Chairman of the Executive Committee and a director of Pacific Enterprises, a holding company for Southern California Gas Company. He is a director of Wells Fargo Bank N.A. and Wells Fargo & Company and a Trustee of Mutual Life Insurance Company of New York and the University of Southern California. Mr. Miller is also a director of the Los Angeles World Affairs Council, and is a member of the Executive Committee of the California Business Round Table. Henry K. Newhall, age 55, has served as a director of the Corporation, the former Managing General Partner and the predecessor corporation, respectively, since 1982. Dr. Newhall is General Manager, Technology, Oronite Additives Division of Chevron Chemical Company. He has served in various managerial and consulting positions with Chevron since 1971. Jane Newhall, age 80, has served as a director of the Corporation, the former Managing General Partner and the predecessor corporation, respectively, since 1960. Miss Newhall, a private investor, is a director of the Henry Mayo Newhall Foundation and a member of the Foundation Board of Donaldina Cameron House. She is a Trustee of Mills College, the San Francisco Theological Seminary, the University Mound Ladies' Home and the Graduate Theological Union. Peter T. Pope, age 59, was elected a director of the Corporation in 1992. Mr. Pope has been Chairman, President and Chief Executive Officer since 1990 and Chairman and Chief Executive Officer since 1971 of Pope & Talbot, Inc. He is a director of Pope Resources, the American Paper Institute, Oregon Independent College Foundation and the World Forestry Center and a trustee of the Medical Research Foundation of Oregon. Carl E. Reichardt, age 62, has served as a director of the Corporation, the former Managing General Partner and the predecessor corporation, respectively, since 1980. Mr. Reichardt is Chairman of the Board of Directors of Wells Fargo & Company and Wells Fargo Bank, N.A. He is also a director of Ford Motor Company, HCA-Hospital Corporation of America, Pacific Gas & Electric Company, The Irvine Company and ConAgra, Inc. Thomas C. Sutton, age 51, was elected a director of the Corporation in November, 1991. He has been Chairman of the Board and Chief Executive Officer since 1990, President and a director from 1987 to 1990 and Executive Vice President from 1984 to 1987 of Pacific Mutual Life Insurance Company. Mr. Sutton is a director of the Association of California Life Insurance Companies, Executive Service Corps of Southern California and the Health Insurance Association of America. He is a trustee of the South Coast Repertory and the Committee for Economic Development. Lawrence R. Tollenaere, age 71, has served as a director of the Corporation, the former Managing General Partner and the predecessor corporation, respectively, since 1972. Mr. Tollenaere is Chairman of the Board of Directors, and until 1993, was the Chief Executive Officer and President of Ameron, Inc., a multi-divisional company producing and marketing products and services for the utility, construction and industrial markets throughout the world. He is Chairman of Gifford-Hill-American, Inc., and Tamco. He is a director of Pacific Mutual Life Insurance Company, The Parsons Corporation and The National Association of Manufacturers. He is past president and a director of The California Club and an honorary board member of The Employers Group. Mr. Tollenaere is a Trustee of the Huntington Library, a fellow of the Society for the Advancement of Management, Emeritus Fellow of Claremount University and Governor of Iowa State University. Edwin Newhall Woods, age 76, is a rancher and has served as a director of the Corporation, the former Managing General Partner and the predecessor corporation, respectively, since 1950. Mr. Woods is a director of the California Association of Winegrape Growers. Ezra K. Zilkha, age 68, has served as a director of the Corporation, the former Managing General Partner and the predecessor corporation, respectively, since 1977. Since 1956, Mr. Zilkha has been President of Zilkha & Sons, Inc., a private investment company, and from 1993, President of 3555 Investment Holding Company, an investment holding company. From 1979 to 1988, he was president of Zilkha Corporation, a consulting company and from 1984 to 1990 and from 1991 to 1993 he was Chairman of Union Holdings, Inc., an industrial holding company. He is a director of CIGNA Corporation, Cambridge Associates, Chicago Milwaukee Corporation, Fortune Bancorp Inc., and Milwaukee Land Company, the general partner of Heartland Partners, L.P. Mr. Zilkha is Trustee Emeritus of Wesleyan University and a Trustee of the Brookings Institution, Lycee Francais de New York and the French Institute/Alliance Francaise. He is also Chairman of the Board of The International Center for the Disabled. Each of the shareholder-directors may be contacted at the principal executive offices of the Partnership and is a citizen of the United States. Jane Newhall and Edwin Newhall Woods are first cousins. Section 16(a) of the Securities Exchange Act of 1934, as amended, requires Newhall Management Corporation and its officers and directors, the general partners, and persons who own more than ten percent of the Company's partnership units, to file reports of ownership and changes in ownership with the Securities and Exchange Commission and the New York Stock Exchange. The Company assists officers, directors and ten-percent unitholders to file their Section 16(a) reports and retains a copy of the forms filed. Written representations that all required reports have been filed are obtained at the end of each year. Based upon this information, the Company believes that, during the year ended December 31, 1993, all such filing requirements were complied with. The Board of Directors manages and controls the overall business and affairs of the Corporation, of the Managing General Partner, and of the Partnership. The members of the Board of Directors are elected by the shareholder-directors of the Corporation, unless there is a vacancy on the Board in which case the remaining board members may fill the vacancy, without the approval of the limited partners and with each shareholder-director of the Corporation having an equal number of votes. Because the shareholders and directors are the same persons, it is expected that the shareholders will re-elect themselves to serve as directors. It is the current policy of the Corporation that all directors of the Corporation, except for the initial directors of the former Managing General Partner and Mr. Lee, will retire at age 70. If a new director is elected, he or she is required to become a shareholder by purchasing the number of shares determined by the Board of Directors. The Limited Partnership Agreement ("the Partnership Agreement") of the Partnership requires the General Partners to own at least one percent (1%) of the total number of Partnership units outstanding at all times. In order to meet this 1% requirement, the shareholder- directors had originally contributed Partnership units as capital to the former Managing General Partner. The determination as to how many Partnership units each shareholder-director would contribute was based upon the shareholdings of the shareholder-director in the predecessor corporation and his or her ability to contribute such Partnership units in order that the General Partners would own at least 1% of the total number of Partnership units outstanding at all times. Mr. Scott Newhall, a shareholder-director, died on October 26, 1992. In 1993, Newhall Management Corporation purchased his 370 shares of common stock for cash and sold an equivalent number of publicly traded partnership units in the open market. Newhall Management Limited Partnership repurchased its 71,630 limited partnership units in exchange for an equal number of publicly traded partnership units. After giving effect to these transactions, the Managing General Partner owns 372,300 units of the Partnership or 1.0% of the total number of partnership units outstanding. Messrs. Henry Newhall, Woods, and Zilkha each effectively has contributed to the Managing General Partner a total of 72,000 Partnership units. Mr. McBean and Ms. Newhall each effectively has contributed to the Managing General Partner a total of 71,650 Partnership units. Messrs. Dickason, Dillon, Lee, Miller, Reichardt, and Tollenaere each effectively has contributed to the Managing General Partner a total of 2,000 Partnership units. Messrs. Pope and Sutton each effectively has contributed to the Managing General Partner a total of 500 Partnership units. It should be noted that a shareholder-director will receive the same distributions from the Partnership with regard to his or her Partnership units regardless of whether such Partnership units are represented by limited partner interests in Newhall Management Limited Partnership or by general partner interests in Newhall Management Limited Partnership (which in turn are represented by common stock in the Corporation). All Partnership distributions and allocations to the Managing General Partner with respect to the Partnership units held by such Partner will be passed on to each limited partner of the Managing General Partner or shareholder-director of the Corporation as distributions in proportion to the actual number of units or shares beneficially owned by such limited partner or shareholder-director, as the case may be. The shareholder-directors of the Corporation and the Corporation are parties to a shareholders' agreement and a voting trust agreement. These agreements provided for the transfer of all the shares of Newhall Management Corporation to a voting trust, held in the name of the Trustee. The Secretary of Newhall Management Corporation serves as Trustee. In all matters the Trustee will vote all the shares in accordance with the direction of a majority of the shareholder-directors, with each shareholder-director having one vote on each matter (irrespective of the actual number of shares beneficially owned by such person). The shareholders' agreement and the bylaws of the Corporation restrict the ability of a shareholder-director to transfer ownership of shares of the Corporation. Certain events such as failure to own at least one limited partner unit in Newhall Management Limited Partnership, failure to consent to a Subchapter S election under the Internal Revenue Code, failure to re-execute the trust agreement, ceasing to serve as a director, failure of a shareholder-director's spouse to sign any required consent, a material breach by a shareholder-director of the shareholders' agreement or voting trust agreement, a levy upon the shares of a shareholder, or a purported transfer of shares to someone other than a new or existing director upon approval of the Board of Directors, are considered to be repurchase events. Upon such a repurchase event, the shareholder must immediately resign as a director and the shareholder will lose voting rights under the voting trust agreement. Upon the occurrence of a repurchase event, a shareholder's shares will be repurchased by the Corporation or the Corporation may direct their purchase by a successor director. The Corporation has agreed to repurchase for cash equal to the market value of the Partnership units representing such shares (or provide for the purchase of) all shares of a shareholder-director subject to a repurchase event within one year of the repurchase event and to use its best efforts to effect such repurchase (purchase) as soon as possible after the repurchase event. There can be no assurance that the Corporation will be able to find a replacement for a departing shareholder-director who will purchase shares. The shareholders' agreement expires if Newhall Management Corporation ceases to serve as the Managing General Partner of the Managing General Partner of the Partnership, or Newhall Management Limited Partnership ceases to be the Managing General Partner of the Partnership, if all parties to the shareholders' agreement consent to its termination, or with respect to any individual shareholder, upon the repurchase of all the shareholder's shares. The term of the voting trust is limited by laws to 10 years, but a party to the voting trust will be deemed to have resigned as a director of the Corporation and will have to sell his shares, subject to repurchase by the Corporation, unless, at the times provided in the voting trust agreement, the party re-executes and renews the voting trust for the purpose of keeping it continually in effect. The voting trust agreement terminates if Newhall Management Corporation ceases to serve as a general partner of the Managing General Partner of the Partnership, or Newhall Management Limited Partnership ceases to be the Managing General Partner of the Partnership, or with respect to any individual shareholder if a shareholder no longer owns any shares. The shareholder-directors, as limited partners, are also parties to the limited partnership agreement of Newhall Management Limited Partnership. At the present time, they are the only limited partners of Newhall Management Limited Partnership. The limited partnership agreement has restrictions on transfer similar to the shareholders' agreement and provides for repurchase of the limited partnership units of a limited partner upon the occurrence of repurchase events which are similar to those of the shareholders' agreement, including the cessation of being a director by a limited partner in the case of a limited partner who is a director. Upon the occurrence of a repurchase event, Newhall Management Limited Partnership would have one full year to transfer Partnership units representing the limited partner's interest to the limited partner. A limited partner could not compel the return of Partnership units for at least one year from the date a limited partner chooses to obtain return of Partnership units. Even then, Newhall Management Limited Partnership cannot, and cannot be compelled to, distribute Partnership units to the limited partner if Newhall Management Limited Partnership would thereafter own less than 1% of the Partnership's Partnership units. The limited partners, as limited partners, have no voting rights except as expressly set forth in the limited partnership agreement or granted pursuant to law. Such voting privileges include matters such as (i) electing general partners in specified instances, (ii) amending the limited partnership agreement, (iii) dissolving the limited partnership, (iv) electing a general partner to serve as the Managing General Partner, and (v) removing a general partner. Items (ii) and (iii) require the separate concurrence of the Managing General Partner. Persons other than directors of Newhall Management Corporation may serve as limited partners of Newhall Management Limited Partnership and Newhall Management Corporation has the authority pursuant to the limited partnership agreement to cause additional units to be issued. The partnership agreement provides limited instances in which a general partner shall cease to be a general partner. Newhall Management Limited Partnership will dissolve (i) when a general partner ceases to be a general partner (other than by removal) unless there is at least one other general partner or all partners agree in writing to continue the business of the partnership and to admit one or more general partners, (ii) if Newhall Management Limited Partnership becomes insolvent, (iii) upon the disposition of substantially all assets of Newhall Management Limited Partnership, (iv) 90 days after an affirmative vote of the limited partners to dissolve pursuant to the partnership agreement, or (v) upon the occurrence of any event which makes it unlawful for the business of Newhall Management Limited Partnership to be continued. Newhall General Partnership, a California general partnership, is a general partner for the purposes of continuing the business of the Partnership and serving as an interim Managing General Partner if Newhall Management Limited Partnership or its successor ceases to serve as Managing General Partner. So long as Newhall Management Limited Partnership or its successor remains as Managing General Partner, Newhall General Partnership will have no right to take part in the management and control of the affairs of the Partnership. The general partners of Newhall General Partnership are Newhall Management Limited Partnership, the chief executive officer of Newhall Management Corporation and another officer or director of Newhall Management Corporation selected from time to time by the board of directors of Newhall Management Corporation. Thomas L. Lee is the chief executive officer of Newhall Management Corporation and, therefore, is a general partner of Newhall General Partnership. Gary M. Cusumano, President and Chief Operating Officer of Newhall Management Corporation, has been selected by the board of directors of Newhall Management Corporation to be a general partner of Newhall General Partnership. For as long as Newhall Management Limited Partnership serves as a general partner of the Partnership, Newhall Management Limited Partnership shall serve as a general partner of Newhall General Partnership and the individual general partners of Newhall General Partnership shall be the chief executive officer of Newhall Management Corporation and another officer or director selected by the board of directors of Newhall Management Corporation. The managing partner of Newhall General Partnership is the chief executive officer of Newhall Management Corporation and shall have management and control of the ordinary course of day to day business of Newhall General Partnership. Matters outside the ordinary course of the day to day business of Newhall General Partnership shall be decided by a majority vote of the partners except that a unanimous vote will be required to, among other things, admit a new partner (other than the chief executive officer or other officer or director of Newhall Management Corporation). After giving effect to 2-for-1 unit splits on December 20, 1985 and January 29, 1990, each of the partners of Newhall General Partnership have contributed twenty Partnership units to Newhall General Partnership. No additional capital contributions are required. The income, losses and distributions allocated to Newhall General Partnership with respect to the units will be allocated among the partners of Newhall General Partnership in the ratio of the units contributed by each of them. The ability of a partner to withdraw from Newhall General Partnership or to transfer an interest in Newhall General Partnership is limited by the partnership agreement of Newhall General Partnership. Individual partners of Newhall General Partnership may not withdraw except upon appointment of a successor by the board of directors of Newhall Management Corporation. In addition, an individual general partner may not transfer his interest in Newhall General Partnership except with the written consent of Newhall Management Limited Partnership. Newhall Management Limited Partnership, as a general partner of Newhall General Partnership, may not withdraw unless: (i) it no longer serves as a general partner of the Partnership; (ii) Newhall General Partnership no longer serves as a general partner of the Partnership; or (iii) Newhall General Partnership dissolves and its business is not continued. If Newhall Management Limited Partnership no longer serves as a general partner of the Partnership, simultaneously, it will stop serving as a general partner of Newhall General Partnership. Any individual general partner of Newhall General Partnership who is serving as a general partner by virtue of holding an office or position with Newhall Management Corporation, will stop serving as a general partner of Newhall General Partnership if either (i) Newhall Management Limited Partnership is replaced as a general partner of the Partnership, or (ii) Newhall Management Limited Partnership is no longer a general partner of Newhall General Partnership and individual partners are designated pursuant to the partnership agreement. Newhall General Partnership will dissolve when the Partnership is dissolved, liquidated and wound up and any trust or other entity formed for the purpose of liquidating or winding up the Partnership is liquidated and wound up. Newhall General Partnership will dissolve earlier upon: (i) the distribution of substantially all of its property; (ii) the unanimous agreement of its partners; (iii) ceasing to serve as a general partner of the Partnership; or (iv) the occurrence of an event which would make it unlawful to conduct its business. The Partnership Agreement requires the Partnership to pay all of the costs and expenses incurred or accrued by the general partners in connection with the business and affairs of the Partnership as the Managing General Partner in its sole discretion authorizes or approves from time to time. These costs and expenses include overhead and operating expenses, officer, employee, director and general partner compensation and other employee benefits paid by the general partners. Such compensation and benefits may be determined and changed from time to time without the approval of the limited partners. EXECUTIVE OFFICERS OF THE MANAGING GENERAL PARTNER ITEM 11: ITEM 11: EXECUTIVE COMPENSATION The following tables set forth information as to each of the five highest paid Executive Officers and their compensation for services rendered to the Company and its subsidiaries : SUMMARY COMPENSATION TABLE (1) Represents bonus accrued during the current calendar year based on earnings for such period and paid in the subsequent calendar year. (2) Includes general partner fees paid to Mssrs. Lee and Cusumano as general partners of Newhall General Partnership of $28,000 each and director fees paid of $28,000 to Mr. Lee as a director of Newhall Management Corporation and $1,000 to Mr. Cusumano as a director of a wholly-owned subsidiary. (3) The number and value of restricted unit holdings at December 31, 1993 were as follows: 6,400 units valued at $102,400 for Mr. Lee; 4,900 units valued at $78,400 for Mr. Cusumano; 2,400 units valued at $38,400 for Mr. Wilke; and 1,200 units valued at $19,200 for Mr. Dierckman. Restricted units are granted subject to a return right which permits the Company to reacquire all or a portion of the restricted units for no consideration if the grantee terminates employment with the Company. The return right lapses as to twenty-five percent of the granted restricted units after expiration of each two-year period from the date of grant. The lapsing of the return right is accelerated as to an additional twenty-five percent if two-year Company performance goals as set by the Compensation Committee are met. (4) Totals include the following: (1) Company matching contributions to the Employee Savings Plan and Savings Restoration Plan, and (2) long-term disability insurance premium for Mssrs. Lee and Cusumano in 1993 and 1992, and Mr. Wilke in 1992. OPTION/SAR GRANTS IN LAST FISCAL YEAR (1) Non-qualified options without appreciation rights granted at 100% of fair market value on the date of grant. Options are exercisable twenty-five percent at the end of each of the first four years following date of grant and expire ten years after date of grant. In the event of any change of control of the Company, as defined, then each option will immediately become fully exercisable as of the date of the change of control. (2) 5% compound growth results in final unit price of $23.823 10% compound growth results in final unit price of $37.934 (3) The Modified Black-Scholes Options Valuation Model modifies the Black-Scholes formula to include the impact of distributions and to allow option exercise prior to maturity. The 10-year distribution yield of 3.10% was used in the modified model. (4) To normal retirement at age 65 in 1996: 5% compound growth results in potential realizable value of $31,118 10% compound growth results in potential realizable value of $65,354 AGGREGATED OPTIONS/SAR EXERCISES IN LAST FISCAL YEAR AND FISCAL YEAR-END OPTION/SAR VALUES (1) Based on the difference in the unit price of $16.00 at December 31, 1993 and the exercise price of the underlying options. EMPLOYEE BENEFIT PLANS The following are descriptions of the principal employee benefit plans of the Company. RETIREMENT PLANS Under the Retirement Plan, participants' benefits are calculated as 40.5% of the average annual compensation of the highest five calendar years of the preceding ten years up to Social Security covered compensation, plus 60% of the average annual compensation in excess of covered compensation, reduced pro rata for years of service less than 30. Under the Pension Restoration Plan, the Company will pay any difference between the ERISA maximum amount payable under the Retirement Plan and the amount otherwise payable, including amounts restricted by the compensation limit. Credited years of service as of December 31, 1993 (to the nearest whole year) and average annual compensation for the highest five years of the last ten years are as follows: 23 years and $450,000 for Mr. Lee, 24 years and $375,000 for Mr. Cusumano, 18 years and $275,000 for Mr. Wilke, 11 years and $240,000 for Mr. Dierckman, and 22 years and $150,000 for Mr. Frye. The following table reflects the estimated annual benefits paid as a single life annuity upon retirement at age 65 under the Retirement Plan and Pension Restoration Plan at various assumed compensation ranges and credited years of service: The Board of Directors has adopted a Supplemental Executive Retirement Plan pursuant to which the Company will pay benefits to specified employees so that such employees' maximum normal retirement benefit under the Retirement Plan and the Pension Restoration Plan will be earned during a period of 20 rather than 30 years of credited service. As of December 31, 1993, Robert D. Wilke and a former officer of the Company were the only participants in the Supplemental Executive Retirement Plan. The following table reflects the estimated annual benefits under the Supplemental Executive Retirement Plan upon retirement at age 65 at various assumed compensation ranges and credited years of service: CHANGE IN CONTROL SEVERANCE PROGRAM The Partnership entered into severance agreements in March 1988 with three executive officers, Thomas L. Lee, Gary M. Cusumano and Robert D. Wilke, under which each such officer is entitled to certain benefits in the event of a "change of control." Under the provisions of the severance agreements, a "change of control" is deemed to have occurred where (i) any "person" (other than a trustee or similar person holding securities under an employee benefit plan of the Partnership, or an entity owned by the Unitholders in substantially the same proportions as their ownership of units) becomes the beneficial owner of 25% or more of the total voting power represented by the Partnership's then outstanding voting securities, (ii) Newhall Management Corporation is removed as Managing General Partner of the Managing General Partner, or (iii) the holders of the voting securities of the Partnership approve a merger or consolidation of the Partnership with any other entity, other than a merger or consolidation which would result in the voting securities of the Partnership outstanding immediately prior thereto continuing to represent (either by remaining standing or by being converted into voting securities of the surviving entity) at least 75% of the total voting power represented by the voting securities of the Partnership or such surviving entity outstanding immediately after such merger or consolidation, or (iv) a plan of complete liquidation of the Partnership is adopted or the holders of the voting securities of the Partnership approve an agreement for the sale or disposition by the Partnership (in one transaction or a series of transactions) of all or substantially all the Partnership's assets. Entitlement to benefits arises if, within two years following a change in control, the officer's employment is terminated or if he elects to terminate his employment following action by the Partnership which results in (i) a reduction in salary or other benefits, (ii) change in location of employment (iii) a change in position, duties, responsibilities or status inconsistent with the officer's prior position or a reduction in responsibilities, duties, or offices as in effect immediately before the change in control, or (iv) the failure of the Partnership to obtain express assumption by any successor of the Partnership's obligations under the severance agreement. Benefits payable under the agreements consist of (i) payment in a single lump sum equal to continuation of monthly payments of base salary for three years, (ii) payment in a single lump sum of three times the average bonus payments for the two fiscal years preceding the change in control, (iii) continuation of participation in insurance and certain other fringe benefits for three years, (iv) immediate vesting of deferred compensation or non-qualified retirement benefits and options and related appreciation rights, (v) immediate lapse of any Partnership rights to the return or repurchase of Units granted pursuant to Units Rights, (vi) a retirement benefit equivalent to the additional benefits that would have accrued under Partnership retirement plans if employment had continued for two years, and (vii) reduction of required service for full retirement benefits from 30 years to 20 years through a non- qualified arrangement. Benefits payable under the agreements are instead of any severance pay benefits under the Partnership's general severance pay policy. The agreements are not contingent upon the officers actively seeking other employment, but provide for some offset of benefits if other employment (other than self-employment) is obtained. For each month of employment (other than self-employment) during the three years following termination of employment with the Partnership, the officer must return to the Partnership the lesser of 1/36 of the salary continuation payment or the compensation received from the new employer for that month. In addition, to the extent the new employer provides the officer with comparable medical, dental, disability or life insurance coverage, such benefits under the severance agreements will terminate. RETIREMENT PLAN FOR DIRECTORS Directors who cease to be directors after at least five years of service on the Board of Directors, will be eligible for retirement benefits under a Retirement Plan for Directors. This Plan covers service only as an outside director. A director who retires as an employee of the Company but continues on the Board is eligible for benefits under this Plan if he or she serves on the Board for at least five years after retirement as an employee. Under the Plan, each eligible director is entitled to an annual retirement benefit equal to the director's annual base retainer plus the Board meeting fees for the number of regular meetings held in the year preceding retirement at the rates in effect at the date of retirement. Quarterly benefit payments will commence after a director ceases to be a director (but not before age 65) and continue for a period equal to the length of the director's service as an outside director or until death, whichever occurs first. COMPENSATION OF THE DIRECTORS The Partnership Agreement provides that the compensation of the general partners and their partners, directors, officers and employees shall be determined by the Managing General Partner. Both the compensation committee and the nominating committee of the Board of Directors of Newhall Management Corporation, the Managing General Partner of Newhall Management Limited Partnership, have been granted authority by the Board of Directors to determine certain compensation issues. Members of the Board receive an annual fee of $22,000 for serving on the Board and non-employee directors receive a fee of $1,000 for each Board or committee meeting attended. Members of the Board of Directors will also receive reimbursement for travel and other expenses related to attendance at meetings of the Board of Directors and of the committees. In addition, the Partnership Agreement requires the Partnership to reimburse the Managing General Partner for any federal or California income taxes imposed upon the Managing General Partner or its Managing General Partner as a result of its activities as Managing General Partner. COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION The Company currently maintains a $30 million unsecured revolving credit facility, and a subsidiary of the Company has a $15 million revolving credit line with Wells Fargo Bank, N.A. (the "Bank"). There were no borrowings outstanding against these credit lines at December 31, 1993. In addition, certain of the Company's employee benefit plans have invested approximately $13 million in Index Funds managed by the Bank and the Bank has extended approximately $2 million in letters of credit to the Company. The Bank is the principal subsidiary of Wells Fargo & Company. Carl E. Reichardt, Chairman of the Board of the Bank and Wells Fargo & Company, is a director of the Managing General Partner of the Managing General Partner. In addition, a director of the Managing General Partner of the Managing General Partner, Paul A. Miller, is also a director of the Bank and Wells Fargo & Company. REPORT OF THE COMPENSATION COMMITTEE OF THE BOARD OF DIRECTORS OF NEWHALL MANAGEMENT CORPORATION COMPENSATION COMMITTEE CHARTER The Compensation Committee is charged with exercising authority with respect to the compensation of all executive officers of the Company and to review management development issues. It has regularly scheduled meetings two times a year, and meets at other times as appropriate. SENIOR MANAGEMENT COMPENSATION PHILOSOPHY The Company believes its success is greatly influenced by the caliber of its employees. The Company's compensation program for senior management is designed to attract, recruit and retain a highly skilled, professional and dedicated work force. In this regard, Newhall Land's senior management compensation program consists of: . Base salary compensation tied to prevailing real estate industry compensation practices. . Annual merit and incentive pay compensation (bonuses) primarily related to the Company's performance for the previous fiscal year. . Long-term incentive compensation in the form of Unit options and restricted Units directly tied to increasing Unitholder value. As it is directly related to corporate performance, this component of compensation can be highly volatile. The Company's objective is for the base salary annual incentive compensation and long-term incentive compensation of senior management over time to approximate the median levels for an industry comparison group consisting primarily of real estate companies with which the Company competes for executive talent. From year-to-year, however, relative compensation levels may vary due largely to variances in individual company performance. In addition, for individual managers, there is also a subjective element relating to his or her success in meeting individual performance goals determined at the beginning of each year. These goals are for the business segment he or she manages including personal goals for increasing Unitholder values through profitability and, most importantly, the value of the Company's landholdings. BASE SALARY COMPENSATION The base salary for each executive officer is determined on the basis of internal comparability considerations and base salary levels in effect for comparable positions at the Company's principal competitors for executive talent. External salary data provided to the Committee by an independent compensation consulting firm indicate that these salaries for 1993 were generally at or below the median level for such companies. Salaries are reviewed on an annual basis, and adjustments to each executive officer's base salary are based upon individual performance and salary adjustments paid by the Company's competitors. ANNUAL MERIT AND INCENTIVE COMPENSATION (BONUSES) Annual cash bonuses under the Company's Incentive Plan are earned by each executive officer primarily on the basis of the Company's earnings in the previous fiscal year. The aggregate amount of such incentive bonuses may not exceed 5% of the Company's net income before deducting the incentive awards. Also considered are comparable industry performance, the accomplishment of individual and Company objectives and an individual's contribution to the Company's business. The bonuses (except for Mr. Lee's own bonus) are recommended by the Company's Chief Executive Officer, Mr. Lee, and approved by the Compensation Committee and the Board of Directors. The aggregate cash bonuses paid for 1993 were $307,000 (or 2.4% of 1993 net income before bonuses), versus $455,000 in 1992, or a 32.5% reduction from 1992 to 1993. This reduction reflects the Company's reduction in earnings from 1992 to 1993 and the fact that Messrs. Lee and Cusumano did not receive cash bonuses in 1994. Each of the five highest paid executive officers received cash bonuses in 1993. The payment of bonuses recognizes significant strategic accomplishments of the Company during the industry downturn, namely successes in obtaining large amounts of entitlements, growth in the portfolio of commercial properties, reduction in overhead costs and the geographic expansion into Arizona. In lieu of cash bonuses, and because of the decrease in the Company's earnings in 1993, Mr. Lee was awarded options for 9,200 Units and Mr. Cusumano was awarded options for 7,500 Units, each option exercisable at $14.75 per Unit, the Company's unit market price on grant date. These option grants, in lieu of cash bonuses, reflect the 1992 bonus cash amounts of Messrs. Lee and Cusumano, reduced to reflect the reduction in the Company's earnings from 1992 to 1993, and increased to reflect the fact that the bonuses were not paid in cash. The options were valued for bonus purposes based upon a Black-Scholes option value of $5.44 per Unit. LONG-TERM INCENTIVE COMPENSATION To encourage growth in the Unitholder value, the equity component of compensation includes Unit options, restricted Units under the Option, Appreciation Rights and Restricted Units Plan adopted by Unitholders in 1988. They are generally granted at mid-year to key management personnel who are in positions to make a substantial contribution to the long-term success of the Company. These Unit awards mature and are expected to grow in value over time and for that reason represent compensation which is attributable to service over a period of up to ten years. This focuses attention on managing the Company from the perspective of an owner with an equity stake in the business. The size of the Unit option grant to each executive officer, based on the aggregate exercise price, generally is set to a multiple of salary which the Committee deems appropriate in order to create a meaningful opportunity for ownership based upon the individual's current position with the Company, but also takes into account comparable awards to individuals in similar positions in the industry as reflected in external surveys and as reported to the Committee by an independent compensation consultant, and the individual's potential for future responsibility and promotion over the option term. CHIEF EXECUTIVE OFFICER COMPENSATION The last increase in the salary of Mr. Lee was in January 1990, to its 1993 annual level of $305,000. Mr. Lee's annual cash incentive bonus was reduced from $120,000 in 1991 to $50,000 in 1992, with no cash bonus in 1993, reflecting the Company's earnings decline. However, the Committee also felt it was necessary to recognize the significant strategic accomplishments of the Company during the industry downturn. This recognition was made in the form of the bonuses, albeit at reduced amounts, with the 1993 bonuses to Messrs. Lee and Cusumano being paid in the form of Unit options. See "Annual Merit and Incentive Compensation (Bonuses)" above. Mr. Lee's long-term incentive compensation was last reviewed in July, 1993. At that time, he was granted 30,000 Unit options, a 50% increase from the 1992 grant, with an exercise price of $14.625, equal to the market value of the Units at that time. The Committee, in determining the number of options to grant Mr. Lee in 1993, considered the following factors, in addition to the Company's earnings decline: Mr. Lee's salary has been frozen since 1990; Mr. Lee's annual incentive bonus awards have been at significantly lower levels each year beginning in 1991; and Mr. Lee's substantial achievements during the downturn in the real estate industry in terms of obtaining large amounts of entitlements, growth in the portfolio of commercial properties, reduction in overhead costs and the Company's geographic expansion into Arizona. SECTION 162 LIMIT Recently enacted Section 162(m) of the Internal Revenue Code ("Section 162") limits federal income tax deductions for compensation paid to the Chief Executive Officer and the four other most highly compensated officers of a public company to $1 million per year, but contains an exception for performance-based compensation that satisfies certain conditions. The Company believes that Unit options granted to its executives will qualify for the performance based-compensation exception to the deduction limit. Because it is unlikely that other compensation to any Company executive would exceed the deduction limit in the near future and final regulations have not been issued under Section 162(m), the Committee has not yet considered whether it will seek to qualify compensation other than options for the performance-based exception or will prohibit the payment of compensation that would exceed the deduction limit. COMPENSATION COMMITTEE MEMBERS The Compensation Committee of the Board of Directors of Newhall Management Corporation is comprised of the following five directors, none of whom is eligible to receive options, appreciation rights or Units under any compensation plan of the Company: George C. Dillon (Chairman) James F. Dickason Peter T. Pope Carl E. Reichardt Lawrence R. Tollenaere ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT DIRECTORS AND OFFICERS The following table sets forth the number of units beneficially owned by each director of Newhall Management Corporation, each of the Company's five highest paid executives and all directors and officers as a group as of December 31, 1993. * Represents less than 0.1% of the securities outstanding. (1) Includes 72,000 units each for Messrs. Henry K. Newhall, Woods and Zilkha, 71,650 units for Mr. McBean and Miss Jane Newhall, 2,000 units each for Messrs. Dickason, Dillon, Miller, Reichardt and Tollenaere and 500 units for Messrs. Sutton and Pope which are held by the Managing General Partner. Includes 2,000 units held by the Managing General Partner and 20 units contributed to Newhall General Partnership in the case of Mr. Lee. Of the total of 372,300 units held by the Managing General Partner beneficially for the directors, 20 units have been contributed to Newhall General Partnership, and of those 20 units, 10 units have been contributed back to the Managing General Partner by Newhall General Partnership. See Item 10 of this Annual Report on Form 10-K for information on a shareholders' agreement, voting trust agreement, and limited partnership agreement relating to these units. (2) Includes 92,375 units which Mr. Cusumano has the right to acquire and 4,900 restricted units which may be returned to the Partnership under certain circumstances pursuant to the Company's Option, Appreciation Rights and Restricted Units Plan. (3) The Partnership is advised that Mr. Dickason has sole voting and investment power as to 46,020 units held by a trust for which he is a trustee. (4) Includes 43,750 units which Mr. Dierckman has the right to acquire and 1,200 restricted units which may be returned to the Partnership under certain circumstances pursuant to the Company's Option, Appreciation Rights and Restricted Units Plan. (5) Includes 3,600 units owned by Mr. Dillon's wife. (6) Includes 39,500 units which Mr. Frye has the right to acquire pursuant to the Company's Option, Appreciation Rights and Restricted Units Plan. (7) Includes 119,375 units which Mr. Lee has the right to acquire and 6,400 restricted units which may be returned to the Partnership under certain circumstances pursuant to the Company's Option, Appreciation Rights and Restricted Units Plan. (8) The Partnership is advised that Mr. McBean has sole voting and investment power as to 1,106,662 of these units which are owned by him and has shared voting and investment power as to 783,012 units held of record by certain trusts under which he is a co-trustee with Henry K. Newhall and others. (9) The Partnership is advised that Henry K. Newhall has sole voting and investment power as to 80,928 held by trusts for which he is the trustee and beneficiary. Voting and investment power is shared with Peter McBean and others as to 889,940 units held by certain trusts. (10) Mr. Reichardt has sole voting and investment power as to 3,000 units held by trusts for which he is the trustee. (11) Includes 85,250 units which Mr. Wilke has the right to acquire and 3,900 restricted units which may be returned to the Partnership under certain circumstances pursuant to the Company's Option, Appreciation Rights and Restricted Units Plan. (12) The Partnership is advised that Mr. Woods has sole voting and investment power as to 342,496 of these units owned by him and sole voting and investment power as to 312,208 of these units held of record by a trust under which he is the trustee. Also included are 54,300 units owned by Mr. Woods' wife as to which he disclaims any beneficial ownership. (13) Includes 230,600 units held by Zilkha & Sons, Inc. for which the Partnership is advised that Mr. Zilkha has sole voting and investment power and 30,000 units held by Mr. Zilkha's wife for which he disclaims beneficial ownership. Except as indicated otherwise in the above notes, the specified persons possess sole voting and investment power as to the indicated number of units to the best knowledge of the Company. Certain provisions of the Partnership's Limited Partnership Agreement require the affirmative vote of holders of at least 75% of the Partnership's voting power to approve (i) the removal of any general partner or the election of any general partner as the Partnership's managing general partner; or (ii) certain business combinations and other specified transactions ("Business Combinations") with, or proposed by or on behalf of, persons beneficially owning 10% or more of the Partnership's voting power, unless such Business Combination is either approved by a majority of the present directors of Newhall Management Corporation (or by directors who are nominated by them) or certain price and procedural requirements are satisfied. CERTAIN UNITHOLDERS The following table sets forth the names and addresses and unitholdings of the only persons known to the Partnership to be beneficial owners of more than five percent of the outstanding units of the Partnership as of December 31, 1993. Except as otherwise indicated, such unitholders have sole voting and investment power to the best knowledge of the Partnership. (1) See footnotes (1) and (8) under Directors and Officers. To the best knowledge of the management of the Company, no other person owned beneficially more than five percent of the outstanding units of the Company on that date. With respect to the above information, the Company has relied upon Schedule 13G filings and information received from such persons. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The Company currently maintains a $30 million unsecured revolving credit facility, and a subsidiary of the Company has a $15 million revolving credit line with Wells Fargo Bank, N.A. (the "Bank"). There were no borrowings outstanding against these credit lines at December 31, 1993. In addition, certain of the Company's employee benefit plans have invested approximately $13 million in Index Funds managed by the Bank and the Bank has extended approximately $2 million in letters of credit to the Company. The Bank is the principal subsidiary of Wells Fargo & Company. Carl E. Reichardt, Chairman of the Board of the Bank and Wells Fargo & Company, is a director of the Managing General Partner of the Managing General Partner. In addition, a director of the Managing General Partner of the Managing General Partner, Paul A. Miller, is also a director of the Bank and Wells Fargo & Company. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) Documents filed with this report: 1. Financial Statements - The Consolidated Financial Statements of the Company: Consolidated Statements of Income for the years ended December 31, 1993, December 31, 1992 and December 31, 1991, Consolidated Balance Sheets as of December 31, 1993 and December 31, 1992, Consolidated Statements of Cash Flows for the years ended December 31, 1993, December 31, 1992 and December 31, 1991, Consolidated Statements of Changes in Partners' Capital for the years ended December 31, 1993, December 31, 1992 and December 31, 1991, and Notes to Consolidated Financial Statements. 2. Schedules - Financial Schedules of the Company for the years ended December 31, 1993, December 31, 1992 and December 31, 1991: Property, Plant and Equipment (Schedule V), Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment (Schedule VI), Short-Term Borrowings (Schedule IX), and Supplemental Income Statement Information (Schedule X). 3. Exhibits (listed by numbers corresponding to the Exhibit Table of Item 601 in Regulation S-K): 3(a) The Newhall Land and Farming Company (a California Limited Partnership) Limited Partnership Agreement incorporated by reference to Exhibit 3(e) to Registrant's Registration Statement on Form S-14 filed August 24, 1984. (b) First Amendment to Limited Partnership Agreement of The Newhall Land and Farming Company (a California Limited Partnership). 4 Depositary Receipt for Units of Interest, The Newhall Land and Farming Company (a California Limited Partnership) incorporated by reference to Exhibit 4 of the Company's Annual Report on Form 10-K for the year ended December 31, 1990. * 10(a) Option, Appreciation Rights and Restricted Units Plan (First Amendment and Restatement) of The Newhall Land and Farming Company (a California Limited Partnership). * (b) Newhall Executive Incentive Plan incorporated by reference to Exhibit 10(f) to Registrant's Registration Statement on Form S- 14 filed August 24, 1984. * (c) The Newhall Land and Farming Company Employee Savings Plan incorporated by reference to the Company's Registration Statement on Form S-8 dated January 25, 1984. * (d) The Newhall Land and Farming Company Retirement Plan Restatement, Amendments No. 1 through 5, incorporated by reference to Exhibit 10(d) to the Company's Annual Report on Form 10-K for the year ended December 31, 1992. * (e) Form of Severance Agreements. (f) Newhall Management Corporation Retirement Plan for Directors (Revised January 16, 1991) incorporated by reference to Exhibit 10(f) to the Company's Annual Report on Form 10-K for the year ended December 31, 1990. * (g) The Newhall Land and Farming Company Supplemental Executive Retirement Plan (Restated effective January 15, 1992) incorporated by reference to Exhibit 10(g) to the Company's Annual Report on Form 10-K for the year ended December 31, 1991. * (h) The Newhall Land and Farming Company Senior Management Survivor Income Plan. (i) Form of Indemnification Agreement between the Partnership and its General Partners and the general partners, partners, shareholders, officers and directors of its General Partners, or of the Managing General Partner of the Managing General Partner, as amended, incorporated by reference to Exhibit 28(g) to the Company's report on Form 8-K filed December 11, 1990. (j) Tax Payment and Tax Benefit Reimbursement Agreement incorporated by reference to Exhibit 28(f) to the Company's report on Form 8-K filed December 11, 1990. * (k) The Newhall Land and Farming Company Deferred Cash Bonus Plan incorporated by reference to Exhibit 10(l) of the Company's Annual Report on Form 10-K for the year ended December 31, 1990. * (l) Form of award issued under The Newhall Land and Farming Company Deferred Cash Bonus Plan incorporated by reference to Exhibit 10(m) of the Company's Annual Report on Form 10-K for the year ended December 31, 1990. * (m) The Newhall Land and Farming Company Employee Savings Restoration Plan (As restated effective January 15, 1992) incorporated by reference to Exhibit 10(n) to the Company's Annual Report on Form 10-K for the year ended December 31, 1991. * (n) The Newhall Land and Farming Company Pension Restoration Plan(As restated effective January 15, 1992) incorporated by reference to Exhibit 10(o) to the Company's Annual Report on Form 10-K for the year ended December 31, 1991. (o) Trust Agreement dated January 15, 1992 between the Partnership and Newhall Management Corporation incorporated by reference to Exhibit 10(p)to the Company's Annual Report on Form 10-K for the year ended December 31, 1991. * (p) Amendment No. 4 to The Newhall Land and Farming Company Employee Savings Plan, incorporated by reference to Exhibit 10(q) of the Company's Annual Report on Form 10-K for the year ended December 31, 1992. * (q) Amendments No. 1, No. 2, and No. 3 to The Newhall Land and Farming Company Employee Savings Plan, incorporated by reference to Exhibit 19(a) of the Company's Annual Report on Form 10-K for the year ended December 31, 1992. 11 Computation of earnings per unit. 21 Subsidiaries of the Registrant. 99(a) Articles of Incorporation of Newhall Management Corporation, as amended, incorporated by reference to Exhibit 28(b) to the Company's report on Form 8-K filed December 11, 1990. (b) Bylaws of Newhall Management Corporation incorporated by reference to Exhibit 28(c) to the Company's report on Form 8-K filed December 11, 1990, and Amendment Number 1 dated July 17, 1991 incorporated by reference to Exhibit 28(b) to the Company's Annual Report on Form 10-K for the year ended December 31, 1991. (c) Shareholders' Agreement between Newhall Management Corporation, its shareholders and the Newhall Management Corporation Voting Trust incorporated by reference to Exhibit 28(d) to the Company's report on Form 8-K filed December 11, 1990, and Amendment to Shareholders' Agreement dated as of November 20, 1991 incorporated by reference to Exhibit 28(c) to the Company's Annual Report on Form 10-K for the year ended December 31, 1991. (d) Voting Trust Agreement between Newhall Management Corporation, the Trustee, and the individual shareholders of Newhall Management Corporation incorporated by reference to Exhibit 28(e) to the Company's report on Form 8-K filed December 11, 1990. (e) Partnership Agreement of Newhall General Partnership incorporated by reference to Exhibit 28(e) to Registrant's Registration Statement on Form S-14 filed August 24, 1984, and the Certificate of Amendment of Partnership Agreement of Newhall General Partnership, dated November 14, 1990 incorporated by reference to Exhibit 28(e) of the Company's Annual Report on Form 10-K for the year ended December 31, 1990. (f) Limited Partnership Agreement of Newhall Management Limited Partnership, incorporated by reference to Exhibit 28(a) to the Company's report on Form 8-K filed December 11, 1990. * The items marked above constitute Executive Compensation Plans and Arrangements. (b) There was no current report on Form 8-K filed with respect to the quarter ended December 31, 1993. 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. THE NEWHALL LAND AND FARMING COMPANY (a California Limited Partnership) ------------------------------------ Registrant By Newhall Management Limited Partnership, Managing General Partner By Newhall Management Corporation, Managing General Partner Date: March 16, 1994 By / S / THOMAS L. LEE ----------------------------- Thomas L. Lee Chairman and Chief Executive 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 dates indicated. Date: March 16, 1994 By / S / THOMAS L. LEE ---------------------------- Thomas L. Lee, Chairman and Chief Executive Officer of Newhall Management Corporation (Principal Executive Officer) Date: March 16, 1994 By / S / ROBERT D. WILKE ---------------------------- Robert D. Wilke, Vice Chairman and Chief Financial Officer of Newhall Management Corporation (Principal Financial Officer) Date: March 16, 1994 By / S / DONALD L. KIMBALL ---------------------------- Donald L. Kimball, Controller of Newhall Management Corporation (Principal Accounting Officer) Directors of Newhall Management Corporation: Date: March 16, 1994 By / S / James F. Dickason ---------------------------- James F. Dickason Date: March 16, 1994 By / S / George C. Dillon ---------------------------- George C. Dillon Date: March 16, 1994 By / S / Thomas L. Lee ---------------------------- Thomas L. Lee Date: March 16, 1994 By ---------------------------- Peter McBean Date: March 16, 1994 By / S / Paul A. Miller ---------------------------- Paul A. Miller Date: March 16, 1994 By / S / Henry K. Newhall ---------------------------- Henry K. Newhall Date: March 16, 1994 By / S / Jane Newhall ---------------------------- Jane Newhall Date: March 16, 1994 By / S / Peter T. Pope ---------------------------- Peter T. Pope Date: March 16, 1994 By / S / Carl E. Reichardt ---------------------------- Carl E. Reichardt Date: March 16, 1994 By / S / Thomas C. Sutton ---------------------------- Thomas C. Sutton Date: March 16, 1994 By ---------------------------- Lawrence R. Tollenaere Date: March 16, 1994 By / S / Edwin Newhall Woods ---------------------------- Edwin Newhall Woods Date: March 16, 1994 By / S / Ezra K. Zilkha ---------------------------- Ezra K. Zilkha S-1 SCHEDULE V THE NEWHALL LAND AND FARMING COMPANY PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992, AND 1991 (Dollars in thousands) S-2 SCHEDULE VI THE NEWHALL LAND AND FARMING COMPANY ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992, AND 1991 (Dollars in thousands) S-3 SCHEDULE IX THE NEWHALL LAND AND FARMING COMPANY SHORT-TERM BORROWINGS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992, AND 1991 (Dollars in thousands) The following information relates to the aggregate of short-term borrowings during the years: The average amount outstanding and average interest rate were computed on a daily weighted average basis during the time there were short-term borrowings. S-4 SCHEDULE X THE NEWHALL LAND AND FARMING COMPANY SUPPLEMENTAL INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992, AND 1991 (Dollars in thousands) As to lines omitted, the amounts are less than 1% of total revenues. THE NEWHALL LAND AND FARMING COMPANY INDEX TO EXHIBITS Item 14 (a) 3

1993 ITEM 1. Business Description of Business First Commonwealth Financial Corporation (the "Corporation") was incorporated as a Pennsylvania business corporation on November 15, 1982 and is registered as a bank holding company under the Bank Holding Company Act of 1956, as amended. After its incorporation it became affiliated as a result of statutory mergers with the following: On April 29, 1983 it affiliated with National Bank of the Commonwealth ("NBOC"), a national bank in Indiana, Indiana County; on March 19, 1984 with Deposit Bank ("Deposit"), a Pennsylvania-chartered bank and trust company in DuBois, Clearfield County; on August 16, 1985 with Dale, a national bank in Dale (Johnstown), Cambria County; and on December 14, 1985 with the First National Bank of Leechburg ("Leechburg"), a national bank in Leechburg, Armstrong County; December 31, 1986 with CNB CORP, Inc. ("CNB"), a one-bank holding company and its wholly-owned subsidiary, Citizens National Bank in Windber ("Citizens"). CNB was then combined with the corporation. Immediately thereafter, and on the same day, Citizens was combined with Dale and the resulting entity was named Cenwest National Bank ("Cenwest"). On May 31, 1990 the Corporation affiliated with Peoples Bank and Trust Company ("PBT"), a Pennsylvania-chartered bank and trust company in Jennerstown, Somerset County. On April 30, 1992 the Corporation affiliated with Central Bank ("Central"), a Pennsylvania-chartered bank in Hollidaysburg, Blair County. On December 31, 1993 the Corporation affiliated with Peoples Bank of Western Pennsylvania ("BPWPA"), a Pennsylvania-chartered commercial bank in New Castle, Lawrence County. NBOC, Deposit, Cenwest, Leechburg, Peoples, Central and PBWPA (the "Subsidiary Banks") are now wholly owned subsidiaries of the Corporation with their principal; places of business in central western Pennsylvania. Commonwealth Systems Corporation ("CSC") was incorporated as a Pennsylvania business corporation in 1984 by the Corporation to function as its data processing subsidiary and it has its principal place of business in Indiana, Pennsylvania. Before August 1984, it had operated as the data processing department of NBOC. First Commonwealth Trust Company ("FCTC") was incorporated on January 18, 1991 as a Pennsylvania chartered trust company to render general trust services. The trust departments of Subsidiary Banks were combined to form FCTC, and the corporate headquarters are located in Indiana, Pennsylvania. The Corporation and its subsidiaries employed approximately 906 persons (full- time equivalents) at December 31, 1993. Through the Subsidiary Banks, the Corporation traces its banking origins to 1880. The Subsidiary Banks conduct their business through 69 community banking offices in 51 communities in the counties of Armstrong (3 offices), Beaver (1), Bedford (3), Blair (8), Cambria (11), Centre (2), Clearfield (6), Elk (3), Huntingdon (1), Indiana (9), Jefferson (4), Lawrence (6), Somerset (7) and Westmoreland (5). The Subsidiary Banks engage in a general banking business and offer a full range of financial services. They offer such general retail banking services as demand, savings and time deposits; mortgage, consumer installment and commercial loans; and credit card loans through MasterCard and VISA. The Subsidiary Banks operate a network of 49 automated teller machines ("ATMs") which permit their customers to conduct routine banking transactions 24 hours a day. Of the ATMS, 29 are located on the premises of their main or branch offices and 20 are in remote locations. All the ATMs are part of the MAC network which consist of nearly 13,000 ATMs owned by numerous banks, savings and loan associations and credit unions located throughout 16 states, of which 14 are east of Mississippi River. The Subsidiary Banks' MAC customers may use the HONOR Network, which has 8,900 ATM's located primarily in the southeast quadrant of the United States. The ATM's operated by the Subsidiary Banks are also part of the Cirrus network which is national in scope. Cirrus comprised of more than 93,700 ATMs located in the United States, Canada and 20 other countries and territories, FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES ITEM 1. Business (Continued) which services over 232 million card holders. Such networks allow the Subsidiary Bank's customers to withdraw cash and in certain cases conduct other banking transactions from ATMs of all participating financial institutions. FCTC has six branch offices in the service areas of the Subsidiary Banks and offers personal and corporate trust services, including administration of estates and trusts, individual and corporate investment management and custody services and employee benefit trust services. On June 1, 1989 Commonwealth Trust Credit Life Insurance Company began operations. The Corporation owns 50% of the voting common stock of the new company. The Commonwealth Trust is authorized to engage in credit life and/or disability reinsurance activities. The Corporation does not engage in any significant business activities other than holding the stock of its subsidiaries. The Corporation does not at present have any plans to expand or modify its business or that of its subsidiaries, other than as described herein. Nevertheless, it will be receptive to and may actively seek out merges and acquisitions in the event opportunities which management considers advantageous to the development of the Corporation's business arise, and may otherwise expand or modify its business as management deems necessary to respond to changing market conditions or the laws and regulations affecting the business of banking. Competition Each of the Subsidiary Banks and FCTC faces intense competition, both from within and without its service area, in all aspects of its business. The Subsidiary Banks compete for deposits, in such forms as checking, savings and NOW (negotiable order of withdrawal) accounts, MMDA (money market deposit accounts) and certificates of deposit, and in making consumer loans and loans to smaller businesses, with numerous other commercial banks and savings banks doing business within their service areas. With respect to loans to larger businesses the Subsidiary Banks also complete with much larger banks located outside of their service areas. They also compete, primarily in making consumer loans and for deposits, with state and federally chartered savings and loan associations and with credit unions. In recent years they have encountered significant competition for deposits from money market funds located throughout the United States. Such funds pay dividends to their shareholders (which are the equivalent are the equivalent of the interest paid by banks on deposits) and they are able to offer services and conveniences similar to those offered by the Subsidiary Banks. The effect of such competition has been to increase the costs of the rest of deposits, which provide the funds with which loans are made. In addition to savings and loan associations and credit unions, the Subsidiary Banks also compete for consumer loans with local offices of national finance companies and finance subsidiaries of automobile manufacturers and with national credit card companies such as MasterCard and VISA, whose cards, issued through financial institutions, are held by consumer throughout their service areas. The Subsidiary Banks believe that the principal means by which they compete for deposits and consumer and smaller commercial loans are the number and desirability of the locations of their offices and ATMs, the sophistication and quality of their services and the prices (primarily interest rates) of their services. CSC is the data processing subsidiary of the Corporation. It provides on- line general ledger accounting services and bookkeeping services for deposit and loan accounts to the Corporation, the Subsidiary Banks and two other bank customer located in Pennsylvania. It competes, principally with data processing subsidiaries of other, mostly larger, banks, on the basis of the price and quality of its services and the speed with which such services are delivered. FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES ITEM 1. Business (Continued) Supervision and Regulation The Corporation is a bank holding company within the meaning of the Bank Holding Company Act of 1956, as amended ("the Bank Holding Company Act") and is registered such with the Federal Reserve Board. As a registered bank holding company, it is required to file with the Federal Reserve Board an annual report and other information. The Federal Reserve Board is also empowered to make examinations and inspections of the Corporation and its subsidiaries. The Bank Holding Company Act and Regulation Y of the Federal Reserve Board require every bank holding company to obtain the prior approval of the Federal Reserve Board before it may acquire direct or indirect ownership or control of more than 5% of the outstanding voting shares or substantially all of the assets of a bank or merger or consolidate with another bank holding company. The Federal Reserve Board may not approve acquisitions by FCFC of such percentage of voting shares or substantially all the assets of any bank located in any state other than Pennsylvania unless the laws of such state specifically authorize such an acquisition. The Bank Holding Company Act generally prohibits a bank holding company from engaging in a non-banking business or acquiring direct or indirect ownership or control of more that 5% of the outstanding voting shares of any non- banking corporation subject to certain exceptions, the principal exception being where the business activity in question is determined by the Federal Reserve Board to be closely related to banking or to managing or controlling banks to be a proper incident thereto. The Bank Holding Company Act does not place territorial restrictions on the activities of such banking related subsidiaries of bank holding companies. Under the Federal Reserve Act, subsidiary banks of a bank holding company are subject to certain restrictions on extensions of credit to the bank holding company or any of its subsidiaries, investments in the stock or other securities thereof, or acceptance of such stock or securities as collateral for loans to any one borrower. A bank holding company and its subsidiaries are prohibited from engaging in certain tie-in arrangements in connection with the extension of credit or the furnishing of property or services. Under the Pennsylvania Banking Code, there is no limit on the number of Pennsylvania banks that may be owned or controlled by a Pennsylvania bank holding company. The Federal Deposit Insurance Corporation Improvement Act of 1991 ("the Act") was signed into law on December 19, 1991 and contains a number of provisions that directly and indirectly affect banks and bank holding companies such as the Corporation and the Subsidiary Banks. For example the Act increased from $5 billion to $30 billion the amount the FDIC can borrow from the Treasury Department to cover bank failures, the loans plus interest to be repaid through increased deposit insurance premiums on banks over the next 15 years; the FDIC was instructed to change the way it assesses banks for deposit insurance by moving away from an across-the-board rate to risk- based rates, with banks engaged in risky practices paying higher deposit insurance premiums than those engaged in conservative operations; the bank regulatory agencies are required to establish within one year a system whereby five capital levels would be set for all banks and savings institutions, ranging from well capitalized to critically undercapitalized, with increased regulatory oversight and restrictions automatically occurring as the capital level falls from one level to the next lower level; the scope of deposit insurance is narrowed with the elimination of the "too big to fail" doctrine, under which the FDIC has protected deposits even in excess of $100,000, but all deposits could still be covered if the FDIC, the Federal Reserve Board and the Treasury, in consultation with the President, determined that a serious adverse economic impact would result from a denial FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES ITEM 1. Business (Continued) of insurance coverage, in which case a special premium would be assessed to pay for the extended coverage; the regulators must adopt, effective December 1, 1993, a new set of noncapital measures of banks safety, such as underwriting standards and minimum earning levels; the Federal Reserve Board's ability to keep banks alive with extended loans from its discount window is restricted starting two years after enactment of the law; and the Act also requires annual, on-site federal bank examinations of most institutions, places limits on real estate lending by banks, and tightens auditing requirements. While FCFC and the Subsidiary Banks, in common with all banks, will bear the costs of increased regulatory supervision resulting from the Act, FCFC, because of its capital position, will benefit from a movement to risk-based deposit insurance premiums and a fewer restrictions and oversight for well capitalized banks. Subsidiary Banks and FCTC Of the Subsidiary Banks, NBOC, Cenwest, and Leechburg are subject to the supervision of and are regularly examined by the Comptroller of the Currency. In addition, because they are members of the Federal Reserve System, they are subject to the supervision of and examination by that System. Deposit, PBT and PBWPA are Pennsylvania-chartered banks and not members of the Federal Reserve System, are subject to the supervision of and regularly examined by the Pennsylvania Department of Banking and the Federal Deposit Insurance Corporation ("FDIC"), and subject to certain regulations of the Federal Reserve Board. Central is a member of the Federal Reserve System. Central is subject to supervision of and are regularly examined by the system. In addition, since they are a Pennsylvania-chartered bank, they are subject to the supervision of the Pennsylvania Department of Banking. All the Subsidiary Banks are members of the FDIC and, as such, are subject to examination by the FDIC. FCTC is subject to the supervision of and is to be regularly examined by the Pennsylvania Department of Banking. The areas of operation subject to regulation by Federal and Pennsylvania laws, regulations and regulatory agencies include reserves against deposits, maximum interest rates for specific classes of loans, truth-in-lending disclosure, permissible types of loans and investments, trust operations, mergers and acquisitions, issuance of securities, payment of dividends, establishment of branches and other aspects of operations. Under the Pennsylvania Banking Code, a state or national bank located in Pennsylvania may establish branches in the county in which its principal office is located, in the contiguous and bicontiguous counties. Reciprocal Regional Interstate Banking As already noted, a bank holding company located in one state cannot acquire a bank or a bank holding company located in another state unless the law of such other state specifically permits it. On June 25, 1986, Pennsylvania passed a law (Act No. 1986-69) which provides that a bank holding company located in any state or the District of Columbia can acquire a Pennsylvania bank or bank holding company if the jurisdiction where the acquiring bank holding company is located has passed an enabling law that permits a Pennsylvania bank holding company to acquire a bank or a bank holding company in such jurisdiction. As of December 31, 1993 enabling laws have been passed so that the required reciprocity presently exists with approximately 34 states, of which the following 18 are east of the Mississippi River; Connecticut, Delaware, Illinois, Indiana, Kentucky, Louisiana, Maine, Maryland, Michigan, Massachussets, New Hampshire, New Jersey, New York, Ohio, Rhode Island, Tennessee, Vermont and West Virginia. It is difficult to determine the precise effects that reciprocal regional interstate banking will have on the Corporation, but the law has increased, and as reciprocity becomes effective will increase further, the number of potential buyers for Pennsylvania banks and bank holding companies. The law also will permit Pennsylvania bank holding companies that desire to expand FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES ITEM 1. Business (Continued) outside Pennsylvania to acquire banks and bank holding companies located in jurisdictions with which Pennsylvania has reciprocity. Effects of Governmental Policies The business and earnings of the Corporation is effected not only be general economic conditions, but also by the monetary and fiscal policies of the United State Government and its agencies, including the Federal Reserve Board. An important function of the Federal Reserve Board is to regulate the national supply of bank credit. Among the instruments of monetary policy used by the Federal Reserve Board to implement these objectives are open market operations in United State government securities, changes in the discount rate on borrowings by member banks from the Federal Reserve System, and changes in reserve requirements against member bank deposits. These instruments, together with fiscal and economic policies of various governmental entities, influence overall growth of bank loans, investments and deposits and may also effect interest rates charged on loans, received on investments or paid for deposits. The monetary policies of the Federal Reserve Board have had a significant effect on the operating results of bank holding companies and their subsidiary banks in the past and are expected to continue to do so in the future. In view of changing conditions in the national and Pennsylvania economies and in the money markets, as well as the effect of actions by monetary and fiscal authorities, including the Federal Reserve Board, no prediction can be made as to possible future changes in interest rates, deposit levels and loan demand or the effect of such changes on the business and earnings the Corporation or its subsidiaries. ITEM 2. ITEM 2. PROPERTIES The Corporation's principal office is located in the old Indiana county Courthouse complex. This certified Pennsylvania and national historic landmark was built in 1870 and restored by NBOC in the early 1970s. The Corporation, NBOC and CSC occupy this grand structure, which provides 32,000 square feet of floor space, under a 25-year restoration lease agreement with Indiana County, which NBOC entered into in 1973 and which contains a renewal option. Under the lease, NBOC is obligated to pay all taxes, maintenance and insurance on the building and to restore it in conformity with historic guidelines. The building is now in excellent condition and provides ample space for the Corporation, NBOC and CSC's operations. The Subsidiary Banks have 69 banking facilities of which 23 are leased and 46 owned in fee, free of all liens and encumbrances. All of the facilities utilized by the Corporation and its subsidiaries are used primarily for banking activities. Management believes all such facilities to be in good repair and well suited to their uses. Management presently expects that such facilities will be adequate to meet the anticipated needs of the Corporation and its subsidiaries for the immediate future. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The information appearing in NOTE 17 of the Notes to the Consolidated Financial Statements included in Item 8 of this filing is incorporated by reference. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES Part II ITEM 5. ITEM 5. Market for Registrant's Common Stock and Related Security Holder Matters First Commonwealth Financial Corporation (the "Corporation") has been listed on the New York Stock Exchange (NYSE) since June 10, 1992 under the symbol "FCF". The table below sets forth the high and low sales prices per share and cash dividends declared per share for common stock of the Corporation. Prices per share and dividends per share have been adjusted to reflect the two-for-one stock split effected in the form of a 100% stock dividend declared on January 18, 1994. During the second quarter of 1992 the Board of Directors of the Corporation began the practice of declaring dividends at the end of a quarter instead of at the beginning of a quarter. The payable dates remained in the period following the end of the quarter. This resulted in dividends being declared twice in the second quarter of 1992, but only one dividend was paid. The approximate number of holders of record of the Corporation's common stock is 5,500. Cash Dividends Period High Sale Low Sale Per Share First Quarter $14.625 $12.375 $.125 Second Quarter $14.875 $13.250 $.125 Third Quarter $16.000 $13.313 $.125 Fourth Quarter $17.625 $14.875 $.135 Cash Dividends Period High Sale Low Sale Per Share First Quarter $10.500 $10.000 $.105 Second Quarter $12.250 $10.250 $.210 Third Quarter $14.875 $12.000 $.105 Fourth Quarter $15.688 $13.688 $.125 The prices contained in the table for the common stock for the periods prior to June 10, 1992 are limited to transactions known to management, including recent inquiries made of local brokers, and are not necessarily indicative of the actual range of prices at which such stock was traded during the periods indicated. FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES ITEM 6. ITEM 6. Selected Financial Data (Dollar Amounts in Thousands, except per share data) The following selected financial data is not covered by the auditor's report and should be read in conjunction with Management's Discussion and Analysis of Financial Condition and Results of Operations, which follows, and with the consolidated financial statements and related notes. All amounts have been restated to reflect the pooling of interests. (a) Average number of shares outstanding has been restated to reflect pooling of interests. Restatements also reflect two-for-one stock split effected in the form of a 100% stock dividend declared on January 18, 1994. FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES ITEM 7. ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Introduction This discussion and the related financial data are presented to assist in the understanding and evaluation of the consolidated financial condition and the results of operations of First Commonwealth Financial Corporation (the "Corporation") including its subsidiaries for the years ended December 31, 1993, 1992 and 1991 and are intended to supplement, and should be read in conjunction with, the consolidated financial statements and related footnotes. Effective December 31, 1993, the Corporation acquired all of the outstanding common stock of Peoples Bank of Western Pennsylvania, a state-chartered bank, headquartered in New Castle, Pennsylvania. The merger was accounted for as a pooling of interests and accordingly, all financial statements have been restated as though the merger had occurred at the beginning of the earliest period presented. Effective April 30, 1992, the Corporation acquired all of the outstanding common stock of Central Bank ("Central"), a state-chartered bank headquartered in Hollidaysburg, Pennsylvania. The merger was accounted for as a purchase transaction, whereby the results of operations of Central from the date of acquisition were included in the financial statements. Results of Operations Net income in 1993 was $23.2 million, an increase of $2.6 million over the 1992 level of $20.6 million and compared to $16.0 million which was reported in 1991. Earnings per share before the cumulative effect of the change of accounting method increased $0.08 per share in 1993 to $1.22. This compared to $1.14 in 1992 and $0.94 in 1991. The cumulative effect of change in the method of accounting for income taxes added $0.02 per share to result in $1.24 earnings per share for 1993. Per share data has been restated to reflect the two-for-one stock split effected in the form of a 100% stock dividend declared on January 18, 1994. Return on average assets was 1.25% during the 1993 period compared to 1.24% for 1992. Return on average equity was 12.91% for both the 1993 and 1992 periods. During 1991 return on average assets was 1.14% and return on average equity was 11.75%. The following is an analysis of the impact of changes in net income on earnings per share: 1993 1992 vs. vs. 1992 1991 Net income per share, prior year $1.14 $0.94 Increase (decrease) from changes in: Net interest income 0.07 0.30 Provision for possible loan losses 0.06 0.10 Security transactions 0.09 0.00 Other income 0.04 0.05 Salaries and employee benefits (0.08) (0.06) Occupancy and equipment costs (0.03) (0.01) Settlement of lender liability claim 0.08 (0.08) Other expenses (0.03) (0.06) Provision for Federal income taxes (0.13) (0.08) Subtotal 1.21 1.10 Inclusion of acquisition during year 0.01 0.04 Cumulative effect of change in accounting method 0.02 0.00 Net income per share $1.24 $1.14 FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Net interest income, the most significant component of earnings, is the amount by which interest generated from earning assets exceeds interest expense on liabilities. Net interest income was $73.7 million in 1993 compared to $69.3 million in 1992 and $58.3 million in 1991. The following is an analysis of the average balance sheets and net interest income for each of the three years in the period ended December 31, 1993. FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES ITEM 7. Management's Discussion and Analysis Both interest income and interest expense increased as volumes increased. Average interest earning assets increased $192.8 million in 1993 to $1,766,284 which is 94.9% of average total assets. Included in the 1993 growth was $41.8 million in investments, primarily mortgage-backed securities, and these purchases were funded with borrowings from the Federal Home Loan Bank and other banks. This leveraging strategy added approximately $1.0 million to net interest income during 1993. Excluding the earning assets resulting from the Central acquisition, average earning assets grew $111.2 million in 1992. Average earning assets were 94.7% of average total assets during 1992, compared to 94.5% during 1991. Average interest-bearing liabilities increased $162.1 million during 1993, which included $41.8 million related to the previously mentioned leveraging strategy. The remainder of the increase occurred primarily through deposit growth. Average interest-bearing liabilities grew $213.6 million during 1992 which included $90.7 million in addition to the Central acquisition. Both asset yields and the cost of funds declined in 1993 and 1992 as the interest rates were generally lower during those periods when compared to previous years. Asset yields, on a tax-equivalent basis, decreased 98 basis points (0.98%) during 1993 and 117 basis points (1.17%) during 1992. The cost of funds declined 76 basis points (0.76%) during 1993 and 134 basis points (1.34%) during 1992. Earning asset yields declined in 1993 faster than liability costs primarily because of lower mortgage rates. Mortgage borrowers have been refinancing loans during the low interest rate environment reducing loan yields. Additionally, mortgage loan refinancing on a national scale had accelerated the repayments of mortgage backed securities in excess of projections. Reinvestment of the proceeds at the then current rates lowered the investment portfolio yields. This trend should stabilize if interest rates remain constant or rise. Deposit customers tended to extend maturities which locked in rates as deposit rates fell, thereby preventing the cost of funds to decline as fast as asset yields. Net interest margin, on a tax-equivalent basis, was 4.35% during 1993 compared to 4.66% in 1992 and 4.69% during 1991. The Corporation's use of computer modeling to manage interest rate risk is further described in the "Interest Sensitivity" section of this discussion herein. The following table shows the effect of changes in volumes and rates on interest income and interest expense. FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES ITEM 7. Management's Discussion and Analysis The provision for possible loan losses is an amount added to the reserve against which loan losses are charged. The amount of the provision is determined by management based upon its assessment of the size and quality of the loan portfolio and the adequacy of the reserve in relation to the risks inherent within the loan portfolio. The provision for possible loan losses was $2.2 million in 1993 and $3.2 million and $4.9 million in 1992 and 1991, respectively. Net charge-offs against the reserve for possible loan losses were $1.9 million, or 0.19% of average total loans in 1993. This is compared to $2.9 million in 1992. Charge-offs were $510 thousand less during 1993 while recoveries of previously charged off loans increased $449 thousand. Net charge-offs were $3.8 million in 1991. Net charge-offs were 0.32% and 0.50% of average total loans during 1992 and 1991, respectively. For an analysis of credit quality, see the "Credit Review" section of this discussion. The following table presents an analysis of the consolidated reserve for possible loan losses for the five years ended December 31, 1993 (dollars in thousands): Total other operating income increased $2.7 million in 1993 to $12.1 million. Net security gains increased $1.7 million to $2.3 million during 1993 compared to $679 thousand during 1992 and $677 thousand in 1991. Security transactions during 1993 and 1992 were primarily the sale of U.S. Treasury securities maturing within a year. Proceeds were reinvested in U.S. Treasury securities and U.S. Government agency securities with maturities of 2-3 years to continue to lock in yields while interest rates were falling. Additionally, during 1993 marketable equity securities with a book value of $1.6 million were sold for a $1.0 million gain. During 1991 FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES ITEM 7. Management's Discussion and Analysis the Corporation also sold low and marginal quality securities which improved the marketability and liquidity of the portfolio. Gross gains of $2.3 million and gross losses of $17 thousand were recognized during 1993. Gross gains of $803 thousand and $1.5 million were recognized during 1992 and 1991, respectively, while gross losses of $124 thousand and $779 thousand were recognized in the corresponding periods. Trust income increased $227 thousand during 1993 to $2.2 million as estate fees decreased $67 thousand, and core revenues increased. Trust income increased $664 thousand during 1992 as the 1991 restructuring of the subsidiary banks' trust departments into a single trust company began to produce benefits. Management of the trust company allows an opportunity to focus on growth, since the specialized areas and back-office operations were centralized. Service charges on deposits increased $320 thousand in 1993 and $1.0 million in 1992 primarily as a result of average total deposits increasing. Additionally, new fee schedules established during the fourth quarter of 1991 provided higher revenues during 1992. Total other operating expenses increased $3.4 million to $51.2 million in 1993 and compared to $47.8 million and $39.9 million in 1992 and 1991, respectively. Results for the 1992 period did not reflect any of Central's results until the merger date of April 30, 1992. Operating expenses related to Central in the first four months of 1993 were $2.2 million. Employee costs experienced an increase of $2.4 million to $25.4 million. Of this increase $946 thousand was a result of including Central for the full year of 1993. Total employee costs were $23.0 million and $20.2 million in 1992 and 1991, respectively. Salary levels are generally maintained through attrition management programs. Employee costs as a percentage of average assets was 1.36% in 1993, reduced from 1.38% in 1992 and 1.44% in 1991. Net occupancy expense and furniture and equipment increased over the three year period primarily as the costs of maintaining branch operations, including utilities, repairs and depreciation continued to increase. Additionally, equipment depreciation increased as computer equipment that was previously being leased was purchased and is being depreciated over a shorter life than the original lease. Additionally, the process of automating loan documentation and the branch network increased depreciation costs but is expected to improve platform productivity and reduce loan documentation risks. The deposit insurance assessment from the Federal Deposit Insurance Corporation ("FDIC") increased as a result of deposit increases. This assessment is not scheduled to increase again in 1994, but the possibility of future increases cannot be eliminated. The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") has established a risk-based assessment system which went into effect January 1, 1993. This system designates an assessment rate for each insured institution based on a combination of its capital and supervisory condition. Because of the Corporation's strong capital position and supervisory condition, only future rate changes will cause a significant change in the related expense. A lender liability claim for which a subsidiary of the Corporation was a defendant, was settled out of court in October 1992 in the amount of $1.4 million. Other operating expenses increased $1.3 million in 1993 over the 1992 related period to $15.0 million. The inclusion of Central for the entire period of 1993 increased this category $829 thousand. An increase in the amortization of core deposit intangibles as a result of the implementation of FAS No. 109 was $715 thousand. One of the subsidiary banks agreed to a settlement of a PA shares tax claim resulting in a refund of $298 thousand. The 1992 increase was primarily a result of including Central for eight months. Cost increases occurred in the process of the collection of loans or the disposition of real estate acquired in lieu of loan repayment but was partially responsible for the increased recovery of previously charged off loans. FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES ITEM 7. Management's Discussion and Analysis Federal income tax expense was $9.7 million during 1993 representing an increase of $2.6 million over the 1992 total of $7.1 million. Taxable income increased nearly $7.0 million during 1993. On August 10, 1993 President Clinton signed into law the Omnibus Budget Reconciliation Act of 1993 ("the Act"). The Act made several changes that will affect financial institutions such as the Corporation and its subsidiaries. While it is difficult to determine the short and long-range effects of the Act on the Corporation and whether it will be able to change its operations and make adaptations to maintain net income levels that would otherwise have prevailed if the Act had not passed, it should be noted that the primary focus of the Act was to raise taxes. One provision of the Act increased the tax rate for corporate taxable income in excess of $10 million to 35 percent from 34 percent. This provision was retroactively applied to taxable income earned after January 1, 1993. The tax rate change increased the Corporation's Federal income tax expense by $259 thousand. Liquidity Liquidity is a measure of the Corporation's ability to efficiently meet normal cash flow requirements of both borrowers and depositors. In the ordinary course of business, funds are generated from deposits (primary source) and the maturity or repayment of earning assets, such as securities and loans. As an additional secondary source, short-term liquidity needs may be provided through the use of overnight Federal funds purchased and borrowings from the Federal Reserve Bank. Additionally, six of the seven banking subsidiaries are members of the Federal Home Loan Bank and may borrow up to ten percent of their total assets at any one time. The sale of earning assets may also provide an additional source of liquidity. The Corporation's long-term liquidity source is a large core deposit base and a strong capital position. Core deposits are the most stable source of liquidity a bank can have due to the long-term relationship with a deposit customer. Deposits increased $30.8 million in 1993 primarily in core customer deposit relationships. Non-core deposits, which are time deposits in denominations of $100 thousand or more represented only 6.1% of total deposits at December 31, 1993. Time deposits of $100 thousand or more at December 31, 1993, 1992 and 1991 had remaining maturities as follows: Net loans increased $41.4 million during 1993 as consumer loans and real estate secured loans were the primary categories of increased volume reflecting a strengthening of loan demand. An additional source of liquidity are certain marketable securities that the Corporation holds in its investment portfolio. These securities are classified as "securities available for sale". While the Corporation does not have specific intentions to sell these securities, they have been designated as "available for sale" because they may be sold for the purpose of obtaining future liquidity, for management of interest rate risk or as FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES ITEM 7. Management's Discussion and Analysis part of the implementation of tax management strategies. As of December 31, 1993, securities available for sale had an amortized cost of $462.8 million and a market value of $465.2 million. Gross unrealized gains were $3.7 million and gross unrealized losses were $1.3 million. Below is a schedule of loans by classification for the five years ended December 31, 1993 and a schedule of the maturity distribution of investment securities at December 31, 1993. *Yields are calculated on a tax-equivalent basis Interest Sensitivity The objective of interest rate sensitivity management is to maintain an appropriate balance between the stable growth of income and the risks associated with maximizing income through interest sensitivity imbalances. While no single number can accurately describe the impact of changes in interest rates on net interest income, interest rate sensitivity positions, or "gaps" when measured over a variety of time periods may be helpful. An asset or liability is considered to be interest-sensitive if the rate it yields or bears is subject to change within a predetermined time period. If interest-sensitive assets ("ISA") exceeds interest-sensitive liabilities ("ISL") during a prescribed time period, a positive gap results. Conversely, when ISL exceeds ISA during a time period, a negative gap results. A positive gap tends to indicate that earnings will be impacted favorably if interest rates rise during the period and negatively when interest rates fall during the period. A negative gap tends to indicate that earnings will be affected inversely to interest rate changes. In other words, as interest rates fall, a negative gap should tend to produce a positive effect on earnings and when interest rates rise, a negative gap should tend to affect earnings negatively. FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES ITEM 7. Management's Discussion and Analysis The following table lists the amounts and ratios of assets and liabilities with rates or yields subject to change within the periods indicated as of December 31, 1993 and 1992 (Dollar Amounts in Thousands): 0-90 Days 0-180 Days 0-365 Days Loans $ 384,639 $ 458,967 $ 593,225 Investments 162,510 210,823 276,518 Other interest-earning assets 1,974 2,172 2,469 Total interest-sensitive assets 549,123 671,962 872,212 Certificates of deposit 160,487 278,868 404,764 Other deposits 503,288 503,288 503,288 Short-term borrowings 155,518 165,096 168,803 Total interest-sensitive liabilities 819,293 947,252 1,076,855 Gap $(270,170) $(275,290) $ (204,643) ISA/ISL 0.67 0.71 0.81 Gap/Total assets 13.82% 14.08% 10.47% 0-90 Days 0-180 Days 0-365 Days Loans $ 395,097 $ 463,995 $ 615,796 Investments 72,879 114,000 185,784 Other interest-earning assets 34,403 37,692 46,859 Total interest-sensitive assets 502,379 615,687 848,439 Certificates of deposit 156,655 288,295 389,704 Other deposits 583,307 583,807 584,648 Short-term borrowings 44,801 50,135 51,492 Total interest-sensitive liabilities 784,763 922,237 1,025,844 Gap $(282,384) $(306,550) $ (177,405) ISA/ISL 0.64 0.67 0.83 Gap/Total assets 15.80% 17.15% 9.92% Final loan maturities and rate sensitivity of the loan portfolio excluding consumer installment and mortgage loans and before unearned income at December 31, 1993 are as follows (Dollar Amounts in Thousands): Within One One to After Year 5 Years 5 Years Total Commercial and industrial $ 92,566 $19,544 $ 14,403 $126,513 Financial institutions -0- 162 -0- 162 Real estate-construction 7,199 1,147 1,372 9,718 Real estate-commercial 99,684 40,003 81,119 220,806 Other 9,276 6,050 11,219 26,545 Totals $208,725 $66,906 $108,113 $383,744 Loans at fixed interest rates 43,902 49,367 Loans at variable interest rates 23,004 58,746 Totals $66,906 $108,113 FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES ITEM 7. Management's Discussion and Analysis The Corporation has not experienced the kind of earnings volatility indicated from the gap analysis. This is because assets and liabilities with similar contractual repricing characteristics may not reprice at the same time or to the same degree. Therefore, to more precisely measure the impact of interest rate changes on the Corporation's net interest margin, management simulates the potential effects of changing interest rates through computer modeling. The Corporation is then better able to implement strategies which would include an acceleration of a deposit rate reduction or a lag in a deposit rate increase. The repricing strategies for loans would be inversely related. The analysis at December 31, 1993, indicated that a 200 basis point movement in interest rates in either direction would not have a significant impact on the Corporation's anticipated net interest income over the next twelve months. Credit Review Maintaining a high quality loan portfolio is of great importance to the Corporation. The Corporation manages the risk characteristics of the loan portfolio through the use of prudent lending policies and procedures and monitors risk through a periodic review process provided by external auditors, internal auditors, regulatory authorities and our loan review staff. These reviews include the analysis of credit quality, diversification of industry, compliance to policies and procedures, and an analysis of current economic conditions. In the management of its credit portfolio, the Corporation emphasizes the importance of the collectibility of loans and leases as well as asset and earnings diversification. The Corporation immediately recognizes as a loss, all credits judged to be uncollectible and has established a reserve for possible credit losses that may exist in the portfolio at a point in time, but have not been specifically identified. Since all identified losses are immediately charged off, no portion of the reserve is restricted to any individual credit or groups of credits, and the entire reserve is available to absorb any and all credit losses. However, for analytical purposes, the following table sets forth an allocation of the reserve for possible loan losses at December 31 according to the categories indicated: FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES ITEM 7. Management's Discussion and Analysis Other than those described below, there are no material credits that management has serious doubts as to the borrower's ability to comply with the present loan repayment terms. The following table identifies nonperforming loans at December 31. A loan is placed in a nonaccrual status at the time when ultimate collectibility of principal or interest, wholly or partially, is in doubt. Past due loans are those which were contractually past due 90 days or more as to interest or principal payments. Renegotiated loans are those which terms have been renegotiated to provide a reduction or deferral of principal or interest as a result of the deteriorating financial position of the borrower. The reduction of income due to renegotiated loans was less than $50 thousand in any year presented. The level of nonperforming loans has increased in recent years, principally as nonaccrual loans increased. These loans are primarily secured by residential and commercial real estate and no significant loss is expected. Management believes that the reserve for possible loan losses and nonperforming loans remained safely within acceptable levels during 1993. Capital Resources Equity capital increased $16.0 million in 1993. Dividends declared decreased equity by $8.9 million. The retained net income remains in permanent capital to fund future growth and expansion. Payments by the Corporation's Employee Stock Ownership Plan ("ESOP") to reduce debt it incurred to acquire the Corporation's common stock for future distribution as employee compensation, net of additional advances, increased equity capital by $464 thousand. The market value adjustment to securities available for sale added $1.6 million to capital while the tax benefit of dividends paid to the ESOP increased equity by $84 thousand and amounts paid to fund the discount on reinvested dividends and optional cash payments reduced equity by $159 thousand. A capital base can be considered adequate when it enables the Corporation to intermediate funds responsibly and provide related services while protecting against future uncertainties. The evaluation of capital adequacy depends on a variety of factors, including asset quality, liquidity, earnings history and prospects, internal controls and management caliber. In consideration of these factors, management's primary emphasis with respect to the Corporation's capital position is to maintain an adequate and stable ratio of equity to assets. FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES ITEM 7. Management's Discussion and Analysis The Federal Reserve Board has issued risk-based capital adequacy guidelines which went into effect in stages through 1992. The risk-based capital standard is designed principally as a measure of credit risk. These guidelines require: (1) at least 50% of a banking organization's total capital be common and certain other "core" equity capital ("Tier I Capital"); (2) assets and off-balance sheet items must be weighted according to risk; (3) the total capital to risk-weighted assets ratio be at least 8%; and (4) a minimum leverage ratio of Tier I capital to total assets. The minimum leverage ratio is not specifically defined, but is generally expected to be 4-5 percent for all but the most highly rated banks, as determined by a regulatory rating system. The table below presents the Corporation's capital position at December 31, 1993: Percent Amount of Adjusted (in thousands) Assets Tier I Capital $169,546 16.29 Risk-Based Requirement 41,642 4.00 Total Capital 182,989 17.58 Risk-Based Requirement 83,285 8.00 Minimum Leverage Capital 169,546 8.88 Minimum Leverage Requirement 76,384 4.00 Inflation and Changing Prices Management is aware of the impact inflation has on interest rates and therefore the impact it can have on a bank's performance. The ability of a financial institution to cope with inflation can only be determined by analysis and monitoring of its asset and liability structure. The Corporation monitors its asset and liability position with particular emphasis on the mix of interest-sensitive assets and liabilities in order to reduce the effect of inflation upon its performance. However, it must be remembered that the asset and liability structure of a financial institution is substantially different from an industrial corporation in that virtually all assets and liabilities are monetary in nature, meaning that they have been or will be converted into a fixed number of dollars regardless of changes in general price levels. Examples of monetary items include cash, loans and deposits. Nonmonetary items are those assets and liabilities which do not gain or lose purchasing power solely as a result of general price level changes. Examples of nonmonetary items are premises and equipment. Inflation can have a more direct impact on categories of noninterest expenses such as salaries and wages, supplies and employee benefit costs. These expenses are very closely monitored by management for both the effects of inflation and increases relating to such items as staffing levels, usage of supplies and occupancy costs. FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES ITEM 8. ITEM 8. Financial Statements and Supplementary Data Consolidated Balance Sheets (Dollar Amounts in Thousands) December 31, 1993 1992 Assets Cash and due from banks on demand...........$ 51,044 $ 63,337 Interest-bearing deposits with banks........ 2,569 18,196 Federal funds sold.......................... -0- 30,555 Securities available for sale............... 465,224 -0- Investment securities, market value $383,943 in 1993 and $674,066 in 1992..... 381,811 664,046 Loans....................................... 1,037,675 994,768 Unearned income........................... (31,499) (30,241) Reserve for possible loan losses.......... (14,544) (14,267) Net loans............................ 991,632 950,260 Property and equipment...................... 21,911 21,107 Other real estate owned..................... 4,929 4,044 Other assets................................ 36,149 36,003 Total assets.........................$1,955,269 $1,787,548 Liabilities Deposits (All Domestic): Noninterest-bearing.......................$ 167,306 $ 167,486 Interest-bearing.......................... 1,408,318 1,377,337 Total deposits....................... 1,575,624 1,544,823 Short-term borrowings....................... 171,497 52,676 Other liabilities........................... 14,332 11,516 Long-term debt.............................. 7,363 8,130 Total liabilities.................... 1,768,816 1,617,145 Shareholders' Equity Preferred stock, $1 par value per share, 3,000,000 shares authorized and unissued.............................. -0- -0- Common stock, $5 par value per share, 25,000,000 shares authorized, 9,321,012 issued and outstanding.................... 46,605 46,605 Additional paid-in capital.................. 35,296 35,455 Retained earnings........................... 107,417 93,256 Unrealized gain on securities available for sale.................................. 1,584 -0- 190,902 175,316 Deferred compensation....................... (4,449) (4,913) Total shareholders' equity........... 186,453 170,403 Total liabilities and shareholders' equity..........$1,955,269 $1,787,548 The accompanying notes are an integral part of these consolidated financial statements. FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES ITEM 8. Financial Statements and Supplementary Data Consolidated Statements of Income (Dollar Amounts in Thousands, except per share data) The accompanying notes are an integral part of these consolidated financial statements. FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES ITEM 8. Financial Statements and Supplementary Data Consolidated Statements of Cash Flows (Dollar Amounts in Thousands) The accompanying notes are an integral part of these consolidated financial statements. FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES ITEM 8. Financial Statements and Supplementary Data Consolidated Statements of Changes in Shareholders' Equity (Dollar Amounts in Thousands) FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES ITEM 8. Financial Statements and Supplementary Data Notes to Consolidated Financial Statements Years Ended December 31, 1993, 1992 and 1991 NOTE 1--Statement of Accounting Policies General The following summary of accounting and reporting policies is presented to aid the reader in obtaining a better understanding of the financial statements and related financial data of First Commonwealth Financial Corporation (the "Corporation") and its subsidiaries contained in this report. Such policies conform to generally accepted accounting principles and to general practice within the banking industry. The Corporation and its subsidiaries are on the accrual basis of accounting except for certain trust related revenues which are recorded on a cash basis. Recording income from such activities on a cash basis does not materially affect net income. Certain items of the consolidated statements for the years ended December 31, 1992 and 1991 have been reclassified to conform with the December 31, 1993 presentation. Basis of Presentation The accompanying consolidated financial statements include the accounts of the Corporation and its wholly-owned subsidiaries. All material intercompany transactions have been eliminated in consolidation. Investments of 20 to 50 percent of the outstanding common stock of investees are accounted for using the equity method of accounting. Securities In May 1993, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 115 ("FAS No. 115"), Accounting for Certain Investments in Debt and Equity Securities. This statement addresses the accounting and reporting for investments in equity securities that have readily determinable fair values and for all investments in debt securities. Those investments are to be classified in three categories and accounted for as follows: (a) securities held-to-maturity, (b) trading securities and (c) securities available-for-sale. Debt securities that the Corporation has the positive intent and ability to hold to maturity are classified as securities held-to-maturity and are reported at amortized cost. Debt and equity securities that are bought and held principally for the purpose of selling them in the near term are classified as trading securities and reported at fair value, with unrealized gains and losses included in earnings. Debt and equity securities not classified as either held-to-maturity securities or trading securities are classified as securities available-for-sale and are reported at fair value, with unrealized gains and losses excluded from earnings and reported as a separate component of shareholders' equity. The Corporation adopted FAS No. 115 effective December 31, 1993 and classified securities as either held-to-maturity or available-for-sale. The Corporation does not engage in trading activities (see NOTES 4 and 5). Prior to the implementation of FAS No. 115, investment securities consisted of debt and equity securities. Debt securities were stated at cost adjusted for amortization of premium and accretion of discount. These securities were principally purchased with the intent of holding them until maturity. Marketable equity securities were carried at the lower of aggregate cost or market value. Net gain or loss on the sale of investment securities was determined by using the specific identification method. FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES ITEM 8. Financial Statements and Supplementary Data Notes to Consolidated Financial Statements Years Ended December 31, 1993, 1992 and 1991 (Dollar Amounts in Thousands) NOTE 1--Statement of Accounting Policies (Continued) Loans Loans are carried at the principal amount outstanding. Unearned income on installment loans is taken into income on a declining basis which results in an approximately level rate of return over the life of the loan. Interest is accrued as earned on nondiscounted loans. When a loan becomes past due and doubt exists as to the ultimate collection of principal and interest, the accrual of income is discontinued and is only recognized at the time payment is received. Renegotiated loans are those loans on which concessions in terms have been granted because of a borrower's financial difficulty. Interest is generally accrued on such loans in accordance with the new terms. Loan Fees Loan origination and commitment fees, net of associated direct costs, are deferred and the net amount is amortized as an adjustment to the related loan yield on the interest method, generally over the contractual life of the related loans or commitments. Other Real Estate Owned Real estate, other than bank premises, is recorded at the lower of cost or market at the time of acquisition. Expenses related to holding the property, net of rental income, are generally charged against earnings in the current period. Other real estate also includes properties that have in substance been foreclosed. In-substance foreclosed properties are those properties where the borrower has little or no remaining equity in the property considering its fair market value; where repayment can only be expected to come from the operation or sale of the property; and where the borrower has effectively abandoned control of the property or it is doubtful that the borrower will be able to rebuild equity in the property. In- substance foreclosed properties included in other real estate owned were $111 and $1,514 at December 31, 1993 and 1992, respectively. Reserve for Possible Loan Losses The reserve for possible loan losses represents management's estimate of an amount adequate to provide for losses which may be incurred on loans currently held. Management determines the adequacy of the reserve based on historical patterns of loan charge-offs and recoveries, the relationship of the reserve to outstanding loans, industry experience, current economic trends and other factors relevant to the collectibility of loans currently in the portfolio. Premises and Equipment Premises and equipment are carried at cost less accumulated depreciation and amortization. Depreciation is computed on the straight-line and accelerated methods over the estimated useful life of the asset. Charges for maintenance and repairs are expensed as incurred. Where a lease is involved, amortization is charged over the term of the lease or the estimated useful life of the improvement, whichever is shorter. FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES ITEM 8. Financial Statements and Supplementary Data Notes to Consolidated Financial Statements Years Ended December 31, 1993, 1992 and 1991 (Dollar Amounts in Thousands) NOTE 1--Statement of Accounting Policies (Continued) Income Taxes In February 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 109 ("FAS No. 109"), Accounting for Income Taxes (see NOTE 14). Under the asset and liability method utilized by FAS No. 109, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amount of existing assets and liabilities and their respective tax bases given the provisions of the enacted tax laws. Deferred tax assets are reduced, if necessary, by the amount of such benefits that are not expected to be realized based upon available evidence. Effective January 1, 1993, the Corporation adopted FAS No. 109 and has reported the cumulative effect of that change in method of accounting for income taxes in the 1993 consolidated statement of income. Cash Flow Statement Cash and Cash Equivalents For purposes of reporting cash flows, cash and cash equivalents include cash on hand, amounts due from banks, and Federal funds sold. Generally, Federal funds are sold for one-day periods. Supplemental Disclosures Cash paid during the year for: 1993 1992 1991 Interest $59,119 $64,546 $67,518 Income taxes $ 9,245 $ 8,175 $ 5,187 Noncash Investing and Financing Activities The Corporation borrowed $250 in 1993 and $1,520 in 1991 and concurrently loaned these amounts to the First Commonwealth Financial Corporation Employee Stock Ownership Plan Trust ("ESOP") on identical terms. The loan has been recorded as long-term debt on the Corporation's books and the offset was recorded as a reduction in common shareholders' equity. Loan payments in the amount of $714 were made by the ESOP in each of the three years ending in 1993, thereby reducing the outstanding amount related to deferred compensation to $4,449 at December 31, 1993. Earnings Per Common Share Earnings per share have been calculated on the weighted average number of common shares outstanding during each year, restated to reflect pooling of interests. Additionally, average number of shares has been restated to reflect the two-for-one stock split effected in the form of a 100% stock dividend declared on January 18, 1994 (see NOTE 22). Fair Values of Financial Instruments The financial statements include various estimated fair values at December 31, 1993, as required by Statement of Financial Accounting Standards No. 107 ("FAS No. 107"). Such information, which pertains to the Corporation's FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES ITEM 8. Financial Statements and Supplementary Data Notes to Consolidated Financial Statements Years Ended December 31, 1993, 1992 and 1991 (Dollar Amounts in Thousands) NOTE 1--Statement of Accounting Policies (Continued) financial instruments, is based on the requirements set forth in FAS No. 107 and does not purport to represent the aggregate net fair value of the Corporation. It is the Corporation's general practice and intent to hold its financial instruments to maturity, except for certain securities designated as securities available for sale, and not to engage in trading activities. Many of the financial instruments lack an available trading market, as characterized by a willing buyer and seller engaging in an exchange transaction. Therefore, the Corporation had to use significant estimations and present value calculations to prepare this disclosure. Changes in the assumptions or methodologies used to estimate fair values may materially affect the estimated amounts. Also, management is concerned that there may not be reasonable comparability between institutions due to the wide range of permitted assumptions and the methodologies in absence of active markets. This lack of uniformity gives rise to a high degree of subjectivity in estimating financial instrument fair values. The following methods and assumptions were used by the Corporation in estimating financial instrument fair values: Cash and short-term instruments: The balance sheet carrying amounts for cash and short-term instruments approximate the estimated fair values of such assets. Securities: Fair values for investment securities and securities available for sale are based on quoted market prices, if available. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments. The carrying value of nonmarketable equity securities, such as Federal Reserve Bank stock and Federal Home Loan Bank stock, is considered a reasonable estimate of fair value. Loans receivable: Fair values of variable rate loans subject to frequent repricing and which entail no significant credit risk are based on the carrying values. The estimated fair values of other loans are estimated by discounting the future cash flows using interest rates currently offered for loans with similar terms to borrowers of similar credit quality. The carrying amount of accrued interest is considered a reasonable estimate of fair value. Off-balance-sheet instruments: Many of the Corporation's off-balance-sheet instruments, primarily loan commitments and standby letters of credit, are expected to expire without being drawn upon, therefore the commitment amounts do not necessarily represent future cash requirements. Management has determined that due to the uncertainties of cash flows and difficulty in predicting the timing of such cash flows, fair values were not estimated for these instruments. Deposit liabilities: For deposits which are payable on demand at the reporting date, representing all deposits other than time deposits, management estimates that the carrying value of such deposits is a reasonable estimate of fair value. The carrying amounts of variable rate time deposit accounts and certificates of deposit approximate their fair values at the report date. Fair values of fixed rate time deposits are estimated by discounting the future cash flows using interest rates currently being offered and a schedule of aggregated expected maturities. The carrying amount of accrued interest approximates its fair value. FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES ITEM 8. Financial Statements and Supplementary Data Notes to Consolidated Financial Statements Years Ended December 31, 1993, 1992 and 1991 (Dollar Amounts in Thousands) NOTE 1--Statement of Accounting Policies (Continued) Short-term borrowings: The carrying amounts of short-term borrowings such as Federal funds purchased, securities sold under agreements to repurchase, borrowings from the Federal Home Loan Bank and treasury, tax and loan notes approximate their fair values. Long-term debt: The carrying amounts of variable rate debt approximate their fair values at the report date. Fair values of fixed rate debt are estimated by discounting the future cash flows using the Corporation's estimated incremental borrowing rate for similar types of borrowing arrangements. NOTE 2--Business Combination Effective December 31, 1993 the Corporation acquired all of the outstanding common shares of Peoples Bank of Western Pennsylvania, a state-chartered bank headquartered in New Castle, Pennsylvania. Each of the 375,000 outstanding shares of common stock were exchanged for two shares of the Corporation's common stock. The merger was accounted for as a pooling of interests, and accordingly, all financial statements were restated as though the merger had occurred at the beginning of the earliest period presented. Effective April 30, 1992, the Corporation acquired all of the outstanding common shares of Central Bank ("Central"), a state-chartered bank headquartered in Hollidaysburg, Pennsylvania, for 808,765 shares of the Corporation's common stock and $3,950 in cash. The acquisition was accounted for as a purchase transaction, whereby the identifiable tangible and intangible assets and liabilities of Central have been recorded at their fair values at the acquisition date. Goodwill of $4,858 and core deposit intangibles of $2,873 acquired in the transaction are being amortized on a straight-line basis over respective periods of fifteen and ten years. Under the purchase method of accounting, the results of operations of Central from the date of acquisition were included in the financial statements. NOTE 3--Cash and Due From Banks on Demand Regulations of the Board of Governors of the Federal Reserve System impose uniform reserve requirements on all depository institutions with transaction accounts (checking accounts, NOW accounts, etc.). Reserves are maintained in the form of vault cash or a noninterest-bearing balance held with the Federal Reserve Bank. The subsidiary banks maintained with the Federal Reserve Bank average balances of $3,355 during 1993 and $3,971 during 1992. FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES ITEM 8. Financial Statements and Supplementary Data Notes to Consolidated Financial Statements Years Ended December 31, 1993, 1992 and 1991 (Dollar Amounts in Thousands) NOTE 4--Investment Securities Below is an analysis of the book values and approximate fair values of debt securities at December 31: Mortgage backed securities include mortgage backed obligations of the U.S. Government agencies and corporations, mortgage backed securities issued by other organizations and other asset backed securities. These obligations have contractual maturities ranging from 5 to 34 years and have an anticipated average life to maturity ranging from less than one year to 10 years. The amortized cost and estimated market value of debt securities at December 31, 1993, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or repay obligations with or without call or prepayment penalties. Estimated Amortized Market Cost Value Due within 1 year $ 20,174 $ 20,326 Due after 1 but within 5 years 111,271 112,482 Due after 5 but within 10 years 30,439 30,662 Due after 10 years 8,519 8,907 170,403 172,377 Mortgage backed securities 211,408 211,566 Total debt securities $381,811 $383,943 Proceeds from the sales of investment securities were $16,840 and $65,362 in 1992 and 1991, respectively. Gross gains of $803 and $1,456 were recognized during 1992 and 1991, respectively, while gross losses of $124 and $779 were recognized in the corresponding periods. FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES ITEM 8. Financial Statements and Supplementary Data Notes to Consolidated Financial Statements Years Ended December 31, 1993, 1992 and 1991 (Dollar Amounts in Thousands) NOTE 4-Investment Securities (Continued) Marketable equity securities included in investment securities at December 31, 1992 with a cost basis of $6,219 had gross unrealized gains of $331 and gross unrealized losses of $122. The Corporation also held nonmarketable equity securities in the amount of $7,476 at December 31, 1992, primarily Federal Home Loan Bank stock and Federal Reserve Bank stock. At December 31, 1993 equity securities have been classified as securities available for sale. Investment securities with a book value of $249,160 and $181,787 were pledged at December 31, 1993 and 1992, respectively, to secure public deposits and for other purposes required or permitted by law. NOTE 5--Securities Available For Sale Below is an analysis of the amortized cost and approximate fair values of securities available for sale at December 31, 1993: Gross Gross Approx. Amortized Unrealized Unrealized Fair Cost Gains Losses Value U.S. Treasury Securities $103,253 $ 862 $ (125) $103,990 Obligations of U.S. Government Corporations and Agencies: Mortgage Backed Securities 285,854 2,507 (978) 287,383 Other 49,726 323 (133) 49,916 Obligations of States and Political Subdivisions 97 -0- -0- 97 Corporate Securities 4,688 50 -0- 4,738 Other Mortgage Backed Securities 6,327 25 (9) 6,343 Total Debt Securities 449,945 3,767 (1,245) 452,467 Equity Securities 12,841 -0- (84) 12,757 Total Securities Available for Sale $462,786 $3,767 $(1,329) $465,224 Mortgage backed securities include mortgage backed obligations of the U.S. Government agencies and corporations, mortgage backed securities issued by other organizations and other asset backed securities. These obligations have contractual maturities ranging from 5 to 34 years and have an anticipated average life to maturity ranging from less than one year to 10 years. FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES ITEM 8. Financial Statements and Supplementary Data Notes to Consolidated Financial Statements Years Ended December 31, 1993, 1992 and 1991 (Dollar Amounts in Thousands) NOTE 5--Securities Available for Sale (Continued) The amortized cost and estimated market value of debt securities at December 31, 1993, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or repay obligations with or without call or prepayment penalties. Estimated Amortized Fair Cost Value Due within 1 year $ 4,960 $ 5,083 Due after 1 but within 5 years 141,804 142,652 Due after 5 but within 10 years 8,815 8,804 Due after 10 years 2,185 2,202 157,764 158,741 Mortgage backed securities 292,181 293,726 Total debt securities $449,945 $452,467 Proceeds from the sales of investment securities during 1993 were $95,658. Gross gains of $2,350 and gross losses of $17 were realized on those sales. NOTE 6--Loans (all domestic) Loans at year end were divided among these general categories: December 31, 1993 1992 Commercial, financial, agricultural and other $ 153,039 $196,979 Real estate loans: Construction and land development 9,718 11,676 1-4 Family dwellings 412,799 373,174 Other real estate loans 220,804 188,226 Loans to individuals for household, family and other personal expenditures 239,904 220,085 Leases, net of unearned income 1,411 4,628 Subtotal 1,037,675 994,768 Unearned income (31,499) (30,241) Total loans and leases $1,006,176 $964,527 Management's estimate of the fair value of loans was $1,035,850 and $991,491 at December 31, 1993 and 1992, respectively. Most of the Corporation's business activity was with customers located within Pennsylvania. The portfolio is well diversified, and as of December 31, 1993, there were no significant concentrations of credit. FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES ITEM 8. Financial Statements and Supplementary Data Notes to Consolidated Financial Statements Years Ended December 31, 1993, 1992 and 1991 (Dollar Amounts in Thousands) NOTE 7--Reserve for Possible Loan Losses Description of changes: 1993 1992 1991 Reserve balance at January 1 $14,267 $ 9,426 $8,323 Additions: Recoveries of previously charged off loans 1,564 1,115 825 Provision charged to operating expense 2,197 3,219 4,946 From acquisition -0- 4,501 -0- Deductions: Loans charged off 3,484 3,994 4,668 Reserve balance at December 31 $14,544 $14,267 $9,426 For Federal tax purposes, the reserve for possible loan losses was $1,911 in 1993 and $2,222 in 1992. NOTE 8--Financial Instruments with Off-Balance-Sheet Risk The Corporation is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financial needs of its customers. These financial instruments include commitments to extend credit, standby letters of credit and commercial letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheet. The contract or notional amount of those instruments reflects the extent of involvement the Corporation has in particular classes of financial instruments. The Corporation does not issue any other instruments with significant off-balance-sheet risk. The Corporation's exposure to credit loss in the event of nonperformance by the other party of the financial instrument for commitments to extend credit, standby letters of credit and commercial letters of credit written is represented by the contract or notional amount of those instruments. The Corporation uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments. The following table identifies the notional amount of those instruments at December 31, 1993 and 1992. 1993 1992 Financial instruments whose contract amounts represent credit risk: Commitments to extend credit $182,013 $153,319 Standby letters of credit $ 17,900 $ 11,858 Commercial letters of credit $ 65 $ 10 Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Corporation FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES ITEM 8. Financial Statements and Supplementary Data Notes to Consolidated Financial Statements Years Ended December 31, 1993, 1992 and 1991 (Dollar Amounts in Thousands) NOTE 8--Financial Instruments with Off-Balance-Sheet Risk (Continued) evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Corporation upon extension of credit, is based on management's credit evaluation of the counter-party. Collateral held varies but may include accounts receivable, inventory, property, plant and equipment, and income-producing commercial properties. Standby letters of credit and commercial letters of credit written are conditional commitments issued by the Corporation to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. NOTE 9--Premises and Equipment Premises and equipment are described as follows: 1993 1992 Land $ 3,615 $ 2,977 Buildings and improvements 22,200 21,084 Leasehold improvements 3,312 3,254 Furniture and equipment 20,377 19,221 Subtotal 49,504 46,536 Less accumulated depreciation and amortization 27,593 25,429 Total premises and equipment $21,911 $21,107 Depreciation and amortization related to premises and equipment was $3,008 in 1993, $2,637 and $1,901, in 1992 and 1991, respectively. FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES ITEM 8. Financial Statements and Supplementary Data Notes to Consolidated Financial Statements Years Ended December 31, 1993, 1992 and 1991 (Dollar Amounts in Thousands) NOTE 10--Interest-Bearing Deposits Components of interest-bearing deposits at December 31 were as follows: 1993 1992 N.O.W. and Super N.O.W. accounts $ 169,897 $ 168,130 Savings and MMDA accounts 426,640 411,380 Time deposits 811,781 797,827 Total interest-bearing deposits $1,408,318 $1,377,337 Included in time deposits at December 31 were certificates of deposit in denominations of $100 or more maturing as follows: 1993 1992 3 months or less $19,734 $ 25,289 3 to 6 months 12,543 15,906 6 to 12 months 16,542 11,140 Over 12 months 47,006 49,731 Total $95,825 $102,066 Interest expense related to $100 or greater certificates of deposit amounted to $5,426 in 1993, $7,389 in 1992, and $7,566 in 1991. Management's estimated fair value of deposits was $1,590,502 and $1,565,065 at December 31, 1993 and 1992, respectively. NOTE 11--Short-term Borrowings Short-term borrowings at December 31 were as follows: FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES ITEM 8. Financial Statements and Supplementary Data Notes to Consolidated Financial Statements Years Ended December 31, 1993, 1992 and 1991 (Dollar Amounts in Thousands) NOTE 11--Short-term Borrowings (Continued) Interest expense on short-term borrowings for the years ended December 31 is detailed below: 1993 1992 1991 Federal funds purchased $ 705 $ 169 $ 58 Borrowings from FHLB 753 -0- -0- Securities sold under agreements to repurchase 1,783 1,201 1,089 Treasury, tax and loan note option 255 353 422 Total interest on short-term borrowings $3,496 $1,723 $1,569 NOTE 12--Long-Term Debt Long-term debt at December 31, 1993 follows: Amount Rate Bank subordinated notes due September, 1997 $ 716 8.38% ESOP loan due September, 1997 2,678 80% of Prime Bank loan due December, 1997 2,000 Prime ESOP loan due March, 2001 1,770 Prime Mortgage note due October, 2003 199 6.26% Total long-term debt $7,363 All subordinated notes are unsecured and equally subordinated in right of payment to depositors and other creditors. The notes are redeemable at 102% of principal until maturity, at the bank's option. The subordinated notes do not provide for sinking fund obligations. Scheduled loan payments and subordinated note maturities are summarized below: 1994 1995 1996 1997 1998 Thereafter Loan payments $1,419 $1,483 $1,484 $1,307 $272 $682 Note maturities -0- -0- -0- 716 -0- -0- Total $1,419 $1,483 $1,484 $2,023 $272 $682 Management estimated the fair value of long-term debt at December 31, 1993 to be $7,433 and $8,207 at December 31, 1992. NOTE 13--Common Share Commitments At December 31, 1993 the Corporation had 25,000,000 common shares authorized and 18,642,024 shares outstanding after reflecting the two-for-one stock split effected in the form of a 100% stock dividend (see NOTE 22). The Corporation may be required to issue additional shares to satisfy common share purchases related to the employee stock ownership plan described in NOTE 15. FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES ITEM 8. Financial Statements and Supplementary Data Notes to Consolidated Financial Statements Years Ended December 31, 1993, 1992 and 1991 (Dollar Amounts in Thousands) NOTE 14--Federal Income Taxes As discussed in Note 1, effective January 1, 1993 the Corporation adopted FAS No. 109. As permitted under FAS No. 109, prior years' financial statements have not been restated. The adoption of this statement resulted in a cumulative benefit of $500 in 1993. This benefit was primarily due to lower tax rates in the year that FAS No. 109 was adopted than tax rates were in the years of purchase business combinations. The income tax provision consists of: 1993 1992 1991 Current tax provision for income before securities transactions $9,591 $7,229 $5,273 Securities transactions 817 231 230 Total current tax provision 10,408 7,460 5,503 Deferred tax provision (credit) on: Loan loss provision (327) (72) (404) Bond discount (53) (130) (62) Leasing income (432) (236) (44) Purchase accounting valuations (209) -0- -0- Depreciation (15) 110 31 Loan origination fees and costs 185 47 172 Other 162 (103) (171) Total deferred tax benefit (689) (384) (478) Total tax provision $9,719 $7,076 $5,025 Temporary differences between financial statement carrying amounts and tax bases of assets and liabilities that represent significant portions of the deferred tax assets (liabilities) at January 1, 1993 and December 31, 1993 were as follows: December January 31, 1, Reserve for possible loan losses $4,422 $4,095 Accumulated accretion of bond discount (278) (331) Lease financing deduction (149) (581) Purchase accounting valuations, other than excess purchase price (2,191) (2,400) Accumulated depreciation (348) (363) Unrealized gain on securities available for sale (851) -0- Loan origination fees and costs (192) (7) Other - net 325 487 Deferred tax asset balance $ 738 $ 900 Management does not feel a need to establish a valuation allowance against the deferred tax asset because of the Corporation's ability to recover previously paid taxes through carrybacks. FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES ITEM 8. Financial Statements and Supplementary Data Notes to Consolidated Financial Statements Years Ended December 31, 1993, 1992 and 1991 (Dollar Amounts in Thousands) NOTE 14--Federal Income Taxes (Continued) The total tax provision for financial reporting purposes differs from the amount computed by applying the statutory income tax rate to income before income taxes. The differences are as follows: NOTE 15--Retirement Plans All employees with at least one year of service are eligible to participate in the employee stock ownership plan. Contributions to the plan are determined by the board of directors, and are based upon a prescribed percentage of the annual compensation of all participants. These contributions are used to purchase the Corporation's common shares. Contributions to the plan were $622 in 1993, $680 in 1992 and $518 in 1991. The Corporation also has a savings plan pursuant to the provisions of section 401(k) of the Internal Revenue Code. Under the terms of the plan, each participant will receive an automatic employer contribution to the plan in an amount equal to 3% of compensation. Each participating employee may contribute up to 5% of compensation to the plan which is matched by the employer's contribution equal to 60% of the employee's contribution. The 401(k) plan expense was $1,158 in 1993, $984 in 1992, $875 in 1991. Statement of Financial Accounting Standards No. 106 ("FAS No. 106"), Employers' Accounting for Postretirement Benefits Other than Pensions established standards for accounting for postretirement benefits, primarily health care benefits. FAS No. 106 was effective for all fiscal years beginning after December 15, 1992. Since the Corporation generally does not offer these benefits, the impact on net income is not considered material. Employees of Central were covered by a noncontributory defined benefit plan, which covered substantially all of its employees. The plan was fully funded, and no contributions were made during the past three years. The net periodic cost was $16 during 1992. The plan was terminated during 1993 and Central employees were included in the Corporation's employee stock ownership plan and 401(k) plan. The plan termination resulted in a gain of $186 thousand recorded during 1993. FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES ITEM 8. Financial Statements and Supplementary Data Notes to Consolidated Financial Statements Years Ended December 31, 1993, 1992 and 1991 (Dollar Amounts in Thousands) NOTE 16--Deferred Compensation The Corporation had borrowed amounts which were concurrently loaned to the First Commonwealth Financial Corporation Employee Stock Ownership Plan Trust ("ESOP") on the same terms. The combined balances of the ESOP related loans were $4,449 at December 31, 1993. The loans have been recorded as long-term debt on the Corporation's consolidated balance sheets. A like amount of deferred compensation was recorded as a reduction of common shareholders' equity. Deferred compensation, included as a component of shareholders' equity, represents the Corporation's prepayment of future compensation expense. As the Corporation makes annual contributions to the ESOP, these contributions, plus dividends accumulated on the Corporation's common stock held by the ESOP, will be used to repay the loan to the Corporation. As the loan is repaid, common stock is allocated to the ESOP participants and deferred compensation is reduced by the amount of the principal payment on the loan. Interest on this loan was $245 in 1993 and $286 in 1992 and $382 in 1991. Dividends on common shares held in the ESOP used for debt service were $417 in 1993, $351 in 1992 and $289 in 1991. NOTE 17--Commitments and Contingent Liabilities During 1990, a subsidiary bank was named as a defendant in a forgery claim where the bank allegedly allowed checks bearing forged endorsements to be negotiated. Management feels that its maximum exposure is not significant and that it has adequate defenses for the claim. This action is being vigorously defended and, in the opinion of management, should be resolved in the bank's favor. There are no material legal proceedings to which the Corporation or its subsidiaries are a party, or of which any of their property is the subject, except proceedings which arise in the normal course of business and, in the opinion of management, will not have any material adverse effect on the consolidated financial position of the Corporation and its subsidiaries. The Corporation leases various premises and assorted equipment under noncancelable agreements. Total future minimum rental commitments at December 31, 1993 were as follows: 1994 1995 1996 1997 1998 Thereafter Total Premises $451 $352 $255 $212 $148 $805 $2,223 Equipment 171 36 17 1 -0- -0- 225 Total $622 $388 $272 $213 $148 $805 $2,448 Under the terms of various lease agreements, increases in utilities and taxes may be passed on to the lessee. Such adjustments are not reflected in the above table. Additionally, various lease renewal options are available and are not included in the minimum lease commitments until such options are exercised. Total lease expense amounted to $1,034 in 1993, $1,326 in 1992 and $1,248 in 1991. FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES ITEM 8. Financial Statements and Supplementary Data Notes to Consolidated Financial Statements Years Ended December 31, 1993, 1992 and 1991 (Dollar Amounts in Thousands) NOTE 18--Related Party Transactions Some of the Corporation's or its subsidiaries' directors, executive officers, principal shareholders and their related interests, had transactions with the subsidiary banks in the ordinary course of business during 1993. All loans and commitments to loans in such transactions were made on substantially the same terms, including collateral and interest rates, as those prevailing at the time for comparable transactions. In the opinion of management, these transactions do not involve more than the normal risk of collectibility nor do they present other unfavorable features. It is anticipated that further such extensions of credit will be made in the future. The following is an analysis of loans to those parties whose aggregate loan balances exceeded $60 during 1993. Balances December 31, 1992 $34,840 Advances 7,599 Repayments (17,307) Other 102 Balances December 31, 1993 $25,234 Three loans to two directors, or their related interests were placed on a nonaccrual status during 1992 due to cash flow deficiencies. The original loans were made on substantially the same terms as those prevailing at the time for comparable transactions. One loan to a director has been in compliance with the terms of the loan and has been removed from a nonaccrual status. The original amount of this loan was $616 and the balance at December 31, 1993 was $500. The remaining two loans to one director remained on a nonaccrual status during 1993. The original balances of these loans were $1,969 and the recorded balance of these loans at December 31, 1993 was reduced to $987. In the opinion of management, adequate amounts have been provided in the reserve for possible loan losses for these loans. NOTE 19--Dividend Restrictions The amount of funds available to the parent from its subsidiary banks is limited by restrictions imposed on all national banks by the Comptroller of the Currency and on all state chartered banks by the Pennsylvania Department of Banking. During 1993, dividends from subsidiary banks were restricted not to exceed $44,908. These restrictions have not had, and are not expected to have, a significant impact on the Corporation's ability to meet its cash obligations. NOTE 20--Jointly-Owned Company Investment in Commonwealth Trust Credit Life Insurance Company ("Commonwealth Trust"), a jointly-owned credit life reinsurance company in which the Corporation has a 50% interest in the voting common stock, is carried at cost, adjusted for the Corporation's proportionate share of the earnings. Dividends, if any, reduce the basis of the investment. Commonwealth Trust has been in operation since June of 1989. The Corporation's net investment in Commonwealth Trust at December 31, 1993 was $1,162 and income from its investment was $221 during 1993. FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES ITEM 8. Financial Statements and Supplementary Data Notes to Consolidated Financial Statements Years Ended December 31, 1993, 1992 and 1991 (Dollar Amounts in Thousands) NOTE 21--Condensed Financial Information of First Commonwealth Financial Corporation (parent company only) Balance Sheets December 31, 1993 1992 Assets Cash $ 2,571 $ 2,625 Investment in subsidiaries 187,054 171,568 Investment in jointly-owned company 1,162 941 Premises and equipment 1,181 890 Dividends receivable from subsidiaries 3,679 3,095 Receivable from subsidiaries 440 842 Other assets 279 397 Total assets $196,366 $180,358 Liabilities and Shareholders' Equity Accrued expenses and other liabilities $ 947 $ 399 Dividends payable 2,517 2,143 Loans payable 6,449 7,413 Shareholders' equity, exclusive of deferred compensation 190,902 175,316 Deferred compensation (4,449) (4,913) Total liabilities and shareholders' equity $196,366 $180,358 Statements of Income Years Ended December 31, 1993 1992 1991 Dividends from subsidiaries $13,490 $11,082 $11,085 Operating expenses (5,598) (4,893) (4,378) Income before taxes and equity in undistributed earnings of subsidiaries 7,892 6,189 6,707 Applicable income tax benefits 1,782 1,433 1,250 Income before equity in undistributed earnings of subsidiaries 9,674 7,622 7,957 Equity in undistributed earnings of subsidiaries 13,516 12,966 8,027 Net income $23,190 $20,588 $15,984 FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES ITEM 8. Financial Statements and Supplementary Data Notes to Consolidated Financial Statements Years Ended December 31, 1991, 1992 and 1991 (Dollar Amounts in Thousands) NOTE 21--Condensed Financial Information of First Commonwealth Financial Corporation (parent company only) (Continued) Statements of Cash Flows Years Ended December 31, 1993 1992 1991 Operating Activities Net income $ 23,190 $ 20,588 $ 15,984 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 1,190 865 723 Decrease (increase) in prepaid income taxes (262) (298) 911 Undistributed equity in subsidiaries (13,516) (12,966) (8,027) Other - net (11) (165) (618) Net cash provided by operating activities 10,591 8,024 8,973 Investing Activities Purchases of premises and equipment (499) (106) (300) Acquisition and additional investment in subsidiary (1,000) (3,950) -0- Net cash used by investing activities (1,499) (4,056) (300) Financing Activities Proceeds from issuance of long-term debt -0- 2,500 -0- Repayment of long-term debt (500) -0- -0- Tax benefit of ESOP dividend 84 119 97 Discount on dividend reinvestment plan purchases (159) (124) (80) Cash dividends paid (8,571) (6,860) (5,899) Net cash used by financing activities (9,146) (4,365) (5,882) Net increase (decrease) in cash (54) (397) 2,791 Cash at beginning of year 2,625 3,022 231 Cash at end of year $2,571 $2,625 $3,022 Supplemental schedule of noncash investing and financing activities The Corporation borrowed $250 in 1993 and $1,520 in 1991 and concurrently loaned these amounts to the ESOP on identical terms. The loans were recorded as long-term debt and the offset was recorded as a reduction of the common shareholders' equity. Loan payments in the amount of $714 were made during each of the three years ended 1993 thereby reducing the outstanding amount related to deferred compensation to $4,449 at December 31, 1993. FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES ITEM 8. Financial Statements and Supplementary Data Notes to Consolidated Financial Statements Years Ended December 31, 1991, 1992 and 1991 (Dollar Amounts in Thousands) NOTE 22--Subsequent Event On January 18, 1994, the Board of Directors declared a two-for-one stock split effected in the form of a 100% stock dividend in the amount of 9,321,012 shares payable on February 10, 1994. Accordingly, the average number of shares and all per share amounts have been restated to reflect the stock split on a retroactive basis. FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES ITEM 8. Financial Statements and Supplementary Data AUDITOR'S REPORT Report of Jarrett Stokes & Co. Independent Certified Public Accountants Board of Directors and Shareholders of First Commonwealth Financial Corporation Indiana, Pennsylvania We have audited the accompanying consolidated balance sheets of First Commonwealth Financial Corporation and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, changes in shareholders' equity and cash flows for each of the three years in the period ended December 31, 1993. These consolidated financial statements are the responsibility of the Corporation's management. Our responsibility is to express an opinion on these consolidated 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 consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated 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 First Commonwealth Financial Corporation and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed in NOTE 1 to the consolidated financial statements, the Corporation changed its method of accounting for income taxes and investments. JARRETT STOKES & CO. Indiana, Pennsylvania March 2, 1994 FIRST COMMONWEALTH FINANCIAL CORPORATION AND SUBSIDIARIES ITEM 8. Financial Statements and Supplementary Data Quarterly Summary of Financial Data - Unaudited (Dollar Amounts in Thousands, except per share data) The unaudited quarterly results of operations for the years ended December 31, 1993 and 1992 are as follows. All amounts have been restated to reflect pooling of interests. (a) Average number of shares outstanding has been restated to reflect two-for -one stock split effected in the form of a 100% stock dividend declared January 18, 1994. FIRST COMMONWEALTH FINANCIAL CORPORATION ITEM 9 ITEM 9 - DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10 ITEM 10 - DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information appearing in the definitive Proxy Statement related to the annual meeting of security holders to be held April 23, 1994 is incorporated herein by reference in response to the listing of directors. The table below lists the current executive officers of the Corporation. Name Age Positions Held During the Past Five Years E. James Trimarchi 71 Chairman of the Board, President and Chief Executive Officer of the Corporation, Chairman of the Board of FCTC and Chairman of the Board of CSC; Director of NBOC, Central, PBWPA and CTCLIC Joseph E. O'Dell 48 Senior Executive Vice President, Chief Operating Officer and Assistant Secretary/Treasurer of the Corporation, Director of Cenwest and FCTC, Vice Chairman of the Board of CSC Gerard M. Thomchick 38 Executive Vice President of the Corporation, President, Chief Executive Officer and Director of CTCLIC; Director of Deposit, Central and FCTC David R. Tomb, Jr. 62 Vice President, Secretary and Treasurer of the Corporation; Director of Leechburg, CSC, NBOC and CTCLIC John J. Dolan 37 Senior Vice President, Comptroller and Chief Financial Officer of the Corporation, Chief Financial Officer/Comptroller of CTCLIC, Treasurer and Assistant Secretary of FCTC, Director of Peoples George E. Dash 43 Senior Vice President/Sales and Marketing, Director of Central Johnston A. Glass 44 President and Chief Executive Officer of NBOC, Director of the Corporation William Miksich 58 President and Chief Executive Officer of Deposit Bank Each of the officers identified above has held the position indicated above or other executive positions with the same entity (or a subsidiary thereof) for at least the past five years. Executive officers of the Corporation serve at the pleasure of the Board of Directors of the Corporation and for a term of office extending through the election and qualification of their successors. FIRST COMMONWEALTH FINANCIAL CORPORATION ITEM 11 ITEM 11 - MANAGEMENT RENUMERATION Information appearing in the definitive Proxy Statement related to the annual meeting of security holders to be held April 23, 1994 is incorporated herein by reference in response to this item. ITEM 12 ITEM 12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information appearing in the definitive Proxy Statement related to the annual meeting of security holders to be held April 23, 1994 is incorporated herein by reference in response to this item. ITEM 13 ITEM 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information appearing in the definitive Proxy Statement related to the annual meeting of security holders to be held April 23, 1994 is incorporated herein by reference in response to this item. PART IV ITEM 14 ITEM 14 - EXHIBITS, FINANCIAL STATEMENTS SCHEDULES AND REPORTS ON FORM 8-K (A) Documents Filed as Part of this Report 1) Financial Statements All financial statements of the registrant as set forth under Item 8 of this Report on Form 10-K. 2) Financial Statement Schedules Schedule Number Description Page I Indebtedness to Related Parties N/A II Guarantees of Securities of Other Issuers N/A Page Number or Exhibit Incorporated by 3) Number Description Reference to 3.1 Articles of Incorporation Exhibit 2 to Form 8-A filed May 8, 1992 3.2 By-Laws of Registrant Exhibit 3.2 to Form S-4 filed October 15, 10.1 Employment Contract Exhibit 10.1 to Form Ronald C. Geiser S-14 Registration Statement dated July 19, 1985. 10.2 Employment Contract Exhibit 10.2 to Form Sumner E. Brumbaugh S-4 Filed October 15, 21.1 Subsidiaries of the Registrant 23.1 Consent of Jarrett.Stokes & Co. Certified Public Accountants 24.1 Power of Attorney (B) Report of Form 8-K Not applicable. FIRST COMMONWEALTH FINANCIAL CORPORATION 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, in Indiana, Pennsylvania, on the 18th day of March 1994. FIRST COMMONWEALTH FINANCIAL CORPORATION (Registrant) /S/DAVID R. TOMB, JR. David R. Tomb, Jr., Vice President Secretary/Treasurer

1993 ITEM 1. BUSINESS The company was founded in 1918 and has been a leader in consumer electronics, first in radio and later in monochrome and color television and other video products. The company's operations involve a dominant industry segment, the design, development, and manufacture of video products (including color television sets and other consumer products) along with parts and accessories for such products. These products along with purchased video cassette recorders are sold principally to retail dealers and wholesale distributors in the United States, Canada and other foreign countries. Independently owned and operated distributors sell to retail dealers who, in turn, sell to consumers. The company sells directly to retail dealers, buying groups, private label customers and the lodging, health care and rent-to-own industries. Also included in the company's video products business are color picture tubes that are produced for and sold to other manufacturers; video monitors which are primarily produced for and sold to computer manufacturers; and cable and subscription television products which are sold primarily to cable television operators. The company also makes power supplies and high-security electronic equipment. During 1993, the monochrome video monitor business was sold and the company reached an agreement (subject to certain contingencies) to sell the power supply business in early 1994. Raw Materials Many materials, such as copper, plastic, steel, wood, glass, aluminum and zinc, are essential to the business. The company experienced shortages in 1993 of picture tube glass and certain other components. Shortages may possibly recur in 1994. Patents The company is licensed under a number of patents which are of importance to its business, and holds numerous patents that expire at various times through 2010. The company has patents and patent applications for numerous high-definition television (HDTV) related inventions. To the extent these inventions are incorporated into the HDTV standard adopted by the Federal Communications Commission, any royalties resulting from these patents would be pooled and shared with the other participants of the Grand Alliance formed in 1993 by the company and other proponents of various HDTV systems. Non-HDTV applications of these patents could produce royalties which would accrue entirely to the company. In addition, major manufacturers of televisions and video cassette recorders agreed during 1992 to take licenses under some of the company's U.S. tuning system patents (the licenses expire in 2003). Based on 1993 U.S. industry unit sales levels and technology, more than $20 million in annual royalty income is expected. While in the aggregate its patents and licenses are valuable, the business of the company is not materially dependent on them. Seasonal Variations in Business Sales of the company's consumer electronics products are generally at a higher level during the second half of the year. Sales of consumer electronics products typically increase in the fall, as the summer vacation season ends and people spend more time indoors, with the new fall programming on the television networks, and during the Christmas holiday season. During 1993, 1992 and 1991, approximately 54 percent, 56 percent and 56 percent, respectively, of the company's net sales were recorded in the second half of the year and approximately 30 percent of the company's net sales were recorded in the fourth quarter of each of the three years ended December 31, 1993. Competitive Conditions Competitive factors in North America include price, performance, quality, variety of products and features offered, marketing and sales capabilities, manufacturing costs, and service and support. The company believes it competes well with respect to each of these factors. The company's major product areas, including the color television market, are highly competitive. The company's major competitors are foreign-owned global giants, generally with greater worldwide television volume and overall resources. In efforts to increase market share or achieve higher production volumes, the company's competitors have aggressively lowered their selling prices in the past several years. Some of the company's foreign competitors have been capable of offsetting the effects of U.S. price reductions through sales at higher margins in their home markets and through direct governmental supports. During 1993, the company continued to pursue efforts to reduce unfair competition from television imports. Research and Development During 1993, expenditures, net of outside funding, for company-sponsored engineering and research relating to new products and services and to improvements of existing products and services amounted to $47.8 million. Amounts expended in 1992 and 1991 were $55.4 million and $54.1 million, respectively. Environmental Issues Compliance with Federal, State and local environmental protection provisions is not expected to have a material effect on capital expenditures, earnings or the competitive position of the company. Further information regarding environmental compliance is set forth under Item 3 of this report. Number of Employees At the end of December 1993, the company employed approximately 22,100 people, of whom approximately 15,600 are hourly workers covered by collective bargaining agreements. Approximately 4,400 of the company's employees are located in the Chicago, Illinois area, of whom approximately 2,800 are represented by unions. Approximately 16,700 of the company's employees are located in Mexico, of whom approximately 12,400 are represented by unions. Mexican labor contracts expire every two years and wages are renegotiated annually. The company believes that its relations with its employees are good. Financial Information about Foreign and Domestic Operations and Export Sales The North American Free Trade Agreement (NAFTA), which took effect on January 1, 1994, will significantly reduce duty costs in 1994 and beyond. This should improve the company's ability to compete against Asian imports in North America and is expected to increase sales of the company's color television receivers in Mexico and Canada and color picture tube production in the U.S. Since the passage of the NAFTA, the company has added more than 300 U.S. jobs that are directly related to increased demand for U.S. picture tubes. Information regarding foreign operations is included in "Note Five - Geographic Segment Data" on page 36 of this report. Export sales are less than 10% of consolidated net sales. The company's product lines are dependent on the continuing operations of the company's manufacturing and assembly facilities located in Mexico. ITEM 2. ITEM 2. PROPERTIES The company utilizes a total of approximately 6.7 million square feet for manufacturing, warehousing, engineering and research, administration and distribution, as described below. In addition, the company owns 95 acres of vacant land adjacent to its Glenview, Illinois headquarters, which is available for sale. Square Feet Location Nature of Operation (in millions) - ------------------- ------------------------------------- ------------ Domestic: - ------------------- Chicago, Illinois Six locations - production of color 2.7 (1) (including suburban picture tubes; parts and service; engi- locations) neering and research, marketing and administration activities; and assembly of electronic components Springfield, Missouri Production of plastic cabinets for 1.0 (2) color television and other plastic parts; and warehouses and distribution McAllen, El Paso and Four locations - warehouses .2 Brownsville, Texas; Douglas, Arizona Various Nine locations - domestic distribution .2 Foreign: - ------------------- Mexico Fourteen manufacturing and warehouse 2.4 (3) locations - sub-assembly production of television chassis, tuners, wooden television cabinets and other components and final assembly of color television, color video monitors and cable products; and assembly of power supplies Canada Three locations - distribution of .2 consumer electronics products Taiwan One location - purchasing office - ------- Total 6.7 ======= (1) The company owns a 500,000 square foot warehouse in Northlake, Illinois of which 100,000 square feet is used for storage (included in the above table) with the remainder leased to another company (not included in the above table). A contract is currently pending to sell the entire facility to this lessee and to thereafter vacate that portion currently occupied by the company. (2) The company owns a 400,000 square foot warehouse in Springfield, Missouri which is being leased to another company and as such is not included in the above table. A contract is currently pending to sell the entire 1.7 million square foot facility to this lessee and to leaseback that portion the company is currently utilizing. The company expects to vacate this space by mid - 1995. (3) The company owns, and has offered for sale or lease, 230,000 square feet of manufacturing and warehousing space in Chihuahua, Mexico. Currently this space is not being utilized by the company and as such is not included in the above table. The company's facilities are suitable and adequate to meet current and anticipated requirements. Substantially all of the total square footage of property used is owned by the company. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The company is involved in various legal actions, environmental matters, patent claims, and other proceedings relating to a wide range of matters that are incidental to the conduct of its business. The company believes, after reviewing such matters with the company's counsel, that any liability which may ultimately be incurred with respect to these matters is not expected to have a material effect on either the company's consolidated financial position or results of operations. The company and other potentially responsible parties have completed negotiations with the United States and the State of Indiana with respect to settlement of certain natural resources claims for environmental damage that were not disposed of in settlement of the so-called Midco environmental litigation at Gary, Indiana. On March 26, 1993, the company signed the Amendment to Consent Decree and the Midco Natural Resources Participation Agreement. The company's share of the settlement was approximately $100,000 which was paid during 1993. On April 27, 1993, the U.S. Environmental Protection Agency sent written notices to all potentially responsible parties, advising the parties of the EPA's proposed plan of remediation at the American Chemical Services site near Griffith, Indiana. The EPA notified the parties that they would be expected to make a good faith offer to perform the remedial action and thereafter to negotiate and enter into a consent decree with the agency. The EPA estimates that the cost of remedial action could range from $38 to $64 million, depending upon the type of remedy actually needed to effect the cleanup. The company is alleged to have contributed less than one-tenth of one percent of the hazardous waste identified at the site. The company and other de minimus waste generators intend to seek a separate de minimus settlement with the EPA. In October 1989, the EPA filed a civil action against certain generator and owner/operator defendants under CERCLA seeking reimbursement for its response costs in connection with an environmental cleanup at a site located at Collegeville, Pennsylvania. One of the original defendants to the EPA case brought a third party action for contribution against a number of third party defendants, including Ford Electronics and Refrigeration Corporation ("FERCO"). FERCO is now seeking $600,000 in contribution from the company on the ground that FERCO is being held liable in part because it hauled certain waste from the company's former Lansdale, Pennsylvania picture tube plant. The claim is now under investigation. Numerous lawsuits against major computer and peripheral equipment manufacturers are pending in the U.S. District Court, Eastern District of New York, the U.S. District Court of New Jersey as well as in the New York State courts. These lawsuits seek several billion dollars in damages from various defendants for repetitive stress injuries claimed to have been caused by the use of word processor equipment. The company has been named as a defendant in sixteen of these cases which relate to keyboards allegedly manufactured by the company for its former subsidiary, Zenith Data Systems Corporation. Plaintiffs in the company's cases seek to recover $22 million actual and $230 million punitive damages from the company. The company believes it has meritorious defenses to the cases. In April, 1993, a group of 47 plaintiffs, individually and on behalf of certain minors and decedents, filed suit in the District Court of Cameron County, Texas against 130 defendants, including the company's subsidiaries, Zenith Electronics Corporation of Texas and Electro Partes de Matamoros, S.A. de C.V., alleging that plaintiffs suffered injuries or death as a result of defendants' negligence, negligent design for and implemented practices of managing, handling, storage, transportation, utilization and disposal of toxic compounds. Plaintiffs seek judgment for actual and exemplary damages against defendants, jointly and severally, in an unspecified amount. The company's two subsidiaries filed answers denying the material allegations of the complaint. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matter was submitted to a vote of security holders during the fourth quarter of 1993, through the solicitation of proxies or otherwise. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS The New York Stock Exchange is the principal United States market in which the company's common stock is traded. The number of stockholders of record was 16,636 as of February 18, 1994. No dividends were paid to stockholders during the two years ended December 31, 1993. The high and low price range by quarter for the past two years is listed below: ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Five-Year Summary of Selected Financial Data ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Analysis of Operations Operating Results -- 1993 vs. 1992 The operating loss before special charges for restructuring and other actions was $51 million in 1993 and $61 million in 1992. Consolidated sales in 1993 were $1,228 million, down 1% from $1,244 million in 1992. The decline was principally due to lower sales in the noncore product areas and lower consumer product pricing, largely offset by higher unit volume in the consumer product line. The effect on operating results of unit volume increases in consumer products was offset by volume declines in the non-core product areas. Substantial cost reductions in all product areas of about $75 million resulted from process and design improvements, consolidation of operations in Mexico, headcount reductions and other operating changes. These cost reductions were offset by $42 million in consumer products price reductions that had been implemented throughout 1992 and early 1993, and $20 million of inflationary cost increases, primarily labor costs in Mexico. Despite the adverse impact of an industry glass shortage, industry color TV unit sales to dealers rose 11 percent in 1993 (following an 11 percent increase in 1992) to set a new record. Zenith's unit sales increase outpaced the industry growth, leading to an increase in market share. While industry unit sales to dealers of video cassette recorder decks remained about equal to 1992, Zenith's volume increased. Unit sales of color picture tubes to other TV manufacturers decreased in 1993 because the company used more of its capacity to support increased sales of Zenith color TVs and because of an industry glass shortage, which also adversely impacted Zenith color TV sales. Additional picture tube capacity became available in late 1993 when the dedicated FTM tube production line was converted to be able to produce both television and monitor picture tubes. Operating results were improved by the full year effect of certain manufacturing operations that were consolidated in Mexico during 1992, as well as continued efforts to reduce headcounts and product costs. These programs, together with new manufacturing process improvements that were initiated in late 1993, should have a positive effect on 1994 operations. Sales of cable products declined in 1993 as a new product for a major contract manufacturing customer was delayed. However, due to major cost savings associated with headcount reductions and consolidations of manufacturing operations, operating results improved compared to 1992. Sales of other products decreased in 1993 as Zenith downsized its non- core magnetics and monitor product areas. However, the cost structures of these areas were improved so that operating results in 1993 were somewhat better than 1992. During the year, the monochrome monitor business was sold (production ended in early 1994) and the company reached an agreement (subject to certain contingencies) to sell the power supply business in early 1994. Operating results in 1994 should benefit from these actions. Engineering and research expenses were $48 million in 1993, compared to $55 million in 1992, with reductions principally in non-core product areas. Selling, general, and administrative expenses declined slightly to $93 million in 1993 from $94 million. These improvements were primarily the result of headcount reductions initiated in late 1992. Other operating income (net) increased to $25 million from $24 million in 1993, as a result of increased royalty income from new licensing activities. Royalty income arising from licensing of Zenith patented tuning-system technology to other color TV and VCR manufacturers was about $26 million in both 1993 and 1992 and is included in Other operating income (net). Based on 1993 U.S. industry unit sales levels and technology, more than $20 million in annual royalty income is expected. Interest expense (net) of $15 million in 1993 was higher than 1992's $13 million as a result of increased average borrowings. The income tax credit in 1992 consisted principally of the reversal of previously accrued tax reserves no longer required in connection with earnings of a foreign subsidiary, and net operating loss carryback applications. Operating Results - 1992 vs. 1991 The operating loss before special charges for restructuring and other actions was $61 million in 1992, compared with $42 million in 1991. Consolidated sales in 1992 were $1,244 million, down 6% from $1,322 million in 1991. The decline was principally due to price reductions and lower unit shipments of consumer electronics products. Cost reductions of about $50 million in 1992 were more than offset by the price reductions and lower consumer electronics unit sales volumes, by sales declines in other categories, and by the effect of increases in the costs of labor, material and services. After two years of declines (approximately 4 percent in both 1990 and 1991), industry color TV unit sales to dealers rose 11 percent in 1992 to a new record level. However, unit shipments of Zenith color TVs declined in 1992, principally as a result of delayed responses to price reductions initiated by competitors during the year. Pricing declined by $21 million in 1992, compared with 1991. Industry sales to dealers of video cassette recorder products increased in 1992. Zenith shipments declined, partially as a result of the company's planned phaseout of camcorders due to inadequate margins. Zenith unit sales of color picture tubes to other TV manufacturers increased in 1992 as the domestic industry increased. The benefits of transferring certain consumer electronics manufacturing operations to Mexico began to be realized in 1992, but were offset in part by startup costs. Sales and operating results for cable products declined in 1992 due to the continuing deferral of equipment purchases by U.S. cable operators. Computer monitor sales increased in 1992, compared with 1991, but operating results were adversely affected by costly new-product start-up and by costs associated with moving monochrome monitor operations from Taiwan to Mexico. Sales of other products declined in 1992 from the prior year, primarily due to reduced lighting products requirements by a customer and the phasing out of several low-margin products. Selling, general and administrative expenses declined to $94 million in 1992 from $101 million in 1991 as a result of reduced compensation and other costs. Engineering and research expenses were $55 million in 1992, compared with $54 million in 1991. Other operating income (net) increased sharply to $24 million in 1992 from $0.5 expense in 1991, principally as a result of $26 million of royalty income arising from licensing of Zenith patented tuning-system technology to other color TV and VCR manufacturers. Interest expense (net) of $13 million in 1992 was higher than 1991's $9 million as a result of increased average borrowings. The income tax credit in 1992 consisted principally of the reversal of previously accrued tax reserves no longer required in connection with earnings of a foreign subsidiary, and net operating loss carryback applications. Operating results for 1991 include a gain on the sale of Zenith's Taiwan monochrome monitor plant which was offset by restructuring charges related to the consolidations of color TV and monitor assembly operations in Mexico. Restructuring and Other Charges In the fourth quarter of 1993, the company initiated major restructuring, re-engineering and other actions designed to reduce ongoing operating expenses and to revalue certain assets. Special charges for these actions were $31 million. The computer monitor and magnetics product areas were restructured in order to downsize production capacity to be more in line with expected reduced levels of business. The charge includes the anticipated expenses of the major efforts to re-engineer processes in all areas of the core business's operations. Major elements of this charge were the non-cash writedown of fixed assets and inventory ($23 million) as well as re-engineering and severance costs ($6 million) to be paid during 1994 and early 1995. The restructuring actions are expected to reduce 1994 operating expenses including reduced compensation expense of about $10 million and reduced depreciation of about $4 million. The 1992 results also included special charges for restructuring and other actions of $48 million. Included in the actions were manufacturing consolidations and related employment reductions in Mexico; consolidation of company-owned distribution; and salaried employment reductions throughout the company. In addition to valuation reserves for inventories and manufacturing equipment ($22 million) and severance and relocation costs ($18 million) of which $11 million was paid in 1993, the special charges also provided for trade-receivable write-offs ($6 million). Liquidity and Capital Resources Following is a three-year summary of cash provided and used: Liquidity Cash decreased $35 million during the three year period of 1991-1993. The decrease consisted of $53 million of cash used by operating activities and $75 million , net , used to purchase fixed assets. These uses of cash were offset by $93 million of cash provided from financing activities which included the issuance of long-term debt and sales of the company's common stock. Operating activities: In 1993, $28 million of cash was used by operating activities mainly to fund $45 million of net losses from operations as adjusted for depreciation and fixed asset write downs as a part of restructuring and other charges. A decrease in current accounts provided $3 million of cash and was composed of a $15 million decrease in receivables offset by a $8 million increase in inventories and a $4 million decrease in accounts payable and accrued expenses. The decrease in receivables was due to lower sales. Also, the company reduced cash used by operating activities by issuing common stock to the profit-sharing retirement plans to fulfill both the 1992 obligation to salaried employees and the 1993 obligation to salaried employees and a portion of the hourly employees. These issuances increased stockholders' equity by $15 million. In 1992, $16 million of cash was used by operating activities mainly to fund $64 million of net losses from operations as adjusted for depreciation, fixed asset write downs as a part of a restructuring and a loss on the disposition of properties. This was offset by cash provided from a $41 million decrease in current accounts composed of a $39 million decrease in inventories and a $21 million decrease in receivables, offset by a $15 million decrease in net income taxes payable and a $4 million decrease in accounts payable and accrued expenses. Also, the company reduced cash used by operating activities by issuing common stock to the profit-sharing retirement plan to fulfill the 1991 obligation to salaried employees, increasing stockholders' equity by $6 million. In 1991, $9 million of cash was used by operating activities mainly to fund $23 million of net losses from operations, as adjusted for depreciation and a gain on the sale of properties. This was offset by cash provided from a $13 million decrease in current accounts which consisted mainly of a $12 million decrease in inventories. Investing activities: In 1993, investing activities used $26 million of cash for capital additions. In 1992, $25 million of cash was used which consisted of capital additions of $32 million offset by $7 million of proceeds from a 1991 property sale. In 1991, $24 million of cash was used which consisted of capital additions of $37 million offset by $13 million of proceeds from property sales. Financing activities: In 1993, financing activities provided $69 million of cash which included $55 million provided from the sale of 8.5% senior subordinated convertible debentures and $24 million provided from sales of the company's common stock (including option exercises). This was offset by $10 million of cash used to repay borrowings under the company's working capital Credit Agreement with a lending group led by General Electric Capital Corporation (the "Credit Agreement"). In 1992, financing activities provided $11 million of cash which included $10 million provided from borrowings under the company's revolving credit and security agreement and $1 million provided from the exercise of stock options. In 1991, financing activities provided $13 million of cash which included $15 million provided from the sale of common stock to GoldStar Co. Ltd., offset by $2 million used to repurchase a portion of the 12 1/8% notes in a private transaction. Capital Resources As of December 31, 1993, total interest-bearing obligations of the company consisted of $170 million of long-term debt , $35 million of long-term debt classified as current and $9 million of extended-term payables with a foreign supplier. The company's long-term debt is composed of $115 million of convertible subordinated debentures due 2011 that require annual sinking fund payments of $6 million beginning in 1997 and $55 million aggregate principal amount of 8.5% senior subordinated convertible debentures due 2000 that were issued and sold during 1993 in a private placement. The $35 million of long-term debt classified as current represents notes due January 1995 that were redeemed by the company in January 1994. In May 1993, the company entered into the Credit Agreement. The maximum commitment for funds available for borrowing under the Credit Agreement is $90 million, but is defined by a defined borrowing base formula related to eligible accounts receivable and inventory. The company used the initial advance under the agreement to repay all amounts outstanding under its former bank agreement, which was simultaneously terminated. The Credit Agreement contains restrictive financial covenants that must be maintained as of the end of each fiscal quarter, including a liabilities to net worth ratio and a minimum net worth amount. As a result of the company's fourth quarter 1993 restructuring charge of $31 million the agreement was amended in January 1994 to relax these financial covenants as of December 31, 1993. The Credit Agreement terminates on December 31, 1994 (unless extended by agreement of the lenders), at which time all outstanding indebtedness under the agreement would have to be refinanced. There can be no assurance that the Credit Agreement will be extended or refinanced. As of December 31, 1993, no borrowings were outstanding under the Credit Agreement in keeping with the seasonal nature of the company's working capital needs. A Registration Statement filed with the Securities and Exchange Commission covering 5 million shares of common stock became effective in May 1993. During 1993, the company sold approximately 3.4 million shares of authorized but unissued shares of common stock to investors under this shelf registration for approximately $23 million, net of expenses. Subsequent to December 31, 1993, the company sold the remaining shares available under the shelf registration. Thereafter, in order to take advantage of favorable market conditions, the company determined to file another Registration Statement with the Securities and Exchange Commission covering an additional 2 million shares of common stock. The new Registration Statement became effective in February 1994, and the company subsequently sold the 2 million shares registered thereunder to investors on the open market. The 1994 common stock sales under both registration statements generated approximately $34 million, net of expenses. On March 1, 1994, the company announced its intention to file a Registration Statement for 5 million shares of the company's common stock to be sold by means of a prospectus. In addition, during January 1994, the company issued and sold $12 million aggregate principal amount of 8.5% senior subordinated convertible debentures due 2001 (similar to the $55 million sold during 1993) in a private placement and, as indicated above, also redeemed the $35 million of notes due January 1995 at a redemption price equal to par value plus accrued interest. Although the company believes that the Credit Agreement, together with extended-term payables expected to be available from a foreign supplier and its continuing efforts to obtain other financing sources, will be adequate to meet its seasonal working capital and other needs in 1994, there can be no assurance that the company will not experience liquidity problems in the future because of adverse market conditions or other unfavorable events. In such event, the company would be required to seek other sources of liquidity, if available. Outlook The company's major product areas, including the color television market, are highly competitive. The company's major competitors are foreign-owned global giants, generally with greater worldwide television volume and overall resources. In efforts to increase market share or achieve higher production volumes, the company's competitors have aggressively lowered their selling prices in the past several years. Some of the company's foreign competitors have been capable of offsetting the effects of U.S. price reductions through sales at higher margins in their home markets and through direct governmental supports. There can be no assurance that such competition will not continue to adversely affect the company's performance or that the company will be able to maintain its market share in the face of such competition. Price competition continued in the first quarter of 1994, and the company selectively reduced color television prices to maintain its historical competitive price position. The North American Free Trade Agreement (NAFTA), which took effect on January 1, 1994, will significantly reduce duty costs in 1994 and beyond. This should improve the company's ability to compete against Asian imports in North America and is expected to increase sales of the company's color television receivers in Mexico and Canada and color picture tube production in the U.S. In light of the company's losses from continuing operations, competitive environment and inflationary cost pressures (including labor costs in Mexico where labor contracts expire every two years and wages are renegotiated annually), the company has undertaken major cost reduction programs each year. In 1994, the company expects to reduce costs by about $50 million from continued process and design improvements, headcount reductions and other operating changes. The company continues to seek additional cost reduction opportunities for 1994 and beyond, although there can be no assurance that any such cost reductions will be achieved. Also, as in 1993, the company may experience an adverse impact as industry shortages of picture tube glass or other components continue in 1994. The goals of the company's business strategy are to improve profitability, to introduce new products (such as home theater TVs), to develop new products (such as digital cable products incorporating the company-developed transmission technology selected in February 1994 by the HDTV Grand Alliance and the FCC Advisory Committee review panel), and to re-engineer operations. This strategy is expected to continue to involve significant expenditures by the company in 1994 and beyond. There can be no assurance that the company will achieve the goals of its business strategy, including an expected improvement in financial results. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The financial information required by Item 8 is contained in Item 14 of Part IV (page 15) of this report. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information concerning directors is incorporated herein by reference from the sections entitled "Election of Directors", "Nominees for Election as Directors" and "Board of Directors, Committees and Directors' Compensation" from the company's definitive Proxy Statement, copies of which will be electronically transmitted to the Commission via EDGAR. EXECUTIVE OFFICERS OF THE REGISTRANT Name Office Held Age - -------------------- ------------------------------------------ --------- Jerry K. Pearlman Chairman and Chief Executive 55 Officer since 1983; Chairman, President and Chief Executive Officer 1983-1993 Gerald M. McCarthy Executive Vice President and 52 member of the Office of the Chairman since 1993; Senior Vice President, Sales and Marketing and member of the Office of the President 1991 - 1993. President, Zenith Sales Company Division since 1983 Albin F. Moschner President and Chief Operating Officer 41 and member of the Office of the Chairman since 1993; Senior Vice President, Operations and member of the Office of the President 1991 - Kell B. Benson Vice President-Finance and Chief 46 Financial Officer since 7/89; Vice President-Controller 1989; Corporate Controller 1987-1989; Director, Financial Control- Consumer and Cable Products 1983-1987 Michael J. Kaplan Vice President-Human Resources since 54 1993; Vice President-Human Resources and Public Affairs 1988 - 1993; Director of Personnel and Industrial Relations 1982-1988 John Borst, Jr. Vice President-General Counsel 66 since 1985 ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Incorporated by reference from the sections entitled "Summary Compensation Table", "Employment Agreement", "Termination and Change of Control Agreements", "Option Grants in 1993", "Option Exercises in 1993 and Year-End Option Values" and "Compensation Committee Report on Executive Compensation" from the company's definitive Proxy Statement, copies of which will be electronically transmitted to the Commission via EDGAR. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Incorporated by reference from the sections entitled "Security Ownership of Certain Beneficial Owners" and "Security Ownership of Management" from the company's definitive Proxy Statement, copies of which will be electronically transmitted to the Commission via EDGAR. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS No material transactions occurred during 1993. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) 1. The following Consolidated Financial Statements of Zenith Electronics Corporation, the Report of Independent Public Accountants, and the Unaudited Quarterly Financial Data are included in this report on pages 30 through 42: Statements of Consolidated Operations and Retained Earnings - Years ended December 31, 1993, 1992 and 1991 Consolidated Balance Sheets - December 31, 1993 and 1992 Statements of Consolidated Cash Flows - Years ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements Report of Independent Public Accountants Unaudited Quarterly Financial Data (a) 2. The following consolidated financial statement schedules for Zenith Electronics Corporation are included in this report on pages 25 through 29: Schedule V - Property, Plant and Equipment Schedule VI - Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment Schedule VIII - Valuation and Qualifying Accounts Schedule IX - Short-term Borrowings Schedule X - Supplementary Income Statement Information The Report of Independent Public Accountants on Financial Statement Schedules is included in this report on page 24. All other schedules for which provision is made in Regulation S-X of the Securities and Exchange Commission, are not required under the related instructions or are inapplicable and, therefore, have been omitted. 3. Exhibits: (3a) Restated Certificate of Incorporation of the company, as amended (incorporated by reference to Exhibit 3a of the company's Report on Form 10-K for the year ended December 31, 1992) (3b) Certificate of Amendment to Restated Certificate of Incorporation of the company dated May 4, 1993 (incorporated by reference to Exhibit 4l of the company's Quarterly Report on Form 10-Q for the quarter ended April 3, 1993) (3c) By-Laws of the company, as amended (incorporated by reference to Exhibit 3 of the company's Current Report on Form 8-K, dated January 31, 1994) (4a) Indenture, dated as of January 15, 1985, for 12-1/8% Notes due 1995 with the Irving Trust Company (incorporated by reference to Exhibit 2 of the company's Report on Form 10-K for the year ended December 31, 1989) (4b) Indenture, dated as of April 1, 1986, for 6-1/4% Convertible Subordinated Debentures due 2011 with The First National Bank of Boston, Trustee (incorporated by reference to Exhibit 1 of the company's Quarterly Report on Form 10-Q for the quarter ended March 30, 1991) (4c) Stockholder Rights Agreement dated as of October 3, 1986 (incorporated by reference to Exhibit 4c of the company's Quarterly Report on Form 10-Q for the quarter ended September 28, 1991) (4d) Amendment, dated April 26, 1988, to Stockholder Rights Agreement (incorporated by reference to Exhibit 4d of the company's Quarterly Report on Form 10-Q for the quarter ended April 3, 1993) (4e) Amended and Restated Summary of Rights to Purchase Common Stock (incorporated by reference to Exhibit 4e of the company's Quarterly Report on Form 10-Q for the quarter ended July 3, 1993) (4f) Amendment, dated July 7, 1988, to Stockholder Rights Agreement (incorporated by reference to Exhibit 4f of the company's Quarterly Report on Form 10-Q for the quarter ended July 3, 1993) (4g) Agreement, dated May 23, 1991, among Zenith Electronics Corporation, The First National Bank of Boston and Harris Trust and Savings Bank (incorporated by reference to Exhibit 1 of Form 8, dated May 30, 1991) (4h) Amendment, dated May 24, 1991, to Stockholder Rights Agreement (incorporated by reference to Exhibit 2 of Form 8 dated May 30, 1991) (4i) Agreement, dated as of February 1, 1993, among Zenith Electronics Corporation, Harris Trust and Savings Bank and The Bank of New York (incorporated by reference to Exhibit 1 of Form 8 dated March 25, 1993) (4j) Credit Agreement, dated as of May 21, 1993, with General Electric Capital Corporation, as agent and lender, and the other lenders named therein (incorporated by reference to Exhibit 4 of the company's Current Report on Form 8-K dated May 21, 1993) (4k) Amendment No. 1 dated November 8, 1993 to the Credit Agreement dated May 21, 1993, with General Electric Capital Corporation, as agent and lender, and the other lenders named therein (incorporated by reference to Exhibit 4(b) of the company's Current Report on Form 8-K, dated November 19, 1993) (4l) Amendment No. 3 dated January 7, 1994 to the Credit Agreement dated May 21, 1993, with General Electric Capital Corporation, as agent and lender, The Bank of New York Commercial Corporation, as lender, and Congress Financial Corporation, as lender (incorporated by reference to Exhibit 4(b) of the company's Current Report on Form 8-K dated January 11, 1994) (4m) Fourth Amendment dated January 28, 1994 to the Credit Agreement dated May 21, 1993, with General Electric Capital Corporation, as agent and lender, The Bank of New York Commercial Corporation, as lender, and Congress Financial Corporation, as lender (incorporated by reference to Exhibit 4 of the company's Current Report on Form 8-K dated January 31, 1994) (4n) Debenture Purchase Agreement dated as of November 19, 1993 with the institutional investors named therein (incorporated by reference to Exhibit 4(a) of the company's Current Report on Form 8-K dated November 19, 1993) (4o) Amendment No. 1 dated November 24, 1993 to the Debenture Purchase Agreement dated as of November 19, 1993 with the institutional investor named therein (incorporated by reference to Exhibit 4(a) of the company's Current Report on Form 8-K dated November 24, 1993) (4p) Amendment No. 2 dated January 11, 1994 to the Debenture Purchase Agreement dated as of November 19, 1993 (incorporated by reference to Exhibit 4(c) of the company's Current Report on Form 8-K dated January 11, 1994) (4q) Debenture Purchase Agreement dated as of January 11, 1994 with the institutional investor named therein (incorporated by reference to Exhibit 4(a) of the company's Current Report on Form 8-K dated January 11, 1994) *(10a) 1987 Zenith Stock Incentive Plan (as amended subject to shareholder approval on April 28, 1992) (incorporated by reference to Exhibit A of the company's definitive Proxy Statement dated March 13, 1992) *(10b) Form of Amended and Restated Employment Agreement with Jerry K. Pearlman, Gerald M. McCarthy, Albin F. Moschner, Kell B. Benson and John Borst, Jr. (incorporated by reference to Exhibit 2 of the company's Report on Form 10-K for the year ended December 31, 1990) *(10c) Restricted Stock Agreement, dated December 3, 1986, of Jerry K. Pearlman (incorporated by reference to Exhibit 10c of the company's Report on Form 10-K for the year ended December 31, 1991) *(10d) Amendment, dated May 27, 1987, to Restricted Stock Agreement of Jerry K. Pearlman (incorporated by reference to Exhibit 10d of the company's Report on Form 10-K for the year ended December 31, 1992) *(10e) Amendment, dated March 28, 1988, to Restricted Stock Agreement of Jerry K. Pearlman *(10f) Amendments, dated October 1, 1990, and January 23, 1991, to Restricted Stock Agreement of Jerry K. Pearlman (incorporated by reference to Exhibit 3 of the company's Report on Form 10-K for the year ended December 31, 1990) *(10g) Restricted Stock Agreement, dated March 31, 1987, with Gerald M. McCarthy, and Amendments thereto dated December 2, 1987, March 28, 1988, August 22, 1988, and January 23, 1991 (incorporated by reference to Exhibit 10b of the company's Quarterly Report on Form 10-Q for the quarter ended June 29, 1991) *(10h) Forms of Amendments, dated as of July 24, 1991, to Restricted Stock Agreement dated December 3, 1986, with Jerry K. Pearlman and to Restricted Stock Agreement dated March 31, 1987, with Gerald M. McCarthy (incorporated by reference to Exhibit 10c of the company's Quarterly Report on Form 10-Q for the Quarter ended June 29, 1991) *(10i) Supplemental Agreement, dated September 12, 1986, with Jerry K. Pearlman (incorporated by reference to Exhibit 10m of the company's Report on Form 10-K for the year ended December 31, 1991) *(10j) Amendment to Supplemental Agreement with Jerry K. Pearlman (incorporated by reference to Exhibit 10j of the company's Report on Form 10-K for the year ended December 31, 1992) *(10k) Form of Amendment, dated as of May 19, 1989, to Supplemental Agreement with Jerry K. Pearlman, (incorporated by reference to Exhibit 6 of the company's Report on Form 10-K for the year ended December 31, 1989) *(10l) Form of Amendment, dated as of July 24, 1991, to Supplemental Agreement with Jerry K. Pearlman (incorporated by reference to Exhibit 10a of the company's Quarterly Report on Form 10-Q for the Quarter ended June 29, 1991) *(10m) Form of Supplemental Agreement with Gerald M. McCarthy, Albin F. Moschner, Kell B. Benson and John Borst, Jr. (incorporated by reference to Exhibit 10q of the company's Report on Form 10-K for the year ended December 31, 1991) *(10n) Form of Stock Indemnification Rights Grant with Jerry K. Pearlman and Kell B. Benson *(10o) Form of Amendment to Stock Indemnification Rights Grant with Jerry K. Pearlman and Kell B. Benson (incorporated by reference to Exhibit 7 of the company's Report on Form 10-K for the year ended December 31, 1989) *(10p) Letter Agreement, dated October 21, 1991, with Albin F. Moschner (incorporated by reference to Exhibit 10u of the company's Report on Form 10-K for the year ended December 31, 1991) *(10q) Form of Indemnification Agreement with Officers and Directors (incorporated by reference to Exhibit 8 of the company's Report on Form 10-K for the year ended December 31, 1989) *(10r) Form of Directors Stock Units Compensation Agreement with Harry G. Beckner (2,000 units) and with G. Ralph Guthrie (1,000 units) (incorporated by reference to Exhibit 10r of the company's Report on Form 10-K for the year ended December 31, 1992) *(10s) Form of Directors 1989 Stock Units Compensation Agreement with Harry G. Beckner, T. Kimball Brooker and G. Ralph Guthrie (1000 units each) (incorporated by reference to Exhibit 9 of the company's Report on Form 10-K for the year ended December 31, 1989) *(10t) Form of Directors 1990 Stock Units Compensation Agreement with Harry G. Beckner, G. Ralph Guthrie, T. Kimball Brooker, David H. Cohen, Charles Marshall, Andrew McNally IV and Peter S. Willmott (1000 units each) (incorporated by reference to Exhibit 6 of the company's Report on Form 10-K for the year ended December 31, 1990) *(10u) Form of Directors 1991 Stock Units Compensation Agreement with Harry G. Beckner, T. Kimball Brooker, David H. Cohen, G. Ralph Guthrie, Charles Marshall, Andrew McNally IV and Peter S. Willmott (1,000 units each) (incorporated by reference to Exhibit 10d of the company's Quarterly Report on Form 10-Q for the Quarter ended June 29, 1991) *(10v) Form of Amendment, dated as of July 24, 1991, to Directors Stock Units Compensation Agreements for 1987, 1988, 1990 and 1991 (incorporated by reference to Exhibit 10e of the company's Quarterly Report on Form 10-Q for the Quarter ended June 29, 1991) *(10w) Directors Retirement Plan and form of Agreement (incorporated by reference to Exhibit 10 of the company's Report on Form 10-K for the year ended December 31, 1989) *(10x) Form of Amendment, dated as of July 24, 1991, to Directors Retirement Plan and form of Agreement (incorporated by reference to Exhibit 10f of the company's quarterly Report on Form 10-Q for the Quarter ended June 29, 1991) (10y) Investment Agreement, dated as of February 25, 1991, with GoldStar Co., Ltd. (incorporated by reference to Exhibit 1 of the company's Current Report on Form 8-K, dated February 25, 1991) (10z) Registration Rights Agreement, dated as of February 25, 1991, with GoldStar Co., Ltd. (incorporated by reference to Exhibit 2 of the company's Current Report on Form 8-K, dated February 25, 1991) (10aa) Investment Agreement dated as of March 25, 1993 between Zenith Electronics Corporation and Fletcher Capital Markets, Inc. (incorporated by reference to Exhibit 1 of the company's Current Report on Form 8-K dated March 26, 1993) (10bb) Investment Agreement dated as of July 29, 1993 between Zenith Electronics Corporation and Fletcher Capital Markets, Inc. (incorporated reference to Exhibit 5(a) of the company's Current Report on Form 8-K dated July 29, 1993) (21) Subsidiaries of the company (23) Consent of Independent Public Accountants * Represents a management contract, compensation plan or arrangement. (b) Reports on Form 8-K The following reports on Form 8-K were filed during the quarter ended December 31, 1993. A report on Form 8-K dated October 21, 1993 was filed by the company stating under Item 5 that Zenith had issued a press release which reported third quarter 1993 financial results. A report on Form 8-K dated November 19, 1993 was filed by the company stating under Item 5 that Zenith had sold to certain institutional investors $42 million principal amount of its 8.5% Senior Subordinated Convertible Debentures due November 19, 2000, pursuant to a Debenture Purchase Agreement dated November 19, 1993, entered into by the company and the purchasers. A report on Form 8-K dated November 24, 1993 was filed by the company stating under Item 5 that Zenith had agreed to sell to certain institutional investors an additional $13 million principal amount of its 8.5% Senior Subordinated Convertible Debentures due November 19, 2000, pursuant to a Debenture Purchase Agreement dated November 19, 1993 entered into by the company and amended on November 24, 1993 to add the additional purchasers. A report on Form 8-K dated December 14, 1993 was filed by the company stating under Item 5 that Zenith had issued a press release announcing that it has called for redemption of its outstanding 12 1/8% Notes due on January 13, 1994. A report on Form 8-K dated December 15, 1993 was filed by the company stating under Item 5 that Zenith had issued a press release announcing that it is planning to restructure its computer monitor and magnetics areas and re-engineer its core consumer electronics and cable business which will result in a fourth quarter special charge of up to $30 million. (c) and (d) Exhibits and Financial Statement Schedules Certain exhibits and financial statement schedules required by this portion of Item 14 are filed as a separate section of this report. 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. ZENITH ELECTRONICS CORPORATION (Registrant) By: /S/ Jerry K. Pearlman --------------------- Jerry K. Pearlman Chairman, and Chief Executive Officer Date March 1, 1994 -------------------- 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 dates indicated. Signatures Title Date ------------------------- ---------------------- ------------------ Director - -------------------------- Harry G. Beckner /s/ T. Kimball Brooker Director March 1, 1994 - ------------------------- T. Kimball Brooker /s/ David H. Cohen Director March 1, 1994 - ------------------------- David H. Cohen /s/ Charles Marshall Director March 1, 1994 - ------------------------ Charles Marshall /s/ Gerald M. McCarthy Director, Executive Vice March 1, 1994 - ----------------------- President - Sales and Marketing, Gerald M. McCarthy and President - Zenith Sales Company /s/ Andrew McNally IV Director March 1, 1994 - ---------------------- Andrew McNally IV /s/ Albin F. Moschner Director, President and Chief March 1, 1994 - ---------------------- Operating Officer Albin F. Moschner /s/ Jerry K. Pearlman Director, Chairman and Chief March 1, 1994 - --------------------- Executive Officer Jerry K. Pearlman (Principal Executive Officer) /s/ Peter S. Willmott Director March 1, 1994 - --------------------- Peter S. Willmott /s/ Kell B. Benson Vice President - Finance and March 1, 1994 - -------------------- Chief Financial Officer Kell B. Benson (Principal Financial Officer) INDEX TO FINANCIAL STATEMENT SCHEDULES AND EXHIBITS Page Number ------ Report of Independent Public Accountants on Financial Statement Schedules 24 Financial Statement Schedules: Schedule V - Property, Plant and Equipment 25 Schedule VI - Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment 26 Schedule VIII - Valuation and Qualifying Accounts 27 Schedule IX - Short-Term Borrowings 28 Schedule X - Supplementary Income Statement Information 29 Consolidated Financial Statements 30 Notes to Consolidated Financial Statements 33 Report of Independent Public Accountants 41 Unaudited Quarterly Financial Data 42 Exhibits: (10e) Amendment, dated March 28, 1988, to Restricted Stock Agreement of Jerry K. Pearlman 43 (10n) Form of Stock Indemnification Rights Grant with Jerry K. Pearlman and Kell B. Benson 46 (21) Subsidiaries of the company 50 (23) Consent of Independent Public Accountants 51 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON ------------------------------------------- FINANCIAL STATEMENT SCHEDULES ----------------------------- To the Stockholders of Zenith Electronics Corporation: We have audited, in accordance with generally accepted auditing standards, the consolidated financial statements included in ZENITH ELECTRONICS CORPORATION's annual report to stockholders included in this Fork 10-K, and have issued our report thereon dated February 14, 1994. Our audit was made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed in the preceding index are the responsibility of the Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic consolidated financial statements. These schedules have been subjected to the auditing procedures applied in the audit of the basic consolidated financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic consolidated financial statements taken as a whole. /s/ARTHUR ANDERSEN & CO. ------------------------ ARTHUR ANDERSEN & CO. Chicago, Illinois, February 14, 1994 FINANCIAL STATEMENT SCHEDULES --------------------------------------------------- ZENITH ELECTRONICS CORPORATION SCHEDULE V-PROPERTY, PLANT AND EQUIPMENT (Amounts in millions) ZENITH ELECTRONICS CORPORATION SCHEDULE VI-ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (Amounts in millions) ZENITH ELECTRONICS CORPORATION SCHEDULE VIII-VALUATION AND QUALIFYING ACCOUNTS (Amounts in millions) ZENITH ELECTRONICS CORPORATION SCHEDULE IX-SHORT-TERM BORROWINGS (Amounts in millions) ZENITH ELECTRONICS CORPORATION SCHEDULE X-SUPPLEMENTARY INCOME STATEMENT INFORMATION (Amounts in millions) Amounts for royalties; depreciation and amortization of intangible assets, pre-operating costs and similar deferrals; and taxes other than payroll and income taxes are not presented as such amounts are less 1% of total sales and revenues. CONSOLIDATED FINANCIAL STATEMENTS ----------------------------------------------------------------- Statements of Consolidated operations and retained earnings In millions, except per share amounts The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. Consolidated balance sheets In millions The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. Statements of Consolidated cash flows In millions The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. Notes to Consolidated Financial Statements --------------------------------------------------------- Note One - Significant Accounting Policies: Principles of consolidation: The consolidated financial statements include the accounts of Zenith Electronics Corporation and all domestic and foreign subsidiaries (the company). All significant intercompany balances and transactions have been eliminated. Statements of consolidated cash flows: The company considers time deposits, certificates of deposit and all highly liquid investments purchased with an original maturity of three months or less to be cash. Inventories: Inventories are stated at the lower of cost or market. Costs are determined for all inventories except picture tube inventories using the first-in, first-out (FIFO) method. Picture tube inventories are valued using the last-in, first-out (LIFO) method. Properties and depreciation: Additions of plant and equipment with lives of eight years or more are depreciated by the straight-line method over their useful lives. Accelerated methods are used for depreciation of virtually all other plant and equipment items, including high technology equipment that may be subject to rapid economic obsolescence. Property held for disposal is stated at the lower of cost or estimated net realizable value. As of December 31, 1993, $5.9 million of property held for disposal was included in Other Noncurrent Assets and included certain facilities and land no longer used in the company's operations. Most tooling expenditures are charged to expense in the year acquired, except for picture tube tooling which is amortized over four years. Certain production fixtures are capitalized as machinery and equipment. Rental expenses under operating leases were $9.0 million, $8.8 million and $8.9 million in 1993, 1992 and 1991, respectively. Commitments for lease payments in future years are not material. The company capitalizes interest on major capital projects. Such interest has not been material. Engineering, research, product warranty and other costs: Engineering and research costs are expensed as incurred. Estimated costs for product warranties are provided at the time of sale based on experience factors. The costs of co-op advertising and merchandising programs are also provided at the time of sale. Foreign currency: The company uses the U.S. dollar as the functional currency for all foreign subsidiaries. Foreign exchange gains and losses are included in Other Operating Expense (Income) and were not material in 1993, 1992 and 1991. Earnings per share: Primary earnings per share are based upon the weighted average number of shares outstanding and common stock equivalents, if dilutive. Fully diluted earnings per share, assuming conversion of the 6 1/4% convertible subordinated debentures and the 8.5% convertible senior subordinated debentures, are not presented because the effect of the assumed conversion is antidilutive. The number of shares used in the computation were 32.3 million, 29.5 million and 28.8 million in 1993, 1992 and 1991, respectively. Note Two - Financial Results and Liquidity: The company has incurred losses from operations of $97.0 million, $105.9 million and $51.6 million in 1993, 1992 and 1991, respectively. For many years the company's major competitors, many with greater resources, have aggressively lowered their selling prices in an attempt to increase market share. Although the company has benefited from cost reduction programs, these lower color television prices together with inflationary cost increases have more than offset such cost reduction benefits. The company's 1994 operating plan is designed to improve financial results through cost reductions, repositioning of product lines and intensified asset management. The plan also seeks to improve the profitability of the core business and contemplates the introduction of new products such as home theater TVs. These efforts along with continued investments in the development of new technologies (such as high definition television and new digital cable products) are expected to involve significant expenditures by the company in 1994 and beyond. The company's Credit Agreement (see Note Nine) expires on December 31, 1994. The maximum commitment for funds available for borrowing under the Credit Agreement is $90 million, but is limited by a defined borrowing base formula related to eligible accounts receivable and inventory. Although the company believes that the Credit Agreement, together with extended-term payables expected to be available from a foreign supplier and its continuing efforts to obtain other financing sources, will be adequate to meet its seasonal working capital needs in 1994, there can be no assurances that the company will not experience liquidity problems in the future because of adverse market conditions or other unfavorable events. Note Three - Restructuring and Other Charges: During the fourth quarter of 1993, the company recorded a charge of $31.0 million primarily to restructure certain product areas and re-engineer its core consumer electronics and cable business. The restructuring will affect computer monitors and magnetics, product areas in which the company is bringing its production capacity more in line with expected reduced levels of business. The fourth-quarter charge was primarily for non-cash fixed asset and inventory write-downs, as well as severance costs, and is designed to reduce fixed costs and operating expenses. During 1992, the company recorded $48.1 million of restructuring and other charges. These included provisions for severance, inventory valuation and other restructuring costs, along with writeoffs of trade receivables. Designed to reduce fixed costs and operating expenses, the restructuring actions include manufacturing consolidations and related employment reductions in Mexico, consolidation of company-owned distribution and other activities, and salaried employment reductions throughout the company. During 1991, the company initiated certain restructuring actions. Integral to the restructuring was the sale and leaseback of the land and building in Taiwan and the consolidation of the color television final assembly operation into Mexico. Taken as a whole, the restructuring actions had no impact on the operating results of the company as the $8.9 million net gain on the sale of the Taiwan property was offset by charges relating to the restructuring. Note Four - Income Taxes: In the fourth quarter of 1992, the company elected early adoption of Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes", which requires the use of the liability method in accounting for income taxes. This statement superseded SFAS No. 96, which the company adopted retroactively in October 1989. The adoption of SFAS No. 109 had no effect on the financial statements of the company because the related net deferred tax assets were offset by a valuation allowance. The valuation allowance was established since the realization of these assets cannot be reasonably assured, given the company's recurring losses. The components of income taxes (credit) were: The $15.9 million income tax credit in 1992, resulted from the reversal of $10.0 million of previously accrued tax reserves no longer required in connection with earnings of a foreign subsidiary and $5.9 million of net operating loss carryback applications which resulted in cash refunds. The statutory federal income tax rate and the effective tax rate are compared below: Deferred tax assets (liabilities) are comprised of the following: As of December 31, 1993, the company had $383.5 million of net operating loss carryforwards (NOLs) available for financial statement purposes. For federal income tax purposes, the company had net operating loss carryforwards of $365.5 million and unused tax credits of $4.6 million, (which expire from 2000 through 2008). The company expects these NOLs and tax credits to be available in the future to reduce the Federal income tax liability of the company. However, should there occur a 50% "ownership change" of the company as defined under section 382 of the Internal Revenue Code of 1986, the company's ability to utilize the NOLs and available tax credits would be restricted to a prescribed annual amount (currently 5.06% of the market value of the company at the time of the ownership change). The company has knowledge of equity holdings and stock options which must be counted as changes in the ownership of the company aggregating about 37 percent as of the three years ended December 31, 1993. As of the three years ended February 28, 1994, this percentage has decreased to about 33 percent. Additional equity-related transactions initiated by the company as well as investment decisions made independently by investors may increase this percentage in the future. Note Five - Geographic Segment Data: The company's operations involve a dominant industry segment-the design, development, manufacture and sale of video products, including color television sets, video cassette recorders and other consumer electronics products, color picture tubes, computer monitors, cable TV products, and parts and accessories for these products. Financial information, summarized by geographic area, is as follows: Foreign operations consist of manufacturing and sales subsidiaries in Mexico and distribution subsidiaries in Canada and Taiwan. Sales to affiliates are principally accounted for at amounts based on local costs of production plus a reasonable return. Note Six -- Other Operating Expense (Income): Major manufacturers of televisions and video cassette recorders agreed during 1992 to take licenses under some of the company's U.S. tuning system patents (the licenses expire in 2003). Royalty income related to the tuning system patents (after deducting legal expenses) was $25.7 million and $26.0 million in 1993 and 1992, respectively, and is included in Other Operating Expense (Income). The $26.0 million in 1992 included $5.3 million of past royalties. Note Seven - Inventories: Inventories consisted of the following: As of December 31, 1993 and 1992, inventories of $24.1 million and $19.6 million, respectively, were valued using the LIFO method. Note Eight - Property, Plant and Equipment: Property, plant and equipment consisted of the following: Note Nine - Short-term Debt and Credit Arrangements: The company entered into a Credit Agreement dated as of May 21, 1993, with a lending group led by General Electric Capital Corporation, for working capital purposes. Borrowings under the Credit Agreement are secured by accounts receivable, inventory, general intangibles, trademarks and the tuning system patent license agreements of the company and certain of its domestic subsidiaries. The Credit Agreement is scheduled to expire on December 31, 1994. The maximum commitment of funds available for borrowing under the Credit Agreement is $90 million, but is limited by a defined borrowing base formula related to eligible receivables and eligible inventory. Net proceeds arising from material asset transactions will result in a partial reduction in the maximum commitment of the lenders thereunder. Interest on borrowing is based on market rates with a commitment fee of 1/2 % per annum payable monthly on the unused balance of the facility. As of December 31, 1993, no borrowings were outstanding under the Credit Agreement. The Credit Agreement contains restrictive financial covenants that must be maintained as of the end of each fiscal quarter, including a liabilities to net worth ratio and a minimum net worth amount. As amended, the ratio of liabilities to net worth, as of December 31, 1993, was required to be not greater than 3.70 to 1.0 and was actually 2.67 to 1.0, and net worth was required to be equal to or greater than 140.0 million and was actually 152.4 million. At the end of each of the first three fiscal quarters of 1994, the liabilities to net worth ratio is required to be maintained at various levels ranging from a high of 4.95 to 1.0 to a low of 3.70 to 1.0 and minimum net worth is required to be maintained at amounts ranging from a high of $120.0 million to a low of $101.0 million. In addition, there are restrictions regarding capital expenditures, specified dollar limits on the amount of inventory for certain of the company's products, investments, acquisitions, guaranties, transactions with affiliates, sales of assets, mergers and additional borrowings, along with limitations on liens. The Credit Agreement prohibits dividend payments on the company's common stock, restricts dividend payments on any of its preferred stock, if issued, and prohibits the redemption or repurchase of stock. As of December 31, 1992, the company had $10.1 million outstanding under its previous $60 million revolving credit and security agreement. The agreement, which was terminated by the company on May 21, 1993, contained restrictive covenants similar in nature to the current Credit Agreement. Borrowings and interest rates on short-term debt were: Contracts with certain foreign suppliers permit the company to elect interest-bearing extended-payment terms. As of December 31, 1993 and 1992, $8.5 million and $10.8 million, respectively, of these obligations were outstanding and shown as accounts payable. Note Ten - Long-term Debt: The components of long-term debt were: Subsequent to December 31, 1993, the company redeemed its outstanding 12 1/8% notes due 1995 at a redemption price equal to par value, totaling $34.5 million plus accrued interest. The 6 1/4% convertible subordinated debentures are unsecured general obligations, subordinate in right of payment to certain other debt obligations, and are convertible into common stock at $31.25 per share. Terms of the debenture agreement include annual sinking-fund payments of $5.8 million beginning in 1997. The debentures are redeemable at the option of the company, in whole or in part, at specified redemption prices at par or above. In November 1993, the company sold to certain institutional investors $55 million of 8.5% senior subordinated convertible debentures due 2000. The debentures are unsecured general obligations, subordinate in right of payment to certain other debt obligations, and are convertible into shares of common stock at an initial conversion price of $9.76 per share. The debentures are redeemable at the option of the company, in whole or in part, at any time on or after November 19, 1997, at specified redemption prices at par or above. The fair value of long-term debt is $134.4 million as of December 31, 1993, as compared to the carrying amount of $170.0 million. The fair value of the company's 6 1/4% convertible subordinated debentures is based on the quoted market price from the New York Stock Exchange. The fair value of the 8.5% convertible senior subordinated debentures is based on the quoted price obtained from third party financial institutions. Currently, the company's Credit Agreement would not allow the company to extinguish the long-term debt through purchase and thereby realize the gain. Note Eleven - Stockholders' Equity: Changes in stockholders' equity accounts are shown below: A Registration Statement filed with the Securities and Exchange Commission covering 5 million shares of common stock became effective in May 1993. The company sold 3.4 million shares of authorized but unissued shares of common stock to investors under this shelf registration during 1993. Subsequent to December 31, 1993, the company sold the remaining 1.6 million shares under this registration and an additional 2.0 million shares under a new shelf registration and intends to file a shelf registration for an additional 5.0 million shares. On February 25, 1991, the company entered into investment and technology agreements with GoldStar Co. Ltd. Under the investment agreement, the company sold to GoldStar 1,450,000 shares of previously authorized but unissued common stock for $15.0 million. Pursuant to a Rights Agreement (as amended), a "right" entitling the holder thereof to purchase under certain conditions, one-half of one share of common stock at an exercise price of $37.50, subject to adjustment, was distributed with respect to each outstanding share of common stock in 1986, and with respect to each additional share of common stock that has become outstanding since then. The rights will become exercisable upon the earlier to occur of (i) the 10th day after a public announcement that a third party has become the beneficial owner of 25% or more of the outstanding common stock (an "acquiring person") or (ii) the 10th day after the commencement of, or the announcement of an intention to commence, an offer the consummation of which would result in a third party beneficially owning 25% or more of the common stock. In the event any person becomes an acquiring person, each holder of a right (other than the acquiring person) will thereafter have the right to receive upon exercise that number of shares of common stock having a market value of two times the exercise price of the right. The rights, which have no voting rights, expire in 1996. The rights may be redeemed at the option of the company at any time prior to such time as any person becomes an acquiring person. Under certain conditions and following a stockholder vote, the rights shall be redeemed by the company. In either case, the redemption price will be $.05 per right, subject to adjustment. The Rights Agreement also provides that under certain circumstances at any time after any person has become an acquiring person, the Board of Directors may exchange the rights (other than rights owned by such person) in whole or in part, for common stock at an exchange ratio of one- half of a share of common stock per right, subject to adjustment. At the company's Annual Meeting of Stockholders in May 1993, the stockholders approved the authorization of 8 million shares of preferred stock of which none are issued or outstanding as of December 31, 1993. The Board of Directors of the company is authorized to issue the preferred stock from time to time in one or more series and to determine all relevant terms of each such series, including but not limited to the following (i) whether and upon what terms, the shares of such series would be redeemable; (ii) whether a sinking fund would be provided for the redemption of the shares of such series and, if so, the terms thereof; and (iii) the preference, if any, to which shares of such series would be entitled in the event of voluntary or involuntary liquidation of the company. Note Twelve - Stock Options and Awards: The 1987 Stock Incentive Plan authorizes the granting of incentive and non-qualified stock options, restricted stock awards and stock appreciation rights to key management personnel. The purchase price of shares under option is the market price of the shares on the date of grant. Options expire 10 years from the date granted. Transactions in 1993 and 1992 are summarized below: The company had 63,837 and 69,836 restricted stock awards issued and outstanding as of December 31, 1993 and 1992, respectively. The market value of the restricted shares is deferred in the additional paid-in capital account and amortized over the years the restrictions lapse. Total compensation expense in 1993 and 1992, related to these awards, was not material. Note Thirteen - Retirement Plans and Employee Benefits: Virtually all employees in the United States and Canada are eligible to participate in noncontributory profit-sharing retirement plans after completing one full year of service. The plans provide for a minimum annual contribution of 6% of employees' eligible compensation. Contributions above the minimum could be required based upon profits in excess of a specified return on net worth. Profit-sharing contributions were $9.7 million, $11.1 million and $11.5 million in 1993, 1992 and 1991, respectively. The 1993, 1992 and 1991 contributions were partially funded through the issuance of approximately 1,021,000, 982,000 and 1,000,000 shares, respectively, of the company's common stock. Employees in Mexico and Taiwan are covered by government- mandated plans, the costs of which are accrued by the company. In the fourth quarter of 1993, the company elected early adoption of Statement of Financial Accounting Standards (SFAS) No.112, "Employers' Accounting for Postemployment Benefits." This statement requires that the company follow an accrual method of accounting for the benefits payable to employees when they leave the company other than by reason of retirement. Since most of these benefits were already accounted for by the company by the accrual method, adoption of SFAS No 112 did not have a material effect on the financial statements of the company, nor is it expected to have a material effect on future results of operations. Presently, the company does not offer any postretirement benefits; as a result, the 1992 adoption of SFAS No. 106 did not have any effect on the financial statements of the company. Note Fourteen - Contingencies: The company is involved in various legal actions, environmental matters, patent claims, and other proceedings relating to a wide range of matters that are incidental to the conduct of its business. In addition, the company remains liable for certain retained obligations of a discontinued business, principally income and other taxes prior to the closing of the sale. The company believes, after reviewing such matters and consulting with the company's counsel, that any liability which may ultimately be incurred with respect to these matters is not expected to have a material effect on either the company's consolidated financial position or results of operations. Note Fifteen - Reclassifications: Certain prior-year amounts have been reclassified to conform with the presentation used in the current year. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS -------------------------------------------------------------- To the Stockholders of Zenith Electronics Corporation: We have audited the accompanying consolidated balance sheets of Zenith Electronics Corporation (a Delaware corporation) and subsidiaries as of December 31, 1993 and 1992, and the related statements of consolidated operations and retained earnings and cash flows for each of the three years in the period ended December 31, 1993. 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 Zenith Electronics Corporation and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. /S/ARTHUR ANDERSEN & CO. ------------------------ ARTHUR ANDERSEN & CO. Chicago, Illinois, February 14, 1994 UNAUDITED QUARTERLY FINANCIAL INFORMATION ----------------------------------------------------- In millions, except per share amounts

1993 ITEM 1. BUSINESS SUMMARY OF SIGNIFICANT TRANSACTIONS Jefferson Smurfit Corporation ("JSC") was incorporated in 1976 under the laws of the State of Delaware. JSC is a wholly-owned subsidiary of SIBV/MS Holdings, Inc. ("Holdings"), a corporation formed in connection with the 1989 Transaction (as defined below), 50% of the voting stock of which is owned by Smurfit Packaging Corporation ("Smurfit Packaging") and Smurfit Holdings B.V. ("Smurfit Holdings"). The remaining 50% is owned by The Morgan Stanley Leveraged Equity Fund II, L.P. ("MSLEF II"). Holdings has no operations other than its investment in JSC. MSLEF II is an investment fund formed by Morgan Stanley & Co. Incorporated ("MS&CO."). Smurfit Packaging and Smurfit Holdings are wholly- owned subsidiaries of Smurfit International B.V. ("SIBV"), which is an indirect wholly-owned subsidiary of Jefferson Smurfit Group plc, a corporation organized under the laws of the Republic of Ireland ("JS Group"). Container Corporation of America ("CCA") was incorporated in 1968 under the laws of the State of Delaware. On September 30, 1986, JSC acquired a 50% equity interest in CCA. Prior to September 30, 1986, CCA was a wholly-owned subsidiary of Mobil Corporation. In December 1989, (i) Holdings acquired the entire equity interest in JSC, (ii) JSC acquired the entire equity interest in CCA, (iii) The Morgan Stanley Leveraged Equity Fund, L.P., a Delaware limited partnership ("MSLEF I"), and certain other private investors, including MS&Co. and certain limited partners of MSLEF I investing in their individual capacities (collectively, the "MSLEF I Group") received $500 million in respect of their shares of CCA common stock and (iv) SIBV received $41.75 per share, or an aggregate of approximately $1.25 billion, in respect of its shares of JSC stock, and the public stockholders received $43 per share of JSC stock. Certain assets of JSC and CCA were also transferred to SIBV or one of its affiliates. Holdings' acquisition of all of the outstanding JSC common stock and CCA's acquisition of the 50% of its common equity owned by the MSLEF I Group are referred to hereafter as the "1989 Transaction". Financing for the 1989 Transaction was provided through borrowings under bank credit facilities, the sale of various debt securities, including $850.0 million of subordinated notes (the "Subordinated Debt") and debentures (the "Secured Notes") sold by CCA which are unconditionally guaranteed by JSC, equity contributions by Holdings and available cash of JSC and CCA. In August 1992, proceeds from a $231.8 million capital contribution by Holdings and a new $400 million senior secured term loan (the "1992 Credit Agreement") were used to prepay $400 million of the 1989 term loan facility (the "1989 Credit Agreement"), retire $193.5 million accreted value of the Junior Accrual Debentures and prepay $19.1 million aggregate principal amount of the subordinated note due in 1993. The proceeds from the capital contribution and the 1992 Credit Agreement and the prepayments of the 1989 Credit Agreement and the subordinated debt are referred to hereafter as the "1992 Transaction". The 1989 Credit Agreement and the 1992 Credit Agreement are collectively referred to herein as the "Old Bank Facilities". Holdings is implementing a recapitalization plan (the "Recapitalization Plan") to repay or refinance a substantial portion of its indebtedness in order to improve operating and financial flexibility by (i) reducing the level and overall cost of debt, (ii) extending maturities of indebtedness, (iii) increasing stockholders' equity and (iv) increasing its access to capital markets. In the first quarter of 1994, Holdings filed a registration statement with the Securities and Exchange Commission (the "SEC") for an offering of 17,250,000 shares of common stock (the "Equity Offerings"). In addition, CCA filed a registration statement with the SEC for an offering of $300 million aggregate principal amount of Series A Senior Notes due 2004 (the "Series A Senior Notes") and $100 million aggregate principal amount of Series B Senior Notes due 2002 (the "Series B Senior Notes"). The Series A Senior Notes and the Series B Senior Notes are referred to herein as the "Senior Notes" or the "Debt Offerings". The Equity Offerings and the Debt Offerings are collectively referred to herein as the "Offerings". The Recapitalization Plan includes, among other things, (i) the Offerings, (ii) the sale of $100 million of Common Stock to SIBV (or a corporate affiliate) (the "SIBV Investment") and (iii) a new credit agreement by JSC and CCA (the "New Credit Agreement") consisting of a $450 million revolving credit facility (the "New Revolving Credit Facility"), a $300 million term loan (the "Initial Term Loan") and a $900 million delayed term loan (the "Delayed Term Loan" and, together with the Initial Term Loan, the "New Term Loans"). Proceeds of the Recapitalization Plan, exclusive of the Delayed Term Loan, will be used to refinance all of the Company's indebtedness under the 1989 and 1992 Credit Agreements and the Secured Notes. The applications of borrowings under the Delayed Term Loan shall be used to redeem or repurchase the Subordinated Debt on approximately December 1, 1994 (the "Subordinated Debt Refinancing"). Prior to the date on which the Registration Statements are declared effective by the SEC, Holdings intends to change its name to "Jefferson Smurfit Corporation" and JSC intends to change its name to "Jefferson Smurfit Corporation (U.S.)". All references in this 10-K to the "Company" or to "JSC" refer to the corporation currently named Jefferson Smurfit Corporation and, when the context requires, its consolidated subsidiaries. All references in this 10-K to "Holdings" refer to the corporation currently named SIBV/MS Holdings, Inc. GENERAL The predecessor to the Company was founded in 1974 when JS Group, a worldwide leader in the packaging products industry, commenced operations in the United States by acquiring 40% of a small paperboard and packaging products company. The remaining 60% of that company was acquired by JS Group in 1977, and in 1978 net sales were $42.9 million. The Company implemented a strategy to build a fully integrated, broadly based, national packaging business, primarily through acquisitions, including Alton Box Board Company in 1979, the paperboard and packaging divisions of Diamond International Corporation in 1982, 80% of Smurfit Newsprint Corporation ("SNC") in 1986 and 50% of CCA in 1986. The Company financed its acquisitions by using leverage and, in several cases, utilized joint venture financing whereby the Company eventually obtained control of the acquired company. While no major acquisition has been made since 1986, the Company has made 18 smaller acquisitions and started up five new facilities which had combined sales in 1993 of $280.3 million. JSC was formed in 1983 to consolidate the operations of the Company, and today the Company ranks among the industry leaders in its two business segments, Paperboard/Packaging Products and Newsprint. In 1993, the Company had net sales of $2.9 billion, achieving a compound annual sales growth rate of 32.6% for the period since 1978. The Company believes it is one of the nation's largest producers of paperboard and packaging products and is the largest producer of recycled paperboard and recycled packaging products. In 1993, the Company's system of 16 paperboard mills produced 1,840,000 tons of virgin and recycled containerboard, 829,000 tons of coated and uncoated recycled boxboard and solid bleached sulfate ("SBS") and 206,000 tons of recycled cylinderboard, which were sold to the Company's own converting operations or to third parties. The Company's converting operations consist of 52 corrugated container plants, 18 folding carton plants, and 16 industrial packaging plants located across the country, with three plants located outside the U.S. In 1993, the Company's container plants converted 1,942,000 tons of containerboard, an amount equal to approximately 105.5% of the amount it produced, its folding carton plants converted 542,000 tons of SBS, recycled boxboard and coated natural kraft, an amount equal to approximately 65.4% of the amount it produced, and its industrial packaging plants converted 123,000 tons of recycled cylinderboard, an amount equal to approximately 59.7% of the amount it produced. The Company's Paperboard/Packaging Products segment contributed 91.6% of the Company's net sales in 1993. The Company's paperboard operations are supported by its reclamation division, which processed or brokered 3.9 million tons of wastepaper in 1993, and by its timber division which manages approximately one million acres of owned or leased timberland located in close proximity to its virgin fibre mills. The paperboard/packaging products operations also include 14 consumer packaging plants. In addition, the Company believes it is one of the nation's largest producers of recycled newsprint. The Company's Newsprint segment includes two newsprint mills in Oregon, which produced 615,000 tons of recycled newsprint in 1993, and two facilities that produce Cladwood, a construction material produced from newsprint and wood by-products. The Company's newsprint mills are also supported by the Company's reclamation division. PRODUCTS PAPERBOARD/PACKAGING PRODUCTS SEGMENT CONTAINERBOARD AND CORRUGATED SHIPPING CONTAINERS The Company's containerboard operations are highly integrated. Tons of containerboard produced and converted for the last three years were: The Company's mills produce a full line of containerboard, including unbleached kraft linerboard, mottled white linerboard and recycled medium. The Company believes it is the nation's largest producer of mottled white linerboard, the largest producer of recycled medium and the fifth largest producer of containerboard. Unbleached kraft linerboard is produced at the Company's mills located in Fernandina Beach and Jacksonville, Florida and mottled white linerboard is produced at its Brewton, Alabama mill. Recycled medium is produced at the Company's mills located in Alton, Illinois, Carthage, Indiana, Circleville, Ohio and Los Angeles, California. In 1993, the Company produced 1,018,000, 315,000 and 507,000 tons of unbleached kraft linerboard, mottled white linerboard and recycled medium, respectively. Large capital investment is required to sustain the Company's containerboard mills, which employ state of the art computer controlled machinery in their manufacturing processes. During the last five years, the Company has invested approximately $246 million to enhance product quality, reduce costs, expand capacity and increase production efficiency, as well as make required improvements to stay in compliance with environmental regulations. Major capital projects completed in the last five years include (i) a rebuild of Jacksonville's linerboard machine to produce high performance, lighter weight grades now experiencing higher demand, (ii) modifications to Brewton's mottled white machine to increase run speed by 100 tons per day and (iii) a project to reduce sulfur emissions from the Fernandina Beach linerboard mill. A key strategy for the next few years will be to reduce wood cost at its virgin fibre mills by modifying methods of woodchip production and handling, utilizing random length roundwood forms and continuing to pursue forest management practices designed to enhance timberland productivity. The Company's sales of containerboard in 1993 were $670.6 million (including $384.1 million of intracompany sales). Sales of containerboard to its 52 container plants are reflected at prices based upon those published by Official Board Markets which are generally higher than those paid by third parties except in exchange contracts. The Company believes it is the third largest producer of corrugated shipping containers in the U.S. Corrugated shipping containers, manufactured from containerboard in converting plants, are used to ship such diverse products as home appliances, electric motors, small machinery, grocery products, produce, books, tobacco and furniture, and for many other applications, including point of purchase displays. The Company stresses the value added aspects of its corrugated containers, such as labeling and multi-color graphics, to differentiate its products and respond to customer requirements. The Company's container plants serve local customers and large national accounts and are located nationwide, generally in or near large metropolitan areas. The Company's total sales of corrugated shipping containers in 1993 were $1,175.7 million (including $81.1 million of intracompany sales). Corrugated shipping container sales volumes for 1991, 1992 and 1993 were 25,178, 26,593 and 27,268 million square feet, respectively. RECYCLED BOXBOARD, SBS AND FOLDING CARTONS The Company's recycled boxboard, SBS and folding carton operations are also integrated. Tons of recycled boxboard and SBS produced and converted for the last three years were: The Company's recycled cylinderboard mills are located in: Tacoma, Washington, Monroe, Michigan (2 mills), Lafayette, Indiana, and Cedartown, Georgia. In 1993, total sales of recycled cylinderboard were $61.8 million (including $17.9 million of intracompany sales). The Company's 16 industrial packaging plants convert recycled cylinderboard, including a portion of the recycled cylinderboard produced by the Company, into papertubes and cores. Papertubes and cores are used primarily for paper, film and foil, yarn carriers and other textile products and furniture components. The Company also produces solid fibre partitions for the pharmaceutical, electronics, cosmetics and plastics industries. In addition, the Company produces a patented self-locking partition especially suited for automated packaging and product protection. The Company believes it is the nation's third largest producer of tubes and cores. The Company's industrial packaging sales in 1993 were $88.1 million (including $1.6 million in intracompany sales). CONSUMER PACKAGING The Company manufactures a wide variety of consumer packaging products. These products include flexible packaging, printed paper labels, foil labels, and labels that are heat transferred to plastic containers for a wide range of industrial and consumer product applications. The contract packaging plants provide cartoning, bagging, liquid- or powder-filling, high-speed overwrapping and fragranced advertising products. The Company produces high-quality rotogravure cylinders and has a full-service organization experienced in the production of color separations and lithographic film for the commercial printing, advertising and packaging industries. The Company also designs, manufactures and sells custom machinery including specialized machines that apply labels to customers' packaging. The Company currently has 14 facilities including the engineering service center referred to below and has improved their competitiveness by installing state- of-the-art production equipment. In addition, the Company has an engineering services center, specializing in automated production systems and highly specialized machinery, providing expert consultation, design and equipment fabrication for consumer and industrial products manufacturers, primarily from the food, beverage and medical products industries. Total sales of consumer packaging products and services were $179.8 million (including $15.1 million of intracompany sales). RECLAMATION OPERATIONS; FIBRE RESOURCES AND TIMBER PRODUCTS The raw materials essential to the Company's business are reclaimed fibre from wastepaper and wood, in the form of logs or chips. The Brewton, Circleville, Jacksonville and Fernandina mills use primarily wood fibres, while the other paperboard mills use reclaimed fibre exclusively. The newsprint mills use approximately 45% wood fibre and 55% reclaimed fibre. The Company believes it is the nation's largest processor of wastepaper. The use of recycled products in the Company's operations begins with its reclamation division which operates 26 facilities that collect, sort, grade and bale wastepaper, as well as collect aluminum and glass. The reclamation division provides valuable fibre resources to both the paperboard and newsprint segments of the Company as well as to other producers. Many of the reclamation facilities are located in close proximity to the Company's recycled paperboard and newsprint mills, assuring availability of supply, when needed, with minimal shipping costs. In 1993, the Company processed 3.9 million tons of wastepaper, which the Company believes is approximately twice the amount of wastepaper processed by its closest competitor. The amount of wastepaper collected and the proportions sold internally and externally by the Company's reclamation division for the last three years were: The reclamation division also operates a nationwide brokerage system whereby it purchases and resells wastepaper (including wastepaper for use in its recycled fibre mills) on a regional and national contract basis. Such contracts provide bulk purchasing, resulting in lower prices and cleaner wastepaper. Total sales of recycled materials for 1993 were $242.9 million (including $120.8 million of intracompany sales). During 1993, the wastepaper which was reclaimed by the Company's reclamation plants and brokerage operations satisfied all of the Company's mill requirements for reclaimed fibre. The Company's timber division manages approximately one million acres of owned and leased timberland. In 1993, approximately 53% of the timber harvested by the Company was used in its Jacksonville, Fernandina and Brewton Mills. The Company harvested 808,000 cords of timber which would satisfy approximately 32% of the Company's requirements for woodfibres. The Company's woodfibre requirements not satisfied internally are purchased on the open market or under long-term contracts. In the past, the Company has not experienced difficulty obtaining an adequate supply of wood through its own operations or open market purchases. The Company is not aware of any circumstances that would adversely affect its ability to satisfy its wood requirements in the foreseeable future. In recent years, a shortage of wood fibre in the spotted owl regions in the Northwest has resulted in increases in the cost of virgin wood fibre. However, the Company's use of reclaimed fibre in its newsprint mills has mitigated the effect of this in significant part. In 1993, the Company's total sales of timber products were $227.8 million (including $185.1 million of intracompany sales). NEWSPRINT SEGMENT NEWSPRINT MILLS The Company believes it is one of the largest producer of recycled newsprint and the fourth largest producer overall of newsprint in the United States. The Company's newsprint mills are located in Newberg and Oregon City, Oregon. During 1991, 1992 and 1993, the Company produced 614,000, 615,000 and 615,000 tons of newsprint, respectively. In 1993, total sales of newsprint were $219.5 million (none of which were intracompany sales). For the past three years, an average of approximately 56% of the Company's newsprint production has been sold to The Times Mirror Company ("Times Mirror") pursuant to a long-term newsprint agreement (the "Newsprint Agreement") entered into in connection with the Company's acquisition of SNC stock in February 1986. Under the terms of the Newsprint Agreement, the Company supplies newsprint to Times Mirror generally at prevailing West Coast market prices. Sales of newsprint to Times Mirror in 1993 amounted to $115.2 million. CLADWOOD Cladwood is a wood composite panel used by the housing industry, manufactured from sawmill shavings and other wood residuals and overlayed with recycled newsprint. The Company has two Cladwood plants located in Oregon. Total sales for Cladwood in 1993 were $29.1 million ($.5 million of which were intracompany sales). MARKETING The marketing strategy for the Company's mills is to maximize sales of products to manufacturers located within an economical shipping area. The strategy in the converting plants focuses on both specialty products tailored to fit customers' needs and high volume sales of commodity products. The Company also seeks to broaden the customer base for each of its segments rather than to concentrate on only a few accounts for each plant. These objectives have led to decentralization of marketing efforts, such that each plant has its own sales force, and many have product design engineers, who are in close contact with customers to respond to their specific needs. National sales offices are also maintained for customers who purchase through a centralized purchasing office. National account business may be allocated to more than one plant because of production capacity and equipment requirements. COMPETITION The paperboard and packaging products markets are highly competitive and are comprised of many participants. Although no single company is dominant, the Company does face significant competitors in each of its businesses. The Company's competitors include large vertically integrated companies as well as numerous smaller companies. The industries in which the Company competes are particularly sensitive to price fluctuations as well as other competitive factors including design, quality and service, with varying emphasis on these factors depending on product line. The market for the Newsprint segment is also highly competitive. BACKLOG Demand for the Company's major product lines is relatively constant throughout the year and seasonal fluctuations in marketing, production, shipments and inventories are not significant. The Company does not have a significant backlog of orders, as most orders are placed for delivery within 30 days. RESEARCH AND DEVELOPMENT The Company's research and development center works with its manufacturing and sales operations, providing state-of-the-art technology, from raw materials supply through finished packaging performance. Research programs have provided improvements in coatings and barriers, stiffeners, inks and printing. The technical staff conducts basic, applied and diagnostic research, develops processes and products and provides a wide range of other technical services. The Company actively pursues applications for patents on new inventions and designs and attempts to protect its patents against infringement. Nevertheless, the Company believes that its success and growth are dependent on the quality of its products and its relationships with its customers, rather than on the extent of its patent protection. The Company holds or is licensed to use certain patents, but does not consider that the successful continuation of any important phase of its business is dependent upon such patents. EMPLOYEES Subsequent to closure in early 1994 of three container plants, two folding carton plants and one recycled boxboard mill, the Company had approximately 16,600 employees at March 1, 1994, of which approximately 11,300 employees (68%), are represented by collective bargaining units. The expiration date of union contracts for the Company's major facilities are as follows: the Alton mill, expiring June 1994; the Newberg mill, expiring March 1995; the Oregon City mill, expiring March 1997; the Brewton mill, expiring October 1997; the Fernandina mill, expiring June 1998; a group of 12 properties, including 4 paper mills and 8 corrugated container plants, expiring June 1998; and the Jacksonville mill, expiring June 1999. The Company believes that its employee relations are generally good and is currently in the process of bargaining with unions representing production employees at a number of its other operations. ITEM 2. ITEM 2. PROPERTIES The Company's properties at December 31, 1993 are summarized in the table below. The table reflects the previously mentioned closure in early 1994 of three container plants, two folding carton plants and one recycled boxboard mill, but does not reflect the additional closures contemplated by the Restructuring Program. Approximately 62% of the Company's investment in property, plant and equipment is represented by its paperboard and newsprint mills. In addition to its manufacturing facilities, the Company owns and leases approximately 758,000 acres and 226,000 acres of timberland, respectively, and also operates wood harvesting facilities. ITEM 3. ITEM 3. LEGAL PROCEEDINGS Litigation In May 1993, CCA received a notice of default on behalf of Otis B. Ingram, as executor of the estate of Naomi M. Ingram, and Ingram- LeGrand Lumber Company with respect to certain timber purchase agreements and timber management agreements between CCA and such parties dated November 22, 1967 pertaining to approximately 30,000 acres of property in Georgia (the "Agreements"). In June 1993, CCA filed suit against such parties in the United States District Court, Middle District of Georgia, seeking declaratory and injunctive relief and damages in excess of $3 million arising out of the defendants' alleged breach and anticipatory repudiation of the Agreements. The defendants have filed an answer and counterclaim seeking damages in excess of $14 million based on allegations that CCA breached the Agreements and failed to pay for timber allegedly stolen or otherwise removed from the property by CCA or third parties. The alleged thefts of timber are being investigated by the Georgia Bureau of Investigation, which has advised CCA that it is not presently a target of this investigation. CCA has filed a third-party complaint against Keadle Lumber Enterprises, Inc. seeking indemnification with respect to such alleged thefts and has filed a reply to the defendants' counterclaims denying the allegations and any liability to the defendants. Management does not believe that the outcome of this litigation will have a material adverse effect on the Company's financial condition or operations. The Company is a defendant in a number of other lawsuits which have arisen in the normal course of business. While any litigation has an element of uncertainty, the management of the Company believes that the outcome of such suits will not have a material adverse effect on its financial condition or operations. Environmental Matters Federal, state and local environmental requirements, particularly relating to air and water quality, are a significant factor in the Company's business. The Company employs processes in the manufacture of pulp, paperboard and other products, resulting in various discharges and emissions that are subject to numerous federal, state and local environmental control statutes, regulations and ordinances. The Company operates and expects to operate under permits and similar authorizations from various governmental authorities that regulate such discharges and emissions. Occasional violations of permit terms have occurred from time to time at the Company's facilities, resulting in administrative actions, legal proceedings or consent decrees and similar arrangements. Pending proceedings include the following: In March 1992, JSC entered into an administrative consent order with the Florida Department of Environmental Regulation to carry out any necessary assessment and remediation of JSC-owned property in Duval County, Florida that was formerly the site of a sawmill that dipped lumber into a chemical solution. Assessment is on-going, but initial data indicates soil and groundwater contamination that may require nonroutine remediation. Management believes that the probable costs of this site, taken alone or with potential costs at other Company-owned properties where some contamination has been found, will not have a material adverse effect on its financial condition or operations. In February 1994, JSC entered into a consent decree with the State of Ohio in full satisfaction of all liability for alleged violations of applicable standards for particulate and opacity emissions with respect to two coal-fired boilers at its Lockland, Ohio recycled boxboard mill (which has been permanently closed as part of the Company's restructuring program), and is required to pay $122,000 in penalties and enforcement costs pursuant to such consent decree. The United States Environmental Protection Agency has also issued a notice of violation with respect to such emissions, but has informally advised JSC's counsel that no Federal enforcement is likely to commenced in light of the settlement with the State of Ohio. The Company also faces potential liability as a result of releases, or threatened releases, of hazardous substances into the environment from various sites owned and operated by third parties at which Company-generated wastes have allegedly been deposited. Generators of hazardous substances sent to off-site disposal locations at which environmental problems exist, as well as the owners of those sites and certain other classes of persons (generally referred to as "potentially responsible parties" or "PRPs"), are, in most instances, subject to joint and several liability for response costs for the investigation and remediation of such sites under the Comprehensive Environmental Response, Compensation and Liability Act ("CERCLA") and analogous state laws, regardless of fault or the legality of the original disposal. The Company has received notice that it is or may be a PRP at a number of federal and/or state sites where remedial action may be required, and as a result may have joint and several liability for cleanup costs at such sites. However, liability of CERCLA sites is typically shared with the other PRPs and costs are commonly allocated according to relative amounts of waste deposited. Because the Company's relative percentage of waste deposited at the majority of these sites is quite small, management of the Company believes that its probable liability under CERCLA, taken on a case by case basis or in the aggregate, will not have a material adverse effect on its financial condition or operations. Pending CERCLA proceedings include the following: In January 1990, CCA filed a motion for leave to intervene and for modification of the consent decree in United States v. General Refuse Services, a case pending in the United States District Court for the Southern District of Ohio. CCA contends that it should be allowed to participate in the proposed consent decree, which provides for remediation of alleged releases or threatened releases of hazardous substances at a site in Miami County, near Troy, Ohio, according to a plan approved by the United States Environmental Protection Agency, Region V (the "Agency"). The Court granted CCA's motion to intervene in this litigation, but denied CCA's motion for an order denying entry of the consent decree. Consequently, the consent decree has been entered without CCA's being included as a party to the decree, meaning that CCA may have some exposure to potential claims for contribution to remediation costs incurred by other participants and for non-reimbursed response costs incurred by the Agency, which costs are reported by the Agency as $3.4 million as of February 1994. CCA's appeal of the Court's decision to the Sixth Circuit Court of Appeals is pending. In December 1991, the United States filed a civil action against CCA in United States District Court, Southern District of Ohio, to recover its unreimbursed costs at the Miami County site, and CCA subsequently filed a third-party complaint against certain entities that had joined the original consent decree. In October 1993, the United States filed an additional suit against CCA in the same court seeking injunctive relief and damages up to $25,000 per day from March 27, 1989 to the present, based on CCA's alleged failure to properly respond to the Agency's document and information requests in connection with this site. In July 1993, counsel for CCA was advised by the Office of the United Stated Attorney, Northern District of Illinois that a criminal inquiry is also underway relating to CCA's responses to the Agency's document and information requests. CCA is investigating the circumstances regarding its responses, and is pursuing settlement with respect to all matters relating to the Miami County Site. CCA has paid approximately $768,000 pursuant to two partial consent decrees entered into in 1990 and 1991 with respect to clean-up obligations at the Operating Industries site in Monterey Park, California. It is anticipated that there will be further remedial measures beyond those covered by these partial settlements. In addition to other Federal and State laws regarding hazardous substance contamination at sites owned or operated by the Company, the New Jersey Industrial Site Recovery Act ("ISRA") requires that a "Negative Declaration" or a "Cleanup Plan" be filed and approved by the New Jersey Department of Environmental Protection and Energy ("DEPE") as a precondition to the "transfer" of an "industrial establishment". The ISRA regulations provide that a transferor may close a transaction prior to the DEPE's approval of a negative declaration if the transferor enters into an administrative consent order with the DEPE. The Company is currently a signatory to administrative consent orders with respect to two formerly leased or owned industrial establishments and has recently closed a facility and received a negative declaration with respect thereto. Management believes that any requirements that may be imposed by the DEPE with respect to these sites will not have a materially adverse effect on the financial condition or operations of the Company. The Company's paperboard and newsprint mills are large consumers of energy, using either natural gas or coal. Approximately 67% of the Company's total paperboard tonnage is produced by mills which have coal-fired boilers. The cost of energy is dependent, in part, on environmental regulations concerning sulfur dioxide and particulate emissions. Because various pollution control standards are subject to change, it is not possible at this time to predict the amount of capital expenditures that will ultimately be required to comply with future standards. In particular, the United States Environmental Protection Agency has proposed a comprehensive rule governing the pulp, paper and paperboard industry, which could require substantial compliance expenditures on the part of the Company. For the past three years, the Company has spent an average of approximately $10 million annually on capital expenditures for environmental purposes. Further sums may be required in the future, although, in the opinion of management, such expenditures will not have a material effect on its financial condition or results of operations. The amount budgeted for such expenditures for fiscal 1994 is approximately $10 million. Since the Company's competitors are, or will be, subject to comparable pollution control standards, including the proposed rule discussed above, if implemented, management is of the opinion that compliance with future pollution standards will not adversely affect the Company's competitive position. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders of the registrant during the fourth quarter of 1993. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS MARKET INFORMATION CCA is an indirect wholly-owned subsidiary of JSC. All of the outstanding common stock of JSC ("JSC Common Stock") is owned by Holdings. As a result, there is no established public market for either the JSC Common Stock or the common stock of CCA ("CCA Common Stock"). DIVIDENDS In connection with the 1989 Transaction, the number of outstanding shares of JSC Common Stock was reduced from 38,557,721 to 1,000. There have been no dividends on the JSC Common Stock or the CCA Common Stock since the date of the 1989 Transaction. Following the consummation of the Offerings, the Senior Notes and the 9.75% Senior Unsecured Notes due 2003 (the "1993 Notes") will allow each of JSC and CCA to pay dividends such that the Company would be able, and permitted thereunder, to pay dividends. However, the New Credit Agreement and, unless and until the Subordinated Debt Refinancing is consummated, the indentures governing the Subordinated Debt, will prohibit the payment of any dividends by JSC or CCA for the foreseeable future. Delaware law generally requires that dividends are payable only out of a company's surplus or current net profits in accordance with the General Corporation Law of Delaware. Such Delaware law limitations apply to the payment of dividends by JSC and CCA. Any determination to pay cash dividends in the future will be at the discretion of the Board of Directors and will be dependent upon the Company's results of operations, financial condition, contractual restrictions and other factors deemed relevant at the time by the Board of Directors. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA (In millions, except statistical data) ITEM 6. SELECTED FINANCIAL DATA (cont'd) (In millions, except statistical data) [FN] Data for the year ended December 31, 1989, includes CCA's results of operations as if CCA were consolidated with JSC as of January 1, 1989. Equity in earnings (loss) of affiliates in 1991 includes after-tax charges of $29.3 million and $6.7 million for the write-off of the Company's equity investments in Temboard and Company Company Limited Partnership, Inc., and PCL Industries Limited, respectively. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS General Industry Conditions Sales of containerboard and corrugated shipping containers, two of the Company's most important products, are generally subject to changes in industry capacity and cyclical changes in the economy, both of which can significantly impact selling prices and the Company's profitability. Operating rates in the industry during 1992 and 1991 were at high levels relative to demand, which was lower due to the sluggish U.S. economy and a decline in export markets. This imbalance resulted in excess inventories in the industry and lower prices for the Company's containerboard and corrugated shipping container products, which began early in 1991 and continued throughout 1992 and most of 1993. From the first quarter of 1991 through the third quarter of 1993 industry linerboard prices fell from $347 per ton to $295 per ton. During 1993, industry operating rates were lower as many containerboard producers, including the Company, took downtime at containerboard mills to reduce the excess inventories. By the end of the third quarter of 1993, inventory levels had decreased significantly. The lower level of inventories and the stronger U.S. economy provided what the Company believes were improved market conditions late in 1993, enabling the Company and other producers to implement a $25 per ton price increase for linerboard. A further linerboard increase of $30 per ton was implemented by all major integrated containerboard producers, including the Company, effective March 1, 1994. Newsprint prices have fallen substantially since 1990 due to supply and demand imbalances. During 1991 and 1992, new capacity of approximately 2.0 million tons annually came on line, representing an approximate 12% increase in supply. At the same time, U.S. consumption of newsprint fell, due to declines in readership and ad linage. As prices fell, certain high cost, virgin paper machines, primarily in Canada, representing approximately 1.2 million tons of annual production capacity, were shut down and remained idle during 1993. While supply was diminished, a price increase announced for 1993 was unsuccessful. Although market demand has improved in the fourth quarter of 1993, the Company does not expect significant improvement in prices before the second quarter of 1994. In addition, prices for many of the Company's other products, including solid bleached sulfate, recycled boxboard, folding cartons and reclaimed fibre weakened in 1993 and 1992. While the effect of the reclaimed fibre price decreases is unfavorable to the reclamation products division, it is favorable to the Company overall because of the reduction in fibre cost to the Company's paper mills that use reclaimed fibre. The Company has taken various steps to extend its business into less cyclical product lines, such as industrial packaging and consumer packaging. As a result of these industry conditions, the Company's gross margin declined from 18.1% in 1991 to 16.6% in 1992 and 12.7% in 1993. The Company's sales and profitability have historically been more sensitive to price changes than changes in volume. There can be no assurance that announced price increases for the Company's products can be implemented, or that prices for the Company's products will not decline from current levels. Cost Reduction Initiatives The recent cyclical downturn in the Paperboard/Packaging Products segment has led management to undertake several major cost reduction initiatives. In 1991, the Company implemented an austerity program to freeze staff levels, defer certain discretionary spending programs and more aggressively manage capital expenditures and working capital in order to conserve cash and reduce interest expense. While these measures successfully reduced expenses and increased cash flow, the length and extent of the industry downturn led the Company, in 1993, to initiate a new six year plan to reduce costs, increase volume and improve product mix (the "Plan"). The Plan is a systematic Company-wide effort designed to improve the cost competitiveness of all the Company's operating facilities and staff functions. In addition to increases in volume and improvements in product mix resulting from a focus on less commodity oriented business at its converting operations, the program will focus on opportunities to reduce costs and other measures, including (i) productivity improvements, (ii) capital projects which provide high returns and quick paybacks, (iii) reductions in fibre cost, (iv) reductions in the purchase cost of materials, (v) reductions in personnel costs and (vi) reductions in waste cost. Restructuring Program To further counteract the downturn in the industries in which the Company operates, management examined its cost and operating structure and developed a restructuring program (the "Restructuring Program") to improve its long-term position. As a result of management's review, in September 1993, the Company recorded a pre- tax charge of $96 million including a provision for direct expenses associated with (i) plant closures (consisting primarily of employee severance and termination benefits, lease termination costs and environmental costs); (ii) asset write-downs (consisting primarily of write-off of machinery no longer used in production and nonperforming machine upgrades); (iii) employee severance and termination benefits for the elimination of salaried and hourly personnel in operating and management realignment; and (iv) relocation of employees and consolidation of plant operations. Management anticipates that it will take approximately two to three years to complete the Restructuring Program due to ongoing customer demands. The Restructuring Program is expected to reduce production costs, employee expenses and depreciation charges. As part of the Restructuring Program, the Company closed certain high cost operating facilities, including a coated recycled boxboard mill and five converting plants, in January 1994. While future benefits of the Restructuring Program are uncertain, the operating losses in 1993 for the plants shut down in January 1994 and those contemplated in the future were $31 million. While the Company believes that it would have realized financial benefits in 1993 had these plants been shut down at the beginning of the year, and that it will realize such benefits in future periods, no assurances can be given in this regard and, in particular, no assurances can be given as to what portion of such loss would not have been realized in 1993 had such plants been shut down for the entire year. The $96 million charge consists of approximately $43 million for the write-down of assets at closed facilities and certain other nonproductive assets and $53 million of future cash expenditures. Significant anticipated cash expenditures reflected in the above amount include $33 million of plant closure costs, $5 million of employee severance and termination benefits and $7 million of consolidation and relocation of plant employees and equipment, a substantial portion of which will be paid in 1994, 1995 and 1996. Environmental Matters The Company recorded a provision of $54 million of which $39 million relates to environmental matters, representing asbestos and PCB removal, solid waste cleanup at existing and former operating sites, and expenses for response costs at various sites where the Company has received notice that it is a potentially responsible party ("PRP"). The Company, as well as other companies in the industry, faces potential environmental liability related to various sites at which wastes have allegedly been deposited. The Company has received notice that it is or may be a PRP at a number of federal and state sites (the "Sites") where remedial action may be required. Because the laws that govern the clean up of waste disposal sites have been construed to authorize joint and several liability, government agencies or other parties could seek to recover all response costs for any Site from any one of the PRPs for such Site, including the Company, despite the involvement of other PRPs. Although the Company is unable to estimate the aggregate response costs in connection with the remediation of all Sites, if the Company were held jointly and severally liable for all response costs at some or all of the Sites, it would have a material adverse effect on the financial condition and results of operations of the Company. However, joint and several liability generally has not in the past been imposed on PRPs, and, based on such past practice, the Company's past experience and the financial conditions of other PRPs with respect to the Sites, the Company does not expect to be held jointly and severally liable for all response costs at any Site. Liability at waste disposal sites is typically shared with other PRPs and costs generally are allocated according to relative volumes of waste deposited. At most Sites, the waste attributed to the Company is a very small portion of the total waste deposited at the Site (generally significantly less than 1%). There are approximately ten Sites where final settlement has not been reached and where the Company's potential liability is expected to exceed de minimis levels. Accordingly, the Company believes that its estimated total probable liability for response costs at the Sites was adequately reserved at December 31, 1993. Further, the estimate takes into consideration the number of other PRPs at each site, the identity, and financial position of such parties, in light of the joint and several nature of the liability, but does not take into account possible insurance coverage or other similar reimbursement. Results of Operations The following tables present net sales on a segment basis for the years ended December 31, 1993, 1992 and 1991 and an analysis of period-to-period increases (decreases) in net sales (in millions): 1993 Compared to 1992 The Company's net sales for 1993 decreased 1.7% to $2.95 billion compared to $3.0 billion in 1992. Net sales decreased 1.9% in the Paperboard/Packaging Products segment and increased 0.3% in the Newsprint segment. The decrease in Paperboard/Packaging Products segment sales for 1993 was due primarily to lower prices and changes in product mix for containerboard, corrugated shipping containers and folding cartons. This decrease was partially offset by an increase in sales volume primarily of corrugated shipping containers, which set a record in 1993. A newly constructed corrugated container facility and several minor acquisitions in 1992 caused net sales to increase $34.9 million for 1993. The net sales increase in the Newsprint segment was a result of an increase in sales volume in 1993 compared to 1992, partially offset by a decline in sales prices. Cost of goods sold as a percent of net sales for 1993 and 1992 were 85.9% and 81.9%, respectively, for the Paperboard/Packaging Products segment and 102.8% and 99.0%, respectively, for the Newsprint segment. The increase in cost of goods sold as a percent of net sales for the Paperboard/Packaging Products segment was due primarily to the aforementioned changes in pricing and product mix. The increase in the cost of goods sold as a percent of net sales for the Newsprint segment was due primarily to the higher cost of energy and fibre and decreases in sales price. In 1993, the Company changed the estimated depreciable lives of its paper machines and major converting equipment. These changes were made to better reflect the estimated periods during which the assets will remain in service and were based upon the Company's historical experience and comparable industry practice. These changes were made effective January 1, 1993 and had the effect of reducing depreciation expense by $17.8 million and decreasing the 1993 net loss by $11.0 million. Selling and administrative expenses increased to $239.2 million (3.4%) for 1993 compared to $231.4 million for 1992. The increase was due primarily to higher provisions for retirement costs, acquisitions, new facilities and other costs. In order to minimize significant year-to-year fluctuations in pension cost caused by financial market volatility, the Company changed, effective January 1, 1993, the method of accounting for the recognition of fluctuations in the market value of pension assets. The effect of this change on 1993 results of operations, including the cumulative effect of prior years, was not material. See Note 8 to the Company's consolidated financial statements. The Company reduced its weighted average discount rate in measuring its pension obligations from 8.75% to 7.6% and its rate of increase in compensation levels from 5.5% to 4.0% at December 31, 1993. The net effect of changing these assumptions was the primary reason for the increase in the projected benefit obligations and the changes are expected to increase pension cost by approximately $3.4 million in 1994. As a result of the $96 million restructuring charge, $54 million environmental and other charges, and the lower margins, primarily for newsprint and containerboard products, the Company had a loss from operations of $14.7 million for 1993, compared to $267.7 million income from operations for 1992. Interest expense for 1993 declined $45.9 million due to lower effective interest rates and the lower level of subordinated debt outstanding resulting primarily from the 1992 Transaction. The benefit from income taxes for 1993 was $83.0 million compared to a tax provision of $10.0 million in 1992. The significant difference in the income tax provision from 1993 to 1992 results from the use of the liability method of accounting which restored deferred income taxes and increased the related asset values for tax effects previously recorded as a reduction of the carrying amount of the related assets under prior business combinations. The Company's effective tax rate for 1993 was lower than the Federal statutory tax rate due to the nondeductibility of goodwill amortization and a $5.7 million provision to adjust deferred tax assets and liabilities in 1993 due to the enacted Federal income tax rate change from 34% to 35%. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes" and SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions". The cumulative effect of adopting SFAS No. 109 was to increase net income for 1993 by approximately $20.5 million. The cumulative effect of adopting SFAS No. 106 was to decrease net income for 1993 by approximately $37 million. The Company will adopt SFAS No. 112 "Employers' Accounting for Postemployment Benefits" in 1994, the effect of which is not expected to be material. The loss before extraordinary item and cumulative effect of accounting changes for 1993 was $174.6 million, compared to $34.0 million for the comparable period in 1992. The Company recorded an extraordinary loss of $37.8 million (net of income tax benefits of $21.7 million) for the early extinguishment of debt associated with the issuance of the 1993 Notes. 1992 Compared to 1991 Net sales for 1992 increased to $3.0 billion (2.0%) compared to $2.94 billion in 1991. Net sales increased 3.7% in the Paperboard/Packaging Products segment and decreased 13.6% in the Newsprint segment. The increase in Paperboard/Packaging Products segment sales was due primarily to a 5.6% increase in sales volume for corrugated shipping containers. Segment sales were also positively affected by increases in sales volumes for papertubes and partitions and to a lesser extent for folding cartons and reclamation products. Prices of containerboard products improved over 1991 but did not increase sufficiently to cover cost increases, causing margins to be somewhat lower in 1992. Prices for most of the Company's other packaging products have declined compared to 1991. A minor acquisition in 1992 and the operation of new facilities in the Paperboard/Packaging Products segment resulted in an increase in net sales of $9.8 million, while plant closings caused net sales to decrease by $2.2 million. The net sales decrease in the Newsprint segment was a result of the lower sales prices as discussed above. Newsprint sales volume for 1992 was virtually the same as 1991. The Company continued to benefit from certain austerity measures first implemented during 1991 to help offset the impact of the recession. These measures had a positive effect on cost of goods sold and selling and administrative expenses. Cost of goods sold as a percent of net sales for 1992 and 1991 were 81.9% and 81.8%, respectively, for the Paperboard/Packaging Products segment and 99.0% and 83.1% respectively, for the Newsprint segment. The increase in the Newsprint segment was due primarily to the aforementioned decrease in sales price. Selling and administrative expense as a percent of net sales for 1992 was 7.7%, unchanged from 1991. The Company continued to benefit from certain cost containment measures implemented in 1991 to reduce expenses to help offset the impact of the recession and inflation. Income from operations for 1992 decreased 12.4% to $267.7 million as a result of the low average selling prices for newsprint and packaging products discussed above. Interest expense for 1992 was lower by $35.1 million, due to lower effective interest rates and the lower level of debt outstanding as a result of the 1992 Transaction. During 1992, the Company replaced $425.0 million of mature swaps with $400.0 million of the new two-year fixed interest rate swaps at an annual savings of approximately 3.8% on such amount (equivalent to an annual savings of approximately $15.1 million). The Company recorded a $10.0 million income tax provision to both 1992 and 1991 on income before income taxes, equity in earnings (loss) of affiliates and extraordinary item of $27.2 million and $24.3 million, respectively. The tax provisions for 1992 and 1991 were higher than the Federal statutory tax rate due to several factors, the most significant of which was the impact of permanent differences from applying purchase accounting. Equity in loss of affiliates for 1991 included a write-down of $36.0 million with respect to the Company's equity investments in Temboard and Company Limited Partnership and PCL Industries Limited. See Note 3 to the Company's consolidated financial statements. For 1992 the Company had an extraordinary loss of $49.8 million (net of income tax benefits of $25.8 million) for the early extinguishment of debt associated with the 1992 Transaction. Impact of Inflation and Changing Prices The Company uses the LIFO method of accounting for approximately 81% of its inventories. Under this method, the cost of products sold reported in the financial statements approximates current cost and thus reduces the distortion in reported income due to increasing costs. In recent years, inflation has not had a material effect on the financial position or results of operations of the Company. Liquidity and Capital Resources The Company's primary uses of cash for the next several years will be principal and interest payments on its indebtedness and capital expenditures. In April 1993, the Company issued $500 million aggregate principal amount of the 1993 Notes. Proceeds of the 1993 Notes were used to refinance a substantial portion of indebtedness in order to improve operating and financial flexibility by extending maturities of indebtedness and improving liquidity. As a result of the issuance of the 1993 Notes, there are no significant scheduled payments due on bank term loans until June 1996 (assuming the refinancing of the Company's indebtedness under 1989 and 1992 Credit Agreements and the Secured Notes is not consummated). In connection with the issuance of the 1993 Notes, SIBV committed to purchase up to $200 million aggregate principal amount of 11 1/2% Junior Subordinated Notes maturing 2005, the proceeds of which must be used to repurchase or otherwise retire Subordinated Debt. The above commitment will be terminated upon the consummation of the Offerings. Holdings and the Company are implementing the Recapitalization Plan to repay or refinance a substantial portion of their indebtedness in order to improve operating and financial flexibility by (i) reducing the level and overall cost of their debt, (ii) extending maturities of indebtedness, (iii) increasing stockholders' equity and (iv) increasing their access to capital markets. The Recapitalization Plan includes (i) the Debt Offerings, (ii) the Equity Offerings, (iii) the SIBV Investment, and (iv) the New Credit Agreement consisting of the New Revolving Credit Facility and the New Term Loans. Proceeds of the Recapitalization Plan, exclusive of funds used to effect the Subordinated Debt Refinancing (including the remaining borrowings under the Delayed Term Loan and available proceeds of the Debt Offerings), will be used to refinance all of the Company's indebtedness under the 1989 and 1992 Credit Agreements and the Secured Notes. Available proceeds of the Debt Offerings, remaining borrowings under the Delayed Term Loan and, to the extent required, borrowings under the New Revolving Credit Facility or available cash shall be used to redeem or repurchase the Subordinated Debt on approximately December 1, 1994. It is anticipated that immediately following the Offerings, borrowings of $65 million and letters of credit of approximately $90 million will be outstanding under the New Revolving Credit Facility. After giving effect to the Recapitalization Plan on a pro forma basis, at December 31, 1993 the Company would have had approximately $2,371.1 million of total long-term debt outstanding, all of which would have been senior debt, as compared to $2,619.1 million of long-term debt actually outstanding. After completion of the Recapitalization Plan there will be no significant scheduled payments due on bank debt (other than required payments out of "excess cash", if any) until 18 months following consummation of the Offerings, at which time approximately $46.0 million will be payable. Assuming consummation of the Recapitalization Plan (whether including or excluding the Subordinated Debt Refinancing), the Company does not currently anticipate that it will experience any liquidity problems which would cause it to fail to make any scheduled payment on its bank debt. As discussed below, the Company expects that liquidity will be provided by its operations and through the utilization of unused borrowing capacity under the New Credit Agreement and the Securitization (defined below). The Company's earnings are significantly affected by the amount of interest on its indebtedness. At December 31, 1993, the Company had $215 million of variable rate debt which had been swapped to a weighted average fixed rate of approximately 9.1%. The Company also had interest rate swap agreements related to the Accounts Receivable Securitization Program (the "Securitization") that effectively converted $95 million of fixed rate borrowings to a variable rate of 5.6% (at December 31, 1993) and converted $80 million of variable rate borrowings to a fixed rate of 7.2% through January 1996. In addition, the Company is party to interest rate swap agreements related to the 1993 Notes which convert $500 million of fixed rate borrowings to a variable rate of 8.6% (at December 31, 1993). Capital expenditures consist of property and timberland additions and acquisitions of businesses. Capital expenditures for 1993, 1992 and 1991 were $117.4 million, $97.9 million and $118.9 million, respectively. Financing arrangements entered into in connection with the 1989 Transaction impose an annual limit on future capital expenditures, as defined in the financing arrangements, of approximately $125.0 million. The capital spending limit is subject to increase in any year if the prior year's spending was less than the maximum amount allowed. For 1993, such carryover from 1992 was $75 million. Because the Company has invested heavily in its core businesses over the last several years, management believes the annual limitation on capital expenditures should not impair its plans for maintenance, expansion and continued modernization of its facilities. It is expected that the New Credit Agreement will contain limitations on capital expenditures substantially similar to those contained in the financing arrangements entered into in connection with the 1989 Transaction. The Company anticipates making capital expenditures of approximately $140 million in 1994. Under the terms of the Old Bank Facilities, the Company is required to comply with certain financial covenants, including maintenance of quarterly and annual interest coverage ratios and earnings, as defined. In anticipation of violating these financial covenants at September 30, 1993, the Company requested and received waivers from its lender group, and in December, 1993 amended the Old Bank Facilities to modify financial covenants. The Company was in compliance with the amended covenants at December 31, 1993. The Company expects to have similar covenants in the New Credit Agreement. Operating activities have historically been the major source of cash for the Company's working capital needs, capital expenditures and debt payments. For 1993 and 1992, net cash provided by operating activities was $78.2 million and $145.7 million, respectively. At December 31, 1993, the Company had $112.1 million in unused borrowing capacity under the Revolving Credit Facility. Following the Offerings, the Company anticipates having $295.0 million of unused borrowing capacity under the New Revolving Credit Facility under the New Credit Agreement. The Company has borrowing capacity of $230.0 million under the Securitization subject to the Company's level of eligible accounts receivable. At December 31, 1993, the Company had borrowed $182.3 million under the Securitization and the level of eligible receivables did not permit any additional borrowings under the Securitization at the date. The Securitization matures in April 1996, at which time the Company expects to refinance it. Although the Company believes that it will be able to do so, no assurance can be given in this regard. The Company's existing indebtedness imposes restrictions on its ability to incur additional indebtedness. Such restrictions, together with the highly leveraged position of the Company, could restrict corporate activities, including the Company's ability to respond to market conditions, to provide for unanticipated capital expenditures or to take advantage of business opportunities. However, the Company believes that cash provided by operations and available financing sources will be sufficient to meet the Company's cash requirements for the next several years. This page is intentionally left blank. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Page No. The following consolidated financial statements of Jefferson Smurfit Corporation are included in this report: Consolidated balance sheets - December 31, 1993 and 1992 . . . . . 30 For the years ended December 31, 1993, 1992 and 1991: Consolidated statements of operations . . . . . . . . . . . . 32 Consolidated statements of stockholder's deficit. . . . . . . . . 33 Consolidated statements of cash flows . . . . . . . . . . . . . . 34 Notes to consolidated financial statements. . . . . . . . . . . . . 35 The following consolidated financial statement schedules of Jefferson Smurfit Corporation are included in Item 14(a): II: Amounts Receivable From Related Parties and Underwriters, Promoters and Employees Other than Related Parties. . . . . . 79 V: Property, Plant and Equipment . . . . . . . . . . . . . . . . 80 VI: Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment . . . . . . . . . . . . . . . . 82 VIII: Valuation and Qualifying Accounts . . . . . . . . . . . . . . 84 X: Supplementary Income Statement Information. . . . . . . . . . 85 All other schedules specified under Regulation S-X for Jefferson Smurfit Corporation have been omitted because they are either not applicable, not required or because the information required is included in the financial statements or notes thereto. MANAGEMENT'S STATEMENT OF RESPONSIBILITY The management of the Company is responsible for the information contained in the consolidated financial statements and in other parts of this report. The consolidated financial statements have been prepared by the Company in accordance with generally accepted accounting principles appropriate in the circumstances, and necessarily include certain amounts based on management's best estimate and judgment. The Company maintains a system of internal accounting control, which it believes is sufficient to provide reasonable assurance that in all material respects transactions are properly authorized and recorded, financial reporting responsibilities are met and accountability for assets is maintained. In establishing and maintaining any system of internal control, judgment is required to assess and balance the relative costs and expected benefits. Management believes that through the careful selection of employees, the division of responsibilities and the application of formal policies and procedures, the Company has an effective and responsive system of internal accounting controls. The system is monitored by the Company's staff of internal auditors, who evaluate and report to management on the effectiveness of the system. The Audit Committee of the Board of Directors is composed of two directors who meet with the independent auditors, internal auditors and management to discuss specific accounting, reporting and internal control matters. Both the independent auditors and internal auditors have full and free access to the Audit Committee. James E. Terrill President, Chief Executive Officer John R. Funke Vice President and Chief Financial Officer (Principal Accounting Officer) REPORT OF INDEPENDENT AUDITORS Board of Directors JEFFERSON SMURFIT CORPORATION We have audited the accompanying consolidated balance sheets of Jefferson Smurfit Corporation as of December 31, 1993 and 1992, and the related consolidated statements of operations, stockholder's deficit and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules 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 financial statements referred to above present fairly, in all material respects, the consolidated financial position of Jefferson Smurfit Corporation at December 31, 1993 and 1992, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As described in Note 6 and Note 7 to the financial statements, in 1993, the Company changed its method of accounting for income taxes and postretirement benefits. Ernst & Young St. Louis, Missouri January 28, 1994 except as to Note 15, as to which the date is February 23, 1994 See notes to consolidated financial statements. See notes to consolidated financial statements. See notes to consolidated financial statements. See notes to consolidated financial statements. JEFFERSON SMURFIT CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 (Tabular amounts in millions) 1. -- Basis of Presentation Jefferson Smurfit Corporation ("JSC" or the "Company") is a wholly-owned subsidiary of SIBV/MS Holdings, Inc. ("Holdings"). Fifty percent of the voting stock of Holdings is owned by Smurfit Packaging Corporation ("SPC") and Smurfit Holdings B.V. ("SHBV"), indirect wholly-owned subsidiaries of Jefferson Smurfit Group plc ("JS Group"), a public corporation organized under the laws of the Republic of Ireland. The remaining 50% is owned by The Morgan Stanley Leveraged Equity Fund II, L.P. ("MSLEF II"). Holdings has no operations other than its investment in JSC. In December 1989, pursuant to a series of transactions referred to hereafter as the "1989 Recapitalization", Holdings acquired the entire equity interest in JSC. Concurrently with Holdings' acquisition of JSC, Container Corporation of America ("CCA") acquired its common equity interest not owned by JSC. Prior to the 1989 Recapitalization, Smurfit International B.V. ("SIBV"), an indirect wholly-owned subsidiary of JS Group, owned 78% of JSC's outstanding common equity, the public owned the remaining common equity of JSC and JSC indirectly owned 50% of the common stock and 100% of the preferred stock of CCA. The remaining 50% of the common stock of CCA was owned by The Morgan Stanley Leveraged Equity Fund, L.P. and other investors ("MSLEF I Group"). Both MSLEF II and MSLEF I Group are affiliates of Morgan Stanley & Co. Incorporated ("MS & Co."). For financial accounting purposes, the 1989 acquisition by CCA of its common equity owned by MSLEF I Group and the purchase of the JSC common equity owned by SIBV were accounted for as purchases of treasury stock, resulting in a deficit balance in stockholder's equity in the accompanying consolidated financial statements. The acquisition of JSC's minority interest, representing approximately 22% of JSC's common equity, was accounted for as a purchase. 2. -- Significant Accounting Policies Principles of Consolidation: The consolidated financial statements include the accounts of the Company and its majority-owned subsidiaries. Significant intercompany accounts and transactions are eliminated in consolidation. Cash Equivalents: The Company considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents. At December 31, 1993 cash and cash equivalents of $42.9 million are maintained as collateral for obligations under the accounts receivable securitization program (see Note 5). Revenue Recognition: Revenue is recognized at the time products are shipped. Inventories: Inventories are valued at the lower of cost or market, principally under the last-in, first-out ("LIFO") method except for $50.6 million in 1993 and $51.9 million in 1992 which are valued at the lower of average cost or market. First-in, first-out costs (which approximate replacement costs) exceed the LIFO value by $44.7 million and $46.3 million at December 31, 1993 and 1992, respectively. 2. -- Significant Accounting Policies (cont) Property, Plant and Equipment: Property, plant and equipment are carried at cost. Provisions for depreciation and amortization are made using straight-line rates over the estimated useful lives of the related assets and the terms of the applicable leases for leasehold improvements. Effective January 1, 1993, the Company changed its estimate of the useful lives of certain machinery and equipment. Based upon historical experience and comparable industry practice, the depreciable lives of the papermill machines that previously ranged from 16 to 20 years were increased to an average of 23 years, while major converting equipment and folding carton presses that previously averaged 12 years were increased to an average of 20 years. These changes were made to better reflect the estimated periods during which such assets will remain in service. These changes had the effect of reducing depreciation expense by $17.8 million and decreasing net loss by $11.0 million in 1993. Timberland: The portion of the costs of timberland attributed to standing timber is charged against income as timber is cut, at rates determined annually, based on the relationship of unamortized timber costs to the estimated volume of recoverable timber. The costs of seedlings and reforestation of timberland are capitalized. Deferred Debt Issuance Costs: Deferred debt issuance costs are amortized over the terms of the respective debt obligations using the interest method. Goodwill: The excess of cost over the fair value assigned to the net assets acquired is recorded as goodwill and is being amortized using the straight-line method over 40 years. Income Taxes: The taxable income of the Company is included in the consolidated federal income tax return filed by Holdings. The Company's income tax provisions are computed on a separate return basis. JSC's state income tax returns are filed on a separate return basis. Effective January 1, 1993, the Company changed its method of accounting for income taxes from the deferred method to the liability method required by Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes" (see Note 6). Interest Rate Swap Agreements: The Company enters into interest rate swap agreements which involve the exchange of fixed and floating rate interest payments without the exchange of the underlying principal amount. The differential to be paid or received is accrued as interest rates change and is recognized over the life of the agreements as an adjustment to interest expense. Reclassifications: Certain reclassifications of prior year presentations have been made to conform to the 1993 presentation. 3. -- Investments Equity in loss of affiliates of $39.9 million in 1991, which is net of deferred income tax benefits of $18.5 million, includes the Company's (i) write-off of its equity investment in Temboard, Inc., formerly Temboard and Company Limited Partnership ("Temboard"), totaling $29.3 million, (ii) write-off of its remaining equity investment in PCL Industries Limited ("PCL") totaling $6.7 million, and (iii) proportionate share of the net loss of equity affiliates, including PCL prior to the write-off of that investment, totaling $3.9 million. 4. -- Related Party Transactions Transactions with JS Group Transactions with JS Group, its subsidiaries and affiliates were as follows: Product sales to and purchases from JS Group, its subsidiaries, and affiliates are consummated on terms generally similar to those prevailing with unrelated parties. The Company provides certain subsidiaries and affiliates of JS Group with general management and elective management services under separate Management Services Agreements. In consideration for general management services, the Company is paid a fee up to 2% of the subsidiaries' or affiliate's gross sales. In consideration for elective services, the Company is reimbursed for its direct cost of providing such services. In October 1991 an affiliate of JS Group completed a rebuild of the No. 2 paperboard machine owned by the affiliate that is located in CCA's Fernandina Beach, Florida paperboard mill (the "Fernandina Mill"). Pursuant to an operating agreement between CCA and the affiliate, the affiliate engaged CCA to operate and manage the No. 2 paperboard machine. As compensation to CCA for its services the affiliate reimburses CCA for production and manufacturing costs directly attributable to the No. 2 paperboard machine and pays CCA a portion of the indirect manufacturing, selling and administrative costs incurred by CCA for the entire Fernandina Mill. The compensation is determined by applying various formulas and agreed upon amounts to the subject costs. The amounts reimbursed to CCA are reflected as reductions of cost of goods sold and selling and administrative expenses in the accompanying consolidated statements of operations. 4. -- Related Party Transactions (cont) Transactions with Times Mirror Under the terms of a long-term agreement, Smurfit Newsprint Corporation ("SNC"), a majority-owned subsidiary of the Company, supplies newsprint to Times Mirror, a minority shareholder of SNC, at amounts which approximate prevailing market prices. The obligations of the Company and Times Mirror to supply and purchase newsprint, respectively, are wholly or partially terminable upon the occurrence of certain defined events. Sales to Times Mirror for 1993, 1992 and 1991 were $115.2 million, $114.0 million and $150.6 million, respectively. 5. -- Long-Term Debt Aggregate annual maturities of long-term debt at December 31, 1993, for the next five years are $10.3 million in 1994, $220.6 million in 1995, $379.8 million in 1996, $431.5 million in 1997, and $273.0 million in 1998. In addition, approximately $77.7 million in accrued interest related to the Junior Subordinated Accrual Debentures (the "Junior Accrual Debentures") becomes due in 1994. Accrued interest of approximately $58.9 million is classified as long-term debt in the accompanying financial statements because it is the Company's intention to refinance the Junior Accrual Debentures in December 1994 with the proceeds from the Equity and Debt Offerings and the new bank facility described in Note 15 or from its $200 million commitment from SIBV described below. 5. -- Long-Term Debt (cont) 1992 Term Loan In August 1992, the Company repurchased $193.5 million of Junior Accrual Debentures, and repaid $19.1 million of the Subordinated Note and $400 million of the 1989 term loan facility ("1989 Term Loan"). The proceeds from a $231.8 million capital contribution by Holdings and a $400 million senior secured term loan ("1992 Term Loan") were used to repurchase the Junior Accrual Debentures and repay the loans. Premiums paid in connection with this transaction, the write-off of related deferred debt issuance costs, and losses on interest rate swap agreements, totaling $49.8 million (net of income tax benefits of $25.8 million), are reflected in the accompanying 1992 consolidated statement of operations as an extraordinary loss. Outstanding loans under the 1992 Term Loan bear interest primarily at rates for which Eurodollar deposits are offered plus 3% (6.375% at December 31, 1993). The 1992 Term Loan, which matures on December 31, 1997, may require principal prepayments before then as defined in the 1992 Term Loan. 1989 Term Loan and Revolving Credit Facility The 1989 Amended and Restated Credit Agreement ("1989 Credit Agreement") consists of the 1989 Term Loan and a $400.0 million revolving credit facility (which expires in 1995) of which up to $125.0 million may consist of letters of credit. The 1989 Term Loan, which expires in 1997, requires minimum annual principal reductions, subject to additional reductions if the Company has excess cash flows or excess cash balances, as defined, or receives proceeds from certain sales of assets, issuance of equity securities, permitted indebtedness or any pension fund termination. Outstanding loans under the 1989 Credit Agreement bear interest primarily at rates for which Eurodollar deposits are offered plus 2.25%. The weighted average interest rate at December 31, 1993 on outstanding Credit Agreement borrowings was 5.95%. A commitment fee of 1/2 of 1% per annum is assessed on the unused portion of the revolving credit facility. At December 31, 1993, the unused portion of the revolving credit facility, after giving consideration to outstanding letters of credit, was $112.1 million. Senior Secured Notes The Senior Secured Notes due in 1998 may be prepaid at any time. Mandatory prepayment is required from a pro rata portion of net cash proceeds of certain sales of assets or additional borrowings. The Senior Secured Notes bear interest at rates for which three month Eurodollar deposits are offered plus 2.75% (6.25% at December 31, 1993). Obligations under the 1992 Term Loan, the 1989 Credit Agreement, and the Senior Secured Notes Agreement share pro rata in certain mandatory prepayments and the collateral and guarantees that secure these obligations. These obligations are secured by the common stock of JSC and CCA and substantially all of their assets, with the exception of cash and cash equivalents and trade receivables, and are guaranteed by Holdings. These agreements contain various business and financial covenants including, among other things, (i) limitations on the incurrence of indebtedness; (ii) limitations on capital expenditures; (iii) restrictions on paying dividends, except for dividends paid by SNC; (iv) maintenance of minimum interest coverage ratios; and (v) maintenance of quarterly and annual cash flows, as defined. 5. -- Long-Term Debt (cont) In anticipation of violation of certain financial covenants at September 30, 1993, in connection with its 1992 Term Loan, 1989 Credit Agreement and the Senior Secured Notes, the Company requested and received waivers from its lender group. In addition, the Company's credit facilities were amended in December 1993, to modify financial covenants that have become too restrictive due to continued pricing weakness in the paper industry. The Company complied with the amended covenants at December 31, 1993. Accounts Receivable Securitization Program Loans The $230.0 million accounts receivable securitization program ("Securitization Program") provides for the sale of certain of the Company's trade receivables to a wholly-owned, bankruptcy remote, limited purpose subsidiary, Jefferson Smurfit Finance Corporation ("JS Finance"), which finances its purchases of the receivables, through borrowings from a limited purpose finance company (the "Issuer") unaffiliated with the Company. The Issuer, which is restricted to making loans to JS Finance, issued $95.0 million in fixed rate term notes, issued $13.8 million under a subordinated loan, and may issue up to $121.2 million in trade receivables backed commercial paper or obtain up to $121.2 million under a revolving liquidity facility to fund loans to JS Finance. At December 31, 1993, $47.1 million was available for additional borrowing. Borrowings under the Securitization Program, which expires April 1996, have been classified as long-term debt because of the Company's intent to refinance this debt on a long-term basis and the availability of such financing under the terms of the program. At December 31, 1993, all assets of JS Finance, principally cash and cash equivalents of $42.9 million and trade receivables of $173.8 million, are pledged as collateral for obligations of JS Finance to the Issuer. Interest rates on borrowings under this program are at a fixed rate of 9.56% for $95.0 million of the borrowings and at a variable rate on the remainder (3.94% at December 31, 1993). Senior Unsecured Notes In April 1993, CCA issued $500.0 million of 9.75% Senior Unsecured Notes due 2003 which are unconditionally guaranteed by JSC. Net proceeds from the offering were used to repay: $100.0 million outstanding under the revolving credit facility, $196.5 million outstanding under the 1989 Term Loan, and $191.0 million outstanding under the 1992 Term Loan. The write-off of related deferred debt issuance costs and losses on interest rate swap agreements, totalling $37.8 million (net of income tax benefits of $21.7 million), are reflected in the accompanying 1993 consolidated statement of operations as an extraordinary item. In connection with the issuance of the Senior Unsecured Notes, the Company entered into an agreement with SIBV whereby SIBV committed to purchase up to $200 million of 11.5% Junior Subordinated Notes to be issued by the Company maturing December 1, 2005. From time to time until December 31, 1994, the Company, at their option, may issue the Junior Subordinated Notes, the proceeds of which must be used to repurchase or otherwise retire subordinated debt. The Company is obligated to pay SIBV for letter of credit fees incurred by SIBV in connection with this commitment in addition to an annual commitment fee of 1.375% on the undrawn principal amount (See Note 4). 5. -- Long-Term Debt (cont) The Senior Unsecured Notes due April 1, 2003, which are not redeemable prior to maturity, rank pari passu with the 1992 Term Loan, the 1989 Credit Agreement and the Senior Secured Notes. The Senior Unsecured Note Agreement contains business and financial covenants which are substantially less restrictive than those contained in the 1992 Term Loan, 1989 Credit Agreement and the Senior Secured Notes Agreement. Other Non-subordinated Debt Other non-subordinated long-term debt at December 31, 1993, is payable in varying installments through the year 2004. Interest rates on these obligations averaged approximately 9.76% at December 31, 1993. Subordinated Debt The Senior Subordinated Notes, Subordinated Debentures and Junior Accrual Debentures are unsecured obligations of CCA and are unconditionally guaranteed on a senior subordinated, subordinated and junior subordinated basis, respectively, by JSC. Semi-annual interest payments are required on the Senior Subordinated Notes, and Subordinated Debentures. Interest on the Junior Accrual Debentures accrues and compounds on a semi-annual basis until December 1, 1994 at which time accrued interest is payable. Thereafter, interest on the Junior Accrual Debentures will be payable semi-annually. The Senior Subordinated Notes are redeemable at CCA's option beginning December 1, 1994 with premiums of 6.75% and 3.375% of the principal amount if redeemed during the 12-month periods commencing December 1, 1994 and 1995, respectively. The payment of principal and interest is subordinated to the prior payment, when due, of all senior indebtedness, as defined. The Subordinated Debentures are redeemable at CCA's option beginning December 1, 1994 with premiums of 7% and 3.5% of the principal amount if redeemed during the 12-month periods commencing December 1, 1994 and 1995, respectively. The payment of principal and interest is subordinated to the prior payment, when due, of all senior indebtedness, as defined, and the Senior Subordinated Notes. Sinking fund payments to retire 33-1/3% of the original aggregate principal amount of the Subordinated Debentures are required on each of December 15, 1999 and 2000. The Junior Accrual Debentures are redeemable at CCA's option beginning December 1, 1994 at 100% of the principal amount. The payment of principal and interest is subordinated to the prior payment, when due, of all senior indebtedness, as defined, the Senior Subordinated Notes and the Subordinated Debentures. Sinking fund payments to retire 33- 1/3% of the original aggregate principal amount of the Junior Accrual Debentures are required on each of December 1, 2002 and 2003. Holders of the Senior Subordinated Notes, Subordinated Debentures, and Junior Accrual Debentures have the right, subject to certain limitations, to require the Company to repurchase their securities at 101% of the principal amount plus accrued and unpaid interest, upon the occurrence of a change of control or in certain events from proceeds of major asset sales, as defined. The Senior Subordinated Notes, Subordinated Debentures and Junior Accrual Debentures contain various business and financial covenants which are less restrictive than those contained in the 1992 Term Loan, the 1989 Credit Agreement and the Senior Secured Notes Agreement. 5. -- Long-Term Debt (cont) Interest Rate Swaps At December 31, 1993, the Company has interest rate swap and other hedging agreements with commercial banks which effectively fix (for remaining periods up to 3 years) the Company's interest rate on $215 million of variable rate borrowings at average all-in rates of approximately 9.1%. At December 31, 1993, the Company had $435 million of swap commitments outstanding which were marked to market in April 1993. The Company also has outstanding interest rate swap agreements related to the Securitization Program that effectively convert $95.0 million of fixed rate borrowings to a variable rate (5.6% at December 31, 1993) through December 1995, and convert $80.0 million of variable rate borrowings to a fixed rate of 7.2% through January 1996. In addition, the Company is party to interest rate swap agreements related to the Senior Unsecured Notes which effectively converts $500.0 million of fixed rate borrowings to a variable rate (8.6% at December 31, 1993) maturing at various dates through May 1995. The Company is exposed to credit loss in the event of non-performance by the other parties to the interest rate swap agreements. However, the Company does not anticipate non-performance by the counter parties. Interest costs capitalized on construction projects in 1993, 1992 and 1991 totalled $3.4 million, $4.2 million and $2.4 million, respectively. Interest payments on all debt instruments for 1993, 1992 and 1991 were $226.2 million, $257.6 million and $273.1 million, respectively. 6. -- Income Taxes Effective January 1, 1993, the Company changed its method of accounting for income taxes from the deferred method to the liability method required by SFAS No. 109, "Accounting for Income Taxes". As permitted under the new rules, prior years' financial statements have not been restated. The cumulative effect of adopting SFAS No. 109 as of January 1, 1993 was to increase net income by $20.5 million. For 1993, application of SFAS No. 109 increased the pretax loss by $14.5 million because of increased depreciation expense as a result of the requirement to report assets acquired in prior business combinations at pretax amounts. In adopting this new accounting principle, the Company (i) adjusted assets acquired and liabilities assumed in prior business combinations from their net-of-tax amounts to their pretax amounts and recognized the related deferred tax assets and liabilities for those temporary differences, (ii) adjusted deferred income tax assets and liabilities to statutory income tax rates and for previously unrecognized tax benefits related to certain state net operating loss carryforwards and, (iii) adjusted asset and liability accounts arising from the 1986 acquisition of CCA and the 1989 Recapitalization to recognize potential tax liabilities related to those transactions. The net effect of these adjustments on assets and liabilities was to increase inventory $23.0 million, increase property, plant and equipment and timberlands $196.5 million, increase goodwill $42.0 million, increase liabilities by $12.6 million, and increase deferred income taxes by $228.4 million. 6. -- Income Taxes (cont) At December 31, 1993, the Company has net operating loss carryforwards for federal income tax purposes of approximately $308.6 million (expiring in the years 2005 through 2008), none of which are available for utilization against alternative minimum taxes. Significant components of the Company's deferred tax assets and liabilities at December 31, 1993 are as follows: Provisions for (benefit from) income taxes before extraordinary item and cumulative effect of accounting changes were as follows: The Company increased its deferred tax assets and liabilities in 1993 as a result of legislation enacted during 1993 increasing the corporate federal statutory tax rate from 34% to 35% effective January 1, 1993. 6. -- Income Taxes (cont) The Internal Revenue Service completed the examination of the Company's consolidated federal income tax returns for 1987 and 1988. The provision for current taxes includes settlement of the additional tax liabilities. The components of the provision for (benefit from) deferred taxes were as follows: A reconciliation of the difference between the statutory Federal income tax rate and the effective income tax rate as a percentage of loss before income taxes, equity in earnings (loss) of affiliates, extraordinary item, and cumulative effect of accounting changes is as follows: The Company made income tax payments of $33.0 million, $6.6 million, and $5.9 million in 1993, 1992, and 1991, respectively. 7. -- Employee Benefit Plans Pension Plans The Company sponsors noncontributory defined benefit pension plans covering substantially all employees not covered by multi-employer plans. Plans that cover salaried and management employees provide pension benefits that are based on the employee's five highest consecutive calendar years' compensation during the last ten years of service. Plans covering non-salaried employees generally provide benefits of stated amounts for each year of service. These plans provide reduced benefits for early retirement. The Company's funding policy is to make minimum annual contributions required by applicable regulations. The Company also participates in several multi-employer pension plans, which provide defined benefits to certain union employees. In order to minimize significant year-to-year fluctuations in pension cost caused by financial market volatility, the Company changed, effective as of January 1, 1993 the method of accounting used for determining the market-related value of plan assets. The method changed from a fair market value to a calculated value that recognizes all changes in a systematic manner over a period of four years and eliminates the use of a corridor approach for amortizing gains and losses. The effect of this change on 1993 results of operations, including the cumulative effect of prior years, was not material. Assumptions used in the accounting for the defined benefit plans were: The components of net pension income for the defined benefit plans and the total contributions charged to pension expense for the multi- employer plans follows: 7. -- Employee Benefit Plans (cont) The following table sets forth the funded status and amounts recognized in the consolidated balance sheets at December 31 for the Company's and its subsidiaries' defined benefit pension plans: Approximately 44% of plan assets at December 31, 1993 are invested in cash equivalents or debt securities and 56% are invested in equity securities, including common stock of JS Group having a market value of $87.7 million. Postretirement Health Care and Life Insurance Benefits The Company provides certain health care and life insurance benefits for all salaried and certain hourly employees. The Company has various plans under which the cost may be borne either by the Company, the employee or partially by each party. The Company does not currently fund these plans. These benefits are discretionary and are not a commitment to long-term benefit payments. The plans were amended effective January 1, 1993 to allow employees who retire on or after January 1, 1994 to become eligible for these benefits only if they retire after age 60 while working for the Company. Effective January 1, 1993, the Company adopted SFAS No. 106, "Employer's Accounting for Postretirement Benefits Other Than Pensions", which requires companies to accrue the expected cost of retiree benefit payments, other than pensions, during employees' active service period. The Company elected to immediately recognize the accumulated liability, measured as of January 1, 1993. The cumulative effect of this change in accounting principle resulted in a charge of $37.0 million (net of income tax benefits of $21.9 million). The Company had previously recorded an obligation of $36.0 million in connection with prior business combinations. The net periodic postretirement benefit cost for 1993 was $9.8 million. In 1992 and 1991, the cost of the postretirement benefits was recognized as claims were paid and was $6.4 million and $5.3 million, respectively. 7. -- Employee Benefit Plans (cont) The following table sets forth the accumulated postretirement benefit obligation ("APBO") with respect to these benefits as of December 31, 1993: Net periodic postretirement benefit cost for 1993 included the following components: A weighted-average discount rate of 7.6% was used in determining the APBO at December 31, 1993. The weighted-average annual assumed rate of increase in the per capita cost of covered benefits ("healthcare cost trend rate") was 11%, with an annual decline of 1% until the rate reaches 5%. The effect of a 1% increase in the assumed healthcare cost trend rate would increase both the APBO as of December 31, 1993 by $5.7 million and the annual net periodic postretirement benefit cost for 1993 by $.8 million. 1992 Stock Option Plan Effective August 26, 1992, Holdings adopted the Holdings 1992 Stock Option Plan (the "Plan") which replaced the 1990 Long-Term Management Incentive Plan. Under the Plan, selected employees of JSC and its affiliates and subsidiaries are granted non-qualified stock options, up to a maximum of 603,656 shares, to acquire shares of common stock of Holdings. The stock options are exercisable at a price equal to the fair market value, as defined, of Holdings' common stock on the date of grant. The options vest pursuant to the schedule set forth for each option and expire upon the earlier of twelve years from the date of grant or termination of employment. The stock options become exercisable upon the earlier of the occurrence of certain trigger dates, as defined, or eleven years from the date of grant. Options for 494,215 and 502,645 shares, were outstanding at December 31, 1993 and 1992, respectively at an exercise price of $100.00, none of which were exercisable. 8. -- Leases The Company leases certain facilities and equipment for production, selling and administrative purposes under operating leases. Future minimum lease payments at December 31, 1993, required under operating leases that have initial or remaining noncancelable lease terms in excess of one year are $30.3 million in 1994, $22.5 million in 1995, $15.5 million in 1996, $11.3 million in 1997, $8.3 million in 1998 and $19.1 million thereafter. Net rental expense was $45.0 million, $42.2 million, and $38.7 million for 1993, 1992 and 1991, respectively. 9. -- Fair Value of Financial Instruments The estimated fair values of the Company's financial instruments are as follows: The carrying amount of cash equivalents approximates fair value because of the short maturity of those instruments. The fair value of the Company's long-term debt is estimated based on the quoted market prices for the same or similar issues or on the current rates offered to the Company for debt of the same remaining maturities. The fair value of the interest rate swap agreements is the estimated amount the Company would pay, net of accrued interest expense, to terminate the agreements at December 31, 1993, taking into account current interest rates and the current credit worthiness of the swap counterparties. 10. -- Restructuring Charge During 1993, the Company recorded a pretax charge of $96.0 million to recognize the effects of a restructuring program designed to improve the Company's long-term competitive position. The charge includes a provision for direct expenses associated with plant closures, reductions in workforce, realignment and consolidation of various manufacturing operations and write-downs of nonproductive assets. 11. -- Contingencies During 1993, the Company recorded a pretax charge of $54.0 million of which $39.0 million represents asbestos and PCB removal, solid waste cleanup at existing and former operating sites, and expenses for response costs at various sites where the company has received notice that it is a potentially responsible party. The Company is a defendant in a number of lawsuits and claims arising out of the conduct of its business, including those related to environmental matters. While the ultimate results of such suits or other proceedings against the Company cannot be predicted with certainty, the management of the Company believes that the resolution of these matters will not have a material adverse effect on its consolidated financial condition or results of operation. 12. -- Business Segment Information The Company's business segments are paperboard/packaging products and newsprint. Substantially all the Company's operations are in the United States. The Company's customers represent a diverse range of industries including paperboard and paperboard packaging, consumer products, wholesale trade, retailing, agri-business, and newspaper publishing located throughout the United States. Credit is extended based on an evaluation of the customer's financial condition. The paperboard/packaging products segment includes the manufacture and distribution of containerboard, boxboard and cylinderboard, corrugated containers, folding cartons, fibre partitions, spiral cores and tubes, labels and flexible packaging. A summary by business segment of net sales, operating profit, identifiable assets, capital expenditures and depreciation, depletion and amortization follows: Sales and transfers between segments are not material. Export sales are less than 10% of total sales. Corporate assets consist principally of cash and cash equivalents, refundable and deferred income taxes, investments in affiliates, deferred debt issuance costs and other assets which are not specific to a segment. 13. -- Summarized Financial Information of CCA Summarized below is financial information for CCA which is the issuer of the Senior Subordinated Notes, Senior Unsecured Notes, Subordinated Debentures and Junior Accrual Debentures. 13. -- Summarized Financial Information of CCA (cont) Intercompany loans to the Company made in connection with the 1989 Recapitalization ($1,262.0 million at December 31, 1993) are classified as long-term by CCA and are evidenced by a demand note which bears interest at 12.65%, which was the weighted average interest rate applicable to the bank credit facilities and the various debt securities sold in connection with the 1989 Recapitalization. Term loans to the Company under the Securitization Program ($262.5 million at December 31, 1993) are included in CCA's current assets and bear interest at the average borrowing rate under the Securitization Program (6.56% at December 31, 1993). Other amounts advanced to or from the Company are non-interest bearing. 14. -- Quarterly Results (Unaudited) The following is a summary of the unaudited quarterly results of operations: 15. -- Subsequent Events Holdings has filed with the Securities and Exchange Commission ("SEC") a Registration Statement on Form S-1 relating to the offering of 25,551,786 shares of common stock. JSC has filed with the SEC a Registration Statement on Form S-2 relating to the offering of $300 million of Senior Notes due 2004 and $100 million of Senior notes due 2002. In addition, JSC has obtained a new $1.65 billion bank facility. The proceeds from the debt and equity offerings and the new bank facility will be used to repay the 1992 Term Loan, the 1989 Term Loan and revolving credit facility, the Senior Secured Notes and the subordinated debentures and related premiums. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Directors The following table sets forth the names and ages of the directors of each of JSC and CCA. The Board of Directors is currently comprised of six directors, three of whom, the Class B Directors, were nominees of MSLEF II and three of whom, the Class A Directors, were nominees of Smurfit Packaging as provided in the Organization Agreement. Name Age Michael W.J. Smurfit 57 Howard E. Kilroy 58 James E. Terrill 60 Donald P. Brennan 53 Alan E. Goldberg 39 David R. Ramsay 30 Following completion of the Offerings and pursuant to the Stockholders Agreement (as described below), the Company intends to expand its Board of Directors to include two additional directors, one of whom will be designated by, but not affiliated with SIBV and, one of whom will be designated by, but not affiliated with MSLEF II. Upon consummation of the Offerings, the current Board of Directors of each of JSC and CCA will be divided into three classes of directors serving staggered three-year terms. The terms of office of Messrs. Terrill and Ramsay expire in 1995, of Messrs. Kilroy and Goldberg expire in 1996 and of Messrs. Smurfit and Brennan expire in 1997. The terms of office of the additional unaffiliated directors who are to be designated by MSLEF II and SIBV as described above shall expire in 1995 and 1996, respectively. Executive Officers The following table sets forth the names and ages of the executive officers of each of JSC and CCA and the positions they will hold immediately prior to the consummation of the Offerings. Name Age Position Michael W.J. Smurfit 57 Chairman of the Board and Director James E. Terrill 60 President, Chief Executive Officer and Director Howard E. Kilroy 58 Senior Vice President and Director Richard W. Graham 59 Senior Vice President and General Manager - Folding Carton and Boxboard Mill Division C. Larry Bradford 57 Vice President - Sales and Marketing Raymond G. Duffy 52 Vice President - Planning Name Age Position Michael C. Farrar 53 Vice President - Environmental and Governmental Affairs John R. Funke 52 Vice President and Chief Financial Officer Richard J. Golden 52 Vice President - Purchasing Michael F. Harrington 53 Vice President - Personnel and Human Resources Alan W. Larson 55 Vice President and General Manager - Consumer Packaging Division Edward F. McCallum 59 Vice President and General Manager - Container Division Lyle L. Meyer 57 Vice President Patrick J. Moore 39 Vice President and Treasurer David C. Stevens 59 Vice President and General Manager - Smurfit Recycling Company Truman L. Sturdevant 59 President of SNC Michael E. Tierney 45 Vice President and General Counsel and Secretary Richard K. Volland 55 Vice President - Physical Distribution William N. Wandmacher 51 Vice President and General Manager - Containerboard Mill Division Gary L. West 51 Vice President and General Manager - Industrial Packaging Division Biographies C. Larry Bradford has been Vice President - Sales and Marketing since January 1993. He served as Vice President and General Manager - Container Division from February 1991 until October 1992. Prior to that time, he was Vice President and General Manager of the Folding Carton and Boxboard Mill Division from January 1983 to February 1991. Donald P. Brennan joined MS&Co. in 1982 and has been a Managing Director since 1984. He is responsible for MS&Co.'s Merchant Banking Division and is Chairman and President of Morgan Stanley Leveraged Equity Fund II, Inc. ("MSLEF II, Inc.") and Chairman of Morgan Stanley Capital Partners III, Inc. ("MSCP III, Inc."). Mr. Brennan serves as Director of Agricultural Minerals and Chemicals, Inc., Agricultural Minerals Corporation, Coltec Industries Inc, Fort Howard Corporation, Hamilton Services Limited, PSF Finance Holdings, Inc., Shuttleway, A/S Bulkhandling and Stanklav Holdings, Inc. Mr. Brennan is also Deputy Chairman and Director of Waterford Wedgwood plc. Raymond G. Duffy has been Vice President - Planning since July 1983 and served as Director of Corporate Planning from 1980 to 1983. Michael C. Farrar was appointed Vice President - Environmental and Governmental Affairs in March 1992. Prior to Joining JSC, he was Vice President of the American Paper Institute and the National Forest Products Association for more than 5 years. John R. Funke has been Vice President and Chief Financial Officer since April 1989 and was Corporate Controller and Secretary from 1982 to April 1989. Richard J. Golden has been Vice President - Purchasing since January 1985 and was Director of Corporate Purchasing from October 1981 to January 1985. In January 1994, he was assigned responsibility for world-wide purchasing for JS Group. Alan E. Goldberg has been a member of MS&Co.'s Merchant Banking Division since its formation in 1985 and a Managing Director of MS&Co. since 1988. Mr. Goldberg is a member of the Finance Committee of MS&Co. Mr. Goldberg is Chairman and President of Morgan Stanley Leveraged Equity Fund I, Inc., a Delaware corporation and is a Director of MSLEF II, Inc. and is a Vice Chairman and a Director of MSCP III, Inc. Mr. Goldberg also serves as Director of Agricultural Minerals and Chemicals, Inc., Agricultural Minerals Corporation, Amerin Guaranty Corporation, CIMIC Holdings Limited, Centre Cat Limited and Hamilton Services Limited. Richard W. Graham was appointed Senior Vice President and General Manager - Folding Carton and Boxboard Mill Division in February 1994. He served as Vice President and General Manager - Folding Carton and Boxboard Mill Division from February 1991 to January 1994. Mr. Graham was Vice President and General Manager - Folding Carton Division from October 1986 to February 1991. Mr. Graham joined CCA in 1959 and has served in various management positions, becoming Group Vice President of Administration for CCA in 1984. Michael F. Harrington was appointed Vice President - Personnel and Human Resources in January 1992. Prior to Joining JSC, he was Corporate Director of Labor Relations/Safety and Health with Boise Cascade Corporation for more than 5 years. Howard E. Kilroy has been Chief Operations Director of JS Group since 1978 and President of JS Group since October 1986. Mr. Kilroy was a member of the Supervisory Board of SIBV from January 1978 to January 1992. He has been a Director of JSC since 1979 and Senior Vice President for over 5 years. In addition, he is Governor (Chairman) of Bank of Ireland and a Director of Aran Energy plc. Alan W. Larson has been Vice President and General Manager - Consumer Packaging Division since October 1988. Prior to joining JSC in 1988, he was Executive Vice President of The Black and Decker Corporation. Edward F. McCallum has been Vice President and General Manager - Container Division since October 1992. He served as Vice President and General Manager of the Industrial Packaging Division from January 1991 to October 1992. Prior to that time, he served in various positions in the Container Division since joining JSC in 1971. Lyle L. Meyer has been Vice President since April 1989. He has also been President of Smurfit Pension and Insurance Services Company since 1982. Patrick J. Moore has been Vice President and Treasurer since February 1993. He was Treasurer from October 1990 to February 1993. Prior to joining JSC in 1987 as Assistant Treasurer, Mr. Moore was with Continental Bank in Chicago where he served in various corporate lending, international banking and administrative capacities. David R. Ramsay is a Vice President of MS&Co.'s Merchant Banking Division where he has worked since his graduation from business school in 1989. Mr. Ramsay also serves as a Director of Agricultural Minerals and Chemicals, Inc., Agricultural Minerals Corporation, ARM Financial Group Inc., Hamilton Services Limited and Stanklav Holdings, Inc. and is President and a Director of PSF Finance Holdings, Inc. Michael W.J. Smurfit has been Chairman and Chief Executive Officer of JS Group since 1977. Dr. Smurfit has been a Director of JSC since 1979 and Chairman of the Board since September 1983. He was Chief Executive Officer from September 1983 to July 1990. David C. Stevens has been Vice President and General Manager - Smurfit Recycling Company since January 1993. He joined JSC in 1987 as General Sales Manager and was named Vice President later that year. He held various management positions with International Paper and was President of Mead Container Division prior to joining JSC. Truman L. Sturdevant has been President of SNC since February 1993. He was Vice President and General Manager of SNC from August 1990 to February 1993. Mr. Sturdevant joined the Company in 1984 as Vice President and General Manager of the Oregon City newsprint mill. James E. Terrill was named a Director and President and Chief Executive Officer in February 1994. He served as Executive Vice President - Operations from August 1990 to February 1994. He also served as Executive Vice President of SNC from February 1993 to February 1994. He was President of SNC from February 1986 to February 1993. He served as Vice President and General Manager - Industrial Packaging Division of JSC from 1979 to February 1986. Michael E. Tierney has been Vice President and General Counsel and Secretary since January 1993. He served as Senior Counsel and Assistant Secretary since joining JSC in 1987. Richard K. Volland has been Vice President - Physical Distribution since 1978. William N. Wandmacher has been Vice President and General Manager - Containerboard Mill Division since January 1993. He served as Division Vice President - Medium Mills from October 1986 to January 1993. Since joining the Company in 1966, he has held increasingly responsible positions in production, plant management and planning, both domestic and foreign. Gary L. West has been Vice President and General Manager - Industrial Packaging Division since October 1992. He served as Vice President - Converting and Marketing for the Industrial Packaging Division from January 1991 to October 1992. Prior to that time, he held various management positions in the Container and Consumer Packaging divisions since joining JSC in 1980. Provisions of Stockholders Agreement Pertaining to Management The Stockholders Agreement will provide that SIBV and MS Holders (as defined in the Stockholders Agreement and which term includes the MSLEF II Associated Entities and, with respect to certain of their shares, includes the Direct Investors (as defined below)) shall vote their shares of Holdings Common Stock, or grant an irrevocable proxy to MSLEF II to vote their shares of Common Stock, to elect as directors of Holdings (a) four individuals selected by SIBV (each, an "SIBV Nominee") one of whom shall be the Chief Executive Officer and one of whom shall not be affiliated with SIBV, Holdings, JSC or CCA (an "SIBV Unaffiliated Director") and (b) four individuals selected by MSLEF II (each, a "MSLEF II Nominee"), one of whom shall not be affiliated with MSLEF II, Holdings, JSC or CCA (a "MSLEF II Unaffiliated Director"), if (i) the MS Holders collectively own more than 10% of the outstanding Holdings Common Stock or SIBV owns less than 25% of the outstanding Holdings Common Stock and the MS Holders shall not have received the Initial Return (as defined below) ("Tier 1") or (ii) the MS Holders collectively own 30% or more of the outstanding Holdings Common Stock or the MS Holders collectively own a greater number of voting shares than SIBV and the MS Holders shall have collectively received the Initial Return ("Tier 2"); provided however, that in the event that the MS Holders collectively own 7 1/2% or more and less than 30% of the outstanding Holdings Common Stock and have collectively received the Initial Return, then SIBV shall not be required to have one of its nominees be an SIBV Unaffiliated Director and the four MSLEF II Nominees shall include two MSLEF II Unaffiliated Directors; provided, further, that in the event that the MS Holders collectively own 6% or more but less than 7 1/2% of the outstanding Holdings Common Stock and have collectively received the Initial Return, then SIBV shall nominate four SIBV Nominees (one of whom shall be the Chief Executive Officer), MSLEF II shall nominate two MSLEF II Nominees and Holdings' Board of Directors shall nominate two persons to the Board of Directors who shall be reasonably acceptable to MSLEF II and SIBV. Unless MSLEF II determines otherwise, MSLEF II, except MSLEF II Unaffiliated Directors, Nominees shall be Managing Directors, Principals or Vice Presidents of MS&Co. The Stockholders Agreement defines "Initial Return" to mean the receipt, as dividends or as a result of sales of shares of Holdings Common Stock, of $400 million in cash or certain other property (or a combination thereof) collectively by the MS Holders. For purposes of calculating the Initial Return, shares which MSLEF II or Equity Investors (as defined below) distributes to its partners will be deemed to have been sold at the closing sales price per share as of the date such distribution is declared. Calculations made for purposes of the foregoing shall not give effect to shares of Holdings Common Stock purchased after the date of the closing of the Offerings (other than shares of Common Stock purchased by SIBV pursuant to the preemptive rights set forth in the Stockholders Agreement). In addition, notwithstanding the termination of the Stockholders Agreement upon the MS Holders ceasing to own six percent or more of the Holdings Common Stock, so long as MSLEF II or MSLEF II, Inc. and its affiliates own Holdings Common Stock with a market value of at least $25 million, MSLEF II shall be entitled to designate, and SIBV shall vote its shares of Holdings Common Stock for the election of, one nominee to the Board of Directors of Holdings (who need not be a MSLEF II Unaffiliated Director). Pursuant to the terms of the Stockholders Agreement, SIBV and MSLEF II will each be entitled to designate four nominees to Holdings' Board of Directors upon the consummation of the Recapitalization Plan (excluding the Subordinated Debt Refinancing). Such designees include, in the case of SIBV, Michael W.J. Smurfit, Howard E. Kilroy, James E. Terrill and, in the case of MSLEF II, Donald P. Brennan, Alan E. Goldberg and David R. Ramsay. The MSLEF II Unaffiliated Director and the SIBV Unaffiliated Director will be named following completion of the Offerings. See "--Directors". Pursuant to the Stockholders Agreement, SIBV and MSLEF II have agreed to ensure the election of only eight directors (unless they otherwise agree). In addition, the MS Holders and SIBV have agreed pursuant to the Stockholders Agreement to use their best efforts to cause their respective nominees to resign from the Holdings' Board of Directors and to cause the remaining Directors, subject to their fiduciary duties, to fill the resulting vacancies, if and to the extent changes in directors are necessary in order to reflect the Board representation contemplated by the Stockholders Agreement. Pursuant to the Stockholders Agreement, the Board of Directors of Holdings shall have all powers and duties and the full discretion to manage and conduct the business and affairs of Holdings as may be conferred or imposed upon a board of directors pursuant to Section 141 of the Delaware General Corporation Law; provided, however, that if the MS Holders' collective ownership of Holdings Common Stock shall be in Tier 1 or Tier 2, approval of certain specified actions shall require approval of (a) the sum of one and a majority of the entire Board of Directors of the Company present at a meeting of the Board of Directors and (b) two directors who are SIBV Nominees and two directors who are MSLEF II Nominees (the "Required Majority"). Without limiting the foregoing, unless the MS Holders collectively own 6% or more but less than 7 1/2% of the Holdings Common Stock during any period when Holdings' Board of Directors does not consist of eight members (or such greater number of members as may be agreed to by SIBV, MSLEF II and Holdings) then all actions of the Board of Directors shall require approval of at least one director who is a SIBV Nominee and one director who is a MSLEF II Nominee. The specified corporate actions that must be approved by a Required Majority include the amendment of the certificate of incorporation or by-laws of Holdings or any of its subsidiaries; the issuance, sale, purchase or redemption of securities of Holdings or any of its subsidiaries; the establishment of and appointments to the Audit Committee of Holdings' Board of Directors; certain sales of assets or investments in, or certain transactions with, JS Group or its affiliates in excess of a specified amount or any other person in excess of other specified amounts; certain mergers, consolidations, dissolutions or liquidations of Holdings or any of its subsidiaries; the filing of a petition in bankruptcy; the setting aside or making of any payment or distribution by way of dividend or otherwise to the stockholders of Holdings or any of its subsidiaries; the incurrence of new indebtedness, the creation of liens or guarantees, the institution, termination or settlement of material litigation, the surrender of property or rights, making certain investments, commitments, capital expenditures or donations, in each case in excess of certain specified amounts; entering into any lease (other than a capitalized lease) of any assets of Holdings located in any one place having a book value in excess of a specified amount; the entering into any agreement or material transaction between Holdings and a director or officer of Holdings, JSC, JS Group, CCA, SIBV or MSLEF II or their affiliates; the replacement of the independent accountants for Holdings or any of its subsidiaries or modification of significant accounting methods; the amendment or termination of Holdings' 1992 Stock Option Plan; except as provided in the Stockholders Agreement, the election or removal of directors and officers of each of JSC and CCA; and any decision regarding registration, except as provided in the Registration Rights Agreement. Pursuant to the Stockholders Agreement, SIBV and MSLEF II shall use their best efforts to cause their respective designees to Holdings' Board of Directors to elect directors to the Boards of Directors of JSC and CCA in an analogous manner. It is currently anticipated that the directors of Holdings, JSC and CCA will be the same individuals. Committees Following consummation of the Offerings, there will be four committees of the Boards of Directors of each of Holdings, JSC and CCA; the Executive Committee, the Compensation Committee, the Audit Committee and the Appointment Committee, which committee shall, among other things, select, replace or remove officers. The Stockholders Agreement provides that SIBV and MSLEF II will use their best efforts to cause their respective designees on the Holdings Board of Directors, subject to their fiduciary duties, to (i) insure that MSLEF II Nominees constitute a majority of the members on the Compensation Committee and any other committees which administer any option or incentive plan of Holdings and the Company and (ii) subject to certain limitations (including limitations based on the percentage stock ownership of the MS Holders and/or SIBV), insure that (a) SIBV Nominees constitute a majority of the members, and a MSLEF II Nominee is a member, of the Appointment Committee and (b) nominees of the SIBV Nominees for officers of Holdings, JSC and CCA (other than Chief Financial Officer), and a nominee of the MSLEF II Nominee for Chief Financial Officer of Holdings, JSC and CCA, are appointed or elected to such positions, whether by the Appointment Committee or the Board of Directors. In addition, SIBV and MSLEF II shall use their best efforts to cause their respective designees on Holdings' Board of Directors, subject to their fiduciary duties, to cause the officers of Holdings to be the respective officers of each of JSC and CCA, unless SIBV and MSLEF II otherwise agree. Appointments to the committees listed above will be made following consummation of the Offerings. Director Compensation Prior to the completion of the Offerings, no directors of Holdings, JSC and CCA received any fees for their services as directors; however, the directors were reimbursed for their travel expenses in connection with their attendance at board meetings. Following the completion of the Offerings, each of Holdings, JSC and CCA intends to reimburse all its directors for their travel expenses in connection with their attendance at board meetings and to pay all its directors who are not officers an annual fee of $35,000 plus $2,000 for attendance at each meeting which is in excess of four meetings per year. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Summary Compensation Table The following table sets forth the cash and noncash compensation for each of the last three fiscal years awarded to or earned by the Chief Executive Officer and the four other most highly compensated executive officers of the Company (the "Named Executive Officers") during 1993. Prior to consummation of the Offerings, the Company intends to pay aggregate cash bonuses of $7.62 million to a number of its and its affiliates' officers, including approximately $1,964,000, $347,000, $87,000, $231,000 and $1,386,000 to Messrs. Smurfit, Terrill, Larson, Bradford and Malloy, respectively, and $1.77 million to officers of JS Group and its affiliates (other than Michael W.J. Smurfit). In addition, the Company paid approximately $2.9 million of bonuses to other employees of the Company in 1992. 1994 Long-Term Incentive Plan Prior to consummation of the Equity Offerings, JSC intends to adopt the Jefferson Smurfit Corporation (U.S.) 1994 Long-Term Incentive Plan (the "Incentive Plan"). Pursuant to the Plan, participants will be granted awards, payable in cash on June 30, 1997 (the "Payment Date") (or earlier in the event of death or disability) if and to the extent vested. A participant's award will vest on the Payment Date if he is still employed by JSC or any of its subsidiaries at such time; provided that such award shall vest in full if the participant dies or becomes disabled and shall vest 20% on June 30, 1995, and an additional 20% on June 30, 1996 if the participant is employed on such date and is thereafter terminated, prior to June 30, 1997, by the Company without cause. Notwithstanding the foregoing, no amounts shall be paid under the Incentive Plan unless the Equity Offerings are consummated. The aggregate amount of awards under the Incentive Plan is $5 million. The awards expected to be granted to Messrs. Terrill, Larson and Bradford are $1,000,000, $200,000 and $75,000, respectively. Aggregate and individual awards will be increased by earnings accrued thereon (by virtue of the actual or deemed investment thereof, as determined by the Compensation Committee) during the period beginning as soon as practicable after the consummation of the Equity Offerings and ending on the Payment Date or earlier date of payment. 1992 Stock Option Plan Option Plan Under Holdings' 1992 Stock Option Plan, the Named Executive Officers and certain other eligible employees have been granted options to purchase shares of stock of Holdings. The options become vested over a ten year period and vest in their entirety upon the death, disability or retirement of the optionee. Non- vested options are forfeited upon any other termination of employment. Options may not be exercised unless they are both exercisable and vested. Upon the earliest to occur of (i) MSLEF II's transfer of all of its Holdings Common Stock or, if MSLEF II distributes its Holdings Common Stock to its partners pursuant to its dissolution, the transfer by such partners of at least 50% of the aggregate Holdings Common Stock received from MSLEF II pursuant to its dissolution, (ii) the 11th anniversary of the grant date of the options, and (iii) a public offering of Holdings common stock (including the Equity Offerings), all vested options shall become exercisable and all options which vest subsequently shall become exercisable upon vesting; provided, however, that if a public offering occurs prior to the Threshold Date (defined below) all vested options and all options which vest subsequent to the public offering but prior to the Threshold Date shall be exercisable in an amount (as of periodic determination dates) equal to the product of (a) the number of shares of Holdings Common Stock vested pursuant to the option (whether previously exercised or not) and (b) the Morgan Percentage (as defined below) as of such date; provided further that in any event a holder's options shall become exercisable from time to time in an amount equal to the percentage that the number of shares sold or distributed to its partners by MSLEF II represents of its aggregate ownership of shares (with vested options becoming exercisable up to such number before any non-vested options become so exercisable) less the number of options, if any, which have become exercisable on January 1, 1995 as set forth below. The Threshold Date is the earlier of (x) the date the members of the MSLEF II Group (as defined in the 1992 Stock Option Plan) shall have received collectively $200,000,000 in cash and/or other property as a return of their investment in Holdings (as a result of sales of shares of Holdings' common equity) and (y) the date that the members of the MSLEF II Group shall have transferred an aggregate of at least 30% of Holdings' common equity owned by the MSLEF II Group as of August 26, 1992. The Morgan Percentage as of any date is the percentage determined from the quotient of (a) the number of shares of Holdings' common equity held as of August 26, 1992, that were transferred by the MSLEF II Group as of the determination date and (b) the number of shares of Holdings' common equity outstanding as of such date. The Plan Committee, with the consent of the Board of Directors of Holdings, may accelerate the exercisability of options at such times and circumstances as it deems appropriate in its discretion. The option exercise price is not adjustable other than pursuant to an antidilution provision. Ten percent of stock options granted prior to 1993 vest and become exercisable on January 1, 1995 so long as the Equity Offerings have been consummated. Already owned shares and shares otherwise issuable upon exercise may be used to pay the exercise price of options and any tax withholding liability. The foregoing describes the terms of the 1992 Stock Option Plan, as intended to be amended prior to the consummation of the Equity Offerings. Option Grants No option grants were made during 1993 to any Named Executive Officers. Effective as of February 15, 1994 options with an exercise price of $20 per share were granted to a number of officers and employees including Messrs. Terrill and Larson who were granted options of 319,000, and 5,000 shares of Holdings Common Stock, respectively (such dollar amount and numbers have been adjusted to reflect the ten-for-one stock split contemplated by the Reclassification). Such options vest over the period ending on December 31, 1999. Option Exercises and Year-End Value Table The following table summarizes the exercise of options relating to shares of Holdings Common Stock by the Named Executive Officers during 1993 and the value of options held by such officers as of the end of 1993. No stock appreciation rights have been granted to any Named Executive Officers. In addition, options to purchase 755,000 shares (as adjusted for the ten-to-one stock split) have been granted to officers and employees of JS Group and its affiliates (other than Michael W.J. Smurfit). Pension Plans Salaried Employees' Pension Plan and Supplemental Income Pension Plans The Company and its subsidiaries maintain a non-contributory pension plan for salaried employees (the "Pension Plan") and non- contributory supplemental income pension plans (the "SIP Plans") for certain key executive officers. The Pension Plan provides monthly benefits at age 65 equal to 1.5% of a participant's final average earnings minus 1.2% of such participant's primary social security benefit, multiplied by the number of years of credited service. Final average earnings equals the average of the highest five consecutive years of the participant's last 10 years of service, including overtime and certain bonuses, but excluding bonus payments under the Management Incentive Plan, deferred or acquisition bonuses, fringe benefits and certain other compensation. Employees' pension rights vest after five years of service. Benefits are also available under the Pension Plan upon early or deferred retirement. The pension benefits for the Named Executive Officers can be calculated pursuant to the following table, which shows the total estimated single life annuity payments that would be payable to the Named Executive Officers participating in the Pension Plan and one of the SIP Plans after various years of service at selected compensation levels. A limit of 20 and 22.5 years of service can be credited for SIP I and SIP II, respectively. Payments under the SIP Plans are an unsecured liability of the Company. In order to participate in the SIP Plans, an executive must be selected by the Board of Directors. SIP Plan I provides annual benefits at normal retirement age (65) equal to 2.5% of a participants' final average earnings multiplied by the number of years of credited service (with a limit of 20 years or 50% of final average earnings), less such participants' regular Pension Plan benefit and a certain portion of the social security benefit, whereas SIP Plan II uses a 2% multiplier (with a limit of 22.5 years or 45% of final average earnings). Final average earnings equals the participant's average earnings, including bonus payments made under the Management Incentive Plan, for the five consecutive highest-paid calendar years out of the last 10 years of service. Participants may elect to receive benefits in the form of either a life annuity, a life annuity with ten years certain or a designated survivor annuity. Dr. Smurfit and Mr. Malloy participate in SIP Plan I and have 21 and 15 years of credited service, respectively. SIP Plan II became effective January 1, 1993, and Mr. Terrill, Mr. Larson and Mr. Bradford participate in such plan and have 22, 5 and 11 years of credited service, respectively. Estimated final average earnings for each of the Named Executive Officers are as follows: Mr. Malloy ($1,185,000); Dr. Smurfit ($1,040,000); Mr. Terrill ($532,000); Mr. Larson ($366,000); and Mr. Bradford ($461,000). Employment Contracts and Termination, Severance and Change of Control Arrangements The Company and its subsidiaries maintain a severance pay plan for all salaried employees who have at least one year of credited service (the "Severance Plan"). Upon a covered termination, the Severance Plan provides for the payment of one week's salary for each full year of service, payable in accordance with payroll practices. Mr. Malloy has a deferred compensation agreement with JSC pursuant to which JSC intends to pay to him, upon his retirement, lifetime payments of $70,000 annually in addition to his accrued benefits under SIP Plan I. Deferred Compensation Capital Enhancement Plan The Company's Deferred Compensation Capital Enhancement Plan (the "DCC") allows for the deferral of compensation of key full-time salaried employees of the Company and its subsidiaries. Participants may defer a portion of their compensation and their employer may defer discretionary bonuses (together the "Deferred Compensation Amount"). Deferrals occur in 18 month cycles. A participant becomes vested with respect to amounts deferred during a particular cycle if he continues to be employed by the Company or its subsidiaries for seven years from the beginning of the cycle, retires at age 65 or leaves employment for reasons of death or disability. Upon Normal Retirement (as defined in the DCC) benefits are distributed under the DCC. Certain participants will receive pre-retirement distributions from the DCC, beginning in the eighth year of each cycle. The amounts distributed upon Normal Retirement for each cycle are determined with reference to the age of the participant at the beginning of the cycle and the participant's Deferred Compensation Amount with respect to the cycle. If a participant is younger than 45 years old at the beginning of a cycle, he will receive upon Normal Retirement a total of fifteen annual payments, each totalling one and one-half times his Deferred Compensation Amount. If at the beginning of a cycle a participant is between the ages of 45 and 55 years old, at Normal Retirement he will receive a total of fifteen annual payments that, in the aggregate, equal his Deferred Compensation Amount with respect to the cycle plus appreciation credited annually at 100% of the Moody's Rate (as defined in the DCC). If at the beginning of a cycle a participant is at least 55 years old, his Normal Retirement benefit will be a total of fifteen annual payments that, in the aggregate, equal his Deferred Compensation Amount with respect to the cycle plus appreciation credited annually at 150% of the Moody's Rate . If at the beginning of a cycle a participant is age 65 or older, the number of such annual payments shall be five. If a participant dies prior to retirement, the value of his death benefit may be more or less than his Normal Retirement benefits, depending on his age at the beginning of the cycle. Benefits may be reduced by the employer if a former participant is engaged in a competing business within two years of termination from the Company or its subsidiaries. Participants may receive early distributions in the event that they experience unforeseen financial emergencies. Benefits otherwise payable to the participant are then actuarially reduced to reflect such early distributions. The benefits payable under the DCC are funded by the Company through life insurance policies. There have been no deferrals under the DCC since 1986. Deferrals made by the Named Executive Officers during 1985 and 1986 and their ages at the time of such deferrals were: Mr. Malloy ($30,000 at 57, $50,000 at 58), Dr. Smurfit ($30,000 at 48), Mr. Terrill ($15,000 at 51, $25,000 at 52), Mr. Bradford ($15,000 at 49, $25,000 at 50) and Mr. Larson ($0). In 1993, the Company made the first preretirement distribution to certain participants totaling $195,000. Compensation Committee Interlocks and Insider Participation The Company has not heretofore maintained a formal compensation committee. Dr. Smurfit, Mr. Malloy and Mr. Kilroy, executive officers of the Company, participated in deliberations of the Board of Directors on executive compensation matters during 1993. Following consummation of the Offerings, the Company will maintain a Compensation Committee of the Board of Directors. Dr. Smurfit and Mr. Kilroy are both directors and executive officers of JS Group, Holdings, JSC and CCA, and Mr. Malloy is a director of JS Group and a former director and executive officer of Holdings, JSC and CCA. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT All of the outstanding JSC Common Stock is owned by Holdings. The outstanding voting stock of Holdings is owned equally by (i) Smurfit Packaging, 8182 Maryland Avenue, St. Louis, Missouri 63105 and Smurfit Holdings, 92/96 Rokin, Amsterdam 1012KZ, The Netherlands, and (ii) MSLEF II, 1251 Avenue of the Americas, New York, New York 10020. The Old Bank Facilities and Senior Secured Notes are secured by, among other things, the CCA Common Stock and the JSC Common Stock. If an Event of Default occurs under the Old Bank Facilities or the Senior Secured Notes, the banks or the holders of the Senior Secured Notes will have the right to foreclose upon such stock. The Organization Agreement (as defined in Item 13 ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Set forth below is a summary of certain agreements and arrangements entered into by the Company and related parties in connection with the 1989 Transaction and the 1992 Transaction, as well as other transactions between the Company and related parties which have taken place during 1993. General As a result of certain transactions which occurred in December 1989 (the "1989 Transaction"), JSC became a wholly-owned subsidiary of Holdings and CCA became an indirect wholly-owned subsidiary of JSC. As part of the 1989 Transaction, Holdings issued (i) 1,510,000 shares of Holdings Class A common stock ("Class A Stock") and 500,000 shares of Holdings Class D common stock ("Class D Stock") to SIBV for $150 million and $50 million, respectively, (ii) 1,510,000 shares of Holdings Class B common stock ("Class B Stock") to MSLEF II for $150 million, (iii) 100,000 shares of Holdings Class C common stock ("Class C Stock") to MSLEF II, Inc. (the general partner of MSLEF II) and 400,000 shares of Class C Stock to the Direct Investors (as defined below) for $10 million and $40 million, respectively (the Direct Investors also purchased Junior Accrual Debentures and Subordinated Debentures in aggregate principal amounts of $129.2 million and $30.8 million, respectively), and (iv) its preferred stock ("Old Preferred Stock") to SIBV for $100 million. SIBV subsequently transferred all of such common and preferred stock to Smurfit Packaging. In addition to the issuances of capital stock by Holdings described above, the financing for the 1989 Transaction was provided by (i) the issuance by CCA of the Secured Notes and the Subordinated Debt, and (ii) the incurrence of term debt and revolving credit indebtedness pursuant to the 1989 Credit Agreement. As a result of the 1992 Transaction, (i) MSLEF II acquired an additional 330,000 and 1,212,788 shares of Class B Stock and Class C Stock, respectively, and certain holders of Class C Stock acquired 457,212 additional shares of Class C Stock, for an aggregate of $200 million, (ii) Smurfit Holdings, B.V., a subsidiary of SIBV, acquired 330,000 shares of Class A Stock for $33 million, (iii) Smurfit Packaging agreed that its Old Preferred Stock (including shares issued since the 1989 Transaction as a dividend) would convert into 1,670,000 shares of Class D Stock on December 31, 1993, (iv) proceeds from the issuances of shares described in clauses (i) and (ii) above were used to acquire, at a purchase price of $1,100 per $1,000 accreted value, an aggregate of $129.2 million principal amount ($193.5 million accreted value) of Junior Accrual Debentures from the Direct Investors, (v) CCA borrowed approximately $400 million under the 1992 Credit Agreement, and used the proceeds to prepay approximately $400 million of scheduled installments relating to term loan indebtedness under the 1989 Credit Agreement, (vi) various provisions of the 1989 Credit Agreement and the Secured Note Purchase Agreement were amended and restated, and (vii) MSLEF II and SIBV amended a number of the provisions contained in the Organization Agreement, agreed to the terms of a Stockholders Agreement (which will replace the Organization Agreement upon the closing of the Equity Offerings) and entered into the Registration Rights Agreement. Currently Smurfit Packaging and Smurfit Holdings, through their ownership of all of the outstanding Class A Stock, and MSLEF II, through its ownership of all of the outstanding Class B Stock, each own 50% of the voting common stock of Holdings. MSLEF II, MSLEF II, Inc., a Delaware Corporation that is a wholly-owned subsidiary of Morgan Stanley Group Inc. ("Morgan Stanley Group") and the general partner of MSLEF II, SIBV/MS Equity Investors, L.P., a Delaware limited partnership the general partner of which is a wholly-owned subsidiary of Morgan Stanley Group ("Equity Investors" and, together with MSLEF II and MSLEF II, Inc., the "MSLEF II Associated Entities"), First Plaza Group Trust, as trustee for certain pension plans ("First Plaza"), Leeway & Co., as nominee for State Street Bank and Trust Co., as trustee for a master pension trust ("Leeway" and, together with First Plaza, the "Direct Investors"), certain other investors and Smurfit Packaging own all of the non-voting stock of Holdings. On December 31, 1993, all of the Old Preferred Stock owned by Smurfit Packaging was converted into 1,670,000 shares of Class D Stock. Since such conversion of Old Preferred Stock, Smurfit Packaging, on the one hand, and the MSLEF II Associated Entities, the Direct Investors and such other investors, on the other, own, through their ownership of Class D Stock and Class C Stock, respectively, 50% of the non-voting common stock of Holdings. Holdings' capital stock currently consists of Class A Stock, Class B Stock, Class C Stock, Class D Stock and Class E common stock (the "Class E Stock" and, together with the Class A, Class B, Class C and Class D Stock, the "Old Common Stock"). The classes of stock comprising the Old Common Stock are identical in all respects except with respect to certain voting rights, and certain exchange provisions that do not affect the percentage of Holdings owned by SIBV and MSLEF II. Holdings' Class E Stock is non-voting stock reserved for issuance pursuant to the 1992 Stock Option Plan. In the Reclassification, the Old Common Stock, which consists of five classes of stock, will be converted into one class, on a basis of ten shares of Common Stock for each share of the Old Common Stock. Following the Reclassification, Holdings' only class of common stock will be Holdings Common Stock. Immediately prior to the consummation of the Equity Offerings, 80,200,000 shares of Holdings Common Stock will be outstanding and such stock will be owned by the Holdings' stockholders in proportion to their ownership of the Old Common Stock as described in the two preceding paragraphs. Substantially concurrently with the consummation of the Equity Offerings, SIBV (or a corporate affiliate of SIBV) will purchase 5,714,286 shares of Holdings Common Stock from Holdings pursuant to the SIBV Investment. Accordingly, following the consummation of the Equity Offerings and the SIBV Investment, MSLEF II Associated Entities and SIBV through its subsidiaries will beneficially own 30.8% and 44.4%, respectively, of the shares of Holdings Common Stock then outstanding. The relationships among JSC, CCA, Holdings and its stockholders are set forth in a number of agreements described below. The summary descriptions herein of the terms of such agreements do not purport to be complete and are subject to, and are qualified in their entirety by reference to, all of the provisions of such agreements, which have been filed as exhibits to the Registration Statement filed February 18, 1994. Capitalized terms not otherwise defined below or elsewhere in the document have the meanings given to them in such agreements. Any reference to either SIBV or MSLEF II in the following descriptions of the Organization Agreement and the Stockholders Agreement or in references to the terms of those agreements set forth in this document shall be deemed to include their permitted transferees, unless the context indicates otherwise. The Organization Agreement Since the 1989 Transaction, the Company has been operated pursuant to the terms of the Organization Agreement, which has been amended on various occasions. The Organization Agreement, among other things, provides generally for the election of directors, the selection of officers and the day-to-day management of the Company. The Organization Agreement provides that one-half of the directors of each of Holdings, CCA and JSC be elected by the holders of the Class A Stock (Smurfit Holdings and Smurfit Packaging) and one-half by the holders of the Class B Stock (MSLEF II) and that officers of such companies be designated by the designees of Smurfit Holdings and Smurfit Packaging on the respective boards, except that the Chief Financial Officer of the Company be designated by the holders of the Class B Stock (MSLEF II). The Organization Agreement also contains certain tag along rights, rights of first refusal and call and put provisions and provisions relating to a sale of Holdings as an entirety, as well as provisions relating to transactions between Holdings, the Company and its affiliates, on the one hand, and SIBV or MSLEF II, as the case may be, and their respective affiliates, on the other. These latter provisions are similar to those contained in the Stockholders Agreement described below. In connection with the Recapitalization Plan, the Organization Agreement will be terminated upon the closing of the Offerings and, at such time, the Stockholders Agreement shall become effective among the Company, SIBV, the MSLEF II Associated Entities and certain other entities. The Organization Agreement also contains provisions whereby each of SIBV, MSLEF II, MSLEF II, Inc., Holdings, JSC, CCA and the holders of Class C Stock indemnify each other and related parties with respect to certain matters arising under the Organization Agreement or the transactions contemplated thereby, including losses resulting from a breach of the Organization Agreement. In addition, Holdings, JSC and CCA have also agreed to indemnify SIBV, MSLEF II, MSLEF II, Inc. and the holders of Class C Stock and related parties against losses arising out of (i) the conduct and operation of the business of Holdings, JSC or CCA, (ii) any action or failure to act by Holdings, JSC or CCA, (iii) the 1989 Transaction and the 1992 Transaction or (iv) the financing for the 1989 Transaction. Further, SIBV has agreed to indemnify Holdings, JSC, CCA and each of their subsidiaries against all liability for taxes, charges, fees, levies or other assessments imposed on such entities as a result of their not having withheld tax upon the issuance or payment of a specified note to SIBV and the transfer of certain assets to SIBV in connection with the 1989 Transaction. The foregoing indemnification provisions survive a termination of the Organization Agreement, including a termination in connection with the Recapitalization Plan. Stockholders Agreement The Stockholders Agreement will be entered into at or prior to the consummation of the Offerings by Holdings, SIBV, the MSLEF II Associated Entities and certain other entities. Directors and Management For a description of certain provisions of the Stockholders Agreement which relate to the management of the Company (including the election of directors of the Company), see Item 10. Directors and Executives Officers of the Registrant -Provisions of Stockholders Agreement Pertaining to Management. Transactions with Affiliates; Other Businesses The Stockholders Agreement specifically permits SIBV and MSLEF II (and their affiliates) to engage in transactions with Holdings, JSC and CCA in addition to certain specific transactions contemplated by the Stockholders Agreement, provided such transactions (except for (i) transactions between any of Holdings, JSC and CCA, (ii) the transactions contemplated by the Stockholders Agreement or by the Organization Agreement, (iii) the transactions contemplated by the Operating Agreement, dated as of April 30, 1992, between CCA and Smurfit Paperboard, Inc. ("SPI"), or in the Rights Agreement, dated as of April 30, 1992, between CCA, SPI and Bankers Trust Company, (iv) the transactions contemplated by the Registration Rights Agreement, (v) the provision of services pursuant to the Financial Advisory Services Agreement, dated as of September 12, 1989, by and among MS&Co., SIBV and Holdings, and (vi) the provisions of certain other specified agreements) are fully and fairly disclosed, have fair and equitable terms, are reasonably necessary and are treated as a commercial arms-length transaction with an unrelated third party. Neither SIBV nor MSLEF II (or their affiliates) is prohibited from owning, operating or investing in any business, regardless of whether such business is competitive with Holdings, JSC or CCA, nor is either SIBV or MSLEF II required to disclose its intention to make any such investment to the other or to advise Holdings, JSC or CCA of the opportunity presented by any such prospective investment. Transfer of Ownership In general, transfers of Holdings Common Stock to entities affiliated with SIBV or any MS Holder are not restricted. The Stockholders Agreement provides MS Holders the right to "tag along" pro rata upon the transfer by SIBV of any Holdings Common Stock, other than transfers to affiliates and sales pursuant to a public offering registered under the Securities Act or pursuant to Rule 144 under the Securities Act. No MS Holder may, without SIBV's prior written consent, transfer shares of Holdings Common Stock to any non-affiliated person or group which, when taken together with all other shares of Holdings Common Stock then owned by such person or group, represent more than ten percent of the Holdings Common Stock then outstanding. Transfers by MS Holders of ten percent or less in the aggregate of the outstanding Holdings Common Stock are subject to certain rights of first offer and rights of first refusal on the part of SIBV. Such transfers by MS Holders which are subject to SIBV's right of first refusal may not be made to any competitor of SIBV or the Company. SIBV and its affiliates have the right, exercisable on or after August 26, 2002, to purchase all, but not less than all, of the Holdings Common Stock then owned by the MS Holders at a price equal to the Fair Market Value (as defined in the Stockholders Agreement). The terms of the Stockholders Agreement do not restrict the ability of MSLEF II or Equity Investors to distribute, upon dissolution or otherwise, shares of Common Stock to their respective partners. Following any such distribution the partners of MSLEF II or Equity Investors, as the case may be (other than MSLEF II, Inc., its affiliates and, in respect of shares owned other than as a result of any such distribution, the Direct Investors) will not be subject to the Stockholders Agreement. In addition, following any such distribution, MSLEF II may, on behalf of its partners or the partners of Equity Investors, include shares in a registration rquested by it under the Registration Rights Agreement of Common Stock which have been distributed to its partners. See "-- Registration Rights Agreement". In general, if JS Group either does not, directly or indirectly, own a majority of the voting stock of SIBV, or directly or indirectly, have the right to appoint a majority of the directors and officers of SIBV, then all of the obligations of MSLEF II may, at its option, terminate the Stockholders Agreement. Termination The Stockholders Agreement shall terminate either upon mutual agreement of SIBV and MSLEF II, or at the option of SIBV or MSLEF II, as the case may be, upon either the MS Holders collectively or SIBV, respectively, ceasing to own six percent or more of the outstanding Holdings Common Stock. Registration Rights Agreement Pursuant to the Registration Rights Agreement, each of MSLEF II and SIBV have certain rights, upon giving a notice as provided in the Registration Rights Agreement, to cause Holdings to use its best efforts to register under the Securities Act the shares of Holdings Common Stock owned by MSLEF II (including its partners) and certain other entities and certain shares of Holdings Common Stock owned by SIBV. See "--Stockholders Agreement -- Transfer of Ownership". Upon consummation of the Recapitalization Plan (other than the Subordinated Debt Refinancing), MSLEF II will be entitled to effect up to four such demand registrations pursuant to the Registration Rights Agreement. SIBV will be entitled to effect up to two such demand registrations pursuant to the Registration Rights Agreement; provided, however, that SIBV may not exercise such rights until the earlier of (i) such time as MSLEF II shall have effected two such demand registrations and (ii) October 31, 1996. Neither MSLEF II nor SIBV may, however, exercise a demand right (i) until the conclusion of any Holdings Registration Process, MSLEF II Registration Process or SIBV Registration Process (each, as defined in the Registration Rights Agreement), or (ii) in certain other limited situations. In addition, MSLEF II (including its partners) and certain other entities and, under certain circumstances, SIBV are entitled, subject to certain limitations, to register their shares of Holdings Common Stock in connection with a registration statement prepared by Holdings to register Holdings Common Stock or any equity securities exercisable for, convertible into, or exchangeable for Holdings Common Stock. In the event that there is a public trading market for the Holdings Common Stock, MSLEF II and certain other entities may not effect a sale of Holdings Common Stock pursuant to the demand registration rights granted in the Registration Rights Agreement without first offering the shares proposed to be sold to SIBV for purchase. Under the terms of the Registration Rights Agreement, Holdings may not effect a common stock registration for its own account until the earlier of (i) such time as MSLEF II shall have effected two demand registrations and (ii) July 31, 1996. In addition, Holdings is generally prohibited from "piggybacking" and selling stock for its own account in demand registrations except in the case of any registration requested by SIBV and any registration requested by MSLEF II after the second completed registration for MSLEF II, in which event SIBV or MSLEF II, as the case may be may require that any such securities which are "piggybacked" be offered and sold on the same terms as the securities offered by SIBV or MSLEF II, as the case may be. Holdings will pay all registration expenses (other than underwriting discounts and commissions) in connection with MSLEF II's first two completed demand registrations, SIBV's first completed demand registrations and all registrations made in connection with a Holdings registration. The Registration Rights Agreement also contains customary terms and provisions with respect to, among other things, registration procedures and certain rights to indemnification and contribution granted by parties thereunder in connection with the registration of Holdings Common Stock subject to such agreement. Financial Advisory Services Agreement Under a financial advisory services agreement (the "Financial Advisory Services Agreement"), MS&Co. agreed to act as Holdings' and the Company's financial advisor and provided certain services and earned certain fees in connection with its roles in the 1989 Transaction, with an expectation that for the term of the Stockholders Agreement, the Company would retain MS&Co. to render it investment banking services at market rates to be negotiated. Other Transactions In connection with the issuance of the 1993 Notes, the Company entered into an agreement with SIBV whereby SIBV committed to purchase up to $200 million aggregate principal amount of 11 1/2% Junior Subordinated Notes maturing 2005 to be issued by the Company. From time to time until December 31, 1994, the Company, at its option, may issue the Junior Subordinated Notes, the proceeds of which must be used to repurchase or otherwise retire Subordinated Debt. The Company is obligated to pay SIBV for letter of credit fees incurred by SIBV in connection with the commitment in addition to an annual commitment fee of 1.375% on the undrawn principal amount. The amount payable for such commitment for 1993 was $2.9 million. The above commitments will be terminated upon the consummation of the Offerings. The Company has agreed to pay certain costs of SIBV associated with such commitments and the termination thereof up to a maximum of $900,000. Net sales by JSC to JS Group, its subsidiaries and affiliates were $18.4 million in 1993. Net sales by JS Group, its subsidiaries and affiliates to JSC were $49.3 million in 1993. Product sales to and purchases from JS Group, its subsidiaries and affiliates were consummated on terms generally similar to those prevailing with unrelated parties. JSC provides certain subsidiaries and affiliates of JS Group with general management and elective management services under separate management services agreements. The services provided include, but are not limited to, management information services, accounting, tax and internal auditing services, financial management and treasury services, manufacturing and engineering services, research and development services, employee benefit plan and management services, purchasing services, transportation services and marketing services. In consideration of general management services, JSC is paid a fee up to 2% of the subsidiaries' or affiliates' gross sales, which fee amounted to $2.3 million for 1993. In consideration for elective services, JSC received approximately $3.5 million in 1993 for its cost of providing such services. In addition, JSC paid JS Group and its affiliates $0.4 million in 1993, for management services and certain other services. In October 1991, an affiliate of JS Group completed a rebuild of the No. 2 paperboard machine owned by it, located in CCA's Fernandina Beach, Florida paperboard mill (the "Fernandina Mill"). Pursuant to the Fernandina Operating Agreement, CCA operates and manages the machine, which is owned by a subsidiary of SIBV. As compensation to CCA for its services, the affiliate of JS Group agreed to reimburse CCA for production and manufacturing costs directly attributable to the No. 2 paperboard machine and to pay CCA a portion of the indirect manufacturing, selling and administrative costs incurred by CCA for the entire Fernandina Mill. The compensation is determined by applying various formulas and agreed upon amounts to the subject costs. The amounts reimbursed to CCA totaled $62.2 million in 1993. CCA, JS Group and MSLEF II have had discussions from time to time regarding the purchase of the No. 2 paperboard machine in the Fernandina Mill by the Company from JS Group in exchange for cash or Holdings Common Stock. No agreement has been reached as to any such transaction. The Company expects, however, that it may in the future reach an agreement with regard to such acquisition from JS Group but cannot predict when and on what terms such acquisition would be consummated. Such acquisition will occur only if it is approved by the Board of Directors of the Company and is determined by the Board of Directors to be on terms no less favorable than a sale made to a third party in an arm's length transaction. The Company has agreed to reimburse SIBV for legal fees and other out-of-pocket expenses incurred by SIBV in connection with the Recapitalization Plan. On February 21, 1986, JSC purchased from Times Mirror 80% of the issued and outstanding capital stock of SNC for approximately $132 million, including a promissory note to National Westminister Bank plc in the amount of $42 million (the "Subordinated Note"). The Subordinated Note was guaranteed by JS Group. In the 1992 Transaction, the Company prepaid $19.1 million aggregate principal amount on the Subordinated Note. The remaining amount of $22.9 million was due and paid on February 22, 1993. In connection with the purchase of the SNC capital stock, JSC and Times Mirror entered into a shareholders agreement dated as of February 21, 1986. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) (1) and (2) The list of Financial Statements and Financial Statement Schedules required by this item are included in Item 8 on page 27. (3) Exhibits. The Company agrees to furnish a copy of any long-term debt instrument wherein the securities authorized do not exceed 10 percent of the registrant's total assets on a consolidated basis upon the request of the Securities and Exchange Commission. 3.1 Restated Certificate of Incorporation of CCA. (i) 3.2 Restated Certificate of Incorporation of JSC. (i) 3.3 By-laws of CCA. (i) 3.4 By-laws of JSC. (i) 4.1 Form of Indenture for the Senior Subordinated Notes. (ii) 4.2 Form of Indenture for the Subordinated Debentures. (ii) 4.3 Form of Indenture for the Junior Accrual Debentures. (ii) 4.4 Form of Indenture for the 1993 Notes. (ii) 10.1 Second Amended and Restated Organization Agreement dated as of August 26, 1992 among the parties thereto. (iii) 10.2 Second Amended and Restated Credit Agreement dated as of November 9, 1989 among the parties thereto. (iii) 10.3(a) Financial Advisory Services Agreement, dated September 12, 1989, among Morgan Stanley & Co. Incorporated, Holdings and SIBV. (iv) 10.3(b) Financial Advisory Services Agreement Amendment dated as of October 19, 1989 among Morgan Stanley & Co. Incorporated, Holdings and SIBV. (iv) 10.4 Stock Purchase Agreement, dated as of January 15, 1986, between JSC and The Times Mirror Company. (v) 10.5 Shareholders Agreement, dated as of February 21, 1986, between JSC and The Times Mirror Company. (v) 10.6 Deferred Compensation Agreement, dated January 1, 1979, between JSC and James B. Malloy, as amended and effective November 10, 1983. (vi) 10.7(a) JSC Deferred Compensation Capital Enhancement Plan. (vii) 10.7(b) Amendment No. 1 to the Deferred Compensation Capital Enhancement Plan. (viii) 10.8 Letter Agreement, dated November 24, 1982, between C. Larry Bradford and Alton Packaging Corporation. (vi) 10.9 Form of Agreement for Indemnification of Directors and Officers of JSC and CCA. (ix) 10.10 Amended and Restated Note Purchase Agreement dated as of December 14, 1989, as amended and restated as of August 26, 1992, among the parties thereto. (iii) 10.11(a) JSC Deferred Director's Fee Plan. (viii) 10.11(b) Amendment No. 1 to JSC Deferred Director's Fee Plan. (viii) See Page 77 for footnotes. 10.12 Restated Newsprint Agreement, dated January 1, 1990, by and between Smurfit Newsprint Corporation and The Times Mirror Company. Portions of this exhibit have been excluded pursuant to Rule 24b-2 of the Securities Exchange Act of 1934, as amended. (i) 10.13 Operating Agreement, dated as of April 30, 1992, by and between CCA and Smurfit Paperboard, Inc. (x) 10.14 Rights Agreement, dated as of April 30, 1992, between CCA, Smurfit Paperboard, Inc. and Bankers Trust Company, as collateral trustee. (x) 10.15 Loan and Note Purchase Agreement dated as of August 26, 1992 among the parties thereto. (iii) 10.16 1992 SIBV/MS Holdings, Inc. Stock Option Plan. (iii) 10.17 Form of Indenture for the Junior Subordinated Notes. (xi) 10.18 Form of Purchase Agreement relating to the Junior Subordinated Notes. (xi) 10.19 Amendment No. 3 to Second Amended and Restated Credit Agreement and Amendment No. 3 to Amended and Restated Note Purchase Agreement. 10.20 JSC Management Incentive Plan 1994. (ii) 12.1 Calculation of Historical Ratios of Earnings to Fixed Charges. (xii) 18.1 Letter regarding change in accounting for pension plans. (xiii) 21.1 Subsidiaries of JSC (ii) 24.1 Powers of Attorney for Directors of JSC and CCA. b) Form 8-K, regarding the adoption of a company-wide restructuring program, was filed with the Securities and Exchange Commission on October 14, 1993. The Company did not file any other reports on Form 8-K during the three months ended December 31, 1993. See page 77 for footnotes. Footnotes to Exhibit List (i) Previously filed as an exhibit to JSC's Annual Report on Form 10-K for the fiscal year ended December 31, 1990, and incorporated by this reference. (ii) Previously filed as an exhibit to Holdings' Registration Statement on Form S-1, which was initially filed on February 18, 1994 (file No. 33-75520), and incorporated by this reference. (iii) Previously filed as an exhibit to JSC's Quarterly Report on Form 10-Q for the quarter ended September 30, 1992, and incorporated by this reference. (iv) Previously filed as an exhibit to JSC/CCA's Registration Statement on Form S-1 which was initially filed on September 22, 1989 (file No. 33-31212), and incorporated by this reference. (v) Previously filed as an exhibit to JSC's Current Report on Form 8-K dated February 21, 1986 and incorporated by this reference. (vi) Previously filed as an exhibit to JSC's final Prospectus dated November 10, 1983, contained in the Registration Statement on Form S-1 (file No. 2-86554), as amended and effective November 10, 1983, and incorporated by this reference. (vii) Previously filed as an exhibit to JSC's Quarterly Report on Form 10-Q for the quarter ended September 30, 1985, and incorporated by this reference. (viii) Previously filed as an exhibit to JSC's Annual Report on Form 10-K for the fiscal year ended December 31, 1989, and incorporated by this reference. (ix) Previously filed as an exhibit to JSC's Annual Report on Form 10-K for the fiscal year ended December 31, 1986, and incorporated by this reference. (x) Previously filed as an exhibit to JSC's Quarterly Report on Form 10-Q for the quarter ended March 31, 1992 and incorporated by this reference. (xi) Previously filed as an exhibit to JSC/CCA's Registration Statement on Form S-2, which was initially filed on February 12, 1993 (file No. 33-58348), and incorporated by this reference. (xii) Previously filed as an exhibit to JSC/CCA's Registration Statement on form S-2, which was initially filed on February 23, 1994 (file No. 33-52383), and incorporated by this reference. (xiii) Previously filed as an exhibit to JSC's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993, and incorporated by this 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. DATE March 31, 1994 JEFFERSON SMURFIT CORPORATION (Registrant) BY /s/ John R. Funke John R. Funke 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 in the capacities and on the date indicated. SIGNATURE TITLE DATE * Chairman of the Board Michael W. J. Smurfit and Director * President, Chief Executive Officer James E. Terrill and Director (Principal Executive Officer) /s/ John R. Funke Vice-President and Chief Financial John R. Funke Officer (Principal Accounting Officer) * Director Howard E. Kilroy * Director Donald P. Brennan * Director Alan E. Goldberg * Director David R. Ramsay * By /s/ John R. Funke , pursuant to Powers of Attorney John R. Funke filed as a part of the Form 10-K. As Attorney in Fact The annual provisions for depreciation have been computed principally in accordance with the following estimated lives: Buildings and leasehold improvements - 20 to 50 years Machinery, fixtures and equipment - 3 to 30 years Amounts for (i) depreciation and amortization of intangible assets, pre-operating costs and similar deferrals, (ii) taxes, other than payroll and income taxes, (iii) royalties and (iv) advertising costs are not presented as such amounts are less than 1% of total sales and revenue in all periods.

1993 Item 1. Business. Introduction INVG Government Securities Corp. (the "Company") is a corporation organized under the laws of the State of Delaware on May 5, 1986. All of the Company's outstanding common stock is owned by INVG Mortgage Securities Corp. ("INVG Mortgage"), a publicly held corporation engaged in the business of issuing and selling mortgage-backed and other collateralized securities. The Company's principal executive offices are located at Meadow Wood Crown Plaza, 1575 Delucchi Lane, Suite 115-20, Reno, Nevada, 89502. Its telephone number is (702) 828-5405. The Company has historically generated revenues primarily from Collateralized Mortgage Obligation ("CMO") investments whereby the company was engaged in the business of acquiring modified mortgage-backed pass through certificates ("GNMA Certificates") and then issuing and selling bonds (Bonds) backed by the GNMA Certificates. These investments in CMO issuances give the Company the right to the excess cashflows and earnings on the GNMA Certificates over the expenses required on the the Bonds ("CMO Issuance Investments"). The Company has also invested in other similar mortgage related investments wherein the Company has the right to receive the cashflows of a CMO bond offering after debt service payments are made, such as CMO Mortgage Derivative Investments and REMIC Mortgage Derivative Investments, ("Mortgage Derivative Investments"). On December 30, 1986, the Company commenced operations by issuing $200,369,000 principal amount of its Collateralized Mortgage Obligations, Series A (the "Series A Bonds" or the "Issued Bonds"). The issuance of the Series A Bonds was financed, in part, by the issuance of 115,000 shares of Series A Participating Preferred Stock (the "Series A Preferred Stock") by INVG Mortgage to certain institutional investors including one or more pension plans for which Robert E. Greeley, a director of the Company, was investment manager, and including the Boston Safe Deposit and Trust Company, a subsidiary of Shearson Lehman Brothers Inc. ("Shearson Lehman"), for a purchase price of $100 per share. INVG Mortgage made a capital contribution to the Company of the full amount of the proceeds received by INVG Mortgage from the sale of the Series A Preferred Stock. The Company used such funds to purchase GNMA Certificates which serve as collateral for the Series A Bonds. No Bonds have been issued by the Company since 1986. The Series A Bonds were redeemed on February 1, 1994. The Company, INVG Mortgage, and its affiliate, Investors GNMA Mortgage- Backed Securities Trust, Inc. ("Investors GNMA" and together with the Company and INVG Mortgage, the "Companies"), are qualified as real estate investment trusts under the Internal Revenue Code of 1986 as amended (the "Code"). The Company intends to operate in a manner so as to continue to qualify for the tax benefits accorded by Sections 856 to 860 of the Code and thereby not be subject to federal income tax at the corporate level. There can be no assurance, however, that the Company will be able to do so. Among the conditions that the Company must satisfy to obtain such benefits is the requirement that the Company distribute to its shareholders an amount equal to substantially all of its taxable income. See "Federal Income Tax Consequences - Federal Income Taxation of a REIT." The Company used up its remaining net operating loss carryforward in 1991. The Company had taxable income of $539,047 in 1992 and made a $1,000 dividend distribution on its preferred stock and $550,000 in dividend distributions on its common stock. In 1993 the Company had a taxable loss of $610,934 and made a $1,000 dividend distribution on its preferred stock and $100,000 dividend distribution on its common stock. The Company intends to make distributions to its shareholder during the years in which it has taxable income. In years in which the Company has no taxable income, any distributions will be subject to the discretion of the Board of Directors and will depend upon the operating capital requirements of the Company and other factors deemed pertinent by the Board of Directors, including the need to conserve cash in order to be in a position to make distributions in an amount substantially equal to its taxable income in other years. The taxable income of the Company is primarily derived from income from Mortgage Certificates or other collateral securing the Bonds issued thereby, including non-cash income resulting from the amortization of market discount on such Mortgage Certificates, less operating expenses, including expenses equal to interest paid on the Bonds and non-cash expenses resulting from the amortization of market premium on such Mortgage Certificates, Bond issuance expenses and original issue discount on the Bonds. The Company's funds available for distribution to its shareholder are derived principally from the excess of interest income received on the Mortgage Certificates over the interest payments due on the Bonds (such excess constituting the "Interest Margin") plus investment earnings on cash balances and Mortgage Derivative Investments less operating expenses (together with the "Interest Margin," the "Net Interest Margin"). If taxable income for any year exceeds its Net Interest Margin for such year, the Company is required to distribute to its shareholders an amount equal to such taxable income in order to preserve its status as a real estate investment trust and, therefore, may be required to distribute a portion of its working capital to its shareholders. Advisory Agreement - ------------------ The principal operating expenses of the Company have been the Company's allocable share of advisory fees for legal, accounting, management and administrative services with respect to the operation of the Company, INVG Mortgage, and Investors GNMA Mortgage-Backed Securities Trust, Inc., another subsidiary of INVG Mortgage, (together, "the Companies"). From February 1990 through December 1991, the Companies had an advisory agreement with Fulcrum Financial Partners, Inc. ("Fulcrum"). As such advisor, Fulcrum was responsible for conducting the day-to-day operations of each of the Companies in connection with policy decisions made by the Board of Directors; and performing such services as were required for disbursing, collecting and investing cash proceeds of each of the Companies, preparing and delivering reports and filings required with respect to each of the Companies and other activities relating to the assets of each of the Companies. Fulcrum received a monthly fee of $15,000 for each month of the year 1991 for its services to the Companies. Administration Agreement - ------------------------ In December 1991, the Companies entered into a year to year Administration Agreement with TIS Asset Management, Inc. (the "Administrator") to perform corporate administrative services for the Companies. Under this agreement, the Administrator administers the day-to- day operations of the Companies and performs or supervises the performance of such other administrative functions as may be agreed upon by the Administrator and the Board of Directors of each of the Companies, including the establishment and posting of books of original record with their attendant quarterly financial statements and maintenance of appropriate computer services to perform such administrative services. The Administrator prepares reports and forms as required to satisfy the continuous reporting and other requirements of any and all governmental bodies and agencies. The Administrator serves as the Companies consultant with respect to the formation of investment criteria and policy guidelines for recommendation to the Boards of Directors. Pursuant to the Administration Agreement, the Administrator received a monthly fee in 1993 of $16,000 (which cost is allocated among the Companies) and pays the employment expenses of its personnel, computer expenses, rent and other office expenses and overhead. Pursuant to the Administration Agreement, the Administrator does not assume responsibility other than to render in good faith the services called for thereunder and is not responsible for any action of the Board of Directors of any of the Companies in following or declining to follow any advice or recommendation of the Administrator. The Administrator, its directors, officers, shareholders and employees are not liable to any Company, any Company's Shareholders or others, except by reason of acts constituting bad faith, willful misfeasance, gross negligence or reckless disregard of its duties. The Companies have agreed to indemnify the Administrator and its Affiliates, shareholders, directors, officers, and employees with respect to all expenses, losses, damages, liabilities, demands, charges and claims of any nature whatsoever in respect of or arising from any acts or omissions performed or omitted by the Administrator in good faith and in accordance with the standard set forth in the Administration Agreement. The foregoing description of the Administration Agreement does not purport to be complete but is merely a summary of the material provisions thereof and is qualified in its entirety by reference to the Administration Agreement which is incorporated by reference in Exhibit 10.3 hereto. Consulting Agreement - -------------------- At the Annual Meeting of Shareholders of the Company's parent, INVG Mortgage Securities Corp., held on October 26, 1993, a consulting agreement with Page Mill Asset Management was ratified. Under this agreement, which is effective January 1, 1993, the Companies will pay Page Mill a monthly fee of $10,000 plus an incentive management fee. The incentive management fee, determined with respect to the Companies' performance each fiscal year is equal to 25% of the dollar amount, if any, by which the Companies' consolidated taxable income for such fiscal year, before payment of any incentive fee to Page Mill, net operating loss deductions arising from prior periods' losses and special Internal Revenue Code deductions pertaining to real estate investment trusts, plus certain other adjustments in accordance with generally accepted accounting principles, exceeds the amount necessary to provide an annualized return on equity equal to 1% over the average ten-year U.S. Treasury rate for such fiscal year. Under this agreement, the Company has recorded expense in the year ended December 31, 1993 of $30,000 as its share of the monthly fee. No expense has been recorded for the incentive management fee as the Company had a taxable loss for the entire year. Page Mill Asset Management is 100% owned by Robert E. Greeley, Chairman of the Board and President of the Company. Expenses of the Company - ----------------------- Other operating expenses include annual fixed fees payable to the trustee (the "Trustee") under the Indenture under which the Bonds are issued. Other services provided by the Trustee (including acting as custodian for the collateral, maintaining the Collection Account, and acting as registrar and paying agent for the Bonds) results in per annum charges which are not expected to exceed 0.02% per annum of principal amount of Bonds outstanding. The Company's annual legal and accounting fees are expected to approximate $60,000, consulting fees for officers' and administrative services are expected to approximate $78,000 and annual fees paid to outside directors are expected to approximate $15,000. Other administrative costs of the Company are not expected to be significant. Future Prospects - ---------------- The Company's Net Interest Margin continues to decline through the process of repayments and prepayments on the mortgages underlying the Company's assets. Additionally, the Company's asset pool is depleted by normal business expenses and the payment of dividends. The Company has been reinvesting its excess cash flows in Mortgage Derivative Investments to include CMO Residuals and REMIC Residual bonds. To the extent the Company continues to have cash in excess of that required for expenses and dividends, the Company intends to continue to reinvest that excess cash in Mortgage Derivative Investments in order to generate income for distribution to the common stockholder. The Bond Offerings - ------------------ The Company currently has an effective shelf registration statement covering approximately $800 million principal amount of Bonds under which the Series A Bonds were issued. Such Bonds may be offered by the Company from time to time. Bonds issued by the Company are issued pursuant to an Indenture (the "Indenture") dated as of December 1, 1986 between the Company and Texas Commerce Bank National Association (the "Trustee"), as amended, and as supplemented by supplemental indentures (each a "Series Supplement") with respect to each series of Bonds. The Indenture does not limit the amount of Bonds which can be issued thereunder and provides that Bonds of any series may be issued thereunder up to the aggregate principal amount that may be authorized from time to time by the Company. The collateral pledged to secure each series of Bonds issued by the Company may consist of (i) Mortgage Certificates together with the distributions of principal and interest thereon, (ii) a Collection Account (as defined in the Indenture) (the "INVG Government Collection Account") and (iii) other reserve funds and accounts which may be required in order to obtain the desired investment rating on the Bonds (collectively, the "Collateral"). On the closing date for each series of Bonds, the value of the Collateral pledged to secure such Bonds (calculated in accordance with the methodology specified in the Indenture) will not be less than the aggregate principal amount of such Bonds. Scheduled distributions of principal of and interest on the Mortgage Certificates collateralizing each series of Bonds are calculated to be sufficient to pay accrued interest on such Bonds and to amortize the entire principal amount of each class of such Bonds by its respective stated maturity. The Collateral for the Bonds of a particular series will secure only that series. Each series of Bonds issued by the Company is issuable in classes (the "Classes"). Each Class will have its own Bond Interest Rate which may be a floating interest rate that is redetermined periodically according to a specified index, and its own stated maturity which is the date on which the Bonds of such Class will be fully paid assuming no prepayments of principal are received on the Mortgage Certificates securing such series. Each series of Bonds will mature serially by Class, and principal payments on the various Classes of Bonds within each series will be made in the order specified in the Series Supplement. The actual maturity of any Class of Bonds could differ substantially from its stated maturity based upon the actual prepayment experience of the Mortgage Certificates and because certain of the underlying mortgage loans may have terms-to-maturity that are shorter than the stated maturity of the related Mortgage Certificate. No assurance can be given that the actual maturity and effective yield with respect to any Class of Bonds will be comparable to that experienced with respect to any other Class of Bonds within such series or within other series of Bonds issued by the Company or any of its affiliates. All distributions of principal of, and interest on, the Mortgage Certificates pledged to secure a series of Bonds will be remitted to the Trustee who will deposit such funds in the Collection Account for such series. Each series of Bonds will have a separate Collection Account. All amounts on deposit in any Collection Account representing distributions of principal of the Mortgage Certificates will be applied on each payment date ("Payment Date") for the related series of Bonds to pay principal on the then amortizing Class of such series. Amounts on deposit in the Collection Account representing distributions of interest on the Mortgage Certificates will be applied on each Payment Date, to the extent necessary to pay interest on the aggregate principal balance of the outstanding Bonds of such series accrued as of the date prior to such Payment Date specified in the Series Supplement. All amounts remaining in the Collection Account for a series of Bonds which are not so applied to the payment of principal of and interest on the Bonds of the related series and the Trustee's operating expenses will be remitted to the Company. The Indenture permits series of Bonds or Classes of Bonds within a series to be redeemed at the option of the Company upon the dates or under the circumstances specified in the related Series Supplement. The redemption price paid for such Bonds will be equal to their outstanding principal amount, together with accrued interest thereon to the date specified in the Series Supplement. THE ISSUED BONDS ---------------- The Series A Bonds were redeemed on February 1, 1994. The table below sets forth certain information with respect to the Issued Bonds to the extent outstanding at December 31, 1993: INVESTMENTS OF THE COMPANY -------------------------- Investment Policies - ------------------- The Company's investment policies and other policies are determined by its Board of directors in accordance with the articles and bylaws of the Company. The objective of the company is to maximize earnings and cashflow for distribution to the shareholder through mortgage related investments. The Company, in its early years, invested in CMO Related Investments through issuance of its own Bonds. Over the last year, the Company has been reinvesting its cashflows from these CMO Related Investments in Mortgage Derivative Investments which are similar in earnings and cashflow nature to its original CMO Related Investments. At all times, the Company intends to make investments in such a manner as to be consistent with the requirements of the Code to qualify as a REIT unless, because of circumstances or changes in the Code (or in the regulations promulgated thereunder), the Company determines that it is no longer in the best interest of the Company to qualify as a REIT. The Company's policies with respect to such activities may be reviewed and modified from time to time by the Company. Government National Mortgage Association - ---------------------------------------- GNMA is a wholly owned corporate instrumentality of the United States within the United States Department of Housing and Urban Development (the "HUD"). Section 306 (g) of Title III of the National Housing Act of 1934, as amended (the "Housing Act"), authorized GNMA to guaranty the timely payment of the principal of, and interest on, certificates which are based on and backed by a pool of mortgage loans insured by the FHA under the Housing Act, or Title V of the Housing Act of 1949, or guaranteed by the United States Veterans Administration (the "VA") under the Servicemen's Readjustment Act of 1944, as amended or Chapter 37 of Title 38, United States Code or by other eligible mortgage loans. Section 306(g) of the Housing Act provides that "the full faith and credit of the United States is pledged to the payment of all amounts which may be required to be paid under any guaranty under this subsection." In order to meet its obligations under such guarantees, GNMA is authorized to borrow from the United States Treasury with no limitations as to amount. GNMA Certificates - ----------------- Each GNMA Certificate is a "fully modified pass-through" mortgage-backed certificate issued under either the GNMA I or the GNMA II program (hereinafter described) and serviced by a mortgage banking company or other financial concern approved by GNMA as a seller-servicer of FHA Loans or VA loans. Although a GNMA certificate does not constitute a liability of, or evidence any right of recovery against, its issuer, the full and timely payment of principal of, and interest on, each GNMA Certificate is guaranteed by GNMA and such guaranty is backed by the full faith and credit of the United States. Each GNMA Certificate evidences a fractional undivided interest in a pool of FHA Loans and VA Loans and provide for the payment to the registered holder of such GNMA Certificate of fixed monthly payments of principal and interest equal to the aggregate amount of the scheduled monthly principal and interest payments on each FHA or VA Loan, less a servicing and guarantee fee based on the outstanding principal balance of the related GNMA Certificate. In addition, each payment includes any prepayments of principal of the FHA or VA Loans underlying the GNMA Certificate and liquidation proceeds in the event of a foreclosure or other disposition of any such FHA or VA Loans. Monthly distributions on each GNMA Certificate (a "GNMA I Certificate") issued under the original GNMA guaranty program (the "GNMA I program") are paid to the Trustee as registered holder on the 15th day of the month, while monthly distributions on each GNMA Certificate (a "GNMA II Certificate") issued under the guaranty program implemented by GNMA on July 1, 1983 (the "GNMA II program") are paid by the central paying and transfer agent and certificate registrar for the GNMA II program (the "GNMA II Agent") to the Trustee as registered holder on the 20th day of the month. Each GNMA Certificate collateralizing the Bonds will have an original maturity of not more than 30 years and while each GNMA I Certificate collateralizing the bonds will be backed by mortgage loans which bear a uniform interest rate and were originated by a single issuer, a GNMA II Certificate collateralizing the Bonds may be backed by mortgage loans with different interest rates (within a 1% range) and by a multi-issuer pool of mortgage loans which is expected to have greater geographic diversity and greater prepayment predictability. GNMA approves the issuance of each GNMA Certificate in accordance with a guaranty agreement (the "Guaranty Agreement") between GNMA and each issuer- servicer of the GNMA Certificates. Pursuant to its Guaranty Agreement such issuer-servicer is required to advance its own funds in order to make timely payments of all amounts due on the GNMA Certificate even if the payments received by such issuer on the FHA Loans and VA Loans backing the GNMA Certificate are less than the amounts due thereon. The Guaranty Agreement provides that in the event of default by the issuer-servicer, including (i) a failure by the issuer-servicer to make a required payment in accordance with the terms and conditions of such Guaranty Agreement, (ii) an advance by GNMA pursuant to a request to GNMA by the issuer- servicer to make a payment of principal of, or interest on, the GNMA Certificates, or (iii) insolvency of the issuer-servicer, GNMA shall have the right, by letter to the issuer-servicer, to effect the complete extinguishment of the issuer-servicer's interest in the pool of FHA Loans and VA Loans backing the GNMA Certificates, and the FHA Loans and VA Loans shall become the absolute property of GNMA, subject only to the unsatisfied rights of the holders of the GNMA Certificates. In such event, the Guaranty Agreement provides that, on and after the time GNMA directs such a letter of extinguishment to the issuer-servicer, GNMA shall be the successor in all respects to the issuer-servicer in its capacity under the Guaranty Agreement, and shall be subject to all responsibilities, duties and liabilities theretofore placed on the issuer-servicer by the terms and provisions of the Guaranty Agreement. At any time thereafter, however, GNMA may enter into an agreement with any other eligible issuer of GNMA Certificates under which such issuer undertakes and agrees to assume all or any part of such responsibilities, duties and liabilities placed on the original issuer-servicer, provided that no such agreement shall detract from the responsibilities, duties and liabilities of GNMA as guarantor of the GNMA Certificates or otherwise adversely affect the rights of the holders thereof to principal and interest payments on the GNMA Certificates. The issuer of a GNMA Certificate expects that interest and principal payments on the FHA Loans and VA Loans backing each GNMA Certificate will be the source of funds for payments due on such GNMA Certificate. If the issuer is unable to make payments on the GNMA Certificates as they become due, it must promptly notify GNMA and request GNMA to make such payments. In the event no payment is made by the issuer and the issuer fails to notify GNMA and request GNMA to make such payment, the holder of the GNMA Certificate has recourse only against GNMA to obtain such payments. The Trustee, as the registered holder of a GNMA Certificate, may proceed directly against GNMA under the terms of the Guaranty Agreement relating to such GNMA Certificate for any amounts which are not paid when due. GNMA Certificates Collateralizing the Bonds - ------------------------------------------- All of the GNMA Certificates collateralizing the Bonds are registered in the name of the Trustee. The Company will not add any GNMA Certificates to, or substitute other GNMA Certificates for, the original GNMA Certificates included in the collateral for each series of Bonds. Other Collateral - ---------------- Although the Company may issue Bonds secured by Mortgage Certificates other than GNMA Certificates, no such Bonds have been issued. FEDERAL INCOME TAX CONSEQUENCES ------------------------------- The Company intends to operate in a manner that will enable it to continue to qualify as a real estate investment trust (a "REIT") under the Code. The discussion below is not intended as a detailed discussion of all applicable Code provisions, the rules and regulations promulgated thereunder, or the administrative and judicial interpretations thereof. In general, if an entity desiring to qualify as a REIT (a "REIT Candidate") satisfies certain tests with respect to the nature of its income, assets, management, and share ownership, and the amount of its distributions, it will qualify as a REIT for federal income tax purposes. As a result, the REIT Candidate generally will not be subject to tax at the corporate level to the extent that it distributes its income to its shareholders. This treatment eliminates most of the "double taxation" (taxation at the corporate level and subsequently at the shareholder level when earnings are distributed) that typically results from the use of corporate investment vehicles. Such qualification, however, depends upon the ability of the Company to meet detailed factual and legal standards in future years. Federal Income Taxation of a REIT - --------------------------------- In any year in which a REIT Candidate qualifies as a REIT, and for which an election to be a real estate investment trust is in effect, it generally will not be subject to federal income tax on that portion of its REIT Taxable Income (as defined below) or capital gain that is distributed to its shareholders. Any such income that is not distributed, however, will be subject to tax at the regular corporate rates. A REIT, moreover, may be subject to special taxes on certain types of income, regardless of distributions to shareholders, and to the corporate minimum tax on certain items of tax preference. The Company, however, does not expect to have income of such types. As a REIT, the Company is required to use the calendar year both for tax purposes and financial reporting purposes. The taxable income of a REIT ("REIT Taxable Income") is generally computed as if it were an ordinary corporation, subject to certain adjustments. Due to the differences, however, between tax accounting rules and generally accepted accounting principles, the REIT Taxable Income of the Company may vary from net income for financial reporting purposes. GROSS INCOME AND ASSET TESTS. In order to qualify as a REIT, a REIT Candidate must satisfy, for each taxable year, various tests with respect to the nature of its gross income and its assets. The three principal income tests are the following: 1. THE 75 PERCENT TEST. At least 75 percent of the gross income (excluding gross income from prohibited transactions) of a REIT Candidate for the taxable year must be derived from certain qualifying real estate related sources, including interest on obligations secured by mortgages on real property, gain from the sale or other disposition of interests in real property and real estate mortgages, dividends from other real estate investment trusts and commitment fees related to mortgage loans. 2. THE 95 PERCENT TEST. In addition to meeting the 75 percent test, at least an additional 20 percent of the gross income of a REIT Candidate for the taxable year must be derived from the items of income that qualify under the 75 percent test, or from certain types of passive investments. Income attributable to dividends from companies other than REITS, interest on obligations not secured by real property, and gains from the sale or disposition of stock or other securities, other than stock or other securities held for sale to customers in the ordinary course of business, will constitute qualified income for purposes of this 95 percent test, but will be non-qualifying income for purposes of the 75 percent test. 3. THE 30 PERCENT TEST. A REIT Candidate must also derive less than 30 percent of its gross income from the sale or other disposition of (i) real property or mortgage loans held for less than four years, other than certain foreclosure property or property involuntarily converted through destruction, condemnation or similar events, (ii) stock or securities held for less than one year, and (iii) property in any prohibited transaction (i.e., sale or other disposition of inventory or property held primarily for sale in the ordinary course of business that is not foreclosure property). In addition, at the end of each quarter of the taxable year of a REIT Candidate, at least 75 percent of the value of such REIT Candidate's assets must be real estate assets (including interests in real property, loans secured by mortgages on real property and shares of other REITS), cash and cash items (including receivables), and certain United States government securities. The balance of a REIT Candidate's assets may be invested without restriction, except that holdings of securities may not exceed 25% of the value of the REIT Candidate's total assets. Moreover, the securities of any one non-governmental issuer must not exceed 5 percent of the value of such REIT Candidate's assets or 10 percent of the outstanding voting securities of that issuer. The securities of another REIT will not be treated as a security of a non-governmental issuer for purposes of the 5 percent and 10 percent asset test. Since the gross income of the Company will be derived principally from interest and gains with respect to GNMA Certificates, and since their assets will consist principally of GNMA Certificates and certain United States government securities, the Company should satisfy the gross income and asset tests during each taxable year or relevant portion thereof. If the Company should inadvertently fail to meet the 75 percent or 95 percent income tests, loss of real estate investment trust status could be avoided by paying a tax equal to 100 percent of any excess non-qualifying taxable income. There is no comparable safeguard that could protect against the failure of the Company to meet the 30 percent test. THE DISTRIBUTION TEST. The distribution test requires that a REIT distribute to its shareholders in each taxable year an amount equal to at least 95 percent of its REIT Taxable Income (computed before the dividends paid deduction and excluding any net capital gain), subject to various adjustments for income from certain foreclosure property, net losses from inventory type sales and certain penalty taxes. Generally, such distribution must be made in the taxable year, or in the following year if declared before the REIT timely files its tax return for such year and if paid on or before the first regular dividend payment after such declaration. The undistributed amount remains subject to tax at the tax rate then otherwise applicable. If a REIT Candidate fails to meet the 95 percent distribution requirement as a result of an adjustment to its tax returns by the Internal Revenue Service (the "Service) a REIT Candidate may retroactively cure the failure by paying a deficiency dividend (plus a penalty and interest). Due to the nature of the income of the Company from its assets and deductions in respect of its obligations, under certain circumstances the Company may generate REIT Taxable Income in excess of cash flow. For example, the maturity and interest rates of the investments of the Company are not likely to match the exact terms of the maturity and interest rates of the debt securities secured by such assets. Similarly, the Company may recognize taxable market discount income realized upon the sale, retirement or other disposition of GNMA Certificates purchased at a discount from the stated redemption price at maturity; whereas the proceeds from such disposition may be used to make nondeductible principal payments on debt securities secured by such assets. Also, if the Company's method of computing original issue discount (as discussed below) delayed its deductions, this could also result in REIT Taxable Income in excess of cash flow. The Company intends to monitor closely the interrelationship between REIT Taxable Income and cash flow. It is possible, although unlikely, that the Company may decide to terminate its REIT status as a result of any such cash shortfall. THE OWNERSHIP TEST. The share ownership test requires that the REIT Candidate's outstanding shares be held by a minimum of 100 persons for at least, approximately, 92 percent of the days in each taxable year and that no more than 50 percent in value of the shares be owned, actually or constructively, by five or fewer individuals at all times during the second half of each taxable year. For this purpose a pension fund and certain other types of tax-exempt entities are included within the meaning of the term "individual." To evidence compliance with these requirements, a REIT Candidate is required to maintain records that disclose the beneficial ownership of its outstanding shares. In fulfilling its obligation to maintain records, a REIT Candidate must demand written statements each year from the record holders of designated percentages of its shares, which would, inter alia, disclose the actual owners of such shares. ----- ---- Deduction of Bond Original Issue Discount - ----------------------------------------- The Company's Bonds may have "original issue discount" for federal income tax purposes. The aggregate amount of original issue discount on a Bond, if any, will be the excess of its "stated redemption price at maturity" over its original issue price. The original issue price for a Bond of a particular Sequence is the initial offering price at which the Bonds in that Sequence are sold to the public. The Company will deduct this original issue discount over the anticipated life of the Bond in computing its REIT Taxable Income. The Company will abide by recently issued Treasury regulations and other available guidance for purposes of computing original issue discount in connection with determining taxable income. Original issue discount for federal income tax purposes is computed with respect to bonds, such as the Bonds, which are subject to acceleration due to prepayments on other debt obligations securing such Bonds, by taking into account the anticipated rate of prepayments assumed in pricing the Bonds (the "Prepayment Assumption"). The amount of original issue discount to be deducted by the Company for an accrual period (generally the period between interest payments or compounding dates) is the excess of the sum of (a) the present value (discounted at the original yield to maturity of the Bond determined with reference to the Prepayment Assumption) of all payments remaining to be made on the Bond as of the close of such period and (b) the principal payments (or any payments made with respect to a bond that does not have qualified periodic interest payments) made during the accrual period, over the "adjusted issue price" of the Bond at the beginning of the accrual period. The adjusted issue price of a Bond is the sum of such Bond issue price plus prior accruals of original issue discount less total prior payments of principal (or any payments made with respect to a bond that does not have qualified periodic interest payments). For purposes of the present value calculation above, the payments remaining to be made as of the end of the accrual period are determined (i) with regard to all events that have occurred before the close of such accrual period and (ii) assuming that the remaining payments will be made in accordance with the original Prepayment Assumption. Failure to Qualify as a REIT - ---------------------------- If a REIT Candidate fails to qualify for taxation as a REIT in any taxable year, it will be subject to tax (including any applicable minimum tax) on its taxable income at regular corporate rates without any deduction for distributions to shareholders. Unless entitled to relief under specific Code provisions, a REIT Candidate will also be disqualified from treatment as a REIT for the following four taxable years. Failure to qualify for even one year could result in a REIT Candidate incurring substantial indebtedness in order to pay any resulting taxes, thus reducing the amount of cash available for distribution to shareholders. ITEM 2: ITEM 2: Properties ---------- On January 1, 1993 the Company entered into a month to month lease for offices at Meadow Wood Crown Plaza, 1575 Delucchi Lane, Suite 115-20, Reno, Nevada 89502. On November 12, 1993 the Company entered into a two year lease for offices at 433 California Street, San Francisco, California 94104. ITEM 3: ITEM 3: Legal Proceedings ----------------- None. ITEM 4: ITEM 4: Submission of Matters to a Vote of Security Holders --------------------------------------------------- On August 6, 1993 Robert E. Greeley and Shaun E. Greeley were elected to serve as directors of the Company until the next annual meeting or until their successors are elected. PART II ITEM 5: ITEM 5: Market for the Registrant's Common Stock and -------------------------------------------- Related Stockholder Matters --------------------------- All of the 1,000 outstanding common shares of the Company are owned by INVG Mortgage. Therefore, there is no market for the common stock of the Company. Dividends declared on the common stock of the Company amounted to $100,000, $550,000 and $1,165,000 in the years ended December 31, 1993, 1992 and 1991, respectively. ITEM 6: ITEM 6: Selected Financial Data ----------------------- The following selected financial data is qualified in its entirety by, and should be read in conjunction with, the financial statements and notes thereto appearing in sections of this Annual Report. The data as of December 31, 1993, 1992 and 1991 and for the years ended December 31, 1993, 1992 and 1991 have been derived from the Company's financial statements which are included elsewhere in this Annual Report on Form 10-K. ITEM 7: ITEM 7: Management's Discussion and Analysis of Financial Condition ----------------------------------------------------------- and Results of Operations ------------------------- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS The net loss for the year ended December 31, 1993 amounted to $704,698 as compared to net income of $694,035 for the year ended December 31, 1992 and net income of $687,853 for the year ended December 31, 1991. The variance from year to year is almost entirely attributable to the change in net interest income (loss). The elements of net interest income (loss) are: Net interest margin declined significantly in 1993 because of the retirement of the Class A-1 floating rate bonds leaving only the fixed rate bonds which bear a higher interest rate. Because of the retirement of these bonds, 1993 amortization of bond discount and bond issuance costs is significantly higher in 1993 than in prior years. Deferred Issuance Costs, premiums and discounts relating to mortgage certificates and GNMA Bonds are amortized to income using the interest method over the stated maturity of the mortgage certificates or bonds. Expenses of the Company were $201,429, $125,317 and $212,318 in the years ended December 31, 1993, 1992 and 1991, respectively. LIQUIDITY AND CAPITAL RESOURCES Cash provided by operating activities of the Company totaled $562,286 for the year ended December 31, 1993; $1,697,813 for the year ended December 31, 1992; and $1,504,653 for the year ended December 31, 1991. The Company's cash and cash equivalents decreased $66,287 in 1993 and $569,808 in 1992, but increased by $394,436 in 1991. In 1993, the Company made investments in mortgage derivative investments, net of principal reductions, of $3,141,216 and made other investments totaling $2,051,244. These investments were largely financed by a $2,408,598 increase in the amount payable to affiliated companies and by $2,400,000 in short-term borrowings. The Company had total assets of $68.1 million and $96.5 million at December 31, 1993 and 1992, respectively. Of these amounts, $61.2 million and $93.3 million, respectively, were invested in GNMA Certificates which collateralize the bonds. The Company was initially capitalized on May 12, 1986 by the issuance and sale of 1,000 shares of its common stock to its parent, INVG Mortgage Securities Corp., for $1,000. On May 23, 1986, the Company sold 200 shares of Series Z Preferred Stock for $10,000. On April 30, 1991, the Board of Directors of INVG Mortgage Securities Corp. voted to contribute the outstanding balance of the non-interest bearing receivable from the Company to the Company as additional paid-in capital. The Company had no capital expenditures during the three years ended December 31, 1993. ITEM 8: ITEM 8: Financial Statements and Supplementary Data ------------------------------------------- AND SUPPLEMENTAL SCHEDULES Page ---- Report of Independent Auditors, Deloitte & Touche 15 Balance Sheets at December 31, 1993 and December 31, 1992 16 Statements of Income (Loss) for the years ended December 31, 1993, 1992 and 1991 17 Statements of Changes in Stockholders' Equity for the years ended December 31, 1993, 1992 and 1991 18 Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991 19 Notes to Financial Statements 20-25 Supplemental Schedules IV and IX 26 REPORT OF INDEPENDENT AUDITORS To the Board of Directors and Stockholder of INVG Government Securities Corp. We have audited the accompanying balance sheets of INVG Government Securities Corp. as of December 31, 1993 and 1992, and the related statements of income (loss), changes in stockholders' equity, and cash flows for the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 8. These financial statements and the financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules 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, such financial statements present fairly, in all material respects, the financial position of the Company at December 31, 1993 and 1992 and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles.Also, in our opinion, such financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note 2, the Company changed its method of accounting for its investments to adopt the provisions of Statement of Financial Accounting Standards No. 115. New York, New York April 13, 1994 INVG GOVERNMENT SECURITIES CORP. NOTES TO FINANCIAL STATEMENTS Note 1. - Organization INVG Government Securities Corp. (the "Company") was incorporated on May 5, 1986 in the State of Delaware as a subsidiary of INVG Mortgage Securities Corp. ("INVG Mortgage"). The Company was formed to engage in the acquisition of certain mortgage securities and the issuance of Collateralized Mortgage Obligations collateralized by such mortgage securities. The Company has historically generated revenues primarily from Collateralized Mortgage Obligation ("CMO") investments whereby the company was engaged in the business of acquiring modified mortgage-backed pass through certificates ("GNMA Certificates") and then issuing and selling bonds (Bonds) backed by the GNMA Certificates. These investments in CMO issuances give the Company the right to the excess cashflows and earnings on the GNMA Certificates over the expenses required on the the Bonds ("CMO Issuance Investments"). The Company has also invested in other similar mortgage related investments wherein the Company has the right to receive the cashflows of a CMO bond offering after debt service payments are made, such as CMO Mortgage Derivative Investments and REMIC Mortgage Derivative Investments, ("Mortgage Derivative Investments"). The Company's investment policies and other policies are determined by its Board of directors in accordance with the articles and bylaws of the Company. The objective of the company is to maximize earnings and cashflow for distribution to the shareholder through mortgage related investments. The Company, in its early years, invested in CMO Related Investments through issuance of its own Bonds. Over the last year, the Company has been reinvesting its cashflows from these CMO Related Investments in Mortgage Derivative Investments which are similar in earnings and cashflow nature to its original CMO Related Investments. At all times, the Company intends to make investments in such a manner as to be consistent with the requirements of the Code to qualify as a REIT unless, because of circumstances or changes in the Code (or in the regulations promulgated thereunder), the Company determines that it is no longer in the best interest of the Company to qualify as a REIT. The Company's policies with respect to such activities may be reviewed and modified from time to time by the Company. On December 30, 1986, the Company sold $200,369,000 principal amount of the Collateral Mortgage Obligations, Series A (the "Bonds"). The net proceeds of the offering were used to partially finance the purchase of Government National Mortgage Association Certificates ("GNMA Certificates") to collateralize the Bonds. INVG Mortgage funded the balance of the purchase of GNMA Certificates through a non-interest bearing loan to the Company. Note 2. - Summary of Significant Accounting Policies Accounting Change - On December 31, 1993 the Company adopted Statement of Financial Accounting Standards No. 115 ("SFAS 115") - Accounting for Certain Investments in Debt and Equity Securities. In accordance with this new Standard, the Company classified its investments as either available- for-sale or held-to-maturity. The Company has elected to classify its investments in CMO Residuals and REMIC Residuals as available-for-sale while it has elected to classify its investments in GNMA Certificates as held-to-maturity investments. SFAS 115 requires that held-to-maturity investments be accounted for at amortized cost. However, if the fair value, as defined, of the investment declines below the amortized cost basis and the decline is considered to be "other than temporary", the cost basis of the individual asset must be written down to its fair value as the new cost basis. Held-to Maturity. The investment in GNMA Certificates is classified as a held-to-maturity investment. In connection with the fourth quarter adoption of SFAS 115 and consistent with the consensus reached by the Emerging Issues Task Force on Issue No. 93-18, the Company measures other than temporary impairment by comparing the net cash flows from the GNMA Certificates (net of GNMA Bonds principal and interest payments and related trustee expenses) discounted at a risk free rate to the net carrying value of the GNMA Certificates (i.e. net of GNMA Bond liabilities). If such discounted cash flows are less than the net carrying value, the Company records a reserve to reduce the net carrying value to fair value. For purposes of determining fair value, the Company discounts the net cash flows as discussed above using an estimated risk adjusted rate of return. The effect of adopting this change in accounting was not material. Available-for-Sale. The Company is not in the business of trading its mortgage-related assets, however, from time to time the Company may sell an asset as part of the Company's efforts to adjust its portfolio composition to reflect changes in economic conditions. Therefore the Company has classified its investments in CMO Residual Interests and REMIC Residual interests as available-for-sale. They are carried at fair value in the financial statements. Unrealized holding gains and losses for available- for-sale investments are excluded from earnings and reported as a net amount in shareholder's equity until realized. Available-for-sale investments are also subject to write down whenever the fair value is less than the future projected cash flows discounted at a risk-free rate. None of the Company's available-for-sale investments were subject to write down as of December 31, 1993. Mortgage Certificates and Collateralized Mortgage Obligation Bonds ("CMOs") - Mortgage certificates and CMO bonds are carried at their outstanding principal balance plus or minus any premium or discount, respectively. Management has the intention and the ability to hold the Mortgage Certificates and CMO Bonds to term. Amortization of Deferred Issuance Costs, Premiums and Discounts - Deferred issuance costs, premiums and discounts relating to mortgage certificates and CMOs are amortized to income using the interest method over the stated maturity of the mortgage certificates or CMOs. Prepayments are not anticipated. When prepayments occur, a proportionate amount of the related costs, premiums and discounts are recognized in income so that the effective interest rate on the remaining balance continues unchanged. Mortgage Derivative Investments - Mortgage Derivative Investments are accounted for under the Prospective method. Under this method, assets are carried at cost and income is amortized over their estimated lives based on a method which provides a constant yield. At the end of each quarter, the yield over the remaining life of the asset is recalculated based on expected future cash flows using current interest rates and mortgage prepayment speeds. This new yield is then used to calculate the subsequent quarter's income. Under certain extended high interest rate periods, or in the event of extremely high prepayment rates on the collateral, the return on the Company's investment in a mortgage derivative investment could be zero or negative. In the event that the projected return on an investment in a mortgage derivative investment falls below a risk free rate, the Company would be required to write down the investment to its fair value. Income Taxes - The Company has elected to be taxed as a real estate investment trust ("REIT") under the Internal Revenue Code of 1986, as amended. As a REIT, the Company must distribute annually at least 95% of its taxable income to its shareholders. No provision has been made for income taxes in the accompanying financial statements as the Company will not be subject to income taxes. Over the life of a mortgage derivative investment, total taxable income will equal total financial statement income. However, the timing of income recognition may differ between the two from year to year. Statement of Cash Flows - For purposes of the statement of cash flows, the Company considers all highly liquid debt instruments with an original maturity of three months or less to be cash equivalents. Reclassifications - Certain reclassifications have been made to the December 31, 1991 financial statements to conform such financial statements to the December 31, 1992 financial statements. Such reclassifications do not effect net income as reported. Note 3. - Investment in GNMA Certificates Information as of December 31, 1993 and 1992 with respect to the GNMA Certificates, all of which collateralize the Bonds, is as follows: On January 24, 1994 the GNMA Certificates securing the Bonds were sold as part of an optional redemption of the Series A Bonds. See Note 5. Note 4. - Bonds Information as of December 31, 1993 and 1992 with respect to the Bonds which are collateralized by the GNMA Certificates is as follows: The Bonds are redeemable at the option of the Company in whole, but not in part, on any payment date on or after the earlier of July 1, 1996 or the payment date on which the Class A-2 Bonds are paid in full. Interest paid during the years ending December 31, 1993, 1992 and 1991 amounted to $6,945,074, $8,254,089 and $9,958,080; respectively. Note 5. - Subsequent Redemption of Series A Bonds On January 5, 1994 the Board of Directors of the Company authorized an optional redemption of the Series A Bonds on February 1, 1994 pursuant to the call provisions of the Series A Bonds. On January 24, 1994, the GNMA Certificates securing the Series A Bonds were sold. The Company realized a gain of $4,500,000 from the sale of the GNMA Certificates. On February 1, 1994, the Series A Bonds were redeemed at par. After accounting for expenses, including amortization of discounts and premiums, the Company incurred an extraordinary loss of $2,236,000 from the redemption of the Series A Bonds. The net cash the Company received from this series of transactions was $5,010,000. The pro forma effect of this redemption has been presented with the accompanying historical balance sheets as if the redemption had taken place on December 31, 1993. Note 6. - Purchase of Mortgage Derivative and Other Investments During the year ended December 31, 1993, the Company purchased Mortgage Derivative Investments as shown in the schedule below: In accordance with FASB-107, the Company shall disclose the fair value of financial instruments for which it is practicable to estimate that value. The Company has disclosed in Notes 3 and 4 the fair value of the GNMA Certificates and Bonds based on market prices for comparable instruments as of December 31, 1993. However, the Company is unable to sell the GNMA Certificates and therefore realize any gain until the Bonds which are collateralized by the certificates either mature or are called in accordance with the underlying bond indenture. The Company computes the estimated fair value of its mortgage derivative investments, including CMO Residuals and REMIC Residuals, by projecting anticipated future cash flows and discounting those cash flows at discount rates established in market transactions for securities having similar characteristics and backed by collateral of similar rate and term. The Company has used available market information as of December 31, 1993 and has concluded that the fair value of the mortgage derivative investments at December 31, 1993 was approximately equal to the carrying value of $3,245,000 as of December 31, 1993. The Company estimated the prospective yield on these investments for the first quarter of 1994 to be approximately 27.0%. During the year ended December 31, 1993, the Company purchased other investments as shown in the schedule below: Pine Street Associates is a limited partnership whose investment objective is to achieve long-term capital appreciation with a diversification of risk. The Company was admitted as a partner in Pine Street Associates, L.P. effective January 1, 1994. Note 7. - Short-Term Debt At December 31, 1993 the Company owed $2,400,000 under a repurchase agreement. This borrowing had an initial term of one month and is renewed on a month-to-month basis. The interest rate of this borrowing at December 31, 1993 was 3.625%. The debt is collateralized by the Company's investment in Merrill Lynch Trust 8-R. Note 8. - Series Z Preferred Stock In May 1986, the Company sold 200 shares of its Series Z Preferred Stock for $10,000. The Series Z Preferred stockholders are entitled to receive dividends, when, as and if declared by the Board of Directors payable annually on the first business day in May of each year commencing May l, 1987. The annual amount per share of the dividend is $5.00. Dividends are cumulative and will accrue as of the date on which such dividends are payable without regard to whether such dividends have been earned or declared. No dividends will be paid or set apart for the common stock so long as dividends on the Series Z Preferred Stock are payable and unpaid. Preferred stock dividends of $1,000, or $5.00 per share, were declared and paid in both 1993 and 1992. The Series Z Preferred Stock may be redeemed, in whole or in part, at the option of the Company by resolution of the Board of Directors, at any time and from time to time at a redemption price of $50.00 per share plus accrued and unpaid dividends. Note 9. - Dividends on Common Stock During 1992, the Company paid dividends on its common stock totaling $550,000. Of this amount $539,047 is ordinary taxable income and the remaining $10,953 is a nontaxable return of capital. During 1993, the Company paid dividends on its common stock totaling $100,000. All of this amount is a nontaxable return of capital. Note 10. - Lease Commitments On November 12, 1993 the Company entered into a two year lease for offices at 433 California Street, San Francisco, California 94104. Required monthly lease payments are $1,377. The rental obligation for 1994 totals $16,526 and for 1995 totals $15,149. Note 11. - Subsequent Events Subsequent to December 31, 1993, the Company purchased the following: Note 12. - Management The Company is managed by the Board of Directors. From February 1990 through December 1991, the day-to-day activities of the Company were managed by Fulcrum, subject to the supervision of the Board of Directors. Under the terms of their agreement, Fulcrum received a monthly management fee of $15,000 which cost is shared by INVG Mortgage and Investors GNMA Mortgage-Backed Securities Trust, Inc., an affiliate of the Company. Effective in January 1992, the day-to-day administrative affairs of the Company are managed, subject to the supervision of the Board of Directors, under an Administration Agreement with TIS Asset Management, Inc. This agreement provided for a monthly fee of $16,000 for administrative services which fee is divided among the affiliated Companies. During 1992, the Company paid to the President, who is also a Director of the Company, an Officer's consulting fee in lieu of a Directors fee. At the Annual Meeting of Shareholders of the Company's parent, INVG Mortgage Securities Corp., held on October 26, 1993, a consulting agreement with Page Mill Asset Management was ratified. Under this agreement, which is effective January 1, 1993, the Company and its affiliates will pay Page Mill a monthly fee of $10,000 plus an incentive management fee. The incentive management fee, determined with respect to the Companies' performance each fiscal year is equal to 25% of the dollar amount, if any, by which the parent company's consolidated taxable income for such fiscal year, before payment of any incentive fee to Page Mill, net operating loss deductions arising from prior periods' losses and special Internal Revenue Code deductions pertaining to real estate investment trusts, plus certain other adjustments in accordance with generally accepted accounting principles, exceeds the amount necessary to provide an annualized return on equity equal to 1% over the average ten-year U.S. Treasury rate for such fiscal year. Under this agreement, the Company has recorded expense in the year ended December 31, 1993 of $30,000. None of the incentive management fee has been allocated to the Company as it had a taxable loss for 1993. Page Mill Asset Management is 100% owned by Robert E. Greeley, Chairman of the Board and President of the Company. Note 13. - Tax Status During the year ended December 31, 1991 the Company utilized the remaining $128,000 of its net operating loss carryforward. As of December 31, 1992 the Company has no net operating loss carryforwards. In 1993 the Company incurred a taxable loss of $610,934 which generates a net operating loss carryforward expiring in 2008. The Company's policy is to comply with the requirements of the Internal Revenue Code that are applicable to real estate investment trusts and to distribute sufficient taxable income to qualify as a REIT. Accordingly, no provision for federal income taxes is required in the Company's financial statements to the extent that sufficient distributions of taxable income have been made to the shareholders for reporting in their respective tax returns. In accordance with Statement of Financial Accounting Standards 109 disclosure requirements, the following differences existed at December 31, 1993 between the tax bases and the reported financial statement amounts of the Company's assets and liabilities (unaudited): Note 14. - Related Party Transactions On April 30, 1991, the Board of Directors of INVG Mortgage voted to contribute the outstanding balance of the non-interest bearing payable in the amount of $6,952,003 to the Company. At December 31, 1992 the Company had an interest bearing receivable from its affiliate Investors GNMA Mortgage-Backed Securities Trust, Inc. in the amount of $1,208,466 and an interest bearing receivable from its parent, INVG Mortgage Securities Corp., in the amount of $331,306. Both receivables accrue interest at a 6% rate. Of the Company's interest income, $14,744 is from related parties. At December 31, 1993 the Company owed Investors GNMA Mortgage-Backed Securities Trust, Inc. $1,290,406 and had a receivable of $421,580 from INVG Mortgage Securities Corp. Both amounts accrue interest income or expense at a 6% rate. Of the Company's interest income, $80,054 is from related parties. As described in Note 11, the Company, together with INVG Mortgage and Investors GNMA, has entered into a Consulting Agreement with Page Mill Asset Management, 100% of which is owned by Robert E. Greeley. Item 9. Item 9. - Changes in and Disagreements with Accountants on Accounting and Financial Disclosure Not applicable PART III Item 10. Item 10. - Directors and Executive Officers of the Registrant The directors and executive officers named below are the directors and executive officers of the Company as of March 30, 1994: Positions Directors and Held With Executive Officers Corporation Age - ------------------ ----------- --- Robert E. Greeley Chairman of the Board 61 President, Director and Treasurer. Shaun E.Greeley Vice President and Director 35 Russell Berg Vice President and Secretary 73 The term for the directors will expire at the next meeting of shareholders of the Company. Currently there is no date set for such a meeting. Since the beginning of the Company's 1990 fiscal year, the Board of Directors has been seeking ways to reduce the Company's operating costs as the assets of the Company continue to attenuate through the normal process of repayments on the mortgages underlying those assets. In connection with attuning the Company to its less active nature and smaller size, the Company accepted the resignations of all of its officers and all but one of its directors effective December 31, 1989. The immediate reason for the resignation was the unavailability of directors' and officers' liability insurance at a reasonable cost. The sole remaining director, Robert E. Greeley, appointed new directors to the Board. As part of the program of cost reduction, the Board then amended the Company's by- laws to reduce the number of directors and officers to two each. The newly constituted board elected officers. Mr. Robert E. Greeley, a director since 1986, was elected to the positions of Chairman of the Board and President of the Company, INVG Mortgage and Investors GNMA. Mr. Greeley is a general partner of Cypress Cove Fund L.P., an investment partnership. He was Manager, Corporate Investment for Hewlett- Packard Company, a diversified company, from 1979 to May 1991. He is also the investment advisor to the William and Flora Hewlett Foundation. Mr. Greeley is a director of Morgan Grenfell Small Cap Fund and of Bunker Hill Income Securities. He is also a principal in Page Mill Asset Management and Greeley Partners. Mr. Greeley also serves as a director of INVG Mortgage and Investors GNMA. Ms. Shaun E. Greeley, daughter of Robert E. Greeley, is currently a director of the Company. From April 1993 to February 1994 she was a financial consultant to Merrill Lynch & Co. From 1988 to 1991, she was a Vice President of Chase Securities, Inc., a subsidiary of Chase Manhattan Bank. From 1984 through 1988 she held various transactional and marketing positions at Citicorp Inc. Mr. Berg has been a Managing Director of Viewpoints International, a management consulting organization since May 1986. Prior to that time he was Director of Marketing Communications for the Hewlett-Packard Company, from which Mr. Berg retired in May 1986. Mr. Berg is a Trustee of the Sensory Aids Foundation of Palo Alto. Mr. Berg is also a director of INVG Mortgage Securities Corp. and Investors GNMA. During 1993, the Board of Directors met seven times and each director attended all of the meetings of the Board. The Board of Directors does not have a standing audit, nominating or compensation committee. Item 11. Item 11. - Executive Compensation No directors, officers or employees of the Administrator (as defined herein) or its affiliated companies are directors or executive officers of the Company. For 1993, each director of the Company, other than those who are executive officers or employees of the Company, was entitled to receive a fee of $500 for each Board of Directors or committee meeting attended by that director (together with all actual out-of-pocket expenses incurred in connection with attendance at such meetings), plus additional compensation at an annual rate of $8,000. Robert E. Greeley, as president, received no compensation. During 1993 all directors and officers as a group consisting of 3 persons received from the Company aggregate remuneration in the amount of $14,500. Robert E. Greeley received aggregate compensation attributable to the Company of $15,000 in each of the years 1992 and 1991. Item 12. Item 12. - Security Ownership of Certain Beneficial Owners and Management The executive officers and directors of the Company do not own any shares of common stock of the Company. All of the outstanding shares of common stock of the Company are owned by INVG Mortgage. The Company has approximately 150 beneficial holders of an aggregate of 200 shares of Series Z Preferred Stock. On March 17, 1993, the Company acquired 6,500 shares of the common stock of INVG Mortgage, thereby reducing the number of outstanding shares of the common stock of INVG Mortgage to 675,775. In November and December 1993, the Company acquired an additional 1,200 and 1,000 shares, respectively, reducing the number of outstanding shares of common stock of INVG Mortgage to 673,575. Item 13. Item 13. - Certain Relationships and Related Transactions On April 30, 1991, the Board of Directors of INVG Mortgage voted to contribute the outstanding balance of the non-interest bearing payable in the amount of $6,952,003 to the Company. At December 31, 1992 the Company had an interest bearing receivable from its affiliate Investors GNMA Mortgage-Backed Securities Trust, Inc. in the amount of $1,208,466 and an interest bearing receivable from its parent, INVG Mortgage Securities Corp., in the amount of $331,306. Both receivables accrue interest at a 6% rate. Of the Company's interest income, $14,744 is from related parties. At December 31, 1993 the Company owed Investors GNMA Mortgage-Backed Securities Trust, Inc. $1,290,406 and had a receivable of $421,580 from INVG Mortgage Securities Corp. Both amounts accrue interest income or expense at a 6% rate. Of the Company's interest income, $80,054 is from related parties. As described in Note 11, the Company, together with INVG Mortgage and Investors GNMA, has entered into a Consulting Agreement with Page Mill Asset Management, 100% of which is owned by Robert E. Greeley. PART IV Item 14. Item 14. - Exhibits, Financial Statements, Schedules and Reports on Form 8- K (a) Documents filed as part of this report: (1) Financial statements of the Company - as listed in the "Index to Financial Statements" included in Part II, Item 8 of this Form 10-K. (2) Financial statement schedules Schedule IV - Indebtedness of and to Related Parties Schedule IX - Short-term Borrowings All financial statement schedules not included have been omitted because they are inapplicable or the information is provided in the Financial Statements, including the notes thereto, included in Part II, Item 8, of this Form 10-K. (b) Reports on Form 8-K No reports on Form 8-K were filed by the Company during the last quarter of the year ended December 31, 1993. (c) Exhibits The following exhibits (unless incorporated by reference to another report) are included in a separate volume filed with this report and are identified by the numbers indicated. Exhibit No. Description - --------- ----------- 3.1 Articles of Incorporation of the Company (Incorporated by reference from Exhibit 3.1 to the Company's Form 10-K for the fiscal year ended December 31, 1987) 3.2 By-Laws of the Company (Incorporated by reference from Exhibit 3.2 to the Company's Form S-11, No. 33-5579) 4.1 Indenture dated as of December 1, 1986 between the Company and Texas Commerce Bank National Association (Incorporated by reference from Exhibit 4.1 to the Company's Form 10-K for the fiscal year ended December 31, 1986) 4.2 Series A Supplement to Indenture dated as of December 30, 1986 between the Company and Texas Commerce Bank National Association (Incorporated by reference from Exhibit 4.2 to the Company's Form 10-K for the fiscal year ended December 31, 1986) 10.1 Management Agreement dated as of May 12, 1986 among the Company, INVG Mortgage and Investors GNMA (Incorporated by reference from Exhibit 10.1 to the Company's Form 10-K for the fiscal year ended December 31, 1987) 10.2 Advisors Agreement dated as of February 14, 1990 among the Company, INVG Mortgage and Investors GNMA (Incorporated by reference from Exhibit 10.2 to the Company's Form 10-K for the fiscal year ended December 31, 1989) 10.3 Administration Agreement dated as of December 1, 1991 among the Company, INVG Mortgage and Investors GNMA and TIS Asset Management, Inc. (Incorporated by reference from Exhibit 10.3 to the Company's Form 10-K for the fiscal year ended December 31, 1991.) 13.1 The Company's Annual Report to Shareholders for 1993 (Furnished for the information of the Commission and not deemed to be filed except for those portions which are expressly incorporated by reference into this Form 10-K) No other exhibits are filed because they are either not applicable or not required. 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. INVG GOVERNMENT SECURITIES CORP. By: /s/ Robert E. Greeley ---------------------------- Robert E. Greeley Chairman of the Board Date: April 14, 1994 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 dates indicated. Signature Date Title - --------- ---- ----- /s/ Robert E. Greeley April 14, 1994 Chairman of The Board, - ----------------------- President and Treasurer. Robert E. Greeley (Principal Executive and Financial Officer) /s/ Shaun Greeley April 14, 1994 Director - ----------------------- Shaun Greeley /s/ Russell Berg April 14, 1994 Secretary - ----------------------- Russell Berg

1993 ITEM 1. BUSINESS. GENERAL References herein to the Company include Beverly Enterprises, Inc. and its wholly-owned subsidiaries. The business of the Company consists principally of operating nursing facilities, including subacute units, pharmacies and pharmacy-related outlets. Additional operations include retirement and congregate living projects and home health care entities. The Company is the largest operator of nursing facilities in the United States. At January 31, 1994, the Company operated 774 nursing facilities with 82,680 licensed beds. The facilities are located in 34 states and the District of Columbia, and range in capacity from 20 to 388 beds with average occupancy of 88.6%, 88.4% and 88.2% during the years ended December 31, 1993, 1992 and 1991, respectively. In addition, at January 31, 1994, the Company operated 23 subacute units, 41 pharmacies and pharmacy-related outlets, 42 retirement and congregate living projects containing 2,554 units and five home health care entities. See "Item 2. ITEM 2. PROPERTIES. At January 31, 1994, the Company operated 774 nursing facilities and 42 retirement and congregate living projects in 34 states and the District of Columbia. Most of the Company's 351 leased nursing facilities are subject to "net" leases which require the Company to pay all taxes, insurance and maintenance costs. Most of the Company's leases have original terms from ten to fifteen years and contain at least one renewal option, which could extend the original term of the leases by five to fifteen years. Many of the Company's leases also contain purchase options. The Company considers its physical properties to be in good operating condition and suitable for the purposes for which they are being used. A substantial portion of the nursing facilities and retirement centers owned by the Company is included in the collateral securing the obligations under its various banking arrangements. See "Part II, Item 8 -- Note 4 of Notes to Consolidated Financial Statements." The following is a summary of the Company's nursing home facilities, retirement and congregate living projects, pharmacies and home health centers at January 31, 1994: - --------------- (1) The Company is currently negotiating the disposition of all of its nursing home facilities in the state of Oregon as part of its continuing efforts under the 1992 restructuring program. See "Part II, Item 8 -- Note 2 of Notes to Consolidated Financial Statements." ITEM 3. ITEM 3. LEGAL PROCEEDINGS. There are various lawsuits and regulatory actions pending against the Company arising in the normal course of business, some of which seek punitive damages. The Company does not believe that the ultimate resolution of these matters will have a material adverse effect on the Company's financial position or results of operations. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. No matters were submitted to a vote of the Company's security holders during the last quarter of its fiscal year ended December 31, 1993. EXECUTIVE OFFICERS AND DIRECTORS The table below sets forth, as to each executive officer and director of the Company, his name, positions with the Company and age. Each executive officer and director of the Company holds office until a successor is elected, or until the earliest of death, resignation or removal. Each executive officer is elected or appointed by the Board of Directors. The information below is given as of March 15, 1994. - --------------- (1) Member of the Finance Committee. (2) Member of the Quality Assurance Committee. (3) Member of the Audit Committee. (4) Member of the Compensation Committee. (5) Member of the Nominating Committee. Mr. Banks has been President and a director of the Company since 1979 and has served as Chief Executive Officer since May 1989 and Chairman of the Board since March 1990. Mr. Banks is a director of Nationwide Health Properties, Inc., Ralston Purina Company, Wal-Mart Stores, Inc., Wellpoint Health Networks, Inc., and trustee for the University of the Ozarks and Occidental College. Mr. Hendrickson joined the Company in 1988 as a Division President. He was elected Vice President of Marketing in May 1989, and Executive Vice President of Operations and Marketing in February 1990. Mr. Hendrickson was President and Chief Operating Officer of Care Enterprises Inc., from 1984 to 1987, and Chairman of the Board and Chief Operating Officer of Hallmark Health Services, Inc. from 1987 through 1988. Mr. Kayne joined the Company in 1979. He was elected Vice President of Professional Services in 1983, Vice President of the Company and President of Pharmacy Corporation of America ("PCA"), a wholly-owned subsidiary of the Company, in 1985, and Executive Vice President of the Company in February 1990. Mr. Moore joined the Company as Executive Vice President -- Managed Care in December 1992. Mr. Moore was employed at Aetna Life and Casualty from 1963 to 1992 and was elected Senior Vice President in 1990. Mr. Stephens joined the Company as a staff accountant in 1969. He was elected Assistant Vice President in 1978, Vice President of the Company and President of the Company's Central Division in 1980, and Executive Vice President -- Development in February 1990. Mr. Stephens is a director of City National Bank in Fort Smith, Arkansas, Beverly Japan Corporation, Western Arkansas Counseling and Guidance Center, Inc. and Harbortown Properties, Inc. Mr. Woltil joined the Company in 1982 as Technical Accounting Manager. From 1984 to 1990 he served in various financial positions. He was elected Vice President -- Financial Planning and Control in January 1990, Senior Vice President and Chief Financial Officer in March 1992 and Executive Vice President, Finance in January 1993. Mr. Clarke joined the Company in 1987 as a Director of Government Program Compliance. He was elected Vice President in 1989 and Senior Vice President -- Quality Assurance in December 1991. Mr. Clarke is a director of St. Edward Mercy Medical Center. Mr. Hollingsworth joined the Company in June 1985 as Assistant Treasurer. He was elected Treasurer in 1988, Vice President in 1990 and Senior Vice President in March 1992. Mr. Hollingsworth is a director of Sparks Regional Medical Center. Mr. Pommerville first joined the Company in 1970 and left in 1976. Mr. Pommerville rejoined the Company as Vice President and General Counsel in 1984 and was elected Secretary in February 1990 and Senior Vice President in March 1990. Mr. Small joined the Company in January 1986 as Reimbursement Manager, was promoted to Division Controller in September 1986, Director of Finance for the California Region in 1989, and elected Vice President -- Reimbursement in September 1990. Mr. Tabakin joined the Company in October 1992 as Vice President, Controller and Chief Accounting Officer. From 1980 to 1992, Mr. Tabakin was with Ernst & Young, in Norfolk, Virginia. Mr. Anthony served as a member of the United States Congress and was Chairman of the Democratic Congressional Campaign Committee from 1987 through 1990. In 1993, he became a partner in the Winston & Strawn law firm. Mr. Anthony serves as a director of Anthony Forest Products Company. He has been a director of the Company since January 1993. Mr. Bradbury is Chairman, President, Chief Executive Officer and a director of Worthen Banking Corporation. He joined Worthen in 1985 as Assistant to the President, and prior thereto was a Vice President in the Corporate Finance Department of Stephens Inc., and Manager of its Bank Services Division. He has been a director of the Company since July 1989. Mr. Greene's principal occupation has been that of a director and consultant to various U.S. and international businesses since 1986. He is a director of ASARCO, Inc., a number of mutual funds of Alliance Capital Management Corporation, American Reliance Group Inc., Buck Engineering Company and Bank Leumi. He has been a director of the Company since January 1991. Mr. Jacoby is Executive Vice President, Chief Financial Officer and a director of Stephens Group, Inc. Mr. Jacoby has held the indicated positions with Stephens Group, Inc. since 1986, and prior to that time, served as Manager of the Corporate Finance Department and Assistant to the President of Stephens Inc. Mr. Jacoby is a director of Medicus Systems, Inc., the Delta Queen Steamboat Company and Delta and Pine Land Company, Inc. He has been a director of the Company since February 1987. Mr. Menk is Chairman of Black Mountain Gas Company. He retired in 1982 as Chairman and Chief Executive Officer of International Harvester Company, the predecessor to Navistar International Corporation. He has been a director of the Company since July 1989. Mr. Weinstein has been Managing Partner of Genesis Merchant Group, a holding company for Genesis Merchant Group Securities, since 1989 and was President of WIG, Inc. from 1987 to 1989. From 1982 to 1987, Mr. Weinstein was Managing Partner of Montgomery Securities. Mr. Weinstein is a director of DHL Corporation. He has been a director of the Company since March 1989. Mr. Joe T. Ford, Chairman, President and Chief Executive Officer of ALLTEL Corporation, and a director of The Dial Corp and LDDS Communications, Inc., was a director of the Company since January 1991. On February 28, 1994, Mr. Ford resigned from the Company's Board of Directors. In connection with the issuance of the Series A preferred stock to Stephens Group, Inc., the Company agreed to use its best efforts to cause a designee of Stephens Group, Inc. to be elected to the Company's Board of Directors so long as Stephens Group, Inc. owned 500,000 of the Series A preferred stock and was the sole owner of all outstanding Series A preferred stock. Mr. Jacoby is the designee of Stephens Group, Inc. pursuant to such agreement. The Series A preferred stock was redeemed on January 3, 1994. During 1993, there were six meetings of the Board of Directors. Each director attended 75% or more of the meetings of the Board and committees on which he served. In 1993, directors, other than Mr. Banks, received a retainer fee of $18,000 for serving on the Board and an additional fee of $1,000 for each Board or committee meeting attended. Mr. Banks, the current Chairman of the Board, President and Chief Executive Officer of the Company, received no additional cash compensation for serving on the Board or its committees. During 1993, the Retirement Plan for Outside Directors was approved and implemented whereby, upon retirement, as defined, each director is eligible to receive an amount equal to the annual retainer fee for each year of service on the Board up to a maximum of ten years, with no survivor benefits. These benefits are paid on a monthly basis beginning on the date of retirement. The Company paid $10,500 under such plan during the year ended December 31, 1993. EMPLOYEE STOCK PURCHASE PLAN The Beverly Enterprises 1988 Employee Stock Purchase Plan (as amended and restated) enables all full-time employees having completed one year of continuous service to purchase shares of the Company's $.10 par value common stock at the current market price through payroll deductions. The Company makes contributions in the amount of 30% of the participant's contribution. Each participant specifies the amount to be withheld from earnings per two-week pay period, subject to certain limitations. The total charge to the Company's statement of operations for the year ended December 31, 1993 related to this plan was approximately $1,493,000. At December 31, 1993, there were approximately 4,600 participants in the plan. Merrill Lynch & Co., Merrill Lynch World Headquarters, North Tower, World Financial Center, New York, New York 10281, was appointed broker to open and maintain an account in each participant's name and to purchase shares of common stock on the New York Stock Exchange for each participant. PART II ITEM 5. ITEM 5. MARKET FOR THE COMPANY'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The Company's common stock is listed on the New York and Pacific Stock Exchanges. The table below sets forth, for the periods indicated, the range of high and low sales prices of the common stock. The Company is subject to certain restrictions under its banking arrangements related to the payment of cash dividends on its common stock. During 1993 and 1992, no cash dividends were paid on the Company's common stock and none are anticipated to be paid during 1994. At March 11, 1994, there were 7,295 record holders of the common stock. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. The following table of selected financial data should be read in conjunction with the Company's consolidated financial statements and related notes thereto included elsewhere in this Annual Report on Form 10-K. - --------------------- (1) The Company reported restructuring costs, extraordinary charge and cumulative effect of change in accounting for income taxes in 1992, and reported a redemption premium and extraordinary charge in 1993. See Notes to Consolidated Financial Statements. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. OPERATING RESULTS Twelve Months 1993 Compared to Twelve Months 1992 Net income was $57,924,000 for the twelve months ended December 31, 1993, compared to a net loss of $10,108,000 for the same period in 1992. Income before income taxes and extraordinary charge for 1993 was $89,953,000 compared to income before income taxes, extraordinary charge and cumulative effect of a change in accounting for income taxes in 1992 of $8,384,000. The results for 1992 included a $57,000,000 pre-tax restructuring charge related to a program to discontinue the Company's operations of certain facilities. During 1993, the Company recorded a $2,345,000 extraordinary charge, net of income taxes, related to the acceleration of unamortized debt issue costs associated with certain debt that was repaid with a portion of the net proceeds from issuance of the Series B preferred stock (as defined herein) as well as certain bond refundings. During 1992, the Company recorded $8,835,000 of extraordinary charges, net of income taxes, related to the acceleration of unamortized debt issue costs associated with the repayment of certain debt. In addition, during 1992, the Company adopted Financial Accounting Standards Statement No. 109, "Accounting for Income Taxes," which resulted in the recording of a $5,454,000 cumulative effect adjustment. The Company's annual effective tax rate was 33% for the twelve months ended December 31, 1993, compared to 50% for the same period in 1992. The higher annual effective tax rate in 1992 resulted from the $57,000,000 pre-tax charge mentioned above which reduced the Company's pre-tax income to a level where the impact of permanent tax differences and state income taxes had a more significant impact on the effective tax rate. In addition, the 1993 annual effective tax rate was lower than the statutory rate primarily due to the utilization of certain tax credit carryforwards. Net operating revenues and operating and administrative costs increased approximately $274,000,000 and $252,100,000, respectively, for the twelve months ended December 31, 1993, as compared to the same period in 1992. These increases consist of the following: increases in net operating revenues and operating and administrative costs for facilities which the Company operated during each of the twelve-month periods ended December 31, 1993 and 1992 ("same facility operations") of approximately $265,700,000 and $261,700,000, respectively; increases in net operating revenues and operating and administrative costs of approximately $71,400,000 and $64,000,000, respectively, due to the acquisition of 14 facilities in 1993 and 16 facilities in 1992; and decreases in net operating revenues and operating and administrative costs of approximately $63,100,000 and $73,600,000, respectively, due to the disposition of, or lease terminations on, 43 facilities in 1993 and 23 facilities in 1992. The increase in net operating revenues for same facility operations for the twelve months ended December 31, 1993, as compared to the same period in 1992, was due to the following: approximately $143,200,000 due to increased ancillary revenues as a result of providing additional ancillary services to the Company's private and Medicare patients; approximately $103,200,000 due primarily to increases in Medicaid room and board rates, and to a lesser extent, private and Medicare room and board rates; approximately $12,900,000 due to an improvement in the Company's patient mix; and approximately $11,900,000 due to increases in pharmacy revenues and various other items. The Company's Medicare, private and Medicaid census for same facility operations was 11%, 19%, and 69%, respectively, for the twelve months ended December 31, 1993, compared to 10%, 19%, and 70%, respectively, for the same period in 1992. These increases in net operating revenues were partially offset by approximately $5,500,000 due to one less calendar day during 1993, as compared to 1992. The increase in operating and administrative costs for same facility operations for the twelve months ended December 31, 1993, as compared to the same period in 1992, was due to the following: approximately $106,700,000 due to increased wages and related expenses principally due to higher wages and greater benefits intended to attract and retain qualified personnel and the hiring of therapists on staff as opposed to contracting for their services; approximately $117,100,000 due to additional ancillary costs (excluding wages and related expenses) associated with the increase in ancillary services provided to the Company's private and Medicare patients; approximately $15,100,000 due to an increase in the provision for reserves on patient, notes and other receivables primarily as a result of an increase in the Company's private and Medicare revenues, as well as, reductions in the provision for doubtful notes in 1992 due to the reacquisition of certain facilities, which did not recur in 1993; approximately $5,300,000 due to increases in supplies and other variable costs required to meet the needs of the Company's higher-acuity patients; and approximately $17,500,000 due primarily to increases in pharmacy-related costs, utilities and property-related expenses, which include taxes (other than income and payroll taxes), insurance and various other items. Ancillary revenues are derived from providing services to residents beyond room and board care. These services include occupational, physical, speech, respiratory and IV therapy, as well as, sales of pharmaceutical products and other services. The Company's overall ancillary revenues for the twelve months ended December 31, 1993 were $618,804,000 and represented 22% of total revenues, as compared to $458,281,000 of ancillary revenues for the same period in 1992 which represented 18% of total 1992 revenues. Although the Company is pursuing further growth of ancillary revenues, through expansion of specialty services, such as rehabilitation and subacute care, there can be no assurance that such growth will continue. Growth in ancillary revenues, as well as increases in Medicare census, have also resulted in higher costs for the Company due to the higher acuity services being provided to these patients. The Company's overall ancillary costs, excluding wages and related expenses, were $347,515,000 for the twelve months ended December 31, 1993, compared to $248,156,000 for the same period in 1992. Although there was no significant overall fluctuation in interest income or interest expense in 1993 as compared to 1992, several offsetting items influenced these amounts. Interest income increased approximately $1,300,000 due to interest earned on $100,000,000 of the net proceeds from issuance of the Series B preferred stock, which was significantly offset by lower investment yield rates and a decrease in the Company's notes receivable. Interest expense increased approximately $2,000,000 due to the issuance and assumption of long- term obligations in conjunction with the acquisitions of certain nursing facilities, which was significantly offset by the repayment of approximately $45,000,000 of debt with a portion of the net proceeds from issuance of the Series B preferred stock and the conversion of approximately $46,000,000 in principal amount of the Company's 9% Debentures (as defined herein) into common stock. Depreciation and amortization expense decreased approximately $1,900,000 as compared to the same period in 1992 primarily due to the disposition of, or lease terminations on, certain nursing facilities and a reduction in debt issue costs associated with the repayment of certain debt, partially offset by additional depreciation and amortization on acquired facilities. The Company's future operating performance will continue to be affected by the issues facing the nursing home industry as a whole, including the maintenance of occupancy, the availability of nursing personnel, the adequacy of funding of governmental reimbursement programs, the demand for nursing home care and the nature of any health care reform measures that may be taken by the federal government, as discussed below, as well as by any state governments. The Company's ability to control costs, including its wages and related expenses which continue to rise and represent the largest component of the Company's operating and administrative expenses, will also significantly impact its future operating results. As a general matter, increases in the Company's operating costs result in higher patient rates under Medicaid programs in subsequent periods. However, the Company's results of operations will continue to be affected by the time lag in most states between increases in reimbursable costs and the receipt of related reimbursement rate increases. Medicaid rate increases, adjusted for inflation, are generally based upon changes in costs for a full calendar year period. The time lag before such costs are reflected in permitted rates varies from state to state, with a substantial portion of the increases taking effect up to 18 months after the related cost increases. On August 10, 1993, the Omnibus Budget Reconciliation Act of 1993 ("OBRA - 93") was signed into law. OBRA - 93 includes certain changes in the Medicare program effective October 1, 1993, including, among other things, the elimination of the return on equity provision of the program. The Company cannot currently predict the future impact this change will have on its financial condition and results of operations; however, for the nine months ended September 30, 1993 (prior to the effective date of OBRA - 93) and for the year ended December 31, 1992, the Company recognized pre-tax income of approximately $8,900,000 for each of such periods as a result of the Medicare return on equity provision. In addition, OBRA - 93 increased corporate income tax rates by one percent retroactive to January 1, 1993. This rate change did not have a material effect on the Company's financial position or results of operations in 1993 and is not expected to have a material effect in the future. The Clinton Administration has made health care reform one of its top priorities. The White House Task Force on Health Care Reform studied the issue of health care reform and presented its report and recommendations to the Administration. The Administration proposed health care reform legislation to Congress in October 1993. Various other legislative and industry groups continue to study numerous health care issues, including access, delivery and financing of long-term health care. These and other groups' recommendations will likely impact the form and content of future health care reform legislation. As a result, the Company is unable to predict the type of legislation or regulations that may be adopted affecting the long-term care industry and their impact on the Company. There can be no assurance that any health care reform will not adversely affect the Company's financial position or results of operations. The Company does not provide significant postretirement health care, life insurance or other benefits to employees. Accordingly, the requirements of Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," did not materially impact the Company's consolidated financial position or results of operations. The Company does not provide significant postemployment health care, life insurance or other benefits to employees. Accordingly, the requirements of Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits," will not materially impact the Company's consolidated financial position or results of operations when implemented in 1994. Twelve Months 1992 Compared to Twelve Months 1991 Net loss was $10,108,000 for the twelve months ended December 31, 1992, as compared to net income of $29,172,000 for the same period in 1991. During the fourth quarter of 1992, the Company recorded a $57,000,000 pre-tax restructuring charge related to a program to discontinue the Company's operation of 33 nursing facilities with historically poor financial performance, and to replace, relocate or sell certain other assets (the "1992 restructuring program"). Income before income taxes, extraordinary charge and cumulative effect of a change in accounting for income taxes for the twelve months ended December 31, 1992 was $8,384,000 compared to $41,582,000 for the same period in 1991, and income before extraordinary charge and cumulative effect of a change in accounting for income taxes was $4,181,000 for 1992, compared to $29,172,000 in 1991. These reductions, as compared to the prior year, resulted from the $57,000,000 pre-tax restructuring charge discussed above. During the first quarter of 1992, the Company recorded a $4,523,000 extraordinary charge, net of income taxes, related to the acceleration of unamortized debt issue costs associated with certain debt that was repaid with the proceeds of a $100,000,000 Bank Credit Facility (as defined herein). At the end of the fourth quarter of 1992, the Company obtained substantial commitments to refinance the remaining debt outstanding under a 1990 credit agreement. Accordingly, in the fourth quarter of 1992, the Company recorded a $4,312,000 extraordinary charge, net of income taxes, related to the acceleration of unamortized debt issue costs associated with the early extinguishment of such remaining debt. Effective January 1, 1992, the Company changed its method of accounting for income taxes from the deferred method to the liability method required by Financial Accounting Standards Statement No. 109, "Accounting for Income Taxes." As permitted by the Statement, the Company elected not to restate the financial statements of prior years. The cumulative effect as of January 1, 1992 of adopting the Statement was to increase net loss for the year ended December 31, 1992 by $5,454,000. The Company's annual effective tax rate was 50% for the twelve months ended December 31, 1992 as compared to 30% for the same period in 1991. The higher annual effective tax rate in 1992 primarily resulted from the $57,000,000 pre-tax charge discussed above which reduced the Company's pre-tax income to a level where the impact of permanent tax differences and state income taxes had a more significant impact on the effective tax rate. In addition, the 1991 annual effective tax rate was lower than the statutory rate due to various items including a settlement of certain tax issues related to the audit of prior years' tax returns by the Internal Revenue Service. Net operating revenues and operating and administrative costs increased approximately $295,800,000 and $272,800,000, respectively, for the twelve months ended December 31, 1992, as compared to the same period in 1991. These increases consist of the following: increases in net operating revenues and operating and administrative costs for facilities which the Company operated during each of the twelve-month periods ended December 31, 1992 and 1991 ("same facility operations") of approximately $281,800,000 and $263,400,000, respectively; increases in net operating revenues and operating and administrative costs of approximately $64,500,000 and $55,800,000, respectively, due to the acquisition of 16 facilities in 1992 and 35 facilities in 1991; and decreases in net operating revenues and operating and administrative costs of approximately $50,500,000 and $46,400,000, respectively, due to the disposition of, or lease terminations on, 23 facilities in 1992 and 28 facilities in 1991. The increase in net operating revenues for same facility operations for the twelve months ended December 31, 1992, as compared to the same period in 1991, was due to the following: approximately $140,200,000 due to increased ancillary revenues as a result of providing additional ancillary services to the Company's private and Medicare patients; approximately $119,500,000 due primarily to increases in Medicaid patient rates, and to a lesser extent, private and Medicare patient rates; approximately $21,800,000 due to an improvement in the Company's patient mix principally due to an increase in Medicare census; approximately $5,100,000 due to one additional calendar day for the twelve months ended December 31, 1992, as compared to the same period in 1991; and approximately $6,200,000 due to various other items. The Company's Medicare, private and Medicaid census for same facility operations was 10%, 19% and 70%, respectively, for the twelve months ended December 31, 1992, as compared to 7%, 20%, and 72%, respectively, for the same period in 1991. The Company's average occupancy for same facility operations was 88.6% for the twelve months ended December 31, 1992 as compared to 88.5% for the same period in 1991. The increases in net operating revenues were partially offset by approximately $11,000,000 of Medicare and Medicaid adjustments during the twelve months ended December 31, 1991, which did not recur in the twelve months ended December 31, 1992. The increase in operating and administrative costs for same facility operations for the twelve months ended December 31, 1992, as compared to the same period in 1991, was due to the following: approximately $117,600,000 due to increased wages and related expenses principally due to higher wages and greater benefits intended to attract and retain qualified personnel, increased staffing levels in the Company's nursing facilities to cover increased patient acuity, and the hiring of therapists on staff as opposed to contracting for their services, including a partial offset due to a decrease in registry (temporary personnel) costs for the same period of approximately $5,600,000; approximately $72,400,000 due to increases in contracted professional services primarily as a result of additional ancillary services such as physical therapy provided to the Company's private and Medicare patients; approximately $58,100,000 due to increases in supplies and other variable costs primarily due to additional supplies required to meet the needs of the Company's patients, including a partial offset of approximately $11,800,000 due to reductions in the provision for doubtful notes which primarily resulted from the reacquisition of certain facilities; and approximately $15,300,000 due primarily to increases in property-related expenses, including rent, taxes (other than income and payroll taxes), insurance and various other items. Interest expense decreased approximately $6,000,000 as compared to the same period in 1991 primarily due to declining interest rates on the Company's variable rate debt, and to a lesser extent the repurchase of Senior Secured Notes and the repayment of indebtedness under a 1990 credit agreement as a result of the sale of common stock on April 4, 1991. Interest income decreased approximately $5,500,000 as compared to the same period in 1991 primarily due to lower investment yield rates and decreases in notes receivable and invested funds. LIQUIDITY AND CAPITAL RESOURCES At December 31, 1993, the Company had approximately $73,773,000 in cash and cash equivalents and net working capital of approximately $151,869,000. The Company anticipates that approximately $25,368,000 of its existing cash at December 31, 1993, while not legally restricted, will be utilized for funding insurance claims, and the Company does not expect to use such cash for other purposes. The Company had $50,000,000 of unused commitments under its Bank Revolving Credit Facility and $15,000,000 of unused commitments under its Commercial Paper Program as of December 31, 1993. Net cash provided by operating activities for the year ended December 31, 1993, was approximately $130,877,000, an increase of approximately $32,311,000 from the prior year primarily as a result of certain income tax payments made during the twelve months ended December 31, 1992 which did not recur in 1993 and an increase in deferred taxes in 1993 over 1992. The Company also experienced an increase in collections on accounts receivable in 1993 as compared to 1992, which amount was primarily used to pay accounts payable and other accrued expenses. Net cash provided by financing activities during the year ended December 31, 1993 was approximately $38,872,000. The Company repaid approximately $99,899,000 of long-term obligations primarily with approximately $45,000,000 of the net proceeds from the Preferred Stock offering (as discussed below), a portion of the proceeds from a $20,000,000 Senior Secured Term Loan Facility, a portion of the proceeds from issuance of $50,000,000 of First Mortgage Bonds (as discussed below) and a portion of the proceeds from issuance of $25,000,000 of 8.75% Notes (as discussed below). Net cash used for investing activities during the year ended December 31, 1993 was approximately $145,573,000. The Company primarily used cash generated from operations to fund capital expenditures and construction totaling approximately $95,364,000 and primarily used proceeds from the issuance of long-term obligations to fund the acquisition of nursing facilities, including certain previously leased facilities. In April 1993, the Company registered with the Securities and Exchange Commission $100,000,000 aggregate principal amount of First Mortgage Bonds (the "First Mortgage Bonds Registration Statement") which are to be offered from time to time as separate series in amounts, at prices and on terms to be determined at the time of sale. Pursuant to such registration, the Company issued two series of First Mortgage Bonds in 1993. On April 22, 1993, the Company issued $20,000,000 aggregate principal amount of 8.75% First Mortgage Bonds (the "Series A Bonds") due July 1, 2008. On July 22, 1993, the Company issued $30,000,000 aggregate principal amount of 8.625% First Mortgage Bonds (the "Series B Bonds") due October 1, 2008. In November 1993, the Company filed a Registration Statement with the Securities and Exchange Commission to amend the First Mortgage Bonds Registration Statement to allow the Company to issue senior unsecured notes, subordinated unsecured notes, or other evidences of indebtedness, as well as First Mortgage Bonds, (collectively, the "Debt Securities") for the remaining $50,000,000 available under the First Mortgage Bonds Registration Statement. On December 22, 1993, the Company issued $25,000,000 aggregate principal amount of 8.75% Notes (the "8.75% Notes"), which are unsecured obligations of the Company, due December 31, 2003. The Company used the net proceeds from issuance of the Series A Bonds, the Series B Bonds and the 8.75% Notes to finance the purchase of nine nursing facilities, to finance construction of a new nursing facility, to refinance certain existing indebtedness with respect to 20 nursing facilities, which debt had a weighted average annual interest rate of 12.1%, and for general corporate purposes. On August 5, 1993, the Company completed the sale of 3,000,000 shares of $2.75 Cumulative Convertible Exchangeable Preferred Stock (the "Series B preferred stock") through a public offering (the "Preferred Stock offering") for net proceeds of approximately $145,000,000. On January 3, 1994, the Company used approximately $100,000,000 of such net proceeds to redeem all of the Company's cumulative convertible preferred stock (the "Series A preferred stock"). The Series A preferred stock dividend rate was scheduled to increase from 1% to 10% on January 1, 1994. The remainder of the net proceeds was used to repay approximately $45,000,000 of the Term Loan under the Bank Credit Facility. The $20,000,000 excess (the "redemption premium") paid above the $80,000,000 original recorded value of the Series A preferred stock was charged to the Company's retained earnings during the twelve months ended December 31, 1993. Although such amount did not impact the Company's net income, for accounting purposes the $20,000,000 redemption premium was treated as a reduction to income available to common stockholders in the calculation of earnings per share for the twelve-month period ended December 31, 1993. During the twelve months ended December 31, 1993, the Board of Directors approved the redemption of approximately $46,000,000 in principal amount of the Company's 9% convertible subordinated debentures (the "9% Debentures"). By the close of business on August 18, 1993, all of the 9% Debentures had been converted to common stock of the Company. Outstanding shares of the Company's common stock increased by approximately 7,131,800 shares as a result of the conversion of the 9% Debentures. Primarily as a result of the Preferred Stock offering and the use of the net proceeds therefrom, and the conversion of the 9% Debentures into shares of the Company's common stock, the Company's debt to equity ratio improved to 1 to 1 at December 31, 1993, as compared to 1.2 to 1 at December 31, 1992. In January 1994, the Company sold or subleased 27 nursing facilities (2,344 beds) in the state of Texas for cash proceeds of approximately $31,000,000. In addition, on January 26, 1994, an option grant for 1,000,000 common shares at $12.00 per share was exercised in full and the Company received $12,000,000 in cash proceeds. The Company intends to file a Registration Statement with the Securities and Exchange Commission to register such 1,000,000 shares. The Company believes that working capital from operations, borrowings under its banking arrangements and Commercial Paper Program, proceeds from issuance of Debt Securities, refinancings of certain existing indebtedness, and proceeds from the sale of facilities and the exercise of the option grant discussed above will be adequate to repay its debts due within one year of approximately $42,873,000, to make normal recurring capital additions and improvements for the twelve months ending December 31, 1994 of approximately $100,000,000, to make selective acquisitions, including the purchase of previously-leased facilities, and to meet working capital requirements. ITEM 8. ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. REPORT OF ERNST & YOUNG, INDEPENDENT AUDITORS The Board of Directors and Stockholders Beverly Enterprises, Inc. We have audited the accompanying consolidated balance sheets of Beverly Enterprises, Inc. as of December 31, 1993 and 1992, and the related consolidated statements of operations, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules 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 consolidated financial position of Beverly Enterprises, Inc. at December 31, 1993 and 1992, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. As discussed in Note 7 to the consolidated financial statements, in 1992 the Company changed its method of accounting for income taxes. Little Rock, Arkansas February 4, 1994 BEVERLY ENTERPRISES, INC. CONSOLIDATED BALANCE SHEETS (DOLLARS IN THOUSANDS) ASSETS See accompanying notes. BEVERLY ENTERPRISES, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS EXCEPT PER SHARE AMOUNTS) See accompanying notes. BEVERLY ENTERPRISES, INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DOLLARS IN THOUSANDS) - --------------- (1) Amount represents the liquidation value of the Series B preferred stock. The Series A preferred stock was outstanding at December 31, 1993 with funds designated for its redemption. The Series A preferred stock was redeemed on January 3, 1994. See accompanying notes. BEVERLY ENTERPRISES, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) See accompanying notes. BEVERLY ENTERPRISES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation References herein to the Company include Beverly Enterprises, Inc. and its wholly-owned subsidiaries. The consolidated financial statements of the Company, which provides long-term health care including the operation of nursing facilities and subacute units, pharmacies, retirement living projects, and home health care centers, include the accounts of the Company and all of its wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated. Cash and Cash Equivalents Cash and cash equivalents include time deposits and certificates of deposit with original maturities of three months or less. Property and Equipment Property and equipment is stated at cost less accumulated depreciation or, where appropriate, the present value of the related capital lease obligations less accumulated amortization. Depreciation and amortization are computed by the straight-line method over the estimated useful lives of the assets. Intangible Assets Operating and leasehold rights and licenses (stated at cost less accumulated amortization of $23,059,000 in 1993 and $24,314,000 in 1992) are being amortized over the lives of the related assets (principally 40 years) and leases (principally 10 to 15 years), using the straight-line method. Goodwill (stated at cost less accumulated amortization of $21,183,000 in 1993 and $19,248,000 in 1992) is being amortized over 40 years or, if applicable, the life of the lease using the straight-line method. On an ongoing basis, the Company reviews the valuation and amortization of intangible assets. As part of this ongoing review, the Company takes into consideration any events or circumstances that could impair the carrying value of such assets. Insurance The Company insures general liability and workers' compensation risks, in most states, through insurance policies with third parties, some of which may be subject to reinsurance agreements between the insurer and Beverly Indemnity, Ltd., a wholly-owned subsidiary of Beverly California Corporation, which is a wholly-owned subsidiary of the Company. The liabilities for estimated incurred losses are discounted at 10% in 1993 and 1992 to their present value based on expected loss payment patterns determined by independent actuaries. The discounted insurance liabilities are included in the consolidated balance sheet captions as follows (in thousands): On an undiscounted basis, the total insurance liabilities as of December 31, 1993 and 1992 were $132,333,000 and $137,605,000, respectively. As of December 31, 1993, the Company has deposited approximately $50,365,000 in funds that are restricted for the payment of insured claims. These funds are BEVERLY ENTERPRISES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES -- (CONTINUED) invested primarily in United States government securities with maturity dates ranging primarily from one to five years and are carried at cost, which approximates market value, and are included in the consolidated balance sheet captions "Prepaid expenses and other" and "Designated and restricted funds." In addition, the Company anticipates that approximately $25,368,000 of its existing cash at December 31, 1993, while not legally restricted, will be utilized for funding insurance claims and the Company does not expect to use such cash for other purposes. Revenues The Company's revenues are derived primarily from providing long-term health care services. Approximately 80.1% in 1993, 79.9% in 1992 and 78.8% in 1991 of the Company's room and board revenues were derived from funds under federal and state medical assistance programs, and approximately $267,035,000, $249,413,000 and $196,082,000 of the Company's patient accounts receivable at December 31, 1993, 1992, and 1991, respectively, are due from such programs. These revenues and receivables are reported at their estimated net realizable amounts and are subject to audit and retroactive adjustment. Provisions for estimated third-party payor settlements are provided in the period the related services are rendered and are adjusted in the period of settlement. Concentration of Credit Risk The Company has significant accounts receivable, notes receivable and other assets whose collectibility or realizability is dependent upon the performance of certain governmental programs, primarily Medicaid and Medicare. These receivables and other assets represent the only concentration of credit risk for the Company. The Company does not believe there are significant credit risks associated with these governmental programs. The Company believes that an adequate provision has been made for the possibility of these receivables and other assets proving uncollectible and continually monitors and adjusts these allowances as necessary. Earnings per share Primary earnings per share for the year ended December 31, 1993 was computed by dividing net income after deduction of preferred stock dividends and the $20,000,000 redemption premium on the Series A preferred stock, discussed below, by the weighted average number of shares of common stock outstanding during the period and the weighted average number of shares issuable upon exercise of stock options, calculated using the treasury stock method. Fully diluted earnings per share for the year ended December 31, 1993 was computed as above and assumed conversion of the Company's 9% convertible subordinated debentures and other notes. Conversion of the Company's 7.625% convertible subordinated debentures would have an anti-dilutive effect and, therefore, was not assumed. During the year ended December 31, 1993, the Company charged retained earnings for the $20,000,000 excess (the "redemption premium") to be paid to redeem the Company's cumulative convertible preferred stock (the "Series A preferred stock") above its $80,000,000 original recorded value. Although this amount did not impact the Company's net income, for accounting purposes the $20,000,000 redemption premium was treated as a reduction to income available to common stockholders in the calculation of earnings per share for the year ended December 31, 1993. Primary and fully diluted earnings per share for the year ended December 31, 1992 were computed by dividing net income after deduction of preferred stock dividends by the weighted average number of shares of common stock outstanding during the period and the weighted average number of shares issuable upon exercise of stock options, calculated using the treasury stock method. BEVERLY ENTERPRISES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES -- (CONTINUED) Primary earnings per share for the year ended December 31, 1991 was computed by dividing net income by the weighted average number of shares of common stock and dilutive common stock equivalents outstanding during the period. Common stock equivalents included the Company's Series A preferred stock and the weighted average number of shares issuable upon exercise of stock options, calculated using the treasury stock method. Fully diluted earnings per share for the year ended December 31, 1991 was computed as above and assumed conversion of the Company's other notes. Conversion of the Company's 7.625% and 9% convertible subordinated debentures would have an anti-dilutive effect and, therefore, were not assumed. Other Certain prior year amounts have been reclassified to conform with the 1993 presentation. 2. ACQUISITIONS AND DISPOSITIONS During the year ended December 31, 1992, the Company recognized a $57,000,000 pre-tax restructuring charge related to a program to discontinue the Company's operation of 33 nursing facilities with historically poor financial performance, and to replace, relocate or sell certain other assets (the "1992 restructuring program"). This charge included the estimated operating losses to be incurred by these 33 facilities during the anticipated period required to implement the program. Certain transactions which were reserved as part of the 1992 restructuring program were not completed by the originally anticipated one-year implementation period; however, the Company anticipates that the remaining transactions will be substantially completed during the first six months of 1994. The Company evaluates the reserves established in connection with the remaining transactions on a regular basis, and believes the current reserves are adequate. During the year ended December 31, 1993, the Company acquired three nursing facilities (328 beds) and leasehold interests in eight nursing facilities (829 beds) and one retirement living project (69 units), all of which were previously managed by the Company, in addition to one nursing facility (60 beds) and one retirement living project (187 units) not previously operated by the Company. The acquisitions of such facilities, and certain other assets, were accounted for as purchases and were consummated with approximately $6,915,000 cash, approximately $18,232,000 assumed and acquired debt, approximately $858,000 of security and other deposits and approximately $454,000 reduction in receivables. In addition, the Company acquired 25 nursing facilities (2,706 beds) and two retirement living projects (435 units), which were previously leased by the Company, for approximately $38,381,000 cash (including approximately $5,000,000 borrowed under the Company's revolving credit agreement), approximately $5,541,000 issuance of debt, approximately $42,285,000 assumed and acquired debt and approximately $2,313,000 of security and other deposits. The operations of these facilities were immaterial to the Company's financial position and results of operations. During the year ended December 31, 1993, the Company sold or terminated the leases on 40 nursing facilities (4,511 beds) (20 of such facilities were included in the 33 facilities discussed above) and three retirement living projects (230 units) (two of which were included in the 33 facilities discussed above). The Company recognized pre-tax losses of approximately $3,769,000 as a result of these dispositions, which was primarily included in the $57,000,000 pre-tax restructuring charge discussed above. In addition, the Company sold certain other assets for pre-tax gains of approximately $4,850,000. Dispositions of such facilities and other assets were consummated for approximately $9,583,000 cash and approximately $5,460,000 assumption of debt. The operations of these facilities were immaterial to the Company's financial position and results of operations. BEVERLY ENTERPRISES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 2. ACQUISITIONS AND DISPOSITIONS -- (CONTINUED) In January 1994, the Company sold or subleased 27 nursing facilities (2,344 beds) in the state of Texas for cash proceeds of approximately $31,000,000. The sale and sublease of these nursing facilities will not have a material impact on the Company's financial position or results of operations, and the operations of these facilities were immaterial to the Company. During the year ended December 31, 1992, the Company acquired 15 nursing facilities (1,669 beds), one retirement living project (24 units) and other assets, accounted for as purchases. The acquisitions were consummated with approximately $6,112,000 cash, approximately $25,639,000 issuance of debt, approximately $20,221,000 assumed and acquired debt and approximately $13,230,000 reduction in notes receivable, which the Company previously took as partial payment for the original sale of certain of the nursing facilities and interest receivable thereon. In addition, the Company acquired 14 nursing facilities (1,450 beds), which were previously leased by the Company, for approximately $12,809,000 cash, approximately $8,340,000 issuance of debt, approximately $11,325,000 assumed and acquired debt and approximately $841,000 of security and other deposits. In addition, the Company sold or terminated the leases on 22 nursing facilities (2,379 beds) (five of such facilities were included in the 33 facilities discussed above) and one retirement living project (77 units) (which was included in the 33 facilities discussed above) for approximately $1,282,000 cash and approximately $4,610,000 notes. The Company recognized pre-tax losses of approximately $5,394,000 as a result of these dispositions, a portion of which was included in the $57,000,000 pre-tax restructuring charge discussed above. The operations of these facilities were immaterial to the Company's financial position and results of operations. During the year ended December 31, 1991, the Company acquired 35 nursing facilities (2,963 beds), accounted for as purchases, including 16 leased facilities, and other assets. The acquisitions were consummated with approximately $5,265,000 cash, approximately $26,777,000 assumed and acquired debt, approximately $1,682,000 security deposits and approximately $21,956,000 reduction in notes receivable, which the Company previously took as partial payment for the original sale of certain of the nursing facilities. In addition, the Company acquired seven nursing facilities (841 beds), which were previously leased by the Company, for approximately $14,521,000 cash and approximately $630,000 of security deposits. The Company sold or terminated the leases on 28 nursing facilities (3,775 beds) for approximately $1,155,000 cash and approximately $601,000 notes and recognized pre-tax losses of approximately $7,450,000 as a result of these dispositions, a portion of which was included in the $128,104,000 pre-tax restructuring charges taken as a result of an asset disposition program in 1989. The operations of these facilities were immaterial to the Company's financial position and results of operations. 3. PROPERTY AND EQUIPMENT Following is a summary of property and equipment and related accumulated depreciation and amortization by major classifications at December 31 (in thousands): BEVERLY ENTERPRISES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 3. PROPERTY AND EQUIPMENT -- (CONTINUED) The Company provides depreciation and amortization using the straight-line method over the following estimated useful lives: land improvements -- 5 to 15 years; buildings -- 35 to 40 years; building improvements -- 5 to 20 years; leasehold improvements -- 5 to 20 years or term of lease, if less; furniture and equipment -- 5 to 15 years. Capitalized lease assets are amortized over the remaining initial terms of the leases. Depreciation and amortization expense related to property and equipment for the years ended December 31, 1993, 1992 and 1991 was $71,730,000, $68,214,000 and $65,051,000, respectively. 4. LONG-TERM OBLIGATIONS Long-term obligations consist of the following at December 31 (dollars in thousands except per share amounts): BEVERLY ENTERPRISES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 4. LONG-TERM OBLIGATIONS -- (CONTINUED) By December 31, 1992, the Company had obtained substantial commitments to refinance the remaining debt outstanding under a 1990 credit agreement. Accordingly, in 1992, the Company recorded a $4,312,000 extraordinary charge, net of income taxes, related to the acceleration of unamortized debt issue costs associated with the early extinguishment of this debt. On March 3, 1993, the Company closed such refinancing and entered into a $20,000,000 Credit Agreement (the "Nippon Credit Agreement") and a $135,000,000 Credit Agreement (the "Morgan Credit Agreement"). The Nippon Credit Agreement provides for a seven-year term loan (the "Nippon Term Loan"). The proceeds from the Nippon Term Loan were used to repay the remaining balance outstanding under a term loan provided by the 1990 credit agreement, and to fund, among other things, the purchase of certain previously-leased facilities. The Morgan Credit Agreement originally provided for a $35,000,000 Working Capital Revolving Credit Facility (the "Revolver") and a $100,000,000 Letter of Credit Facility (the "LOC Facility"). Effective September 30, 1993, the Morgan Credit Agreement was amended to increase the Revolver to $50,000,000 and to decrease the LOC Facility to $85,000,000. The Revolver and the LOC Facility replaced the Company's revolving credit facility and letter of credit facility originally entered into under the 1990 credit agreement. The Nippon Term Loan bears interest at the Prime Rate, as defined, plus 1.50% or Adjusted LIBOR plus 2.50%, at the Company's option, and requires interest-only payments for the first three years. Amounts outstanding under the Revolver bear interest at Adjusted LIBOR plus 1.25% or the Base Rate, as defined, plus .25%, at the Company's option, until maturity on February 15, 1996. At December 31, 1993, there were no outstanding borrowings under the Revolver. The Company pays certain commitment fees and commissions with respect to the Revolver and the LOC Facility. The Nippon Credit Agreement is secured by a mortgage interest in 13 nursing facilities with a net book value totaling approximately $16,392,000 at December 31, 1993, and a security interest in certain personal property. The Morgan Credit Agreement is secured by a mortgage interest in 61 nursing facilities with net book value totaling approximately $78,836,000 at December 31, 1993, a security interest in certain personal property and a security interest in the stock of substantially all of the Company's operating subsidiaries. These credit agreements each impose on the Company certain financial tests and certain restrictive covenants. During 1992, the Company executed a $100,000,000 Bank Credit Facility (the "Bank Credit Facility") which provides for a seven-year term loan (the "Term Loan"). The Company incurred an extraordinary charge in 1992 of $4,523,000, net of income taxes, related to the acceleration of unamortized debt issue costs associated with the early extinguishment of certain debt that was repaid with a portion of the proceeds from the Bank Credit Facility. A portion of the net proceeds from the Preferred Stock offering (as discussed below) was used to repay approximately $45,000,000 of the Term Loan during 1993. Accordingly, in 1993, the Company recorded a $2,345,000 extraordinary charge, net of income taxes, related to the acceleration of unamortized debt issue costs associated with such debt as well as certain bond refundings. The Term Loan bears interest at Adjusted LIBOR plus 2.50% or the Prime Rate, as defined, plus 1.50%, at the Company's option, and requires interest-only payments for the first three years. The Bank Credit Facility is secured by a mortgage interest in 68 nursing facilities and retirement centers with net book value totaling approximately $130,358,000 at December 31, 1993, and a security interest in certain personal property and imposes on the Company certain financial tests and restrictive covenants. As of December 31, 1993, the Company had $17,750,000 of fixed rate senior secured notes (the "Senior Secured Notes") outstanding which were previously issued in conjunction with a refinancing in 1990. The Senior Secured Notes have interest payable semi-annually at 14.25%, require a sinking fund payment on December 15, 1996 and mature on December 15, 1997. The Senior Secured Notes are secured by a mortgage interest in 20 nursing facilities with net book value totaling approximately $28,156,000 at December 31, 1993, BEVERLY ENTERPRISES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 4. LONG-TERM OBLIGATIONS -- (CONTINUED) and a security interest in certain personal property and impose on the Company certain financial tests and certain restrictive covenants. In April 1993, the Company registered with the Securities and Exchange Commission $100,000,000 aggregate principal amount of First Mortgage Bonds (the "First Mortgage Bonds Registration Statement") which are to be offered from time to time as separate series in amounts, at prices and on terms to be determined at the time of sale. Pursuant to such registration, the Company issued two series of First Mortgage Bonds in 1993. On April 22, 1993, the Company issued $20,000,000 aggregate principal amount of 8.75% First Mortgage Bonds (the "Series A Bonds") due July 1, 2008. On July 22, 1993, the Company issued $30,000,000 aggregate principal amount of 8.625% First Mortgage Bonds (the "Series B Bonds") due October 1, 2008. In November 1993, the Company filed a Registration Statement with the Securities and Exchange Commission to amend the First Mortgage Bonds Registration Statement to allow the Company to issue senior unsecured notes, subordinated unsecured notes, or other evidences of indebtedness, as well as First Mortgage Bonds, (collectively, the "Debt Securities") for the remaining $50,000,000 available under the First Mortgage Bonds Registration Statement. On December 22, 1993, the Company issued $25,000,000 aggregate principal amount of 8.75% Notes (the "8.75% Notes"), which are unsecured obligations of the Company, due December 31, 2003. The Company used the net proceeds from issuance of the Series A Bonds, the Series B Bonds and the 8.75% Notes to finance the purchase of nine nursing facilities, to finance construction of a new nursing facility, to refinance certain existing indebtedness with respect to 20 nursing facilities, which debt had a weighted average annual interest rate of 12.1%, and for general corporate purposes. As of December 31, 1993, $50,000,000 was outstanding under the Company's Commercial Paper Program, pursuant to which eligible receivables of selected nursing facilities are sold to Beverly Funding Corporation ("Beverly Funding"), a wholly-owned subsidiary of the Company. The commercial paper has due dates ranging primarily from one to three months, and is backed by a commercial paper liquidity facility due December 31, 1995. The Company's maximum borrowing level under the program is $65,000,000. At December 31, 1993, Beverly Funding had total assets of approximately $75,951,000 which cannot be used to satisfy claims of the Company or any of its subsidiaries. On August 5, 1993, the Company completed the sale of 3,000,000 shares of $2.75 Cumulative Convertible Exchangeable Preferred Stock (the "Series B preferred stock") through a public offering (the "Preferred Stock offering") for net proceeds of approximately $145,000,000. On January 3, 1994, the Company used approximately $100,000,000 of such net proceeds to redeem all of the Company's Series A preferred stock. The remainder of the net proceeds was used to repay approximately $45,000,000 of the Term Loan under the Bank Credit Facility. Had the Preferred Stock offering been completed prior to January 1, 1993, and the net proceeds from the offering applied as discussed above, the pro forma net income per share for the twelve months ended December 31, 1993 would have been $.66. During the twelve months ended December 31, 1993, the Board of Directors approved the redemption of approximately $46,000,000 in principal amount of the Company's 9% convertible subordinated debentures (the "9% Debentures"). By the close of business on August 18, 1993, all of the 9% Debentures had been converted to common stock of the Company. Outstanding shares of the Company's common stock increased by approximately 7,131,800 shares as a result of the conversion of the 9% Debentures. BEVERLY ENTERPRISES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 4. LONG-TERM OBLIGATIONS -- (CONTINUED) Maturities and sinking fund requirements of long-term obligations, including capital leases, for the years ending December 31 are as follows (in thousands): Many of the capital and operating leases contain at least one renewal option (which could extend the term of the leases by five to fifteen years), purchase options, escalation clauses and provisions for payments by the Company of real estate taxes, insurance and maintenance costs. The industrial development revenue bonds were originally issued prior to 1985 primarily for the construction or acquisition of nursing facilities. The funds generated from certain of the initial bond issues are designated for facility construction and are maintained in interest bearing accounts (designated funds) until used. Bond reserve funds are also included in designated funds. These funds are invested primarily in certificates of deposit and in United States government securities and are carried at cost, which approximates market value. Net capitalized interest relating to construction was not material in 1993, 1992 or 1991. 5. COMMITMENTS AND CONTINGENCIES The future minimum rental commitments required by all noncancelable operating leases with initial or remaining terms in excess of one year as of December 31, 1993, are as follows (in thousands): Total future minimum rental commitments above include approximately $24,606,000 of minimum sublease rentals due in the future under noncancelable subleases. Rent expense on operating leases for the years ended December 31 was as follows: 1993 -- $133,567,000; 1992 -- $138,623,000; 1991 -- $140,330,000. Sublease rent income was approximately $3,226,000, $3,289,000 and $2,592,000 for the years ended December 31, 1993, 1992 and 1991, respectively. Contingent rent, based primarily on revenues, was approximately $20,000,000, $19,000,000 and $17,800,000 for the years ended December 31, 1993, 1992 and 1991, respectively. Effective August 1, 1992, the Company entered into an agreement to outsource its management information systems functions for a period of seven years, with an option to renew based on mutual agreement BEVERLY ENTERPRISES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 5. COMMITMENTS AND CONTINGENCIES -- (CONTINUED) among the parties. The future minimum commitments required under such agreement as of December 31, 1993, are as follows: 1994 -- $7,941,000; 1995 -- $7,941,000; 1996 -- $7,941,000; 1997 -- $7,941,000; 1998 -- $7,941,000; thereafter -- $4,632,000. The Company incurred approximately $10,179,000 under such agreement during the year ended December 31, 1993. The Company is contingently liable for approximately $71,674,000 of long-term obligations maturing on various dates through 2019, as well as annual interest of approximately $6,155,000 principally related to the Company's sale of nursing facilities and retirement living projects. In addition, the Company has working capital guarantees resulting from the disposition of facilities totaling $3,000,000. The Company operates the facilities or projects related to approximately $53,292,000 of the principal amount for which it is contingently liable, pursuant to long-term agreements accounted for as operating leases or management contracts. In addition, the Company is contingently liable for various operating leases that were assumed by purchasers and are secured by the rights thereto. There are various lawsuits and regulatory actions pending against the Company arising in the normal course of business, some of which seek punitive damages. The Company does not believe that the ultimate resolution of these matters will have a material adverse effect on the Company's consolidated financial position or results of operations. 6. STOCKHOLDERS' EQUITY The Company had 300,000,000 shares of authorized $.10 par value common stock at December 31, 1993 and 1992. The Company is subject to certain restrictions under its banking arrangements related to the payment of cash dividends on its common stock. The Company had 25,000,000 shares of authorized $1 par value preferred stock at December 31, 1993 and 1992, a portion of which has been issued as described below. The Board of Directors has authority, without further stockholder action, to set rights, privileges and preferences for any unissued shares of preferred stock. In December 1986, the Company issued 999,999 shares of its preferred stock ("the Series A preferred stock") with a stated and liquidation value of $100 per share to a wholly-owned subsidiary of Stephens Group, Inc. On January 3, 1994, the Company used approximately $100,000,000 of the net proceeds from the Preferred Stock offering (as defined below) to redeem the Series A preferred stock. The Series A preferred stock dividend rate was scheduled to increase from 1% to 10% on January 1, 1994. On August 5, 1993, the Company completed the sale of 3,000,000 shares of $2.75 Cumulative Convertible Exchangeable Preferred Stock (the "Series B preferred stock"), with a liquidation value of $50 per share through a public offering (the "Preferred Stock offering"). As of December 31, 1993, the Series B preferred stock is convertible into 11,252,813 shares of the Company's common stock. The holders of the Series B preferred stock are entitled to receive out of legally available funds, when and as declared by the Company's Board of Directors, quarterly cash dividends equal to $2.75 per share (aggregate of $8,250,000 per annum). Except as required by law, holders of the Series B preferred stock have no voting rights unless dividends on the Series B preferred stock have not been paid in an aggregate amount equal to at least six full quarters (whether or not consecutive), in which case holders of the Series B preferred stock will be entitled to elect two additional directors to the Company's Board of Directors to serve until such dividend arrearage is eliminated. The Company paid all required quarterly dividends on the Series B preferred stock during 1993. The Series B preferred stock is exchangeable, in whole or in part (but in no more than two parts), at the option of the Company, on any dividend payment date beginning November 1, 1995, for the Company's 5 1/2% BEVERLY ENTERPRISES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 6. STOCKHOLDERS' EQUITY -- (CONTINUED) Convertible Subordinated Debentures due August 1, 2018 (the "5 1/2% Debentures"), at the rate of $50 principal amount of 5 1/2% Debentures for each share of the Series B preferred stock. The Series B preferred stock is redeemable at any time on and after August 1, 1996, in whole or in part, only at the option of the Company, initially at a redemption price of $51.925 per share, and thereafter at prices decreasing ratably annually to $50 per share on and after August 1, 2003, plus accrued and unpaid dividends. The Series B preferred stock is not a common stock equivalent and is accounted for only in the computation of fully diluted earnings per share. During 1993, the Beverly Enterprises, Inc. 1993 Long-Term Incentive Stock Plan was approved. Such plan, as amended and restated (the "1993 Incentive Stock Plan"), became effective July 1, 1993 and will remain in effect until June 30, 2003, subject to the earlier termination by the Board of Directors. The Company has 3,000,000 common shares authorized for issuance, subject to certain adjustments, under the 1993 Incentive Stock Plan in the form of nonqualified stock options, incentive stock options, restricted stock, performance awards and other stock unit awards. Incentive stock options must be granted at a purchase price equal to market price at date of grant. Nonqualified stock options may be granted at no less than 85% of market price on the date of grant. All grants made at less than market price must be in lieu of cash payments. All options are exercisable no sooner than one year from the grant date and expire 10 years from the grant date. Restricted stock awards are outright stock grants which have a minimum vesting period of one year for performance-based awards, and three years for other awards. Performance awards and other stock unit awards will be granted based on the achievement of certain performance or other goals and will carry certain restrictions, as defined. The Compensation Committee of the Board of Directors is responsible for administering the 1993 Incentive Stock Plan and will have complete discretion in determining the number of shares or units to be granted, setting performance goals and applying other restrictions to awards, as needed, under the plan. The Company has 2,400,000 common shares authorized for issuance under its 1985 Beverly Nonqualified Stock Option Plan. Under the plan, options are granted at a purchase price equal to market price at date of grant, become exercisable no sooner than one year after date of grant and expire no later than twelve years after date of grant, as determined by a committee appointed by the Board of Directors. In addition to options, the plan provides for outright grants of common stock, subject to forfeiture provisions. As a condition precedent to the release of such shares, the employee must be continuously employed with the Company from and after the date of grant and remain employed on share release dates. Commencing one year after the grant date, the shares will be released in accordance with a schedule determined at the time of grant. During 1991, the Company terminated its Amended and Restated 1981 Beverly Incentive Stock Option Plan and its Amended and Restated 1981 Beverly Stock Option Plan. No new options or restricted shares may be granted under these plans. The terminations of these plans did not affect any of the options or restricted shares previously granted pursuant to the plans. BEVERLY ENTERPRISES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 6. STOCKHOLDERS' EQUITY -- (CONTINUED) The following table summarizes stock option and restricted stock data relative to the Company's 1981, 1985 and 1993 option plans for the years ended December 31: - --------------- (1) Includes 2,108,743 options exercisable at December 31, 1993. As of December 31, 1993, the Company had 1,000,000 common shares authorized for issuance under a separate option grant at an option price of $12.00 per share. On January 26, 1994, such option was exercised in full and the Company received $12,000,000 in cash proceeds from such transaction. The Company intends to file a Registration Statement with the Securities and Exchange Commission to register such 1,000,000 shares. The Beverly Enterprises 1988 Employee Stock Purchase Plan (as amended and restated) enables all full-time employees having completed one year of continuous service to purchase the Company's common shares at the current market price through payroll deductions. The Company makes contributions in the amount of 30% of the participant's contribution. Each participant specifies the amount to be withheld from earnings per two-week pay period, subject to certain limitations. The total charges to the Company's consolidated statements of operations for the years ended December 31, 1993, 1992 and 1991 related to this plan were approximately $1,493,000, $1,102,000, and $850,000, respectively. 7. INCOME TAXES Effective January 1, 1992, the Company changed its method of accounting for income taxes from the deferred method to the liability method required by Financial Accounting Standards Statement No. 109, "Accounting for Income Taxes." As permitted by the Statement, the Company elected not to restate the financial statements of prior years. The cumulative effect as of January 1, 1992 of adopting the Statement was to increase net loss for the year ended December 31, 1992 by $5,454,000. BEVERLY ENTERPRISES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 7. INCOME TAXES -- (CONTINUED) The provision for taxes on income before extraordinary charge and cumulative effect of change in accounting for income taxes consists of the following for the years ended December 31 (in thousands): The Company's annual effective tax rate was 33% for the year ended December 31, 1993, as compared to 50% for the same period in 1992. The Company's annual effective tax rate in 1993 is lower than the statutory rate primarily due to the utilization of certain tax credit carryforwards. In addition, the higher annual effective tax rate in 1992 primarily resulted from the $57,000,000 pre-tax charge (as discussed herein) which reduced the Company's pre-tax income to a level where the impact of permanent tax differences and state income taxes had a more significant impact on the effective tax rate. A reconciliation of the provision for income taxes computed at the statutory rate to the Company's annual effective tax rate is summarized as follows (dollars in thousands): In accordance with Statement No. 109, deferred income taxes for 1993 and 1992 reflect the impact of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes BEVERLY ENTERPRISES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 7. INCOME TAXES -- (CONTINUED) and the amounts used for income tax purposes. The tax effects of temporary differences giving rise to the Company's deferred tax assets and liabilities at December 31, 1993 and 1992 are as follows (in thousands): At December 31, 1993, the Company had targeted jobs tax credit carryforwards of $29,118,000 for income tax purposes which expire in years 2003 through 2008. For financial reporting purposes, the targeted jobs tax credit carryforwards have been utilized to offset existing net taxable temporary differences reversing during the carryforward periods. However, due to taxable losses in prior years, future taxable income has not been assumed and a valuation allowance of $15,097,000 and $17,611,000 for the years ended December 31, 1993 and 1992, respectively, has been recognized to offset the deferred tax assets related to those carryforwards. The valuation allowance decreased $2,514,000 from January 1, 1993 due to the utilization of targeted jobs tax credits. The components of the benefit from deferred income taxes for the year ended December 31, 1991 are as follows (in thousands): The caption "Prepaid expenses and other" includes prepaid federal and state income taxes of $5,279,000 at December 31, 1992. BEVERLY ENTERPRISES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 8. RELATED PARTY TRANSACTIONS During 1993 and 1992, the Company declared and paid all required quarterly dividends to the holder of its Series A preferred stock which amounted to $1,000,000 per year. During 1991, the Company declared and paid all current dividends and all dividends in arrears to such preferred shareholder which amounted to $4,000,000. An affiliate of the Company's Series A preferred shareholder provides certain investment services relating to the disposition of certain assets of the Company, and has provided underwriting and placement services on the Company's public and private offerings. The Company did not require such services in 1993 and 1992. Fees paid by the Company for such services amounted to approximately $1,421,000 for the year ended December 31, 1991. As of December 31, 1991, an affiliate of the Company's Series A preferred shareholder held $5,000,000 of the Company's 14.25% fixed rate Senior Secured Notes which were repurchased in February 1992 for $5,850,000. 9. FAIR VALUES OF FINANCIAL INSTRUMENTS Financial Accounting Standards Statement No. 107, "Disclosures about Fair Value of Financial Instruments," requires disclosure of fair value information about financial instruments, whether or not recognized in the balance sheet, for which it is practicable to estimate that value. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instrument. Statement No. 107 excludes certain financial instruments and all nonfinancial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company. The following methods and assumptions were used by the Company in estimating its fair value disclosures for financial instruments: Cash and Cash Equivalents The carrying amount reported in the consolidated balance sheets for cash and cash equivalents approximates its fair value. Notes Receivable (Including Current Portion) For variable-rate notes that reprice frequently and with no significant change in credit risk, fair values are based on carrying values. The fair values for other loans are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. Investment in a Real Estate Mortgage Investment Conduit (REMIC) The fair value of the Company's REMIC investment, which is included in the consolidated balance sheet caption "Other, net," is based on information obtained from the REMIC servicer. Invested Funds Designated for the Redemption of Series A preferred stock The carrying amounts reported in the consolidated balance sheets for these invested funds approximate their fair value. BEVERLY ENTERPRISES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 9. FAIR VALUES OF FINANCIAL INSTRUMENTS -- (CONTINUED) Long-term Obligations (Including Current Portion) The carrying amounts of the Company's Commercial Paper, Term Loan, Bank Term Loan and certain other variable-rate borrowings approximate their fair values. The fair values of the remaining long-term obligations are estimated using discounted cash flow analyses, based on the Company's incremental borrowing rates for similar types of borrowing arrangements. The carrying amounts and estimated fair values of the Company's financial instruments at December 31, 1993 and 1992 are as follows (in thousands): It was not practicable to estimate the fair value of the Company's off-balance-sheet guarantees (See Note 5). In order to consummate certain dispositions and other transactions, the Company has agreed to guarantee the debt assumed or acquired by the purchaser or the performance under a lease, by the lessor. The Company does not charge a fee for entering into such agreements. 10. ADDITIONAL INFORMATION Effective July 31, 1987, Beverly Enterprises, a California corporation ("Beverly California"), became a wholly-owned subsidiary of Beverly Enterprises, Inc., a Delaware corporation ("Beverly Delaware"). Beverly Delaware (the parent) provides financial, administrative and legal services to Beverly California for which Beverly California is charged management fees. The following summarized financial information is being reported because Beverly California's 7.625% convertible subordinated debentures due March 2003 and its zero coupon notes (collectively, the "Debt Securities") and the Senior Secured Notes are publicly held. Beverly Delaware is co-obligor of these Debt Securities and guarantor of the Senior Secured Notes. Summary financial information for Beverly California is as follows (in thousands): BEVERLY ENTERPRISES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 10. ADDITIONAL INFORMATION -- (CONTINUED) In addition to Beverly Delaware, one of its direct wholly-owned subsidiaries and each of Beverly California's material wholly-owned subsidiaries (collectively, the "Subsidiary Guarantors") have guaranteed the obligations of Beverly California under the Senior Secured Notes. Separate financial statements of Beverly California and the Subsidiary Guarantors are not considered to be material to holders of the Senior Secured Notes since the guaranty of each of the Subsidiary Guarantors is joint and several and full and unconditional (except that liability thereunder is limited to an aggregate amount equal to the largest amount that would not render its obligations thereunder subject to avoidance under Section 548 of the Bankruptcy Code of 1978, as amended, or any comparable provisions of applicable state law) and the aggregate net assets, earnings and equity of the Subsidiary Guarantors and Beverly California together, after adjustment for intercompany management fees, are substantially equivalent to the net assets, earnings and equity of Beverly Delaware on a consolidated basis. BEVERLY ENTERPRISES, INC. SUPPLEMENTARY DATA (UNAUDITED) QUARTERLY FINANCIAL DATA (IN THOUSANDS EXCEPT PER SHARE DATA) The following is a summary of the quarterly results of operations for the years ended December 31, 1993 and 1992. Operating results for the first quarter of 1992 have been restated to reflect the cumulative effect of a change in accounting for income taxes. The annual effective tax rates for 1993 and 1992 were 33% and 50%, respectively. The Company's annual effective tax rate in 1993 is lower than the statutory rate primarily due to the utilization of certain tax credit carryforwards. In addition, the higher annual effective tax rate in 1992 primarily resulted from the $57,000,000 pre-tax charge (as discussed herein) which reduced the Company's pre-tax income to a level where the impact of permanent tax differences and state income taxes had a more significant impact on the effective tax rate. Where fully diluted earnings per share would be anti-dilutive, primary earnings per share were used. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY. Incorporated herein by reference from the Company's definitive proxy statement for the Annual Meeting of Stockholders to be held May 19, 1994, to be filed pursuant to Regulation 14A. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. Incorporated herein by reference from the Company's definitive proxy statement for the Annual Meeting of Stockholders to be held May 19, 1994, to be filed pursuant to Regulation 14A. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. Incorporated herein by reference from the Company's definitive proxy statement for the Annual Meeting of Stockholders to be held May 19, 1994, to be filed pursuant to Regulation 14A. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Incorporated herein by reference from the Company's definitive proxy statement for the Annual Meeting of Stockholders to be held May 19, 1994, to be filed pursuant to Regulation 14A. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a) 1 and 2. The Consolidated Financial Statements and Consolidated Financial Statement Schedules The consolidated financial statements and consolidated financial statement schedules listed in the accompanying index to consolidated financial statements and financial statement schedules are filed as part of this annual report. 3. Exhibits The exhibits listed in the accompanying index to exhibits are filed as part of this annual report. (b) Reports on Form 8-K The Company filed Current Reports on Form 8-K and Form 8-K/A, each dated January 4, 1994, which reported under Item 5 that the Company's Registration Statement No. 33-50965 became effective on November 17, 1993, and filed under Item 7 the Underwriting Agreement dated December 21, 1993, and the First Supplemental Indenture for the Notes dated December 30, 1993, pursuant to such Registration Statement. BEVERLY ENTERPRISES, INC. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES (ITEM 14(A)) 2. Consolidated financial statement schedules for each of the three years in the period ended December 31, 1993: Consolidated financial statement schedule as of December 31, 1993: All other schedules are omitted because the required information is not present or is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the consolidated financial statements and notes thereto. BEVERLY ENTERPRISES, INC. SCHEDULE II -- AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 - --------------- All employee loans are non-interest bearing and are payable in full on date due. (1) Unsecured. (2) Amount represents an equity interest in debtor's personal residence and can be repurchased by the debtor at face value at any time during the option period. At the end of this period, the cost to debtor to repurchase the Company's interest will be based upon a fair market value appraisal (exercise of purchase option). (a) Includes a $15,070 reduction in the amount owed to the debtor under a consulting agreement. BEVERLY ENTERPRISES, INC. SCHEDULE V -- PROPERTY AND EQUIPMENT YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) BEVERLY ENTERPRISES, INC. SCHEDULE VI -- ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY AND EQUIPMENT YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) BEVERLY ENTERPRISES, INC. SCHEDULE VII -- GUARANTEES OF SECURITIES OF OTHER ISSUERS DECEMBER 31, 1993 The guarantees detailed above include principal amounts of industrial development revenue bonds, lines of credit and mortgages. Such guaranteed long-term obligations mature on various dates through 2019. The annual aggregate amount of interest guaranteed (including fees for letters of credit issued in connection with the bonds) is approximately $6,155,000. In addition, the Company has working capital guarantees resulting from the disposition of facilities totaling $3,000,000. The guaranteed obligations relate principally either to the Company's sale of nursing facilities and retirement living projects or to bonds issued for the construction of retirement living projects or nursing facilities. Consistent with the long-term care industry, the operators of the facilities for which the Company guarantees obligations are dependent on their participation in certain governmental programs. The Company operates the facilities or projects related to approximately $53,292,000 of the principal amount for which it is contingently liable, pursuant to long-term agreements accounted for as operating leases or management agreements. In addition, the Company is contingently liable for various operating leases that were assumed by purchasers and are secured by the rights thereto. BEVERLY ENTERPRISES, INC. SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) - --------------- * Includes amounts classified in long-term other assets as well as current assets. BEVERLY ENTERPRISES, INC. SCHEDULE X -- SUPPLEMENTARY INCOME STATEMENT INFORMATION YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) Amounts for maintenance and repairs and advertising costs are not presented as such amounts are less than 1% of total revenues. BEVERLY ENTERPRISES, INC. INDEX TO EXHIBITS (ITEM 14(A)) - --------------- * Exhibits 10.1 through 10.22 are the management contracts, compensatory plans, contracts and arrangements in which any director or named executive officer participates. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. BEVERLY ENTERPRISES, INC. Registrant Dated: March 17, 1994 By: DAVID R. BANKS ------------------------------- David R. Banks Chairman of the Board, President, Chief Executive Officer and Director Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of Registrant and in the capacities and on the dates indicated:

1993 ITEM 1 - BUSINESS Coal Marketing Westmoreland Coal Company's (the "Company") principal business is the production and marketing of coal on a worldwide basis. More than half of the coal sold by the Company is processed at and shipped from its coal properties, and includes both steam coal, sold primarily to electric utilities, and metallurgical coal, sold primarily to the steel industry. The remaining coal sold by the Company is produced by other domestic mining companies, principally smaller producers seeking to utilize the Company's expertise in the marketing of coal. The following table shows, for each of the past five years, the total tons of coal sold, tons sold from company production and tons sold that were sourced from unaffiliated producers (tons ooo's): Total sales Company production Sales for others 1993 16,687 11,551 5,136 1992 19,380 11,774 7,606 1991 20,627 11,570 9,057 1990 20,279 11,679 8,600 1989 19,613 10,813 8,800 Of the total tons of coal sold for others, approximately 37%, 30% and 38% was produced by domestic mining companies affiliated with Adventure Resources, Inc. ("Adventure") in 1993, 1992 and 1991, respectively. The coal sold by the Company which is produced by Adventure decreased in 1992 and 1993 due to Adventure's mine closings caused by higher operating costs and depletion of its coal reserves. On December 2, 1992 Adventure filed voluntary petitions for reorganization under Chapter 11 of the Bankruptcy Code with the United States Bankruptcy Court for the Southern District of West Virginia. Adventure continues to operate its remaining mines and the Company is continuing in its role of sales agent. Acting as sales agent for Adventure, the Company purchases all of Adventure's clean coal production at the time it is produced thus carrying all inventory and accounts receivable related to the sale of Adventure's coal production. The Company's obligation to buy coal from Adventure expired on March 1, 1994 and discussions are underway to determine the ongoing relationship with Adventure. At this time, it is expected that this relationship will be terminated as of June 30, 1994 due to the Company's need to conserve its working capital in order to sufficiently fund its internal coal production activities and its independent power activities. In January 1993, another West Virginia coal operation for which the Company acted as sales agent, stopped producing coal. Approximately 2,178,000 tons were sold for this producer in 1992. See Management's Discussion and Analysis of Financial Condition and Results of Operations for additional discussion. In the case of coal sold for others, the Company may or may not take title to the coal, but in substantially all such transactions the Company assumes the credit risk of the purchaser. In 1993, the Company had no bad debt experience related to coal sold for others. In 1992, the Company established reserves for bad debts related to coal sold for others in the amount of $4,801,000. The bad debt expense in 1991 relating to coal sold for others was not material. The Company is able to offer customers a wide variety of coals, including both steam coal and metallurgical coal, and a range of services related to its coal sales, including sourcing, blending, quality control and transportation. Transportation services include arrangements with railroads, barge lines and vessel charterers. The Company's wholly owned subsidiary, Westmoreland Coal Sales Company, Inc. ("WCSC"), also has its own leased fleet of railcars to increase the availability of transportation and to reduce transportation costs. The Company markets coal worldwide, primarily through WCSC, using both its own sales force and a network of agents in foreign countries. WCSC has sales offices in Philadelphia, Pennsylvania and Charlotte, North Carolina. It also has field offices in Banner, Kentucky and Beckley, West Virginia. These field offices serve the function of sourcing coals from mines owned by unaffiliated producers. This gives WCSC access to coals which complement the Company's own production. The field offices also have full service quality control laboratories and sampling personnel in order to assure that coal being shipped to the customer meets specifications. Approximately 77% of the tonnage sold by the Company in 1993 was sold under contracts calling for deliveries over a period longer than one year. The table below presents the amount of coal tonnages sold under long-term contracts for the last five years: Sales under long- Total sales term contracts tonnage (000s) % Tons (000s) 1993 77% 12,774 16,687 1992 72% 13,867 19,380 1991 68% 13,969 20,627 1990 73% 14,761 20,279 1989 71% 13,850 19,613 On December 31, 1993, the Company, together with its subsidiaries (including 3,450,000 tons for 1994 at Westmoreland Resources, Inc. ("WRI"), its 60% owned subsidiary) had sales contracts requiring it to deliver in 1994 a minimum of 12,825,000 tons of coal, which commitments will be met from the production of the Company and other producers. Of this amount, approximately 554,000 tons are under contracts expiring in a year or less, and approximately 12,271,000 tons are under contracts for more than a year. The table below presents total sales tonnage under existing long-term contracts as they expire over the next five years: Total sales tonnage under existing long- term contracts (000s) 1994 12,271 1995 11,409 1996 9,242 1997 5,340 1998 4,781 Included in the tonnage figures above are certain coal sales covered by agreements of WRI. Under these agreements, WRI has exercised its right to receive "take or pay" payments from its customers if they elect not to purchase the minimum tonnages specified in the agreements. These payments will produce approximately the same net margin for WRI as if the coal were delivered. Substantially all of the Company's long-term contracts have price adjustment provisions for changes in specified production costs' indices which generally reflect changes in wage rates, costs of supplies, union benefits, general and administrative costs, taxes, environmental and safety legislation and royalties. Some of the long-term contracts also provide for periodic price renegotiation and allow for termination after one year's notice upon failure to agree on a new price. Virtually all long-term contracts contain provisions for suspension of deliveries in the event of force majeure. Before long-term commitments expire, it is the Company's practice to renegotiate them, when appropriate, and thereby extend the contract, or to acquire new contracts to replace them. In 1993, the 10 largest customers of the Company accounted for 62% of its coal revenues. Its two largest customers, Duke Power Company and Georgia Power Company, accounted for 22% and 10%, respectively, of the Company's coal revenues in 1993. No other customer accounted for as much as 10% of the Company's 1993 coal revenues. Sales to Georgia Power Company and Duke Power Company are made pursuant to long-term contracts expiring in April 1995 and July 1996, respectively. Pursuant to a scheduled price renegotiation under the Duke Power Company contract, on August 20, 1992 the Company agreed to reduce its price under this contract, effective January 1, 1993, by 10%. This price decrease, net of contractual price escalations in 1993, resulted in a reduction of revenues, and therefore profits, by approximately $7,100,000 in 1993 as compared to 1992. Cleancoal Terminal Company ("Cleancoal"), a wholly owned subsidiary of the Company, is a rail-to-barge transloading and storage facility on the Ohio River between Louisville, Kentucky and Cincinnati, Ohio. The terminal gives the Company increased access to producers in Kentucky and affords the Company greater access to midwestern, southern and foreign markets. The terminal is also able to blend western Powder River Basin coals with eastern Kentucky coals. Cleancoal has an annual transloading capacity of 6,000,000 tons. It transloaded 2,511,000 tons in 1993, 2,144,000 tons in 1992. Westmoreland Terminal Company, a wholly owned subsidiary of the Company, has a 20% interest in Dominion Terminal Associates ("DTA"), a consortium formed for the construction and operation of a coal storage and vessel-loading facility in Newport News, Virginia. DTA's annual throughput capacity is 20,000,000 tons, and its ground storage capacity is 1,700,000 tons. In 1993, DTA loaded 12,285,000 tons, including 2,428,000 tons for the Company. Coal Production The Company produces coal at properties in Virginia, West Virginia, Kentucky and Montana. Mining activities in the Eastern United States are conducted by the Company's Virginia Division, which mines reserves located in Virginia and eastern Kentucky, its Hampton Division, which mines reserves in West Virginia, Criterion Coal Company ("Criterion"), a wholly owned subsidiary of the Company, which mines reserves located in Kentucky and Pine Branch Mining Incorporated ("Pine Branch"), a wholly owned subsidiary of the Company, which mines reserves located in Virginia and eastern Kentucky. The Company's mining operations in Montana are conducted through WRI which is 60% owned by the Company. Virginia Division. The Company's Virginia Division consists of nine mines located in Virginia and eastern Kentucky, including five underground mines operated by the Company and four mines operated by contractors, three of which are underground mines and one of which is a surface mine. In 1993, 1992 and 1991, the Virginia Division shipped 4,878,000 tons, 4,708,000 tons, and 4,325,000 tons of coal, respectively, including coal produced by independent contractors on Virginia Division properties and coal purchased from off-property locations including Pine Branch Mining. The Virginia Division properties total approximately 60,000 acres and employs approximately 770 people. The Virginia Division is currently operating two preparation plants for processing and loading coal. In late 1994 one of these two plants and one mine will cease operations for economic reasons. See Management's Discussion and Analysis of Financial Condition and Results of Operations for additional discussion. Hampton Division. The Company's Hampton Division is situated in West Virginia. Its operations currently consist of two underground mines, a large surface mine and shop and preparation plant facilities. In 1993, 1992 and 1991, the Hampton Division shipped 1,561,000 tons, 1,745,000 tons and 1,543,000 tons of coal, respectively, including coal produced by an independent contractor on Hampton Division properties and coal purchased from off- property locations. The Hampton Division has one preparation plant for processing and loading coal. The Hampton Division's properties total approximately 14,000 acres and it employs approximately 130 people. During the first half of 1994 the Hampton Division will be closed down with the exception of the surface mine which is operated by a contractor with capacity to produce approximately 840,000 tons on an annual basis. All other mines together with the preparation plant and shop facilities will be closed down and the employees will be terminated. This closedown has been necessitated by market conditions, including the termination of an above-market coal sales contract. See Management's Discussion and Analysis of Financial Condition and Results of Operations for additional discussion. Criterion Coal Company. Criterion is a wholly owned subsidiary of the Company with mining operations in Kentucky. Criterion, through its wholly owned subsidiary, Kentucky Criterion Coal Company, consists of five mines, including two surface mines and three underground mines. All of these mining operations are conducted by independent contractors on Criterion's properties. Criterion's total shipments in 1993, 1992 and 1991 were 1,853,000 tons, 1,786,000 tons and 1,600,000 tons of coal, respectively. In 1993, Criterion began operating a new coal preparation plant, which increased the capacity of the property to 3,000,000 tons per year. Criterion expects to open a new underground mine in 1994. Westmoreland Resources, Inc. WRI is 60% owned by the Company, 24% owned by Morrison-Knudsen Corporation and 16% owned by Penn Virginia Corporation. WRI operates one large surface mine in Montana on approximately 15,000 acres of subbituminous coal lands. In 1993, WRI mined and shipped approximately 3,224,000 tons of coal. Morrison-Knudsen Corporation mines this coal under a contract with WRI. The majority of the coal sold by WRI is sold under long-term contracts. One of these long-term contracts, which expires in 2005, accounted for 62% of the coal sold by WRI in 1993. Pine Branch Mining Incorporated. Pine Branch is a wholly owned subsidiary of the Company with mining operations in Virginia and eastern Kentucky. Pine Branch began operations in 1992 and it consists of one surface mine. Pine Branch produced 210,000 tons in 1993 and 117,000 tons in 1992, the majority of which was sold to the Virginia Division where it was processed and loaded into railcars for shipment to customers. Cogeneration Westmoreland Energy, Inc.("WEI") a wholly owned subsidiary of the Company, has been offered for sale by the Company and is therefore being accounted for as a discontinued operation. (See Note 6 to the Consolidated Financial Statements.) WEI is engaged in the business of developing and owning interests in cogeneration and other non-regulated independent power plants throughout the United States. Cogeneration is a power production technology that provides for the sequential generation of two or more useful forms of energy (e.g., electricity and steam) from a single primary fuel source (e.g., coal). The key elements of a cogeneration project are contracts for sales of electricity and steam, contracts for fuel supply, a suitable site, required permits and project financing. The economic benefit of cogeneration technology can be substantial because a significant portion of the energy which is wasted in the application of conventional technology is used by cogeneration technology to produce steam or hot water for industrial processes or the generation of additional electricity. Electricity is sold to utilities and end-users of electrical power, including large industrial facilities. Thermal energy from the cogeneration plant is sold to commercial enterprises and other institutions. Large industrial users of thermal energy include plants in the chemical processing, petroleum refining, food processing, pharmaceutical and pulp and paper industries. A significant market has been rapidly developing in the United States for power generated by cogeneration and other independent power plants. This development was fostered by the energy crises of the 1970s, which led to the enactment of legislation that encouraged companies to enter the cogeneration and independent power generation industry by reducing regulatory requirements and facilitating the sale of electricity by such companies to utilities. Cogeneration and other independent power producers are also an attractive, economical source of energy for large industrial users which require dedicated energy sources for major facilities. WEI, through various subsidiaries, currently has an interest in the eight cogeneration projects described in the table filed as an exhibit to this report. Employees and Labor Relations The Company, including subsidiaries, employed 1,090 people on December 31, 1993 compared with 1,195 on December 31, 1992. On July 1, 1993, the Company, through its membership in the Independent Bituminous Coal Bargaining Alliance, ("IBCBA") entered into an interim agreement with the United Mine Workers of America ("UMWA"). This agreement provides for the Company and the UMWA at the local level to work together to reduce health care costs, maximize the utilization of the Company's investments, recognize special local operating and competitive conditions, provide flexibility in work and scheduling, create incentive programs, recognize employees' skills and performance, involve and integrate employees and the UMWA in the success of their mines and the Company, and improve overall labor management relations. These features were incorporated into a five-year agreement that succeeded the interim agreement, and became effective as of December 1993 ("1994 Agreement"). The Company and the UMWA are in the process of implementing the 1994 Agreement, including its health care cost reduction provisions, which should make those operations more competitive. The 1994 Agreement provides for a wage increase of $.50 per hour, retroactive to February 1, 1993, the date on which the prior five- year agreement expired. Employees will receive the retroactive portion of this wage increase in the form of an additional $.50 per hour until the retroactive portion is paid. The 1994 Agreement provides for additional wage increases of $.40 per hour on December 16, 1994 and December 16, 1995, and for additional reopeners in 1996 and 1997. Competition The coal industry is highly competitive, and the Company competes (principally in price and quality of coal) in both the steam coal and metallurgical coal markets with many other coal producers of all sizes. The Company, including the 1993 production of WRI, accounted for an estimated 1% of the nation's 1993 coal production, compared to the nation's largest coal producer which accounted for an estimated 9%. The Company's steam coal also competes with other energy sources in the production of electricity. WEI is subject to increasing competition with respect to the development of new cogeneration projects from unregulated affiliates of utility companies, affiliates of fuel and equipment suppliers and independent developers. Mining Safety and Health Legislation The Company is subject to state and federal legislation prescribing mining health and safety standards, including the Federal Coal Mine Safety and Health Act of 1969 and the 1977 Amendments thereto. In addition to authorizing fines and other penalties for violations, the Act empowers the Mine Safety and Health Administration to suspend or halt offending operations. Energy Regulation WEI's cogeneration operations are subject to the provisions of various laws and regulations, including the federal Public Utilities Regulatory Policies Act of 1978 ("PURPA"). PURPA provides qualifying cogeneration facility status ("QF") to operations such as WEI's which allows them certain exemptions from substantial federal and state legislation and regulation, including regulation of rates at which electricity can be sold. The most significant recent change in energy regulation was the passage of the National Energy Policy Act of 1992 ("EP Act"). The EP Act reformed the Public Utility Holding Company Act of 1935. Companies can apply for Exempt Wholesale Generator ("EWG") status with the Federal Energy Regulatory Commission. An EWG can exclusively provide electric energy at wholesale prices without the requirement to sell thermal energy to a steam user. WEI applied for and received EWG status for its Roanoke Valley I ("RV I") project in December 1993. WEI intends to maintain the QF status for all projects except RV I. In the future, a case-by-case determination of QF or EWG status will be completed to optimize project returns. Protection of the Environment Mining Operations. The Company believes its mining operations are substantially in compliance with applicable federal, state and local environmental laws and regulations, including those relating to surface mining and reclamation, and it is the policy of the Company to operate in compliance with such standards. The Company believes that this policy will not substantially affect its ability to compete with similarly situated companies in the marketplace. Present compliance is largely a result of capital expenditures made in prior years and of current capital investments, maintenance and monitoring activities. The Company invested approximately $413,000 for capital additions and charged approximately $7,247,000 to earnings and $2,306,000 to reserves in 1993 in order to comply with environmental regulations applicable to its mining operations. Of the $7,247,000 charged to earnings, $4,235,000 was accrued as part of the Company's mine closure costs, discussed in Management's Discussion and Analysis of Financial Condition and Results of Operations. In addition, reclamation fees imposed by the Federal Surface Mining Control and Reclamation Act of 1977 (the "Surface Mining Act") amounted to approximately $2,148,000 in 1993. Based on its present interpretation of existing applicable environmental requirements, the Company has projected that it will expense approximately $2,400,000 and will spend approximately $625,000 for capital expenditures related to its mining operations to meet such requirements in 1994. Estimates of capital expenditures will be adjusted as necessary, either to reflect the impact of new regulations or because presently unforeseeable conditions may be imposed on future mining permits. The Surface Mining Act regulations set forth standards, limitations and requirements for surface mining operations and for the surface effects of deep mining operations. Under the regulatory scheme contemplated by the Surface Mining Act, the Federal Office of Surface Mining ("OSM") issued regulations which set the minimum standards to which state agencies concerned with the regulation of coal mining must adhere. States that wish to regulate such coal mining must present their regulatory plans to OSM for approval. Once a state plan receives final approval, the state agency has primary regulatory authority over mining within the state, and OSM acts principally in a supervisory role. State agencies may impose standards more stringent than those required by OSM, and in some states this has been or is expected to be done. The four states in which the Company mines coal, Virginia, West Virginia, Kentucky and Montana, have all submitted regulatory plans to OSM, and these plans have received final approval. There is potential risk to the Company in the event it, or any of its independent contractors, fails to satisfy the obligations created by the Surface Mining Act. The Company's surface-mined Eastern coal production is mined to a large extent by independent contractors which, pursuant to their agreements with the Company, are primarily responsible for compliance with environmental laws. In the event, however, that any of its independent contractors fail to satisfy their obligations under the Surface Mining Act, the Company, depending upon the circumstances, might have, and has had, to carry out such obligations in order to avoid having its existing permits revoked or applications for new permits or permit modifications blocked. Compliance with the Surface Mining Act regulations has been costly for the Company and the coal mining industry in general. In 1990 certain amendments were enacted to the Clean Air Act ("1990 Amendments"). As the first major revisions to the Clean Air Act since 1977, the 1990 Amendments vastly expand the scope of federal regulations and enforcement in several significant respects. In particular, the 1990 Amendments require that the United States Environmental Protection Agency (the "EPA") issue new regulations related to ozone non-attainment, air toxics and acid rain. Phase I of the acid rain provisions require, among other things, that electrical utilities reduce their sulfur dioxide emissions by 1995. Phase II requires an additional reduction in emissions by the year 2000. The acid rain provisions of the 1990 Amendments may have a positive impact on the Company, in large part because a substantial amount of the Company's coal reserves are relatively low in sulfur content, i.e., less than 1 percent. This legislation allows utilities the freedom to choose the manner in which they will effect compliance with the required emission standards, increasing, in the opinion of the Company's management, the demand for low sulfur coal. The Company currently anticipates little or no impact on the coal industry from the ozone non- attainment provision of the 1990 Amendments, and is currently studying the potential impact of the air toxics provision, which management believes at this point will have a minimal effect on the coal industry. A significant, but indirect, cause of lower coal demand in the electric utility sector has been low gas prices. The perception that gas prices will remain low throughout the 1990's has allowed utilities to plan to meet electricity growth with a combination of demand-side management and small gas-fired capacity additions. This strategy may displace potential new coal-fired capacity through the 1990's. The Company's marketing response has been to concentrate on maintaining, and attempting to increase, its market share with existing customers and grow on the basis of utilities switching from high sulfur to low sulfur coal rather than on the basis of future coal-fired power plant additions. Cogeneration. The environmental laws and regulations applicable to the projects in which WEI participates primarily involve the discharge of emissions into the water and air, but can also include wetlands preservation and noise regulation. These laws and regulations in many cases require a lengthy and complex process of obtaining licenses, permits and approvals from federal, state and local agencies. Meeting the requirements of each jurisdiction with authority over a project can delay or sometimes prevent the completion of a proposed project, as well as require extensive modifications to existing projects. The limited partnerships formed to carry out these projects have the primary responsibility for obtaining the required permits and complying with the relevant environmental laws. The Clean Air Act and the 1990 Amendments contain provisions that regulate the amount of sulfur dioxide and nitrogen oxides that may be emitted by a project. These emissions may be a cause of acid rain. Most of the projects in which WEI has investments are fueled by low sulfur coal and are not expected to be significantly affected by the acid rain provisions of the 1990 Amendments. Segment Information For financial information about Westmoreland's industry segments and export sales for the years 1993, 1992 and 1991 refer to Note 12 to the Consolidated Financial Statements, appearing on pages 97-101 inclusive. For a discussion of certain factors affecting the business of Westmoreland in 1993, 1992 and 1991 refer to the section entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations," appearing on pages 38-53 inclusive, and Notes 1, 6 and 7 to the Consolidated Financial Statements, appearing on pages 66-67, 76-83 inclusive. ITEM 2 ITEM 2 - PROPERTIES The Company owns or leases coal properties located in Virginia, West Virginia, Kentucky and Montana. The Company's estimated demonstrated reserves (excluding reserves deemed by the Company to be uneconomic to mine) in owned or leased property on December 31, 1993 in the three eastern states were 142,791,000 tons and in Montana were 672,378,000 tons. In the three eastern states the Company also owns or leases 347,093,000 tons currently classified by the Company as Unassigned Uneconomic. Unassigned Uneconomic tonnages require significant capital expenditures and construction of new mine openings and are legally recoverable with current technology, but are not in the Company's mining plans today, because they cannot be mined profitably based on current projected economic conditions. With the exception of the coal reserves in Kentucky, which reserves are owned in fee simple, nearly all of the Company's eastern reserves are leased from others including 343,242,000 tons under lease from Penn Virginia Resources Corporation, a wholly owned subsidiary of Penn Virginia Corporation (together "Penn Virginia") which controlled an 18.96% voting interest in the Company at December 31, 1993 and December 31, 1992. All leases with Penn Virginia run to exhaustion of the coal reserves. Properties located in Montana are leased by WRI from the Crow Tribe of Indians and run to exhaustion. The balance of the Company's leases are for varying terms, including to exhaustion. Refer to Note 5 to the Consolidated Financial Statements, on pages 74-75 inclusive. The table below shows the Company's estimated demonstrated coal reserve base and production in 1993. The term "demonstrated coal reserve base" is as defined in the "Coal Resource Classification System of the U.S. Geological Survey" (Circular 891). This represents the sum of the measured and indicated reserve bases and includes assigned and unassigned economic reserves. Estimates of reserves in the eastern states are based mainly upon yearly evaluations made by the Company's professional engineers and geologists. The Company periodically modifies estimates of reserves under lease which may increase or decrease previously reported amounts. The reserve evaluations are based on new information developed by bore-hole drilling, examination of outcrops, acquisitions, dispositions, production, changes in mining methods, abandonments and other information. Coal reserves in Montana represent recoverable tonnage held under the terms of the principal Crow Tribe lease, as amended in 1982, as well as other minor leases, and were estimated at 799,803,000 tons as of January 1, 1980, based principally upon a report by independent consulting geologists, prepared in February 1980. The reserve estimate has been adjusted for subsequent production, changes in mining practices and coal recovery experience. In addition to the coal reserves mentioned above, the Company owns a number of coal preparation and loading facilities in Virginia, West Virginia and Kentucky. WRI owns and operates a dragline and coal crushing and loading facilities at its mine in Montana. ITEM 3 ITEM 3 - LEGAL PROCEEDINGS No material proceedings. ITEM 4 ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS This item is inapplicable. Executive Officers of the Registrant Below is a table showing the executive officers of the Company, their ages as of March 1, 1994, positions held and year of election to their present offices. No family relationships exist among them. All of the officers are elected annually by the Board of Directors and serve at the pleasure of the Board of Directors. Name Age Position(s) Held Since Christopher K. Seglem 47 President and 1992 Chief Executive Officer (1) 1993 R. Page Henley, Jr. 58 Senior Vice President-Government Affairs (2) 1992 Theodore E. Worcester 53 Senior Vice President and 1992 General Counsel (3) 1990 Ronald W. Stucki 49 Senior Vice President- Operations (4) 1992 Francis J. Boyle 48 Senior Vice President, Chief Financial Officer and Treasurer (5) 1993 Joseph W. Lee 50 President Westmoreland Coal Sales Company (6) 1991 Charles J. Brown, III 46 President Westmoreland Energy, Inc. (7) 1987 Ronald R. Rominiecki 40 Controller (8) 1988 ____________________________ (1) Effective January 1988, Mr. Seglem was elected to the positions of Vice President, General Counsel, and Secretary for the Company. In November 1988 he was elected a Senior Vice President of the Company. In May 1990, he relinquished the position of Secretary. In December 1990, he was elected an Executive Vice President of the Company, at which time he relinquished the position of General Counsel. In June 1992, he was elected President and Chief Operating Officer, and in December 1992 he was elected a Director of the Company. In June 1993, he was elected Chief Executive Officer of the Company, at which time he relinquished the position of Chief Operating Officer. He is a member of the bar of Pennsylvania. (2) Mr. Henley was elected Vice President-Development and Government Affairs in May 1988, which position he held until he was elected Senior Vice President-Development and Government Affairs in May 1990. In June 1992, he was elected Senior Vice President-Government Affairs. In 1993, Mr. Henley was also elected Vice President, General Counsel and Secretary of the Company's WEI subsidiary, and undertook additional duties, including project development. Subsequently, on March 29, 1994, he was elected Senior Vice President-Development of the Company. (3) Mr. Worcester was a member of the law firm of Sherman & Howard, with its principal office in Denver, Colorado, from 1972, and a partner in the firm from 1978 until December 1990, at which time he was elected Vice President & General Counsel of the Company. In June 1992, he was elected Senior Vice President while retaining his position of General Counsel of the Company. He is a member of the bar of Colorado. (4) Mr. Stucki was General Manager and Vice President of Colorado Westmoreland Inc. (a former wholly owned subsidiary of the Company) until the operation was sold to Cyprus Coal Company (Cyprus) in November 1988, where he continued and became Vice President of Colorado and Wyoming operations. He left Cyprus to rejoin the Company as Senior Vice President-Operations in July 1992. (5) Mr. Boyle was Chief Financial Officer and Senior Vice President of El Paso Natural Gas Company from 1985 through 1992. He was elected Senior Vice President, Chief Financial Officer and Treasurer of the Company, effective August 9, 1993. (6) Mr. Lee was elected Vice President-Purchasing and Northern Sales of Westmoreland Coal Sales Company in 1988, which position he held until he was elected Senior Vice President of Westmoreland Coal Sales Company on July 1, 1991. Mr. Lee was elected President of Westmoreland Coal Sales Company on August 1, 1991. (7) Mr. Brown terminated employment with the Company effective April 8, 1994. (8) Mr. Rominiecki terminated employment with the Company effective March 31, 1994. PART II ITEM 5 ITEM 5 - MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Reference is hereby made to the section entitled "Market Information on Capital Stock" appearing on pages 109-110. ITEM 6 ITEM 6 - SELECTED FINANCIAL DATA Reference is hereby made to the section entitled "Five-Year Review" appearing on pages 54-55 inclusive. ITEM 7 ITEM 7 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Reference is hereby made to the section entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations" appearing on pages 38-53 inclusive. ITEM 8 ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Reference is hereby made to pages 56-61 inclusive. Reference is also made to the financial statement schedules included on pages 33-36 inclusive. ITEM 9 ITEM 9 - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE This item is inapplicable. PART III ITEM 10 ITEM 10 - DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT ITEM 11 ITEM 11 - EXECUTIVE COMPENSATION ITEM 12 ITEM 12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT ITEM 13 ITEM 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS For Items 10-13, inclusive, except for information concerning executive officers of Westmoreland included as an unnumbered item in Part I above, reference is hereby made to Westmoreland's definitive proxy statement dated April 29, 1994, to be filed in accordance with Regulation 14A pursuant to Section 14(a) of the Securities Exchange Act of 1934, which is incorporated herein by reference thereto. PART IV ITEM 14 ITEM 14 - EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K a) 1. The financial statements filed herewith are listed in the Index to Financial Statements on page 37 2. The financial statement schedules filed herewith are listed in the Index to Financial Statements on page 32. The financial statement schedules are on pages 33-36. 3. The following exhibits are filed herewith as required by Item 601 of Regulation S-K: (3) (a) Articles of incorporation, as amended to date. (b) Bylaws, as amended on December 4, 1990, were filed as Exhibit 3(b) to Westmoreland's Annual Report on Form 10-K for 1990 (SEC File No. 0-752), which Exhibit 3(b) is incorporated herein by reference thereto. (4) Instruments defining the rights of security holders (a) A Loan Agreement dated August 10, 1977 between Westmoreland and six insurance companies was filed as Exhibit 2(b) to Westmoreland's Annual Report on Form 10-K for 1977 (SEC File #0-752). That Loan Agreement is incorporated herein by reference thereto. (b) A Revolving Credit Loan Agreement dated September 25, 1990 between Westmoreland and four banks - Reference is hereby made to Exhibit 4(b) to Westmoreland's Annual Report on Form 10-K for 1990 (SEC File #0- 752), which Exhibit 4(b) is incorporated herein by reference thereto. (c) Certificate of Designation of Series A Convertible Exchangeable Preferred Stock of the Company defining the rights of holders of such stock, filed July 8, 1992 as an amendment to the Company's Certificate of Incorporation, and filed as Exhibit 3(a) to Westmoreland's Form 10-K for 1992. (d) Form of Indenture between Westmoreland and Fidelity Bank, National Association, as Trustee relating to the Exchange Debentures. Reference is hereby made to Exhibit 4.1 to Form S-2 Registration 33- 47872 filed May 13, 1992, and Amendments 1 through 4 thereto, which Exhibit is incorporated herein by reference. (e) Form of Exchange Debenture Reference is hereby made to Exhibit 4.2 to Form S-2 Registration 33-47872 filed May 13, 1992, and Amendments 1 through 4 thereto, which Exhibit is incorporated herein by reference. (f) Form of Deposit Agreement among Westmoreland, First Chicago Trust Company of New York, as Depositary and the holders from time to time of the Depositary Receipts. Reference is hereby made to Exhibit 4.3 to Form S-2 Registration 33- 47872 filed May 13, 1992, and Amendments 1 through 4 thereto, which Exhibit is incorporated herein by reference. (g) Form of Certificate of Designation for the Series A Convertible Exchangeable Preferred Stock. Reference is hereby made to Exhibit 4.4 to Form S-2 Registration 33-47872 filed May 13, 1992, and Amendments 1 through 4 thereto, which Exhibit is incorporated herein by reference. (h) Specimen certificate representing the common stock of Westmoreland, filed as Exhibit 4(c) to Westmoreland's Registration Statement on Form S-2, Registration No. 33- 1950, filed December 4, 1985, is hereby incorporated by reference. (i) Specimen certificate representing the Preferred Stock. Reference is hereby made to Exhibit 4.6 to Form S-2 Registration 33- 47872 filed May 13, 1992, and Amendments 1 through 4 thereto, which Exhibit is incorporated herein by reference. (j) Form of Depositary Receipt. Reference is hereby made to Exhibit 4.7 to Form S-2 Registration 33-47872 filed May 13, 1992, and Amendments 1 through 4 thereto, which Exhibit is incorporated herein by reference. (k) In accordance with paragraph (b)(4)(iii) of Item 601 of Regulation S-K, Westmoreland hereby agrees to furnish to the Commission, upon request, copies of all other long-term debt instruments. (10) Material Contracts (a) On January 5, 1982, the Board of Directors of Westmoreland adopted a Management by Objectives Plan (MBO Plan) for senior management. A description of this MBO Plan is set forth on page 9 of Westmoreland's definitive proxy statement dated March 31, 1982, which description is incorporated herein by reference thereto. (b) Westmoreland Coal Company 1982 Incentive Stock Option and Stock Appreciation Rights Plan--Reference is hereby made to Exhibit 10(b) to Westmoreland's Annual Report on Form 10-K for 1981 (SEC File #0-752), which Exhibit 10(b) is incorporated herein by reference thereto. (c) Westmoreland Coal Company 1985 Incentive Stock Option and Stock Appreciation Rights Plan--Reference is hereby made to Exhibits 10(d) to Westmoreland's Annual Report on Form 10-K for 1984 (SEC File #0-752), which Exhibit 10(d) is incorporated herein by reference thereto. (d) Agreement dated July 1, 1984 between Georgia Power Company and Westmoreland. Reference is hereby made to pages 33 - 79, inclusive, of Westmoreland's Annual Report on Form 10-K for 1985 (SEC File #0-752), which pages 33 - 79, inclusive, is incorporated herein by reference thereto. (e) Letter agreement dated June 11, 1987 relating to the coal supply agreement between Georgia Power Company and Westmoreland Coal Company. See (10)(d) above. (f) Agreement dated January 1, 1986 between Mill-Power Supply Company, agent for Duke Power Company, and Westmoreland Coal Sales Company, agent for Westmoreland, which is incorporated herein by reference thereto. Reference is hereby made to pages 80 - 103, inclusive, of Westmoreland's Annual Report on Form 10-K for 1985 (SEC File #0-752), which pages are incorporated herein by reference thereto. (g) In 1990, the Board of Directors established an Executive Severance Policy for certain executive officers, which provides a severance award in the event of termination of employment. Reference is hereby made to Exhibit 10(h) to Westmoreland's Annual Report on Form 10-K for 1990 (SEC File #0- 752), which Exhibit 10(h) is incorporated herein by reference thereto. (h) Westmoreland Coal Company 1991 Non- Qualified Stock Option Plan for Non- Employee Directors - Reference is hereby made to Exhibit 10(i) to Westmoreland's Annual Report on Form 10-K for 1990 (SEC File #0-752), which Exhibit 10(i) is incorporated herein by reference thereto. (i) Agreement dated April 1, 1986 between Finsider Mining Company, Ltd. and Westmoreland Coal Sales Company, relating to a contract for the purchase and sale of coking coal, and Assignment dated March 1, 1990 from Finsider to ILVA, S.p.A.- Reference is hereby made to Exhibit 10(j) to Westmoreland's Annual Report on Form 10- K for 1990 (SEC File #0-752), which Exhibit 10(j) is incorporated herein by reference thereto. (j) Effective January 1, 1992, the Board of Directors established a Supplemental Executive Retirement Plan ("SERP") for certain executive officers and other key individuals, to supplement Westmoreland's Retirement Plan by not being limited to certain Internal Revenue Code limitations. A description of this SERP is set forth on page 11 of Westmoreland's definitive proxy statement dated June 9, 1992, which description is incorporated herein by reference thereto. (k) Amended Coal Mining Agreement between Westmoreland Resources, Inc. and Crow Tribe of Indians, dated November 26, 1974, as further amended in 1982, filed as Exhibit (10)(a) to Westmoreland's Quarterly Report on Form 10-Q for the quarter ended March 31, 1992, is incorporated by reference thereto. (l) Amendment and Restatement of Virginia Lease between Penn Virginia Resources Corporation and Westmoreland, effective as of July 1, 1988, as further amended May 6, 1992, filed as Exhibit 10(b) to Westmoreland's Quarterly Report on Form 10-Q for the quarter ended March 31, 1992, is incorporated by reference thereto. (m) Amendment and Restatement of Hampton Lease between Penn Virginia Resources Corporation and Westmoreland, effective as of July 1, 1988, as further amended May 6, 1992, filed as Exhibit 10(c) to Westmoreland's Quarterly Report on Form 10-Q for the quarter ended March 31, 1992, is incorporated by reference thereto. (n) Acquisition Agreement, dated May 6, 1992 by and among Westmoreland, Penn Virginia Corporation and Penn Virginia Equities Corporation, including as Exhibit A thereto, a form of agreement to be executed by the parties on the Closing Date described therein, filed as Exhibit 10(d) to Westmoreland's Quarterly Report on Form 10-Q for the quarter ended March 31, 1992, is incorporated by reference thereto. (o) Agreement dated July 9, 1992 by and among Westmoreland, Penn Virginia Corporation and Penn Virginia Equities Corporation, with respect to (i) registration rights granted to Penn Virginia, (ii) the number of directors which Penn Virginia for a period of two years may designate to be elected to Westmoreland's Board of Directors and (iii) other conditions, as set forth therein, which is discussed in Item 13 of Westmoreland's Form 10-K for 1992. (p) Agreement dated October 9, 1992 by and among Westmoreland, Penn Virginia Corporation and Penn Virginia Equities Corporation amending and modifying prior agreements by and among the parties as set forth therein, which is discussed in Item 13 of Westmoreland's Form 10-K for 1992. Exhibits 10(a), (b), (c), (g), (h) and (j) represent management contracts or compensatory plan arrangements required to be filed as exhibits, pursuant to Item 14(c) of this report. (13) Annual Report to Security Holders. The Westmoreland Coal Company 1993 Annual Report to Shareholders, has not yet been distributed to shareholders. (21) Subsidiaries of the Registrant (23) Consent of Independent Certified Public Accountants b) Reports on Form 8-K. (1) On November 1, 1993 Westmoreland Coal Company filed a Report on Form 8-K. This report contained discussion related to the intended sale of its subsidiary, Westmoreland Energy, Inc. and its press release dated November 1, 1993 as an exhibit. (2) On December 2, 1993 Westmoreland Coal Company filed a Report on Form 8-K. This report contained discussion related to the termination of its proposed sale of Westmoreland Energy, Inc. to California Energy Company, Inc. and its press release dated December 1, 1993 as an exhibit. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. WESTMORELAND COAL COMPANY April 15, 1994 By /s/ Francis J. Boyle Francis J. Boyle Senior Vice President, Chief Financial Officer & Treasurer 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 dates indicated. Signature Title Date Principal Executive Officer: President, Chief Executive Officer /s/ Christopher K. Seglem and Director April 15, 1994 Christopher K. Seglem Directors: /s/ Pemberton Hutchinson Chairman of the Board April 15, 1994 Pemberton Hutchinson /s/ E. B. Leisenring, Jr. Director April 15, 1994 E. B. Leisenring, Jr. /s/ William R. Klaus Director April 15, 1994 William R. Klaus /s/ A. Linwood Holton, Jr. Director April 15, 1994 A. Linwood Holton, Jr. /s/ Brenton S. Halsey Director April 15, 1994 Brenton S. Halsey /s/ Edwin E. Tuttle Director April 15, 1994 Edwin E. Tuttle /s/ Lennox K. Black Director April 15, 1994 Lennox K. Black Principal Accounting Officer: /s/ Thomas C. Sharpe Acting Controller April 15, 1994 Thomas C. Sharpe Independent Auditors' Report The Board of Directors and Shareholders Westmoreland Coal Company: We have audited the consolidated financial statements of Westmoreland Coal Company and subsidiaries as listed in the accompanying index. In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedules as listed in the accompanying index. These consolidated financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules 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 Westmoreland Coal Company and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the years in the three year period ended December 31, 1993 in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. As discussed in Note 10 to the consolidated financial statements, the Company adopted the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, in 1993. The accompanying consolidated financial statements and financial statement schedules have been prepared assuming that Westmoreland Coal Company will continue as a going concern. As discussed in Note 1 to the consolidated financial statements, the Company has suffered recurring losses from operations, is in violation of various covenants in its credit arrangements and other obligations and has a net working capital deficiency that raise substantial doubt about its ability to continue as a going concern. Management's plans in regard to these matters are also described in Note 1. The consolidated financial statements and financial statement schedules do not include any adjustments that might result from the outcome of this uncertainty. KPMG Peat Marwick April 15, 1994 Philadelphia, PA WESTMORELAND COAL COMPANY AND SUBSIDIARIES The consolidated balance sheets of the Company and subsidiaries as of December 31, 1993 and December 31, 1992, and the related consolidated statements of income, shareholders' equity and cash flows for each of the years in the three-year period ended December 31, 1993 together with the related notes and the summary of significant accounting policies are contained on pages 56-108. The following schedules should be read in conjunction with the consolidated financial statements of the Company contained on pages 33-36. Schedules not included have been omitted because they are not applicable or the required information is presented in the consolidated financial statements or related notes. Year ended or at December 31 Schedules submitted: V - Property, plant and equipment 1993, 1992, 1991 VI - Accumulated depreciation and depletion of property, plant and 1993, 1992, 1991 equipment VIII - Valuation and qualifying accounts 1993, 1992, 1991 X - Supplementary income statement information 1993, 1992, 1991

1993 ITEM 1. BUSINESS Huffy Corporation, an Ohio corporation, and its subsidiaries (collectively called "Huffy" or the "Company") are engaged in the design, manufacture and sale of Recreation and Leisure Time Products, Juvenile Products, and the furnishing of Services for Retail. The Company's executive offices are located in Miamisburg, Ohio and its principal business offices and/or manufacturing facilities are located in San Diego, California; Aurora, Ontario, Canada; Thornton, Colorado; Miamisburg and Celina, Ohio; Camp Hill and Harrisburg, Pennsylvania; Anderson, South Carolina; Waukesha and Suring, Wisconsin; and Whites Cross, Cork, Ireland. The general development of business within each business segment (Recreation and Leisure Time Products, Juvenile Products and Services for Retail) is discussed in more detail below. See also Part IV herein for financial information relating to each such business segment. RECREATION AND LEISURE TIME PRODUCTS Huffy Bicycle Company, Huffy Sports Company, and True Temper Hardware Company comprise the Recreation and Leisure Time Products segment of the Company. Bicycles are one of the principal products produced within the business segment. Bicycles sold to high volume retailers represented 44.2 percent, 44.6 percent, and 47.5 percent of consolidated revenues of the Company for the years ended December 31, 1993, 1992, and 1991, respectively. Sales to high volume retailers of lawn and garden tools and cutting tools, which are also principal products within the business segment, represented 13.6 percent, 15.6 percent and 10.5 percent of consolidated revenues of the Company for the years ended December 31, 1993, 1992, and 1991, respectively. Although to date the export business is not significant, the companies in the Recreation and Leisure Time Products segment participate in various foreign markets and are actively involved in expanding export volume. a. PRODUCTS, MARKETING AND DISTRIBUTION Huffy Bicycle Company: The Huffy registered trademark bicycle brand is the largest selling brand of bicycles sold in the United States. The full line of Huffy registered trademark bicycles is produced by Huffy Bicycle Company, a division of the Company, whose manufacturing facilities are located in Celina, Ohio. Included in the Huffy registered trademark bicycle line are adult all purpose bicycles; adult all terrain bicycles; a series of innovative boys' and girls' 20" bicycles; and a series of popular children's 16" sidewalk bicycles. Huffy registered trademark bicycles are extensively advertised and are sold predominantly through national and regional high volume retailers, a distribution network accounting for approximately 75 to 80 percent of all bicycles sold in the United States. Over 90 percent of Huffy Bicycle Company's bicycles are sold under the Huffy registered trademark brand name with the balance being sold under private label brands. Huffy Sports Company: Huffy Sports Company, a division of the Company, located in Waukesha, Wisconsin, is the leading supplier of basketball backboards, goals, and related products for use at home. Huffy Sports Company products, which bear the logo of the National Basketball Association ("NBA"), as well as the Huffy Sports registered trademark trademark, are sold predominantly through national and regional high volume retailers in the United States. True Temper Hardware Company: True Temper Hardware Company, a wholly-owned subsidiary of the Company, is headquartered in Camp Hill, Pennsylvania. The Company acquired the True Temper Hardware business from certain affiliates of Black & Decker, Inc. in 1990. True Temper Hardware Company is one of three leading suppliers of non-powered lawn and garden tools, snow tools and cutting tools; products include long-handled shovels, hoes, forks, wheelbarrows, spreaders, snow shovels, rakes, hitched accessories, pruners, and grass shears for use in the home and in agricultural, industrial and commercial businesses. Manufacturing facilities are located in Camp Hill and Harrisburg, Pennsylvania, and Anderson, South Carolina. True Temper Hardware Company also owns five sawmill facilities located in Indiana, New York, Ohio, Pennsylvania, and Vermont and staffs a sales office and distribution center for Canada located in Aurora, Ontario, Canada. In addition, True Temper Limited, an Irish Corporation and a wholly-owned subsidiary of the Company, has offices and a manufacturing facility in Whites Cross, Cork, Ireland. True Temper Hardware products are extensively advertised and are sold both directly, and through wholesale distributors, to national and regional high volume retailers and hardware stores. Over 82 percent of True Temper Hardware's products are sold under the True Temper registered trademark name; the remainder are sold under the Jackson registered trademark, Cyclone registered trademark or other names, or under private labels. In the quarter ended December 31, 1993, the Company recorded a $28,755,000 ($20,329,000 after tax) charge to restructure the True Temper Hardware Company lawn and garden tool business to address inefficiencies in the manufacturing process and to improve future profitability of True Temper Hardware Company. Information regarding the Company's restructure of True Temper Hardware Company is incorporated herein by reference to pages 28 and 29 and note 2 to the consolidated financial statements on page 41 of the Company's Annual Report to Shareholders for the year ended December 31, 1993. b. SUPPLIERS Basic materials such as raw steel, steel tubing, plastic, ash timber, and welding materials used in the manufacturing operations are purchased primarily from domestic sources. Alternate sources are available for all critical products and components, but the sudden loss of any major supplier could, on a temporary basis, cause a negative effect on the segment's operations. c. PATENTS, TRADEMARKS AND LICENSES The patents, trademarks (including the registered trademarks "Huffy", "Huffy Sports", "True Temper" and "Jackson"), licenses (including the license to use the NBA logo) and other proprietary rights of the companies in this segment are deemed important to the Company. The loss by the Company of its rights under any individual patent, trademark (other than "Huffy" or "True Temper"), license or other proprietary right used by this segment would not have a material adverse effect on the Company or the segment. The loss of either the registered trademark "Huffy" or "True Temper" could have a material adverse effect on the Company and this segment. The Company has no reason to believe that anyone has rights to either the trademark "Huffy" or the trademark "True Temper" for the products in connection with which such trademarks are used. d. SEASONALITY AND INVENTORY Due to the relatively short lapse of time between placement of orders for products and shipments, the Company normally does not consider its backlog of orders as significant to this business segment. Because of rapid delivery requirements of their customers, the companies in this segment maintain significant quantities of inventories of finished goods to meet their customers' requirements. Sales of bicycles are seasonal in that sales tend to be higher in the spring and fall of each year. Basketball products tend to have varying degrees of seasonality, none of which are significant to the operations of the Company. Sales of lawn and garden products, cutting tools and snow tools tend to be higher in the spring and winter of each year, respectively. e. COMPETITION AND CUSTOMERS In the high volume retailer bicycle business, Huffy Bicycle Company has numerous competitors in the United States market, only two of which are deemed significant. Although importers in the aggregate provide significant competition, no individual importer is deemed a significant competitor. Even though competition among domestic manufacturers and importers of bicycles is intense, Huffy Bicycle Company believes it is cost competitive in the high volume retailer bicycle market and maintains its position through continued efforts to improve manufacturing efficiency and product value. Huffy Bicycle Company's ability to provide its customers with low cost, innovative new products has enabled it to maintain its market position despite the targeted marketing efforts of competitors from Taiwan, China, and other nations. On December 10, 1993, the Board of Directors of the Company approved plans for Huffy Bicycle Company to establish an additional bicycle manufacturing facility in order to increase manufacturing flexibility and capacity and market share. The selection of a proposed Farmington, Missouri site as the location for the additional manufacturing facility is in the final stages, and acquisition and financing alternatives are currently being examined. Huffy Sports Company has several competitors, but only one is deemed significant. Huffy Sports Company maintains its competitive position by offering its customers high quality, innovative products at competitive prices and by supporting its products with outstanding customer service. True Temper Hardware Company has numerous competitors in the United States and Canada, but considers only two competitors significant. True Temper Hardware Company believes it remains competitive by offering its customers in the home use, agricultural, industrial, and commercial markets competitively priced, high quality, innovative products. The loss by the Recreation and Leisure Time Products segment of either of its two largest customers could result in a short-term, material adverse effect on the segment. JUVENILE PRODUCTS The Juvenile Products segment is comprised of Gerry Baby Products Company, Snugli-Canada, Ltd., and Gerry Wood Products Company (collectively, the "Gerry Companies"). Although to date the export business is not significant, the Gerry Companies participate in various foreign markets and are actively involved in expanding export volume. a. PRODUCTS, MARKETING AND DISTRIBUTION Juvenile Products include products sold under two prominent brand names: "Gerry" and "Snugli". Gerry registered trademark baby products include a wide range of market entries, including car seats, infant carriers, frame carriers, safety gates, toilet trainers, electronic baby monitors, and a broad line of various wood juvenile products including portable cribs, changing tables and safety gates sold under the "Nu-Line" brand name prior to 1992 and under the Gerry registered trademark brand name since 1992. Snugli registered trademark baby products include infant carriers and other accessories. All of the juvenile products have wide distribution; the products are marketed through all of the retail channels that sell juvenile products: mass merchants, toy chains, warehouse clubs, catalog showrooms, national and regional retailers, and specialty shops. Juvenile Products represented 16.4 percent, 16.4 percent, and 15.9 percent of consolidated revenues of the Company for the years ended December 31, 1993, 1992, and 1991, respectively. The Juvenile Products segment has been developed through selective acquisitions and internal growth and expansion. It is comprised of three direct or indirect subsidiaries of the Company: Gerry Baby Products Company ("GBPC"); Snugli-Canada, Ltd.; and Gerry Wood Products Company. GBPC's headquarters and principal manufacturing facilities are located in Thornton, Colorado. Snugli-Canada, Ltd. is located in Vancouver, British Columbia, Canada, and enables GBPC to extend its operations into Canada. Gerry Wood Products Company is a manufacturer of juvenile wooden products and is located in Suring, Wisconsin. In 1987, GBPC entered into a joint venture known as Takata-Gerico Corporation ("TGC"), with Takata Corporation of Japan, to manufacture children's car seats in the United States for distribution by GBPC. The joint venture was subsequently terminated by the parties' mutual agreement in 1992, and in connection with such termination GBPC purchased certain assets of TGC. b. SUPPLIERS Basic materials such as steel and aluminum tubing, plastic, wood, fabric, and resins used in domestic manufacturing operations are purchased primarily from domestic sources. All electronic products and some sewn products are imported. Alternate sources are available for all critical products and components, but the sudden loss of any major supplier could, on a temporary basis, cause a negative effect on the segment's operations. c. PATENTS, TRADEMARKS AND LICENSES The patents, trademarks (including the registered trademarks "Gerry" and "Snugli") and other proprietary rights of the Gerry Companies in this segment are deemed important to the Company. However, the loss of any rights under any individual patent, trademark (other than "Gerry" or "Snugli"), or other proprietary right used by this segment would not have a material adverse effect on the Company or this segment. The loss of the registered trademark "Gerry" or "Snugli" could have a material adverse effect on the Company and this segment, but the Company has no reason to believe anyone has rights to either the "Gerry" or "Snugli" trademark for the products in connection with which either is used. d. SEASONALITY AND INVENTORY The Gerry Companies do not consider their backlog of orders significant to this business segment, due to the relatively short lapse of time between placement of orders for products and shipments. Because of the rapid delivery requirements of their customers, the Gerry Companies maintain significant quantities of inventories of finished goods to meet their customers' requirements. Most products within this business segment are not seasonal. e. COMPETITION AND CUSTOMERS There are numerous juvenile products competitors in the U.S. market, four of which are deemed significant. The Gerry Companies believe they are competitive because of their continued efforts to provide innovative new products of high quality at competitive costs and to support their products with outstanding customer service. The loss by the Gerry Companies of their largest customer could have a short-term, material adverse effect on the segment. SERVICES FOR RETAIL Huffy Service First, Inc. ("HSF") and Washington Inventory Service ("WIS") each provide certain services to retailers. Inventory, assembly, repair and merchandise services provided by WIS and HSF to their customers represented 15.8 percent, 15.6 percent, and 15.5 percent of consolidated revenues of the Company for the years ended December 31, 1993, 1992, and 1991, respectively. a. PRODUCTS, MARKETING AND DISTRIBUTION Huffy Service First: HSF, a wholly-owned subsidiary of the Company, headquartered in Miamisburg, Ohio, serves the needs of major retailers in 50 states, Puerto Rico and the Virgin Islands by providing in-store assembly, repair, and display services for a variety of products, including among other things, bicycles, gas grills, physical fitness equipment, lawn mowers, and furniture. HSF is the only assembly service business of this kind available to high volume retailers on a nationwide basis. HSF also offers merchandising services (installation and periodic maintenance of displays and merchandise replenishment) to vendors who supply high volume retailers. Washington Inventory Service: WIS, a wholly-owned subsidiary of the Company, headquartered in San Diego, California, provides physical inventory services on a nationwide basis to meet the financial reporting and inventory control requirements of mass retailers, drugstores, home centers, sporting goods stores, specialty stores and grocery stores. WIS operates from more than 140 offices nationwide. b. SEASONALITY The demand for services provided by this business segment is seasonal in that assembly service demand is generally strongest in spring and at the winter holiday season, and inventory service demand is generally strongest in the first and third calendar quarters of the year. c. COMPETITION AND CUSTOMERS Although WIS has numerous competitors in the United States market, only one is significant. HSF has numerous competitors in the United States market, none of which is deemed significant. WIS and HSF believe they remain competitive due to their nationwide network of operations, competitive pricing and full service. The loss by either WIS or HSF of its largest customer could result in a short-term, material adverse effect on the segment. Sales to Kmart Corporation and Wal-Mart Corporation aggregated over ten percent or more of the Company's consolidated revenues from each such customer for the year ended December 31, 1993, and the loss of either customer could have a short-term, material adverse effect on the Company and its subsidiaries as a whole. The number of persons employed full-time by the Company (excluding seasonal employees in the Services for Retail Segment) as of December 31, 1993, was 5,854. ITEM 2. ITEM 2. PROPERTIES: Location and general character of the principal plants and other materially important physical properties of the Company as of January 15, 1994. - ------------------------------------------------------------------------------ There are no encumbrances on the Harrisburg, Pennsylvania; Anderson, South Carolina; Suring, Wisconsin; and Whites Cross, Cork, Ireland properties which are owned. The San Diego, California property is subject to a mortgage and to a deed of trust which at December 31, 1993, totaled $939,322. All of the Company's facilities are in good condition and are considered suitable for the purposes for which they are used. The Camp Hill, Pennsylvania manufacturing facility normally operates on a three full shift basis. The Celina, Ohio and Suring, Wisconsin manufacturing facilities normally operate on a two full shift basis, with third shift operations scheduled as needed to meet seasonal production requirements. The Thornton, Colorado, Harrisburg, Pennsylvania, and Waukesha, Wisconsin manufacturing facilities normally operate on a two full shift basis. The Anderson, South Carolina manufacturing facility normally operates on a one full shift basis, with additional shift operations scheduled as needed to meet seasonal production requirements. The Whites Cross, Cork, Ireland, manufacturing facility normally operates on a one full shift basis. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company is not a party, nor is its property subject, to any material pending legal proceedings. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Not applicable. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The market information and other related security holder matters pertaining to the Common Stock of the Company are incorporated herein by reference to pages 54 and 55 and notes 4, 5 and 6 to the consolidated financial statements on pages 42 through 45 of the Company's Annual Report to Shareholders for the year ended December 31, 1993. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Selected unaudited financial data for each of the last 10 calendar years are incorporated herein by reference to pages 26 and 27 of the Company's Annual Report to Shareholders for the year ended December 31, 1993. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Discussion and analysis of financial condition and results of operations are incorporated herein by reference to pages 28 through 33, and note 4 to the consolidated financial statements on pages 42 and 43 of the Company's Annual Report to Shareholders for the year ended December 31, 1993. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The financial information included in the Company's Annual Report to Shareholders for the year ended December 31, 1993, is set forth on pages 34 through 53 thereof and is incorporated herein by reference. See also the information contained in Item 14 of Part IV of this Report. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT DIRECTORS OF THE COMPANY The name, age and background information for each of the Company's Directors is incorporated herein by reference to the section entitled ELECTION OF DIRECTORS and the table therein contained in the Company's Proxy Statement for its 1994 Annual Meeting of Shareholders. EXECUTIVE OFFICERS OF THE COMPANY The Executive Officers are elected annually to their respective positions, effective at the April meeting of the Board of Directors. The Executive Officers of the Company at February 15, 1994, were as follows: Prior to being elected an Executive Officer in 1991, Mr. George was Vice President and Treasurer of USAir Inc. and Treasurer of USAir Group Inc. from September, 1989, to July, 1991; prior to that time he served as Director Corporate Finance, Allied-Signal Inc. from 1985 to August, 1989. Prior to being elected an Executive Officer in 1993, Ms. Michaud was Senior Counsel of the Company from 1986 to February, 1993. Prior to being elected President and Chief Executive Officer of the Company in 1993, Mr. Molen served as President and Chief Operating Officer of the Company. Prior to being elected as an Executive Officer in 1993, Mr. Morin was President and General Manager of Huffy Bicycle Company from June, 1992, to February, 1993; prior to that time he served as President and General Manager of Washington Inventory Service from March, 1991, to June, 1992; prior to that time he served as Vice President - Finance, Chief Financial Officer and Treasurer of the Company from 1989 to March, 1991. Prior to being elected an Executive Officer in 1992, Mr. Plotner was Vice President - Quality and Human Resources of Huffy Bicycle Company from 1989 to March, 1992, and prior thereto, Vice President - Human Resources of such company. Prior to being elected an Executive Officer in 1994, Ms. Whipps was Assistant Treasurer and Manager Investor Relations of the Company from 1990 to February 1994; prior to that time she served as Assistant Treasurer and Cash Manager, Robbins & Myers, Inc. Prior to being elected Vice President - Chief Administrative Officer and Secretary of the Company in 1993, Mr. Wieland served as Vice President - General Counsel and Secretary of the Company. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Information on executive compensation is incorporated by reference to the sections entitled EXECUTIVE COMPENSATION and the tables therein, contained on pages 17 through 20 in the Company's Proxy Statement for its 1994 Annual Meeting of Shareholders. Notwithstanding anything to the contrary set forth herein or in any of the Company's previous filings under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended, that might incorporate future filings, including this Form 10-K, the REPORT OF COMPENSATION COMMITTEE OF BOARD OF DIRECTORS ON EXECUTIVE COMPENSATION which begins on page 11 and ends on page 16 and the graph which is set forth on page 21 in the Company's Proxy Statement for its 1994 Annual Meeting of Shareholders are not deemed to be incorporated by reference in this Form 10-K. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The number of shares of Common Stock of the Company beneficially owned by each Director and by all Directors and Officers as a group as of January 1, 1994, is incorporated herein by reference to the section entitled SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT, and the table therein, contained on pages 8 through 11 in the Company's Proxy Statement for its 1994 Annual Meeting of Shareholders. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information on certain transactions with management is incorporated herein by reference to the section entitled CERTAIN RELATIONSHIPS AND OTHER RELATED TRANSACTIONS contained on page 16 in the Company's Proxy Statement for its 1994 Annual Meeting of Shareholders. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) DOCUMENTS (1) The following Consolidated Financial Statements of the Company included in the Company's Annual Report to Shareholders are incorporated by reference as part of this Report at Item 8 hereof: Consolidated Balance Sheets as of December 31, 1993, and 1992. Consolidated Statements of Operations for the years ended December 31, 1993, 1992, and 1991. Consolidated Statements of Shareholders' Equity for the years ended December 31, 1993, 1992, and 1991. Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992, and 1991. Notes to Consolidated Financial Statements. The Annual Report to Shareholders for the year ended December 31, 1993, is not deemed to be filed as part of this Report, with the exception of the items incorporated by reference in Items 1, 5, 6, 7 and 8 of this Report and those financial statements and notes thereto listed above. (2) The Accountants' Report on Consolidated Financial Statements and the following Financial Statement Schedules of the Company are included as part of this Report at Item 8 hereof: Schedule VIII. Valuation and Qualifying Accounts -years ended December 31, 1993, 1992, and 1991. Schedule X. Supplementary Income Statement Information - years ended December 31, 1993, 1992, and 1991. All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable and, therefore, have been omitted. (3) The exhibits shown in "Index to Exhibits" are filed as a part of this Report. (b) REPORTS ON FORM 8-K During the fiscal quarter ended December 31, 1993, the Company filed no report on Form 8-K. 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. HUFFY CORPORATION By /s/ Richard L. Molen Date: March 21, 1994 ---------------------- Richard L. Molen President and Chief Executive 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 dates indicated. /s/ Richard L. Molen Date: March 21, 1994 ---------------------- Richard L. Molen President and Chief Executive Officer and Director (Principal Executive Officer) /s/ Charlton L. George Date: March 21, 1994 ---------------------- Charlton L. George Vice President-Finance, Chief Financial Officer (Principal Financial Officer) /s/ Timothy G. Howard Date: March 21, 1994 ---------------------- Timothy G. Howard Vice President and Controller (Principal Accounting Officer) /s/ Thomas D. Gleason Date: February 12, 1994 ---------------------- Thomas D. Gleason, Director /s/ William K. Hall Date: February 12, 1994 ---------------------- William K. Hall, Director /s/ Stephen P. Huffman Date: February 12, 1994 ---------------------- Stephen P. Huffman, Director /s/ Linda B. Keene Date: February 12, 1994 ---------------------- Linda B. Keene, Director /s/ Jack D. Michaels Date: February 12, 1994 ---------------------- Jack D. Michaels, Director /s/ Donald K. Miller Date: February 12, 1994 ---------------------- Donald K. Miller, Director /s/ Stuart J. Northrop Date: February 12, 1994 ---------------------- Stuart J. Northrop, Director /s/ Boake A. Sells Date: February 12, 1994 ---------------------- Boake A. Sells, Director /s/ Harry A. Shaw Date: February 12, 1994 ---------------------- Harry A. Shaw III, Director /s/ Geoffrey W. Smith Date: February 12, 1994 ---------------------- Geoffrey W. Smith, Director /s/ Robin B. Smith Date: February 12, 1994 ---------------------- Robin B. Smith, Director /s/ Fred G. Wall Date: February 12, 1994 ---------------------- Fred G. Wall, Director INDEPENDENT AUDITORS' REPORT ON FINANCIAL STATEMENT SCHEDULES The Board of Directors, Huffy Corporation: Under date of February 11, 1994, we reported on the consolidated balance sheets of Huffy Corporation and subsidiaries as of December 31, 1993, and 1992, and the related consolidated statements of operations, shareholders' equity, and cash flows for each of the years in the three-year period ended December 31, 1993, as contained in the 1993 Annual Report to Shareholders. These consolidated financial statements and our report thereon are incorporated by reference in the Annual Report on Form 10-K for the year 1993. In connection with our audits of the aforementioned consolidated financial statements, we also have audited the related financial statement schedules as listed in Part IV, Item 14(a)(2) of Form 10-K. The financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statement schedules based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. /s/ KPMG PEAT MARWICK Cincinnati, Ohio February 11, 1994 ____________________________ INDEPENDENT AUDITORS' CONSENT ----------------------------- The Board of Directors, Huffy Corporation: We consent to the incorporation by reference in the Registration Statements, and the Prospectuses constituting part thereof, of (i) the Form S-8 Registration Statement (Nos. 2-46912, 2-51064, 2-55162, 2-60973) pertaining to the 1974 Stock Option Plan; (ii) the Form S-8 Registration Statement (No. 2-95128) pertaining to the 1984 Stock Option Plan; (iii) the Form S-8 Registration Statement (No. 33-25487) pertaining to the 1988 Stock Option Plan and Restricted Share Plan; (iv) the Form S-8 Registration Statement (No. 33-25143) pertaining to the 1987 Director Stock Option Plan; (v) the Form S-8 Registration Statement (Nos.33-28811, 33-42724) pertaining to the 1989 Employee Stock Purchase Plan; (vi) the Form S-8 Registration Statement (No. 33-44571) pertaining to five company savings plans and (vii) the Form S-8 Registration Statement (No. 33-60900) pertaining to the W.I.S. Savings Plan of our report dated February 11, 1994, relating to the consolidated balance sheets of Huffy Corporation and subsidiaries as of December 31, 1993 and 1992 and the related consolidated statements of operations, shareholders' equity, and cash flows for each of the years in the three-year period ended December 31, 1993, which report appears in the 1993 Annual Report to Shareholders, which is incorporated by reference in the Company's 1993 Annual Report on Form 10-K and our report dated February 11, 1994 relating to the financial statement schedules for each of the years in the three-year period ended December 31, 1993, which report appears in the Company's 1993 Annual Report on Form 10-K. /s/ KPMG PEAT MARWICK Cincinnati, Ohio March 21, 1994

1993 ITEM 1. BUSINESS GENERAL Sealy Corporation (the "Company") is the largest bedding manufacturer in North America. The Company manufactures through its subsidiaries a broad range of mattresses and boxsprings, wood furniture and convertible sleep sofas. The Company's conventional bedding products (mattresses and boxsprings) include the SEALY Registered Trade-mark POSTUREPEDIC Registered Trade-mark brand and the STEARNS & FOSTER Registered Trade-mark CORRECT COMFORT Registered Trade-mark brand and account for approximately 90% of the Company's total net sales for the year ended November 30, 1993. The Company also manufactures Sealy and Stearns & Foster brand convertible sleep sofas and markets its wood furniture under the SAMUEL LAWRENCE Trade-mark and WOODSTUFF Registered Trade-mark brands. The Company has a components parts manufacturing subsidiary which produces approximately 75% of the Company's mattress innerspring requirements and a significant portion of the Sealy brand boxspring component parts units. Another subsidiary, Sealy, Inc., provides corporate and administrative services for the Company. HISTORY OF THE COMPANY The Company was founded in 1907 under the name Ohio Mattress Company. In 1924, the Company was granted its first license to produce Sealy-brand products. Starting in 1956, the Company began acquiring Sealy-brand licenses in other geographic areas, and by 1987, had acquired all of the capital stock of its licensor Sealy, Incorporated (which prior to that time was independent of the Company), along with all but one of the remaining Sealy conventional bedding domestic licensees (the "Sealy Acquisitions"). The Company expanded its bedding manufacturing operations in 1983 by acquiring Stearns & Foster, a producer of top quality premium mattresses, boxsprings and convertible sleep sofas. In 1985, the Company acquired Woodstuff Manufacturing, Inc., a manufacturer of bedroom furniture. In 1989, the Company's common stock was acquired through a leveraged buyout (the "LBO") which was financed in part by First Boston Securities Corporation ("FBSC"), an affiliate of The First Boston Corporation ("First Boston"). In April 1990, the Company exchanged (the "Exchange") certain outstanding debt issued to FBSC for new debt at lower interest rates plus additional common stock. In December 1990, FBSC transferred its equity and debt interest in the Company to MB L.P. I, an affiliate of First Boston ("MBLP"). In November 1991, the Company successfully completed a recapitalization (the "Recapitalization") in which the Company's capital structure was significantly improved, the face amount of its indebtedness and interest thereon was reduced by approximately $417 million, the Company's interest expense obligations were substantially reduced and the principal repayment schedule on a portion of its existing bank term loan facility was extended. As a result of the Recapitalization, MBLP's equity interest in the Company increased to approximately 94%. On February 12, 1993, Zell/Chilmark Fund, L.P., a Delaware limited partnership ("Zell/Chilmark"), led an investor group (the "Zell/Chilmark Purchasers") which purchased Class A Common Stock of the Company (the "Shares") from MBLP, representing approximately 94% of the equity of the Company (the "Acquired Shares") for a cash purchase price of $250 million (the "Acquisition"). On May 7, 1993, the Company consummated a refinancing transaction (the "Refinancing"). The Refinancing consisted of (i) the public offering and sale of $200.0 million aggregate principal amount of 9 1/2% Senior Subordinated Notes Due 2003 (the "Notes"), (ii) the application of the net proceeds therefrom to redeem all of the Company's previously outstanding 12.4% Senior Subordinated Notes Due 2001 (the "Subordinated Notes") and to reduce amounts outstanding under the Company's pre-existing senior secured credit agreement (the "Old Credit Agreement"), and (iii) execution of a new senior secured credit agreement by and among the Company, certain banks and other financial institutions and Banque Paribas, Citicorp USA, Inc., Continental Bank N.A. and General Electric Capital Corporation, as Managing Agents (the "New Credit Agreement") providing for two term loan facilities together aggregating $250.0 million and a $75.0 million revolving credit facility in connection with the refinancing of the Old Credit Agreement. CONVENTIONAL BEDDING INDUSTRY AND COMPETITION. According to industry sales data compiled by the International Sleep Products Association ("ISPA"), a bedding industry trade group, more than 750 manufacturers of mattresses and boxsprings make up the domestic conventional bedding industry, generating wholesale revenues of approximately $2.7 billion during calendar year 1993. The market for conventional bedding represents more than 85% of the entire bedding market in North America. Approximately 60% of conventional bedding is sold to furniture stores, national mass merchandisers and department stores. Most of the remaining conventional bedding is sold to specialty sleep shops and contract customers such as motels, hotels and hospitals. Management estimates that approximately two-thirds of conventional bedding is sold for replacement purposes and that the average time between consumer purchases of conventional mattresses is approximately 10 to 12 years. According to ISPA, factors such as sales of existing homes, housing starts and disposable income, as well as birth and marriage rates, affect bedding purchases. Management believes that sales by companies with recognized national brands account for more than half of total conventional bedding sales. The Company supplies such nationally recognized brands as Sealy, Sealy Posturepedic and Stearns & Foster. Competition in conventional bedding is generally based on quality, brand name recognition, service and price. The following table sets forth certain information regarding the domestic market shares of major producers of conventional bedding, and is based upon industry executives' estimates as published in the December 27, 1993 edition of HFD, THE WEEKLY HOME FURNISHINGS NEWSPAPER , an industry trade publication: PRODUCTS. The Company manufactures a variety of Sealy and Stearns & Foster brand and private label conventional bedding in various sizes ranging in retail price from under $200 to $2,400. Sealy Posturepedic brand mattress is the largest selling mattress brand in North America. Approximately 97% of the Sealy brand conventional bedding products sold in North America are produced by the Company, with the remainder being produced by Sealy Mattress Company of New Jersey, Inc. ("Sealy New Jersey"), a licensee. The Stearns & Foster product line consists of top quality, premium mattresses sold under the Correct Comfort trademark, as well as a range of other bedding products sold under the Stearns & Foster brand name. CUSTOMERS. The Company serves over 7,000 retail outlets (approximately 3,200 customers), which include furniture stores, national mass merchandisers, department stores, specialty sleep shops, contract customers and other stores. The top five conventional bedding customers accounted for approximately 24% of net sales for the year ended November 30, 1993, with sales to Sears accounting for approximately 13% of such net sales. The following table sets forth the customer profile for the Company's conventional bedding sales, the percentage of total net sales made to that group of customers in fiscal year 1993 and the names of representative customers: SALES AND MARKETING. The Company's sales depend primarily on its ability to provide quality products with recognized brand names at competitive prices. The Company's marketing emphasis has been on increasing the brand loyalty of its ultimate consumers, principally through more extensive national advertising and through cooperative advertising with its dealers along with improved "point-of-sale" materials designed to emphasize the various features and benefits of the Company's products which differentiate them from other brands. The Company engages in extensive national and cooperative advertising to promote the brand names of its products. For fiscal year 1993 the Company spent approximately $20 million on national advertising and approximately $85 million on cooperative advertising and promotional expenses. The Company's sales force is generally structured based on regions of the country and the plants located within those regions, and also includes a sales staff for specific national accounts operated out of the Company's Chicago, Illinois office. The Company believes that it has one of the most comprehensive training and development programs for its sales force, including its University of Sleep curriculum, which provides on-going training sessions with programs focusing on advertising, merchandising and sales education, including techniques to help analyze a dealer's business and profitability. The Company's sales force emphasizes follow-up service to retail stores and provides retailers with promotional and merchandising assistance as well as extensive specialized professional training and instructional materials. Training for retail sales personnel focuses on several programs, designed to assist retailers in maximizing the effectiveness of their own sales personnel, store operations, and advertising and promotional programs, thereby creating loyalty to, and enhanced sales of, the Company's products. At December 31, 1993, the Company had a conventional bedding sales and marketing force of 240 people who receive a base salary, plus expenses, and quarterly and annual sales incentive bonuses. Approximately 25 independent sales representative organizations service the Company's contract customers. SUPPLIERS. The Company purchases fabric, polyfiber, wire and foam from a variety of vendors. The Company purchases a significant portion of its Sealy boxspring parts from a single source, which has patents on various interlocking wire configurations (the "Wire Patents"), and also purchases 100% of its Stearns & Foster boxspring parts from another single source. In order to eliminate certain of the risks of dependence on external supply sources and to enhance profitability, the Company has expanded its own internal components parts manufacturing capacity and, as a licensee of the Wire Patents, internally produces the remainder of its Sealy boxspring parts. See "-- Components Division." The Company believes that this vertical integration provides it with a significant competitive advantage, as it is the only conventional bedding manufacturer in the United States with substantial innerspring and form wire components making capacity. As is the case with all of the Company's product lines, the Company does not consider itself dependent upon any single outside vendor as a source of supply to its conventional bedding business and believes that sufficient alternative sources of supply for the same or similar components are available. MANUFACTURING AND FACILITIES. The Company manufactures most conventional bedding to order and has adopted "just-in-time" inventory techniques in its manufacturing process to more efficiently serve its dealers' needs and minimize their inventory carrying costs. Most bedding orders are scheduled, produced and shipped within 24 to 72 hours of receipt. This rapid delivery capability allows the Company to minimize its inventory of finished products and better satisfy customer demand for prompt shipments. The Company operates 28 plants which manufacture conventional bedding in 21 states, three Canadian provinces and Puerto Rico. See Item 2. Item 2. "-- Properties," included elsewhere herein. Over the last three years, the Company has made substantial commitments to ensure that the coil-making equipment at its component plants remains state-of-the-art. Since 1989, the Company has installed 26 automated coil-producing machines. This equipment has resulted in higher capacity at lower per-unit costs and has increased self-production capacity for the Company's innerspring requirements from approximately 60% to 75%. WOOD FURNITURE The Company manufactures and markets bedroom furniture through its Woodstuff subsidiary ("Samuel Lawrence") under the Samuel Lawrence and Woodstuff labels. During 1993, conventional bedroom furniture sales accounted for approximately 70% of Samuel Lawrence's total sales. Samuel Lawrence has approximately 500 customers, six in-house sales people, 20 independent sales representatives, and is one of many manufacturers of wood furniture. CONVERTIBLE SLEEP SOFAS The Company manufactures and sells primarily convertible sleep sofas under the Sealy and Stearns & Foster brand names in one facility with six sales employees and 18 commissioned, self-employed sales representatives. The sleep sofa industry is fragmented, and management believes that no single manufacturer comprises more than 10% of that market. LICENSING The Company's licensing division generates royalties by licensing Sealy brand technology and trademarks to manufacturers located throughout the world. The Company also provides its licensees with product specifications, quality control inspections, research and development, statistical services and marketing programs. There are currently 14 separate license arrangements in effect with independent licensees, international bedding licensees and upholstered furniture licensees. In fiscal year 1993, the licensing division as a whole generated royalties of approximately $5 million, which were accounted for as a reduction of selling, general and administrative expenses in the Consolidated Financial Statements included herein. Sealy New Jersey and a crib mattress licensee are the only domestic bedding manufacturers that are licensed to use the Sealy trademark subject to the terms of license agreements. Subject to the terms of a license agreement between Sealy New Jersey and the Company, Sealy New Jersey has the perpetual right to use certain Sealy trademarks, including the Sealy "Butterfly" logo, in the manufacture and sale of Sealy brand products in the United States. In return, Sealy New Jersey pays the Company royalties, which vary by product, on all of its Sealy brand net dollar sales and such royalties can be changed over time upon the occurrence of certain events and subject to limitations contained in the license agreement. The Company sells component parts to Sealy New Jersey and provides it with various research and development, advertising, marketing, and other services, for which Sealy New Jersey may be required to pay additional compensation to the Company under varying circumstances. In accordance with a currently effective waiver provided by the Company, the license agreement no longer restricts Sealy New Jersey's manufacturing territory to any defined areas of primary responsibility in New Jersey. To date, Sealy New Jersey has not engaged in manufacturing outside such area and its sales efforts outside such area have been limited to specific situations. The license precludes the Company from manufacturing its Sealy brand products in the licensee's area of primary responsibility in New Jersey. Subject to certain conditions and limitations, as specified in the license agreement, the Company has a right of first refusal with respect to any sale of Sealy New Jersey. WARRANTIES Sealy and Stearns & Foster bedding offer limited warranties on their currently manufactured products. Such warranties range from one year on promotional bedding to 15 years on Posturepedic and Stearns & Foster Correct Comfort bedding. The periods for "no- charge" warranty service varies among products. All currently manufactured Posturepedic and Correct Comfort products offer a 15 year non-prorated warranty service period. Sealy and Stearns & Foster convertible sleep sofas offer a 10-year limited warranty on mattresses, mechanisms and frames, with no warranty on upholstery fabric. Historically, the Company's warranty costs have been immaterial for each of its product lines. TRADEMARKS AND LICENSES The Company owns, among others, the Sealy, Stearns & Foster and Samuel Lawrence trademarks and tradenames and also owns the Posturepedic, Correct Comfort, Dataman and University of Sleep trademarks, service marks and certain related logos and design marks. EMPLOYEES As of December 31, 1993, the Company had 4,844 full-time employees. Approximately 2,553 employees at 25 plants are represented by various labor unions, generally with separate collective bargaining agreements. Due to the large number of collective bargaining agreements, the Company is periodically in negotiations with certain of its employees. The Company considers its overall relations with its work force to be satisfactory. The following table sets forth certain information regarding employees in each division of the Company as of December 31, 1993: SEASONALITY The Company's business is somewhat seasonal, with lower sales usually experienced during the first quarter of each fiscal year. See Note 12 to the Consolidated Financial Statements of the Company included in Part II, Item 8 herein. ITEM 2. PROPERTIES The offices of the Company are located at 520 Pike Street, Seattle, Washington 98101. Corporate, licensing and marketing services are provided to the Company by Sealy, Inc. (a wholly-owned subsidiary of the Company), located in Cleveland, Ohio. The principal address of Sealy, Inc. is Halle Building, 10th Floor, 1228 Euclid Avenue, Cleveland, Ohio 44115. The Company services certain national account customers in offices located in Chicago, Illinois, and also administers component operations at its Rensselaer, Indiana facility. The Company leases a research and development facility in Cleveland, Ohio. The Company's leased facilities are occupied under leases which expire from 1994 to 2015, including renewal options. The following table sets forth certain information regarding manufacturing facilities operated by the Company at February 1, 1994: (a) The Company has granted a mortgage or otherwise encumbered its interest in this facility as collateral for secured indebtedness. (b) The Company has leased 154,800 square feet to an unrelated tenant. (c) The Company has subleased 76,000 square feet to an unrelated tenant. (d) The Company has the option to purchase the property for specified costs at certain intervals during the lease term. The Company considers its present facilities to be generally well maintained, in sound operating condition and adequate for its needs. When viewed as a whole, the Company has excess capacity available in its facilities and the necessary equipment (as owner or lessee) to carry on its business. REGULATORY MATTERS The Company's principal wastes are wood, cardboard and other nonhazardous materials derived from product component supplies and packaging. The Company also periodically disposes of small amounts of used machine lubricating oil and waste glue used in connection with product components. The furniture operations of the Company in Phoenix, Arizona use some volatile solvent-based wood stains, although non-volatile solvent and/or water-based wood stains are used whenever possible. The Company, generally, is subject to the Federal Water Pollution Control Act, the Comprehensive Environmental Response, Compensation and Liability Act and amendments and regulations thereunder and corresponding state statutes and regulations. The Company's furniture operations are also subject to the Resource Conservation and Recovery Act, the Clean Air Act and amendments and regulations thereunder and corresponding state statutes and regulations. The Company believes that it is in material compliance with all applicable federal and state environmental statutes and regulations. Except as set forth in Item 3. ITEM 3. LEGAL PROCEEDINGS In accordance with procedures established under the Environmental Cleanup Responsibility Act ("ECRA"), Sealy Corporation and one of its subsidiaries are parties to an Administrative Consent Order (the "ACO") issued by the New Jersey Department of Environmental Protection and Energy (the "Department"), pursuant to which the Company and such subsidiary agreed to conduct soil and groundwater sampling to determine the extent of environmental contamination found at the plant owned by the subsidiary in South Brunswick, New Jersey. The Company does not believe that any of its manufacturing processes was a source of any of the contaminants found to exist above regulatorily acceptable levels in the groundwater, and the Company is exploring other possible sources of the contamination, including former owners of the facility. As the current owners of the facility, however, the Company and its subsidiary are primarily responsible for site investigation and any necessary clean-up plan approved by the Department under the terms of the ACO. The Company and its environmental consultant have been conducting investigation and remediation activities since preliminary evidence of contamination was first discovered in August, 1991. On November 15, 1993, the Company received a letter from the Department approving the findings and substantially all of the recommendations of the Company's consultant contained in a June 4, 1993 report submitted to the Department, but also requiring the Company to undertake additional remedial and investigative activities, including the installation of shallow groundwater monitoring wells off-site. On December 1, 1993, the Company's consultant submitted to the Department a report updating and supplementing the June, 1993 report with regard to activities completed prior to receipt of the Department's November 15, 1993 letter. On December 23, 1993, the Company submitted to the Department a Remedial Investigation Schedule of activities to be conducted within the next six (6) months in accordance with the Department's November 15, 1993 letter. In its November 15, 1993 letter, the Department postponed any required activity by the Company to delineate and/or remediate contaminants in the fractured bedrock, which it had previously requested the Company to undertake. The Company, however, still has reservations regarding any such required activities which the Department may attempt to impose in the future. Because of the nature of certain of the contaminants and their geological location in fractured bedrock, the Company and its consultant remain unaware of any accepted technology for successfully remediating the contamination either in the shallow groundwater or the fractured bedrock. The Company has established an accrual for further site investigation and remediation. Based on the facts currently known by the Company, management believes that the accrual is adequate to cover the Company's probable liability and does not believe that resolution of this matter will have a material adverse effect on the Company's financial position or future operations. However, because of many factors, including the uncertainties surrounding the nature and application of environmental regulations, the practical and technical difficulties in obtaining complete delineation of the contamination, the level of clean-up that may be required, if any, or the technology that could be involved, and the possible involvement of other potentially responsible parties, the Company cannot presently predict the ultimate cost to remediate this facility, and there can be no assurance that the Company will not incur material liability with respect to this matter. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's merger warrants to acquire shares of Class B common stock (which warrants were issued in conjunction with the LBO, and which do not become exercisable until August 9, 1995, except under certain limited circumstances) (the "Merger Warrants") are registered for trading in the over-the-counter market; however, because of the extremely limited and sporadic nature of quotations for such Merger Warrants, there is no established public trading market for the Merger Warrants. There is no established public trading market for any other class of common equity of the Company. As of February 20, 1994, there are 57 holders of record of the Company's shares, 1,281 holders of record of the Merger Warrants and 45 holders of record of the Restructure Warrants. No dividends have been paid on any class of common equity of the Company during the last three fiscal years. The Company's New Credit Agreement prohibits the paying of cash dividends on any of its classes of common equity. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The following tables set forth selected consolidated financial and other data of the Company (some periods of which are less than one year due to accounting requirements for acquisition transactions) for the ten months ended November 30, 1993, for the two months ended January 31, 1993, for the year ended November 30, 1992, for the one month ended November 30, 1991, for the eleven months ended October 31, 1991, for the year ended November 30, 1990, for the seven months ended November 30, 1989, and for the five months ended April 30, 1989. During the period from December 1, 1988 through November 30, 1993, the Company's capital structure and business changed significantly, in large part as a result of (i) the LBO, (ii) the Recapitalization, and (iii) the Acquisition in February 1993. Due to required purchase accounting adjustments relating to such transactions, and the resultant changes in control, the consolidated financial and other data for each period reflected in the following tables during this period are not comparable to such data for the other such periods. The selected consolidated financial and other data set forth in the following tables have been derived from the Company's audited consolidated financial statements. The report of KPMG Peat Marwick, independent auditors, covering the Company's Consolidated Financial Statements for the ten months ended November 30, 1993 (Successor period), for the two months ended January 31, 1993, the year ended November 30, 1992, and the one month ended November 30, 1991 (Pre-Successor Periods); and for the eleven months ended October 31, 1991 (Predecessor Period), is included elsewhere herein. These tables should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the Consolidated Financial Statements of the Company included elsewhere herein. (a) The Company employed the purchase method of accounting for the February, 1993 Acquisition, the April 1990 Exchange and the November 1991 Recapitalization, and the LBO. Accordingly, historical financial and other data for the Successor, Pre- Successor, Predecessor and Pre-Predecessor periods are not comparable. (b) During 1993, the Company recorded an extraordinary loss of $2.9 million, net of income tax of $1.5 million, representing the remaining unamortized debt issuance costs related to long term obligations repaid as a result of the Refinancing. (c) Operating income is calculated by adding interest expense, net to net sales less costs and expenses. (d) EBITDA is calculated by adding interest expense, net, income tax (benefit) and depreciation and amortization of intangibles to net income (loss) before extraordinary item. EBITDA is presented because it is a widely accepted financial indicator of a company's ability to service and incur debt. EBITDA does not represent net income or cash flows from operations as those terms are defined by generally accepted accounting principles ("GAAP") and does not necessarily indicate whether cash flows will be sufficient to fund cash needs. (e) For purposes of calculating the ratio of earnings to fixed charges, earnings represent income before income tax and extraordinary item plus fixed charges. Fixed charges consist of interest expense, net, including amortization of discount and financing costs and the portion of operating rental expense which management believes is representative of the interest component of rent expense. (f) Amounts reflected for long-term obligations and total debt at November 30, 1990 are net of debt discount of $74.9 million. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS INTRODUCTION The Company employed the purchase method of accounting for both the Acquisition in February 1993 and the Recapitalization in November 1991. As a result of the required purchase accounting adjustments, the post-Acquisition financials for the ten months ended November 30, 1993 (the "Successor Financials") are not comparable to the pre-Acquisition financials for the two months ended January 31, 1993, the year ended November 30, 1992 and the one month ended November 30, 1991 (collectively, the "Pre-Successor Financials"), which were prepared on the Recapitalization basis of accounting, and are not comparable to the pre-Recapitalization financials for the eleven months ended October 31, 1991 (the "Predecessor Financials"), which were prepared on the basis of accounting resulting from a 1989 acquisition of the Company (see Note 2 to the Consolidated Financial Statements, Part II, Item 8 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA SEALY CORPORATION Consolidated Financial Statements November 30, 1993 and 1992 (With Independent Auditors' Report Thereon) REPORT OF INDEPENDENT AUDITORS The Board of Directors and Stockholders Sealy Corporation: We have audited the accompanying consolidated balance sheets of Sealy Corporation and subsidiaries (Company) as of November 30, 1993 (Successor) and 1992 (Pre-Successor), and the related consolidated statements of operations, stockholders' equity, and cash flows for the ten months ended November 30, 1993 (Successor period); for the two months ended January 31, 1993, the year ended November 30, 1992 and the one month ended November 30, 1991 (Pre-Successor periods); and for the eleven months ended October 31, 1991 (Predecessor period). In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedules for the Successor period, Pre-Successor periods, and Predecessor period, as listed in Item 14(a)(2) of Form 10-K of Sealy Corporation for the year ended November 30, 1993. These consolidated financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules 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 aforementioned consolidated financial statements present fairly, in all material respects, the financial position of Sealy Corporation and subsidiaries at November 30, 1993 and 1992, and the results of their operations and their cash flows for the Successor period, Pre-Successor periods, and Predecessor period, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules for the Successor period, Pre-Successor periods, and Predecessor period, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. As discussed in Note 2 to the consolidated financial statements, on February 12, 1993 a majority of the outstanding common stock of the Company was acquired in a business combination accounted for as a purchase. Further, on November 6, 1991, the Company completed a recapitalization which resulted in a change in control of the Company. These transactions have been accounted for under the purchase method and accordingly the consolidated financial statements of the Company for the Successor period, Pre-Successor periods, and Predecessor period are presented on a different cost basis and therefore, are not comparable. As discussed in Notes 1 and 7 to the consolidated financial statements, in connection with the application of purchase accounting, effective February 1, 1993 the Company changed its method of accounting for income taxes to adopt the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes". KPMG Peat Marwick Cleveland, Ohio January 28, 1994 SEALY CORPORATION CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT PAR VALUE AMOUNTS) SEALY CORPORATION CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT PAR VALUE AMOUNTS) See accompanying notes to consolidated financial statements. SEALY CORPORATION CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) See accompanying notes to consolidated financial statements. SEALY CORPORATION CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (IN THOUSANDS) See accompanying notes to consolidated financial statements. SEALY CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) In November 1991, the Company completed a Recapitalization under which approximately $534 million in face amount of, and interest on, its outstanding subordinated indebtedness to an affiliate ("MBLP") of First Boston Securities Corporation was exchanged for 26.3 million additional shares of common stock of the Company and a $116.7 million 12.4% Senior Subordinated Note. See accompanying notes to consolidated financial statements. SEALY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Significant accounting policies used in the preparation of the consolidated financial statements are summarized below. (a) BUSINESS Sealy Corporation (the "Company"), is engaged in the home furnishings business and produces mattresses, boxsprings, bedroom furniture and convertible sleep sofas. Substantially all of the Company's trade accounts receivable are from retail businesses. Sales to Sears, Roebuck & Co., the Company's largest customer, were approximately 12%, 17%, 13%, 15% and 12% of total net sales for the ten months ended November 30, 1993, the two months ended January 31, 1993, the year ended November 30, 1992, the one month ended November 30, 1991 and the eleven months ended October 31, 1991 (the "Reporting Periods"). The Company recognizes revenue upon shipment of goods to customers. (b) PRINCIPLES OF OF SOLIDATION The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All intercompany accounts and transactions have been eliminated in consolidation. (c) CASH EQUIVALENTS For purposes of the statement of cash flows, the Company considers all highly liquid debt instruments purchased with an original maturity of three months or less to be cash equivalents. Cash equivalents are stated at cost which approximates market value. (d) PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment are depreciated over their expected useful lives principally by the straight-line method for financial reporting purposes and by both accelerated and straight-line methods for tax reporting purposes. (e) AMORTIZATION OF INTANGIBLES Goodwill represents the excess of the purchase price paid over the fair value of net assets acquired and is amortized on a straight-line basis over the expected periods to be benefitted. The Company assesses the recoverability of this intangible asset by determining whether the amortization of the goodwill balance over its remaining life can be recovered through projected undiscounted future earnings. The amount of goodwill impairment, if any, would be measured based on projected discounted future results using a discount rate reflecting the Company's average cost of funds. Other intangibles include patents and trademarks which are amortized on the straight-line method over periods ranging from 5 to 17 years. (f) NET EARNINGS (LOSS) PER COMMON SHARE Net earnings (loss) per common share is based upon weighted average number of shares of the Company's common stock and common stock equivalents outstanding for the periods presented. Common stock equivalents included in the computation, using the treasury stock method, represent shares issuable upon the assumed exercise of warrants, stock options and performance shares that would have a dilutive effect in periods in which there were earnings. Common stock equivalents had no material effect on the computation of earnings (loss) per common share in the Reporting Periods. SEALY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) (g) INCOME TAXES In February 1992, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standard No. 109, "Accounting For Income Taxes" ("Statement 109"). Under the asset and liability method of Statement 109, deferred tax assets and liabilities are recognized for future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Under Statement 109, the effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. The Company adopted Statement 109 effective February 1, 1993, in connection with the Acquisition of the Company disclosed in Note 2. The adoption of Statement 109 had no material effect on the amount of income tax expense reported in the ten months ended November 30, 1993. Prior to February 1, 1993, the Company followed Statement of Financial Accounting Standard No. 96 ("Statement 96") to account for income taxes. (h) RECLASSIFICATION Certain items in the consolidated financial statements for 1992 and 1991 have been reclassified to conform to the 1993 presentation. (2) BASIS OF ACCOUNTING On February 12, 1993, Zell/Chilmark Fund, L.P. ("Zell/Chilmark") led an investor group (the "Zell/Chilmark Purchasers") which purchased the 93.6% equity interest in the Company (the "Acquired Shares") held by MB L.P. I, an affiliate of The First Boston Corporation ("MBLP"), for a cash purchase price of $250 million (the "Acquisition"). The Company employed the purchase method of accounting for the Acquisition. The consolidated financial statements as of November 30, 1993 and for the ten months then ended reflect an allocation of the sum of the total consideration paid in the Acquisition for the approximately 94% equity interest and the remaining 6% equity interest valued at historical book value (collectively, the "New Basis"). A summary of the New Basis follows: The New Basis has been allocated to the tangible and identifiable intangible assets and liabilities of the Company as of February 1, 1993 based, in large part, upon independent appraisals of their fair values, with the remainder of the New Basis allocated to goodwill. The New Basis in excess of historical book value of the identifiable net assets acquired is as follows: SEALY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) The excess New Basis has been allocated as follows: Increase (decrease) in net assets: A favorable ruling with respect to certain tax contingencies and the recognition of available net operating loss carryforwards has been reflected as purchase accounting adjustments in the allocation of the New Basis. On November 6, 1991, the Company completed a recapitalization (the "Recapitalization") in which the Company's capital structure was significantly improved, the face amount of its indebtedness and interest thereon held by MBLP was reduced by approximately $417 million, the Company's interest expense obligations were substantially reduced and the principal repayment schedule on a portion of the Company's existing bank term loan facility was extended. As a result of an exchange in April 1990 of certain outstanding debt issued to First Boston Securities Corporation ("FBSC") for new debt at lower interest rates plus additional common stock (the "Exchange"), and subsequent Recapitalization in November 1991, MBLP (as successor transferee by FBSC) obtained a controlling interest in the Company. These transactions have been accounted for under the purchase method of accounting as a step acquisition. As a result of the required purchase accounting adjustments, the post-Acquisition financials as of and for the ten months ended November 30, 1993, (the "Successor Financials") are not comparable to the pre-Acquisition financials for the two months ended January 31, 1993, the year ended November 30, 1992 and the one month ended November 30, 1991 (collectively, the "Pre-Successor Financials", which were prepared on the Recapitalization basis of accounting), and are not comparable to the pre-Recapitalization financials for the eleven months ended October 31, 1991 (the "Predecessor Financials"). (3) INVENTORIES Inventories are valued at cost not in excess of market, using the first-in, first-out (FIFO) method. The major components of inventory as of November 30, 1993 and 1992 were as follows: SEALY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) (4) LONG-TERM OBLIGATIONS On May 7, 1993, the Company completed a refinancing plan (the "Refinancing"), which consisted of (i) the sale of $200.0 million of 9 1/2% Senior Subordinated Notes Due 2003 (the "Notes") pursuant to a public offering, (ii) the application of $194.5 million of net proceeds therefrom to redeem all of the then outstanding 12.4% Senior Subordinated Notes of the Company Due 2001 (approximately $139.6 million), and to reduce amounts outstanding under the Company's existing credit agreement prior thereto (the "Old Credit Agreement") and (iii) the execution of a new secured credit agreement (the "New Credit Agreement") with a new group of senior lenders providing for two term loan facilities (together, the "New Term Loan Facility") and a revolving credit facility (the "New Revolving Credit Facility") in connection with the refinancing of the Old Credit Agreement. During May 1993, the Company recorded a $2.9 million extraordinary loss, net of income tax of $1.5 million, representing the remaining unamortized debt issuance costs related to the long term obligations repaid as a result of the Refinancing. The Notes mature on May 1, 2003 and bear interest at the rate of 9 1/2% per annum from May 7, 1993, payable semiannually in cash on May 1 and November 1 of each year, commencing November 1, 1993. The Notes may be redeemed at the option of the Company on or after May 1, 1998, under the conditions and at the redemption prices as specified in the note indenture, dated as of May 7, 1993, under which the Notes were issued (the "Note Indenture"). Notwithstanding the foregoing, at any time prior to May 1, 1996, the Company may redeem with the net proceeds of one or more Public Equity Offerings as defined in the Note Indenture, up to $60.0 million aggregate principal amount of the Notes at the redemption prices as specified in the Note Indenture. The Notes are subordinated to all existing and future Senior Debt of the Company as defined in the Note Indenture. The New Credit Agreement provides for loans of up to $325 million and consists of the $75 million New Revolving Credit Facility and the $250 million New Term Loan Facility. The New Revolving Credit Facility provides sublimits for a $30 million discretionary letter of credit facility ("Letters of Credit") and a discretionary swing loan facility of up to $5 million ("Swing Loans"). The New Revolving Credit Facility terminates and is due and payable on November 30, 1998 unless extended as provided for in the New Credit Agreement. SEALY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) The New Term Loan Facility consists of a $175 million term loan (the "Tranche A Term Loan") and a $75 million term loan (the "Tranche B Term Loan") (collectively, the "Term Loans"). Under the terms of the New Credit Agreement, the Company is required to make certain mandatory principal prepayments of the Term Loans in the event of the sale of any of the Company's principal operating subsidiaries, certain sales of assets, excess cash flow, sales of stock and issuances of new debt securities and in certain other circumstances. In addition, the Company is permitted to make voluntary prepayments. During the year ended November 30, 1993, the Company made prepayments of $33.2 million under these provisions. Such prepayments will reduce pro rata future annual amounts to be amortized under the New Credit Agreement. In addition, the Company made the scheduled principal payments aggregating $20 million in 1993. After application of the 1993 prepayments, the Term Loans amortize according to the following schedule: In addition, the outstanding principal amount under the New Revolving Credit Facility must not exceed a certain amount for a thirty day period during each fiscal year of the Company. The Company is also subject to certain affirmative and negative covenants under both the New Credit Agreement and the Note Indenture, including, without limitation, requirements and restrictions with respect to capital expenditures, dividends, working capital, cash flow, net worth and other financial ratios. At November 30, 1993, the Company had approximately $53 million available under the Revolving Credit Facility, with $3 million outstanding and letters of credit issued totalling approximately $19 million. A commitment fee of 0.50% per annum on the unused portion of the New Revolving Credit Facility is payable quarterly in arrears. Two separate interest rate options exist and are available to the Company at its option as follows: (a) A Base Rate plus a Base Rate Applicable Margin; or (b) A Eurodollar Rate plus a Eurodollar Applicable Margin. Borrowings under the Revolving Credit Facility and the Tranche A Term Loan initially have a Base Rate Applicable Margin of 1.25% and a Eurodollar Applicable Margin of 2.50%. The Tranche B Term Loan initially has a Base Rate Applicable Margin of 1.75% and a Eurodollar Applicable Margin of 3.00%. The initial Base Rate Applicable Margin and Eurodollar Applicable Margin are in effect until May 6, 1994, and thereafter are subject to decreases or increases (not in excess of initial applicable margins) based on the Company's leverage ratio as defined in the New Credit Agreement. The Secured Credit Agreement requires that interest rate protection be maintained on an aggregate notional amount at least equal to 50% of outstanding Term Loans during the period from August 5, 1993 through at least May 7, 1996. SEALY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) All obligations of the Company under the Credit Agreement are jointly and severally guaranteed by each direct and indirect domestic subsidiary of the Company and secured by first priority liens on and security interests in substantially all of the assets of the Company and its domestic subsidiaries and by first priority pledges of substantially all of the capital stock of most of the subsidiaries of the Company. (5) LEASE COMMITMENTS The Company leases certain operating facilities, offices and equipment. The following is a schedule of future minimum annual lease commitments and sublease rentals at November 30, 1993. At November 30, 1993, property, plant and equipment included approximately $2.2 million of aggregate cost and $0.1 million of accumulated depreciation related to assets under capitalized leases. Rental expense charged to operations is as follows: The Company has the option to renew certain plant operating leases, with the longest renewal period extending through 2015. Most of the operating leases provide for increased rent through increases in general price levels. SEALY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) (6) STOCK OPTION PLAN The Company adopted the 1989 Stock Option Plan ("1989 Plan") in 1989 and the 1992 Stock Option Plan ("1992 Plan") in 1992 and reserved 100,000 shares and 600,000 shares, respectively, of Class A Common Stock for future issuance. Options under the 1989 Plan and the 1992 Plan may be granted either as Incentive Stock Options as defined in Section 422A of the Internal Revenue Code or Nonqualified Stock Options subject to the provisions of Section 83 of the Internal Revenue Code. During fiscal years 1990 and 1991, the Company issued options under the 1989 Plan totalling 8,250 shares (net of subsequent forfeitures) of which 7,937 are exercisable at November 30, 1993. The remaining 1989 Plan options are cumulatively exercisable as to one quarter of the underlying shares on each of the first through fourth anniversaries of date of grant. Any unexercised options terminate on the tenth anniversary of the date of grant or earlier, in connection with termination of employment. The exercise price for all 1989 Plan options exercisable or outstanding as of November 30, 1993 is $50.00 per share. No 1989 Plan options have been exercised since the date of grant. During fiscal years 1992 and 1993, the Company granted nonqualified options totalling 198,000 shares (net of subsequent forfeitures) under the 1992 Plan. The options granted in 1992 totalled 92,000 with an exercise price of $7.52 per share, and the options granted in June, 1993 totalled 106,000 and have an exercise price of $9.05 per share. The 1992 Plan options are exercisable 25% upon grant and 25% per year thereafter. The exercise price is equal to the estimated fair value of the Company's stock at the date of grant. 1992 Plan options totalling 750 shares were exercised during 1993. At November 30, 1993, options for 72,500 shares issued under the 1992 Plan are exercisable. During fiscal year 1993 the Company adopted the 1993 Non-Employee Director Stock Option Plan, providing for the one-time automatic grant of ten-year options to acquire up to 10,000 shares of Class A Common Stock of the Company (the "Shares") to all current and future directors who are not employed by the Company, by Zell/Chilmark or by their respective affiliates ("Non-Employee Directors"). Options granted under the 1993 Non-Employee Director Stock Option Plan vest immediately and are initially exercisable at a price equal to the fair market value of the Shares on the date of grant. The exercise price of options granted pursuant to this Plan increases on each anniversary date of such grant by 4% compounded annually. Pursuant to this Plan, the Company granted options to acquire up to 50,000 Shares to Non-Employee Directors in fiscal year 1993 at an initial exercise price of $9.05 per Share. (7) INCOME TAXES As discussed in Note 1(g), the Company adopted Statement 109 effective February 1, 1993. Prior years' financial statements have not been restated to apply the provisions of Statement 109. SEALY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) The Company and its domestic subsidiaries file a consolidated U.S. Federal income tax return. Income tax expense (benefit) attributable to income from continuing operations consists of: Income before income taxes from Canadian operations amount to $7,255, $1,140, $7,972, $25 and $8,933 for the Reporting Periods. The differences between the effective tax rate and the statutory U.S. Federal income tax rate are explained as follows: As required by Statement 109, the significant components of deferred income tax expense attributable to income from continuing operations for the ten months ended November 30, 1993 include adjustments to deferred tax assets and liabilities for enacted changes in tax rates of $216, and the recognition of the benefit of Successor net operating losses of $1,936. SEALY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) As required under Statement 96, deferred income taxes are provided for temporary differences between the financial reporting bases and the tax bases of the Company's assets and liabilities. The sources of these differences and the effects of changes from these differences on the deferred tax expense (benefit) are as follows: At November 30, 1993, the total deferred tax assets are $44,464, the total deferred tax liabilities are $33,257, and the valuation allowance is $13,123. The significant components of the deferred tax assets are accrued salaries and benefits of $11,699 and the net operating loss carryforwards of $19,579, and of the deferred tax liabilities are property, plant and equipment of $26,439 and intangible assets of $7,154. As a result of the Recapitalization, the future usage of net operating losses created prior to November 6, 1991 will be substantially limited. The Company has net operating loss carryforwards of approximately $43 million for U.S. Federal income tax purposes. These losses cannot be carried back against income of prior periods, and will expire, if not utilized, by the year 2008. The entire amount of the valuation allowance, the amount which has not changed since the adoption of Statement 109, shall be allocated to goodwill should the tax benefit for deferred tax assets, to which the valuation allowance relates, be subsequently realized. A provision has not been made for U.S. or foreign taxes on undistributed earnings of subsidiaries which operate in Canada and Puerto Rico. Upon repatriation of such earnings, withholding taxes might be imposed that are then available for use as credits against a U.S. Federal income tax liability, subject to certain limitations. The amount of taxes that would be payable on repatriation of the entire amount of undistributed earnings is immaterial. (8) RETIREMENT PLANS Substantially all employees are covered by profit sharing plans, where specific amounts are set aside in trust for retirement benefits. The Company has defined benefit pension plans covering a limited number of employees pursuant to negotiated labor contracts. The funded status of the defined benefit pension plans, as well as the amounts expensed for the Reporting Periods, are considered immaterial. The total profit sharing and pension expense was $4.0 million, $0.8 million, $4.1 million, $0.3 million and $4.5 million for the Reporting Periods, respectively. SEALY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (9) WARRANTS SERIES A AND SERIES B WARRANTS As part of the Recapitalization, the Series A and Series B Warrants (collectively, "Restructure Warrants") were issued under a Warrant Agreement ("Agreement I") dated as of November 6, 1991 between the Company and its subsidiary, Sealy, Inc., as warrant agent. Each holder (other than MBLP) of the Company's common stock immediately prior to the Recapitalization received warrants entitling all such holders to future ownership (when added to their then existing holdings) of up to 21.6% of the fully diluted common stock of the Company upon exercise. The Restructure Warrants, when exercised, will entitle the Holder thereof to receive one share of Class A Common Stock of the Company in exchange for the exercise price of $16.00 per share for Series A warrants and $22.50 per share for Series B warrants, subject to adjustment under certain circumstances. The Series A and Series B Warrants are exercisable into 4,288,700 and 1,649,500 shares of Class A Common Stock of the Company, respectively. The Restructure Warrants are exercisable at any time and from time to time on or prior to November 6, 2001 ("Expiration Date"). The Restructure Warrants may terminate and become void prior to the Expiration Date in the event that such warrants are redeemed as described below or if, prior to November 6, 1996 (after notice to Restructure Warrant holders, who may then exercise such warrants), the Company merges or consolidates with another entity with the other entity as the survivor. The Company has the right to redeem the Restructure Warrants on any date after November 6, 1996 at a redemption price per share as defined in Agreement I. MERGER WARRANTS Merger Warrants were issued under a Warrant Agreement ("Agreement II") dated as of August 1, 1989 between the Company and First Chicago Trust Company of New York, as warrant agent. Each Merger Warrant, when exercised, will entitle the holder thereof to receive one fiftieth of one share of Class B Common Stock of the Company in exchange for the exercise price of $.01 per share, subject to adjustment under certain circumstances. The Merger Warrants are exercisable after August 9, 1995 or upon the occurrence of certain other events as described in Agreement II. Within 90 days after August 9, 1994 (or sooner, under certain circumstances), the Company will offer to repurchase for cash all outstanding Merger Warrants and shares issued under such Agreement II ("Warrant Shares") in a single transaction ("Repurchase Offer") at a purchase price as defined in Agreement II, provided certain conditions are met. At the present time, the Company's debt Agreements restrict its ability to repurchase such Merger Warrants or Warrant Shares. Due to the possible occurrence of the Repurchase Offer, the Merger Warrants are not considered to be a part of the Company's stockholders' equity and therefore, are included in other noncurrent liabilities in the accompanying consolidated balance sheets. The Merger Warrants, subject to certain conditions, are exercisable into an aggregate of 212,500 shares of Class B Common Stock. SEALY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (10) COMMON STOCK Holders of Class A Common Stock are entitled to one vote per share on all matters submitted to a vote of stockholders while the holders of Class B Common Stock are entitled to one-half vote per share. Except with respect to voting rights, the terms of the Class A Common Stock and the Class B Common Stock are identical. Shares of Class B Common Stock, under certain circumstances, are convertible into shares of Class A Common Stock. (11) PERFORMANCE SHARE PLAN Effective April 1, 1992, the Company adopted a Performance Share Plan ("Plan") for certain employees of the Company. Under the Plan, the Board of Directors may approve the issuance of up to 3.0 million performance share units each representing the right to receive up to one share of Class A Common Stock of the Company ("Shares") if the Company meets specified cumulative operating cash flow targets over the five-year period ended November 30, 1996. As of November 30, 1993, there are 2.4 million performance share units outstanding under the Plan which represent the right to receive Shares having an estimated fair value of $19.7 million. The performance share units vest over the five years ending November 30, 1996 and, as of November 30, 1993, none of the units were convertible into Shares. The Plan is a variable stock compensation plan pursuant to which the fair value of Shares issuable under the Plan will be recorded as compensation expense over the Plan's five-year term ending November 30, 1996. In addition to the annual amount of compensation expense under the Plan, such amount will be adjusted to give cumulative effect to any change in the amount of non-cash compensation expense previously recorded in prior reporting periods, resulting from subsequent increases or decreases in the fair value of the Shares or the number of performance share units outstanding since such reporting period and to any change in management's estimate of its ability to achieve the cumulative operating cash flow targets as defined in the Plan. During the ten months ended November 30, 1993, the two months ended January 31, 1993 and the year ended November 30, 1992, the Company recorded $2.2 million, $0.9 million and $5.4 million, respectively, of non-cash compensation expense under the Plan. Based on the value of the Shares at November 30, 1993, and giving consideration to management's estimate of the expected cumulative operating cash flow target to be achieved over the five year period ended November 30, 1996, the Company expects to record future non-cash charges totalling approximately $11 million. To the extent that the fair value of the Shares or the number of performance share units outstanding increases or decreases, such non-cash expense will also increase or decrease in future reporting periods. (12) SUMMARY OF INTERIM FINANCIAL INFORMATION (UNAUDITED) SEALY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) During the second quarter of fiscal year 1993, the Company recorded an extraordinary loss of $2.9 million, net of income taxes ($.10 per share), from early extinguishment of debt in connection with the Refinancing. During the fourth quarter of fiscal year 1993, the Company recorded a $3.0 million charge for estimated costs of closing certain manufacturing facilities which is expected to be completed during fiscal year 1994. (13) CONTINGENCIES Sealy Corporation and one of its subsidiaries are parties to an Administrative Consent Order (the "ACO") issued by the New Jersey Department of Environmental Protection and Energy (the "Department"), pursuant to which the Company and such subsidiary agreed to conduct soil and groundwater sampling to determine the extent of environmental contamination found at the plant owned by the subsidiary in South Brunswick, New Jersey. The Company does not believe that any of its manufacturing processes was a source of any of the contaminants found to exist above regulatorily acceptable levels in the groundwater, and the Company is exploring other possible sources of the contamination, including former owners of the facility. As the current owners of the facility, however, the Company and its subsidiary are primarily responsible for site investigation and any necessary clean-up plan approved by the Department under the terms of the ACO. The Company and its environmental consultant have been conducting investigation and remediation activities since preliminary evidence of contamination was first discovered in August, 1991. On November 15, 1993, the Company received a letter from the Department approving the findings and substantially all of the recommendations of the Company's consultant contained in a June 4, 1993 report submitted to the Department, but also requiring the Company to undertake additional remedial and investigative activities, including the installation of shallow groundwater monitoring wells off-site. On December 1, 1993, the Company's consultant submitted to the Department a report updating and supplementing the June, 1993 report with regard to activities completed prior to receipt of the Department's November 15, 1993 letter. On December 23, 1993, the Company submitted to the Department a Remedial Investigation Schedule of activities to be conducted within the next six (6) months in accordance with the Department's November 15, 1993 letter. In its November 15, 1993 letter, the Department postponed any required activity by the Company to delineate and/or remediate contaminants in the fractured bedrock, which it had previously requested the Company to undertake. The Company, however, still has reservations regarding any such required activities which the Department may attempt to impose in the future. Because of the nature of certain of the contaminants and their geological location in fractured bedrock, the Company and its consultant remain unaware of any accepted technology for successfully remediating the contamination either in the shallow groundwater or the fractured bedrock. SEALY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) The Company has established an accrual for further site investigation and remediation. Based on the facts currently known by the Company, management believes that the accrual is adequate to cover the Company's probable liability and does not believe that resolution of this matter will have a material adverse effect on the Company's financial position or future operations. However, because of many factors, including the uncertainties surrounding the nature and application of environmental regulations, the practical and technical difficulties in obtaining complete delineation of the contamination, the level of clean-up that may be required, if any, or the technology that could be involved, and the possible involvement of other potentially responsible parties, the Company cannot presently predict the ultimate cost to remediate this facility, and there can be no assurance that the Company will not incur material liability with respect to this matter. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT DIRECTORS The following table sets forth the name, age, principal occupation and employment and business experience during the last five years of each of the Company's directors: Mr. Zell is a director of Revco D.S., Inc., Carter Hawley Hale Stores, Inc., The Delta Queen Steamboat Co., The Vigoro Corporation and Jacor Communications, Inc. Mr. Schulte is a director of Revco D.S., Inc., Carter Hawley Hale Stores, Inc. and Jacor Communications, Inc. Mr. Fenster serves on the board of American Management Systems, Inc. Ms. Hefner is a director of Playboy Enterprises, Inc. Mr. Johnston serves as a director of The Wachovia Corporation, RJR Nabisco, Inc., RJR Nabisco Holdings Corp, R.J. Reynolds Tobacco Co. and R.J. Reynolds Tobacco International, Inc. Mr. Towe is a director of The American Heritage Life Insurance Company and Long John Silver's Restaurants, Inc. EXECUTIVE OFFICERS The following table sets forth the name, title, age, and certain other information with respect to the executive and certain other appointed officers of the Company: COMPLIANCE WITH SECTION 16 (A) OF THE EXCHANGE ACT Based solely upon a review of Forms 3 and 4, and amendments thereto, furnished to the Company pursuant to Rule 16a-3(e) during Fiscal 1993 and Form 5, and amendments thereto, furnished to the Company with respect to Fiscal 1993, the Company is not aware of any person that is subject to Section 16 of the Securities Exchange Act of 1934 (the "Exchange Act") with respect to the Company, that has failed to file, on a timely basis, (as disclosed in the aforementioned Forms) reports required by Section 16 (a) of the Exchange Act during Fiscal 1993 or prior fiscal years. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The following table sets forth information concerning the annual and long-term compensation for services in all capacities to the Company for each of the years ended November 30, 1993, 1992 and 1991, of those persons who were, at November 30, 1993 (i) the chief executive officer and (ii) the other four most highly compensated executive officers of the Company for the year ended November 30, 1993 (collectively, the "Named Executive Officers"): SUMMARY COMPENSATION TABLE (a) Pursuant to his Employment Agreement (as hereinafter defined), Mr. Beggs commenced employment with the Company as of August 24, 1992. Under the terms of his Employment Agreement, Mr. Beggs received $117,045 and $180,850 in 1993 and 1992, respectively, as the result of: (i) the forgiveness of a portion of an equity loan from the Company to Mr. Beggs, reflecting the loss of equity in his previous residence (1993-$44,034; 1992-$91,751); (ii) closing costs on a new home, moving expenses, temporary living expenses and costs relating to the termination of a contract to purchase another residence (1993-$44,000; 1992-$89,099); (iii) professional fees, travel and entertainment expenses; and (iv) payments to cover Mr. Beggs' tax liabilities on the foregoing items, all as described more fully in "--Compensation Pursuant to Plans and Other Arrangements -- Executive Employment Agreements." (b) Such amount reflects the Company's determination of the fair value at the date of grant of 100,000 Shares issued to Mr. Beggs in 1992 pursuant to his Employment Agreement, certain of which are subject to forfeiture under certain circumstances. Although the New Credit Agreement and the indenture relating to the Notes contain restrictions on the Company's ability to pay dividends, if dividends were declared and paid on the Company's Shares, such dividends would be paid on such Shares issued to Mr. Beggs. The Employment Agreement also provides for the future issuance to Mr. Beggs of an additional 100,000 Shares, subject to certain conditions. See "-- Compensation Pursuant to Plans and Other Arrangements -- Executive Employment Agreements." Hence, Mr. Beggs' aggregate stock holdings consist of 200,000 Shares with an estimated fair market value of $2,696,000 at the end of fiscal year 1993. No other Named Executive Officer had any holdings of stock which were subject to forfeiture at the end of fiscal year 1993. (c) Represents amounts paid in fiscal year 1993 on behalf of each of the Named Executive Officers for the following three respective categories of compensation: (i) Company premiums for life and accidental death and dismemberment insurance, (ii) Company premiums for long-term disability benefits, and (iii) Company contributions to the Company's defined contribution plans. Amounts for each of the Named Executive Officers for each of the three respective preceding categories is as follows: Mr. Beggs: (1993- $2,220, $1,000, $16,020; 1992- $510, $0, $0); Mr. Fazio: (1993- $1,159, $870, $12,180; 1992- $1,040, $850, $11,900); Mr. McIlquham: (1993- $1,026, $770, $10,780; 1992- $887, $725, $10,150); Mr. Fellmy: (1993- $999, $750, $10,500; 1992- $765, $625, $9,042); and Mr. Claypool: (1993- $1,039, $780, $10,920; 1992- $918, $750, $0). (d) The bonus amounts reflected for such persons include a portion of such bonus paid in Shares, valued at $7.52 per Share, which the Company determined was the fair value of such Shares on the date of the bonus award. (e) All of Mr. McIlquham's amount and $33,331 of such amount for Mr. Fellmy represent payments made by the Company to cover their respective tax liabilities relating to the portion of their bonuses paid in Shares in fiscal year 1992. The balance of such amount for Mr. Fellmy represents payment made by the Company to reimburse moving expenses and cover the tax liability thereon. LONG-TERM INCENTIVE PLAN AWARDS IN LAST FISCAL YEAR (a) The Company's Performance Share Plan (the "Plan") effective in 1992 provides for the issuance to key employees of the Company and its subsidiaries (the "Participants") of performance share units ("Performance Shares"), each of which represents the right to receive, without any additional consideration, up to one Share, based on the extent to which the Company achieves specified cumulative operating cash flow ("COCF") targets over the five-year period ending November 30, 1996 (the "Measurement Period"). An aggregate of 2,366,000 Performance Shares, net of forfeitures, have been granted to Participants, and up to 247,100 Performance Shares have been granted and reserved for individuals who will occupy certain open positions effective, in each case, upon the hire date of any such individual, under the Plan. The maximum number of Performance Shares authorized to be granted is 3,000,000. Generally, the Plan provides that if the Company's COCF for the Measurement Period is $500 million, then each vested Performance Share shall convert into .10 Shares (the "Threshold"); if COCF is $575 million, then each vested Performance Share shall convert into .417 Shares (the "Target"), and if COCF equals or exceeds $650 million, then each vested Performance Share shall convert into one Share (the "Maximum"). If COCF for such period is between $500 million and $650 million, then the conversion ratio will be interpolated on a straight-line basis between the two closest of the three aforementioned target ratios. If COCF is less than $500 million, then all Performance Shares shall be forfeited without conversion. The estimated fair value of one Share on November 30, 1993 was $13.48. In the event that the Company is a party to an acquisition, merger or other significant corporate event or makes an in-kind distribution on any equity security, the COCF targets or ratios may be equitably adjusted to reflect an equivalent value. The Performance Shares generally vest over a five-year period. If a Participant incurs a termination of employment during the periods indicated, the following percentages of Initial Performance Shares become vested: from December 1, 1992 through November 30, 1993 -- 30%; from December 1, 1993 through November 30, 1994 -- 45%; from December 1, 1994 through November 30, 1995 -- 60%; from December 1, 1995 through November 29, 1996 -- 80%; and on or after November 30, 1996 -- 100%. In the event that a Participant incurs a termination of employment for cause (as defined in the Plan) or engages in a breach of certain noncompetition covenants following a voluntary termination, the Participant shall forfeit all Performance Shares, whether or not vested. The Human Resources Committee of the Board (the "Human Resources Committee") may, in its sole discretion, terminate the Plan at any time without the consent of any Participant. The Plan shall terminate automatically on the date upon which the Performance Shares are converted into Shares (or are forfeited) following the Measurement Period (the "Payment Date") or, if earlier, upon a Change in Control (as defined in the Plan) unless the person(s) who purchased 50% or more of the common stock or substantially all of the assets of the Company in effecting such a Change in Control (a "Third Party Purchaser") agrees to continue the Plan or a replacement plan in a manner that is fair and equitable to the Participants. As part of the Acquisition, Zell/Chilmark consented to the continuation of the Plan. In the event that the Plan is terminated because of changes in the laws or accounting rules which frustrate the intent of the Plan or because of the inability to preserve the integrity of the COCF formula by reason of material changes to the business or operations of the Company, then the disinterested members of the Board may replace the Plan with an alternative plan that is comparable in scope and effect or the Board may have the Company distribute that number of Shares as would be arrived at by multiplying the unforfeited Performance Shares by a fraction (which may not be greater than one) the numerator of which is the COCF through the date of termination and the denominator of which is $650 million. In all other cases of termination of the Plan, all Performance Shares awarded to a Participant, which have not previously been forfeited, shall become vested Performance Shares and the Participant shall receive that number of Shares equal to the number of that Participant's vested Performance Shares on the date of termination of the Plan. Notwithstanding any of the foregoing, upon the termination of the Plan because of a Change in Control where the Third Party Purchaser did not offer the same or a replacement plan, the Company shall, unless the common stock of the Company is publicly traded on the termination date of the Change in Control, make a lump-sum cash payment to the Participant equal to the fair market value of the applicable number of Shares, less applicable withholdings, in satisfaction of all rights of such Participant under the Plan. Upon the conversion of the Performance Shares into Shares following the Payment Date, the Company will, at the discretion of the Participant, lend to those Participants that are still employees a sum (bearing interest at the prime rate) sufficient to cover his or her estimated tax liability (a "Tax Loan") or, alternatively, the Participant can elect to have the Company withhold a sufficient number of Shares as necessary to cover such estimated tax liability, and pay such withholding tax liability, in cash, on behalf of the Participants. The holders of Shares issued under the Plan also will have certain registration rights which will apply after an initial public offering of Shares (the "Initial IPO"), for a period of five years following the Payment Date. The Tax Loans, if any, would be due and payable 30 days following the Initial IPO or such other time as designated by the Human Resources Committee. Mr. Beggs was granted his Performance Shares in connection with his execution of the Employment Agreement. See "-- Compensation Pursuant to Plans and Other Arrangements -- Executive Employment Agreements." COMPENSATION PURSUANT TO PLANS AND OTHER ARRANGEMENTS SEVERANCE BENEFIT PLANS. Effective December 1, 1992, the Company established the Sealy Executive Severance Benefit Plan (the "Executive Severance Plan") for employees in certain salary grades. Benefit eligibility includes, with certain exceptions, termination as a result of a permanent reduction in work force or the closing of a plant or other facility, termination for inadequate job performance, termination of employment by the participant following a reduction in base compensation, reduction in salary grade which would result in the reduction in potential plan benefits or involuntary transfer to another location. Benefits include cash severance payments calculated using various multipliers varying by salary grade, subject to specified minimums and maximums depending on such salary grades. Such cash severance payments are made in equal semi-monthly installments calculated in accordance with the Executive Severance Plan until paid in full. Certain executive-level officers would be entitled to a minimum of one-year's salary and a maximum of two-year's salary under the Executive Severance Plan. However, if a Participant becomes employed prior to completion of the payment of benefits, such semi-monthly installments shall be reduced by the Participant's base compensation for the corresponding period from the Participant's new employer. Participants receiving cash severance payments under the Executive Severance Plan also would receive six months of contributory health and dental coverage and six months of group term life insurance coverage. The Company currently follows the terminal accrual approach to accounting for severance benefits under the Executive Severance Plan and records the estimated cost of these benefits as expense at the date of the event giving rise to payment of the benefits. EXECUTIVE EMPLOYMENT AGREEMENT. Effective October 31, 1992, the Company entered into an employment agreement and related reimbursement letter agreement (collectively, the "Employment Agreement") with Mr. Beggs, pursuant to which Mr. Beggs became employed as Chairman, President and Chief Executive Officer of the Company for a period (the "Employment Period") commencing on August 24, 1992 and continuing through November 30, 1997 (the "Expiration Date"). Pursuant to the Employment Agreement, Mr. Beggs' base salary was $500,000 for Fiscal 1993. Such salary may be increased but not decreased in an annual review, and Mr. Beggs is entitled to receive an annual cash bonus in an amount to be determined on the basis of certain corporate and individual performance targets determined by the Board of Directors, or a committee thereof. Pursuant to the Employment Agreement, Mr. Beggs was granted an aggregate of 200,000 Shares, 100,000 of which were issued as of October 31, 1992 (the "Issued Shares"). If Mr. Beggs is terminated for cause or voluntarily terminates his employment with the Company, other than for "good reason" (as such terms are defined in the Employment Agreement), 55,000 or 35,000 of such Issued Shares are forfeitable through November 30, 1994, and November 30, 1995, respectively. In addition, the following number of additional Shares will be issued if he remains employed by the Company on the dates indicated: November 30, 1995 -- 10,000 shares; November 30, 1996 --40,000 shares; and November 30, 1997 -- 50,000 shares. Mr. Beggs also entered into a Stockholder's Agreement with the Company (the "Stockholder's Agreement") in connection with the Employment Agreement, which provides that, prior to the Expiration Date, Mr. Beggs may sell his Shares only after an Initial IPO or approval by the Board of Directors and, after the Expiration Date, the Company shall have certain rights of first refusal with respect to any proposed transfers of Mr. Beggs' Shares (other than to certain permitted transferees). The Stockholder's Agreement also provides that the holders of the Shares issued to Mr. Beggs under the Employment Agreement shall have certain ""piggyback'' registration rights with respect to such Shares. Mr. Beggs recognized taxable income in 1992 in connection with the Issued Shares and borrowed $279,300 from the Company (the "Stock Loan") to be used in payment of the required withholding taxes. The Stock Loan bears interest at the applicable federal rate in effect on the date of the loan, with all unpaid and outstanding principal and interest due and payable on November 30, 1995. In addition, Mr. Beggs was granted an award of 1,000,000 Performance Shares, representing the right to receive up to 1,000,000 Shares pursuant to, and subject to the terms of, the Performance Share Plan. See Note (a) to "--Long-Term Incentive Plan Awards in Last Fiscal Year." Pursuant to the Employment Agreement, Mr. Beggs is entitled to health and life insurance and certain other benefits and he also received relocation expenses. The relocation expenses included closing costs on a new home, moving expenses, temporary living expenses, and costs relating to the termination of a contract to purchase another residence (collectively, "Relocation Expenses"). The Company increased its payments to Mr. Beggs for Relocation Expenses by the resulting income tax liability created by such reimbursements. Mr. Beggs has agreed to reimburse the Company for any Relocation Expenses received by him if he voluntarily terminates his employment within two years after his relocation is completed unless such termination is for good reason (as defined in the Employment Agreement). The Company purchased Mr. Beggs' previous residence from him for $712,500 and sold such residence for $690,000 in February 1993. Mr. Beggs borrowed $157,673 from the Company (the "Equity Loan") upon the purchase of a new home in the Cleveland area, reflecting the loss of equity in his previous residence. Such Equity Loan is interest free to the extent allowed under applicable tax laws and otherwise bears interest at the applicable federal rate. In accordance with the terms of the Employment Agreement, $20,000 and $57,673 of such Equity Loan was forgiven on November 30, 1993 and December 31, 1992, respectively. In addition, $4,070 in interest related to such equity loan was also forgiven on November 30, 1993, and the Company paid Mr. Beggs an additional $44,034 and $34,077, as additional compensation for his tax liability as a result of such forgiveness of indebtedness in each period, respectively. The balance of the Equity Loan has four equal annual payments of principal due on November 30, 1994 and each November 30 thereafter for three years. If Mr. Beggs remains employed by the Company through the date when a payment is due, such indebtedness will be forgiven by the Company and the Company will pay Mr. Beggs an amount necessary to offset any tax liability to him as a result of such forgiveness of indebtedness. If Mr. Beggs voluntarily terminates his employment with the Company, other than for good reason, the remaining balance of the Equity Loan and any accrued interest will become immediately due and payable. If Mr. Beggs' employment is terminated prior to the Expiration Date other than for cause, (as defined in the Employment Agreement), death or disability or if Mr. Beggs terminates his employment for good reason, he will continue to receive his base salary until the later of November 30, 1997 or one year, plus the forgiveness of the Equity Loan, the payment of a portion of any then-applicable bonus on a pro-rata basis and the issuance of the remainder of the unissued Shares noted above. In addition, if Mr. Beggs' employment is terminated prior to the Expiration Date under such circumstances or because of his death or disability, then the Stockholder's Agreement grants to Mr. Beggs or his representative the right to cause the Company to repurchase all of Mr. Beggs' Shares at their "fair market value" (determined in accordance with the Shareholders' Agreement). In the event that Mr. Beggs' employment is terminated prior to the Expiration Date for "cause" or if he voluntarily terminates his employment other than for "good reason," then the Company shall have the option to repurchase Mr. Beggs' Shares for their "fair market value." REMUNERATION OF DIRECTORS. Effective upon the Acquisition, the Company began compensating its directors who are not employees with a retainer at the rate of $30,000 on an annual basis, reduced by $1,000 for each Board meeting not attended, plus $1,000 ($1,250 for Committee Chairmen, if any) for each Committee meeting attended if such meeting is on a date other than a Board meeting date, and incidental expenses in connection with traveling to or attending such meetings. Directors Zell, Schulte, Friedland, Davis, Fenster, Towe, Johnston and Hefner are eligible for such remuneration. During 1993, the Company adopted the 1993 Non-Employee Director Stock Option Plan, providing for the one-time automatic grant of ten-year options to acquire up to 10,000 Shares to all current and future directors who are not employed by the Company, by Zell/Chilmark or by their respective affiliates ("Non-Employee Directors"). Options granted under the 1993 Non-Employee Director Stock Option Plan vest immediately and are initially exercisable at a price equal to the fair market value of the Shares on the date of grant. The exercise price of options granted pursuant to this Plan increases on each anniversary date of such grant by 4% compounded annually. Pursuant to this Plan, during 1993, the Company granted options to acquire up to 10,000 Shares to each of Messrs. Davis, Fenster, Towe and Johnston and Ms. Hefner at an initial exercise price of $9.05 per Share. COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION At the end of fiscal year 1992, Messrs. Robert B. Calhoun, Jr. and John F. Maypole, former directors of the Company, and Rolf H. Towe were the directors who served as the members of the Human Resources Committee at that time (which functions as the Compensation Committee of the Board of Directors). For information regarding certain relationships or transactions that Messrs. Towe and Calhoun, or entities with which they are affiliated, have with the Company, see "Certain Relationships and Related Transactions - Compensation Committee Interlocks and Insider Participation." ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The following table sets forth certain information with respect to those holders which, according to the records of the Company, beneficially own more than 5% of the outstanding Shares as of February 20, 1994: (a) The percent of class calculation assumes that the stockholder for whom the percent of class is being calculated has exercised all Restructure Warrants (as described in Note 9 of the Notes to the Consolidated Financial Statements) owned by such stockholder and that no other stockholder has exercised any other Restructure Warrants. Accordingly, the total of the percentages for all the stockholders listed exceeds 100%. (b) For further information with respect to Zell/Chilmark, see Item 10. "Directors and Executive Officers" and Item 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION At the end of fiscal year 1992, Messrs. Robert B. Calhoun, Jr. and John F. Maypole, former directors of the Company, and Rolf H. Towe were the directors who served as the members of the Human Resources Committee at that time (which functions as the Compensation Committee of the Board of Directors)(the "Committee"). Effective March 4, 1993, the Committee consisted of Messrs. Zell, Towe, Fenster and Johnston. FBSC, an affiliate of First Boston, owns, directly and through its subsidiaries, all of the common stock of FBMB I, Inc., a Delaware corporation and a general partner of MBLP. Messrs. Calhoun and Towe each own 50% of the common stock of, and are executive officers of, CIG, Inc., the sole general partner of The Clipper Group L.P. ("Clipper"), which had managed the investments of MBLP in the Company, including the 12.4% Senior Subordinated Notes (the "Subordinated Notes"). During the period between the Recapitalization and the Acquisition, MBLP owned 27,630,000 Shares and all of the Subordinated Notes, and, following the Acquisition, and until the Refinancing, owned a warrant to purchase up to 4,000,000 million shares of the stock acquired by Zell/Chilmark in the Acquisition (the "MBLP Warrant") and the Subordinated Notes. Through the repayment of the Subordinated Notes on May 7, 1993, MBLP received, or had accrued, interest payments on the Subordinated Notes aggregating approximately $23 million. In connection with the Acquisition, MBLP waived its right, as holder of the Subordinated Notes, to require the Company to repurchase the Subordinated Notes upon the change in control of the Company effected by the Acquisition. In addition, MBLP consented to and caused the Company and the Trustee under the Subordinated Note Indenture to enter into a supplemental indenture which (i) granted the Company the option to redeem the Subordinated Notes at any time at a redemption price of 100% of the principal amount, plus accrued interest thereon to the redemption date, (ii) provided that the Subordinated Notes would no longer be convertible into Preferred Stock of the Company and (iii) modified certain ratios relating to the issuance of certain debt obligations of the Company. In consideration of MBLP executing the supplemental indenture, Zell/Chilmark agreed to pay, or to cause the Company to pay, all out-of-pocket costs and expenses (including reasonable fees and expenses) incurred by MBLP in connection with the sale or redemption of the Subordinated Notes. As part of the Refinancing, the MBLP Warrant was cancelled and all of the outstanding Subordinated Notes were repaid and redeemed. Zell/Chilmark assigned a portion of its rights and obligations under the Stock Purchase Agreement to Mr. Towe, pursuant to which he acquired 27,630 Shares from MBLP at the same cash price per Share as paid by the other Zell/Chilmark Purchasers. As part of the Acquisition and pursuant to the Stock Purchase Agreement, Zell/Chilmark, MBLP and the Company entered into a Registration Rights Agreement relating to the Acquired Shares, including the 27,630 Shares purchased by Mr. Towe. Pursuant to such Stock Purchase Agreement, the holders of a majority of such Acquired Shares have the right to demand, up to five times but no more than once every six months, registration of their Acquired Shares under the Securities Act. In addition, under certain conditions, the holders of the Acquired Shares have a right to include some or all of their Acquired Shares in any subsequent registration statement filed by the Company with respect to the sale of Shares. The Company has agreed to bear all expenses associated with any registration statement relating to the Acquired Shares other than any underwriting discounts or commissions, brokerage commissions and fees. In connection with the Acquisition, the Company and Zell/Chilmark executed a release (the "Release") dated February 12, 1993 of MBLP and its affiliates, subsidiaries, stockholders, partners, controlling persons and their respective directors, officers, employees and certain other related persons (collectively, the "Related Persons"), which would include, among others, First Boston, FBSC, Robert B. Calhoun, Jr. (a director of the Company prior to the Acquisition) and Rolf H. Towe (collectively, MBLP and MBLP's Related Persons shall be referred to collectively as the "MBLP Released Parties") from any obligation or liability in any way relating to (i) the acquisition, ownership or operation of the Company or (ii) the negotiation, execution and closing of the Stock Purchase Agreement and related documents (the "Stock Purchase Documents"). The Release does not release the MBLP Released Parties from any obligation or liability in connection with (i) covenants contained in the Stock Purchase Documents required to be performed following the Acquisition, (ii) breaches of certain representations made by MBLP in the Stock Purchase Agreement, or (iii) actions taken by any MBLP Released Party after February 12, 1993. MBLP executed a similar release of Zell/Chilmark and the Company and their respective Related Persons which was substantially equivalent in scope and coverage (except that such release did not cover any obligations in respect of the Subordinated Notes). Pursuant to the Stock Purchase Agreement, Zell/Chilmark and the Company have agreed that, so long as MBLP (or any of its affiliates) held any Subordinated Notes, First Boston would have the exclusive right (for competitive fees and terms) to act (i) as the Company's exclusive financial advisor with respect to any acquisitions or divestitures in which the Company engaged a financial advisor (other than Zell/Chilmark or its affiliates) and (ii) as lead underwriter or placement agent with respect to any transactions in which the Company employed the services of an underwriter or placement agent. Pursuant to such agreed terms, First Boston served as the lead underwriter in connection the issuance of the Notes as part of the Refinancing. Zell/Chilmark and the Company agreed that for three years following the date of the Refinancing, First Boston will have the right to act (for competitive fees and terms) as a co-manager or co-placement agent in any transaction in which the Company employs the services of an underwriter or placement agent. In addition, the Stock Purchase Agreement provides that, until three years following the Refinancing, MBLP and First Boston will not (i) directly or indirectly participate, anywhere in the United States, in the business in which the Company is currently engaged; (ii) induce or influence any employee of the Company or Zell/Chilmark to terminate such employee's employment or become an employee of MBLP or First Boston; or (iii) disclose or furnish to any other person any of the Company's confidential business information, trade secrets or manner of conducting its business. MBLP and First Boston further agreed not to use certain trademarks owned by the Company and, for a period of time, not to serve as underwriter or placement agent with respect to the sale of securities by certain entities that use such trademarks. THE ACQUISITION. On January 27, 1993, Zell/Chilmark, MBLP and the Company entered into the Stock Purchase Agreement pursuant to which MBLP agreed to sell to Zell/Chilmark up to 27,630,000 Shares (representing a 93.6% equity interest in the Company). In accordance with the terms of the Stock Purchase Agreement, Zell/Chilmark acquired 88.7% of the outstanding common stock of the Company (26,143,506 Shares) and assigned a portion of its rights and obligations under the Stock Purchase Agreement to Bankers Trust New York Corporation ("BT") and Rolf H. Towe, a director of the Company. In the Acquisition, BT acquired 1,458,864 Shares and Mr. Towe acquired 27,630 Shares. Zell/Chilmark has informed the Company that the monies used to fund the cash purchase price that it paid for its portion of the Acquired Shares were obtained from partnership capital contributions. All of the Zell/Chilmark Purchasers paid the same $9.05 cash price per Share for their Acquired Shares. The Acquisition was completed on February 12, 1993. As part of the Acquisition, Zell/Chilmark granted to MBLP a warrant, exercisable on or after November 30, 1993, to purchase up to 4,000,000 Acquired Shares (the "MBLP Warrant") held by Zell/Chilmark, which Warrant expired upon repayment of the Subordinated Notes. As part of the Acquisition and pursuant to the Stock Purchase Agreement, Zell/Chilmark and the Company entered into the Capital Contribution Agreement whereby Zell/Chilmark agreed to purchase or cause to be purchased, and the Company agreed to issue, Shares having an aggregate purchase price of $50.0 million (subject to adjustment), computed at a price of $9.05 per Share on or before November 30, 1993. The Capital Contribution Agreement terminated with the Refinancing. See "-- Compensation Committee Interlocks and Insider Participation," above for certain additional information regarding the Acquisition. MANAGEMENT SUBSCRIPTION AND BENEFIT ARRANGEMENTS. See "Management -- Compensation Pursuant to Plans and Other Arrangements -- Severance Arrangements" for a description of the Company's severance arrangements with certain executive officers. See "Management -- Compensation Pursuant to Plans and Other Arrangements -- Executive Employment Agreements" for a description of the Company's employment arrangements with Mr. Beggs. STOCK REPURCHASE AGREEMENTS. Certain officers, key employees of the Company and a former employee of the Company (collectively, the "Management Investors") are the beneficial owners of 90,426 Shares, not including 100,000 Shares held by Mr. Beggs pursuant to his Employment Agreement (the "Management Investors' Shares"). Such Shares were acquired in connection with the LBO pursuant to subscription agreements between the Company and such individuals (the "Subscription Agreements") or subsequently acquired as stock bonuses pursuant to the same Subscription Agreements. The Subscription Agreements provide that the Management Investors' Shares are subject to "put" options whereby the Company may be required to redeem such Shares at fair market value in the event of a Management Investor's death, disability, or termination of employment under certain circumstances, at the option of the Management Investor or his estate. Under certain circumstances, such Shares also are subject to "call" options whereby the Company, at its option, may purchase such Shares from a Management Investor at fair market value, so long as the Company has not effected a public offering of its common stock, in the event of either (i) a Management Investor's voluntary termination of employment on or before January 1, 1994, or (ii) a Management Investor's termination for cause (as defined). Due to the possibility of repurchase, such Management Investors' Shares were not considered to be part of the Company's stockholders' equity for periods prior to Fiscal 1993. The Subscription Agreements also grant to the Management Investors certain registration rights in the event that the Company (or, in certain circumstances, other investors in the Company) registers any common stock under the Securities Act. FULCRUM. In connection with the LBO, The Fulcrum III Limited Partnership and The Second Fulcrum III Limited Partnership (together, the "Fulcrum Partnerships"), purchased, after giving effect to the reverse stock split, 961,400 Shares pursuant to a stock subscription agreement with the Company (the "Fulcrum Stock Subscription Agreement") which provides that, under certain circumstances, the Company has a right of first refusal in the event of a proposed sale of such Shares by the Fulcrum Partnerships. The Fulcrum Subscription Agreement also grants to the Fulcrum Partnerships certain rights to demand the registration of their Shares and certain registration rights in the event that the Company (or, in certain circumstances, other investors in the Company) registers any common stock under the Securities Act. In addition, in connection with the Recapitalization, the Fulcrum Partnerships were issued Restructure Warrants to acquire up to an aggregate of 3,461,040 Shares. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a)(1) The following consolidated financial statements of Sealy Corporation and its subsidiaries are included in Part II, Item 8: Sealy Corporation Report of Independent Auditors Consolidated Balance Sheets at November 30, 1993 and 1992 Consolidated Statements of Operations for the ten months ended November 30, 1993 (Successor), the two months ended January 31, 1993, year ended November 30, 1992, one month ended November 30, 1991 (Pre-Successor), and the eleven months ended October 31, 1991 (Predecessor). Consolidated Statements of Stockholders' Equity for the ten months ended November 30, 1993 (Successor), the two months ended January 31, 1993, year ended November 30, 1992, one month ended November 30, 1991 (Pre-Successor), and the eleven months ended October 31, 1991 (Predecessor). Consolidated Statements of Cash Flows for the ten months ended November 30, 1993 (Successor), the two months ended January 31, 1993, year ended November 30, 1992, one month ended November 30, 1991 (Pre-Successor), and the eleven months ended October 31, 1991 (Predecessor). Notes to consolidated financial statements (a)(2) Financial Statement Schedules Schedule VIII -- Valuation Accounts Schedule X -- Supplementary Income Statement Information (b) The Company filed no reports on Form 8-K during the fourth quarter of its fiscal year ended November 30, 1993. (c) Exhibits: - -------------- * Management contract or compensatory plan or arrangement identified pursuant to Item 14(a) of this Form 10-K. SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934, SEALY CORPORATION HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED. SEALY CORPORATION Date: February 28, 1994 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 DATES INDICATED: SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 SCHEDULES TEN MONTHS ENDED NOVEMBER 30, 1993, TWO MONTHS ENDED JANUARY 31, 1993, YEAR ENDED NOVEMBER 30, 1992, ONE MONTH ENDED NOVEMBER 30, 1991, ELEVEN MONTHS ENDED OCTOBER 31, 1991 FORMING A PART OF ANNUAL REPORT PURSUANT TO THE SECURITIES EXCHANGE ACT OF 1934 FORM 10-K OF SEALY CORPORATION SEALY CORPORATION SCHEDULE VIII -- VALUATION ACCOUNTS SEALY CORPORATION SCHEDULE X -- SUPPLEMENTARY INCOME STATEMENT INFORMATION

1993 ITEM 1. BUSINESS Ashland Coal, Inc. (Ashland Coal or the Company) is engaged in the mining, processing, marketing and distribution of low-sulfur bituminous coal. The Company sells its coal primarily to electric utilities in the eastern United States. The Company also exports coal, primarily to European customers. Ashland Coal was incorporated in Delaware in 1975. The Company's consolidated results for 1993 were significantly affected by a selective strike by the United Mine Workers of America (UMWA) from May to December 1993 against the operations of two subsidiaries of the Company's Dal-Tex Coal Corporation subsidiary (Dal-Tex) and the operations of the Company's Hobet Mining, Inc. subsidiary (Hobet). These Dal-Tex subsidiaries (Dal-Tex Subsidiaries) and Hobet were signatories to the National Bituminous Coal Wage Agreement of 1988 (1988 Wage Agreement). For further information about the strike and the terms of its settlement, see "Employees" on page 4. The Company was engaged in preliminary discussions with Arch Mineral Corporation about a possible business combination of the two entities, but the parties terminated these discussions in mid-February 1994. For the year ended December 31, 1993, the Company and its independent operating subsidiaries sold approximately 16 million tons of coal, as compared to approximately 19.1 and 14.3 million tons sold in 1992 and 1991, respectively. Approximately 57% of the total number of tons sold during 1993 was sold under long-term contracts as compared to approximately 66% for 1992 and 67% for 1991. The balance was sold on the spot market (which includes contracts with a duration of one year or less). In 1993, the Company sold approximately 2.1 million tons of coal in the export market, compared to approximately 3.9 million tons in 1992 and 3.8 million tons in 1991. Approximately 61%, 71% and 71% of total revenues for 1993, 1992 and 1991, respectively, were derived from long-term contracts. For the year ended December 31, 1993, the Company's independent operating subsidiaries produced approximately 14.2 million tons of coal as compared to approximately 16.7 and 12.2 million tons for 1992 and 1991, respectively. In addition, the Company purchased for resale approximately 1.6 million tons of coal during 1993 and approximately 2.0 million tons of coal during each of 1992 and 1991. Selling prices in many of the Company's long-term coal sales contracts are adjusted for changes in broad price indices and labor costs, including wage rates and other benefits under the National Bituminous Coal Wage Agreement of 1993 (Wage Agreement) between the UMWA and the Bituminous Coal Operators' Association (BCOA), or any successor agreement. Some of these contracts also provide for price adjustment if certain federal and state levies on coal mining and processing are changed. In addition, most of the Company's long-term contracts provide that the customer may vary from the base annual quantity, usually by not more than 15%, the quantity of coal purchased under the contract in a particular year. In addition to customary adjustment provisions, in order to accommodate changing market or operational conditions, the renegotiation of coal sales contract terms after execution of the contract is not unusual in the industry. During 1993, the Company completed the renegotiation of three low-sulfur coal supply agreements with Appalachian Power Company (APCO), an operating subsidiary of the American Electric Power Company and two supply agreements with Consumers Power Company (Consumers). The coal under all the APCO contracts is for delivery principally to APCO's John E. Amos Plant in Putnam County, West Virginia. One APCO contract, which is supplied by Hobet, was to expire on September 30, 1998, but has now been extended to December 31, 2003. Under the original contract, approximately 1.1 million tons would have been shipped in 1994, and thereafter the tonnage was scheduled to decline each year until the contract's 1998 expiration. The amended contract calls for annual coal deliveries of 1.2 million tons beginning January 1, 1994, and continuing to December 31, 2003. It also provides for significant price reductions on January 1, 1994, July 1, 1994 and January 1, 1995. In addition, the price under a second APCO contract, which is supplied by Dal-Tex and expires on December 31, 1994, was reduced and will be reduced again on July 1, 1994. In connection with the foregoing price reductions, a third APCO contract, under which shipments from Dal-Tex are to begin on January 1, 1995, and which originally was to expire on December 31, 1999, has been extended through December 31, 2003. One Consumers contract, which is supplied by Dal-Tex, was renegotiated to decrease the annual tonnage from 1 million tons a year to 970,000 tons, and the price was reduced through December 31, 1994. Thereafter, the contract price returns to the price that was in effect before the reduction, as adjusted under the terms of the contract to December 31, 1994. The per ton price of a second Consumers contract was reduced pursuant to a price reopener provision. In addition, the parties amended the quality provisions and extended the term of this contract two years. The quantities deliverable under this contract did not change. The Company estimates that as of December 31, 1993, approximately 723 million recoverable tons of proven and probable coal reserves were held by the Company's subsidiaries in West Virginia and eastern Kentucky, of which approximately 276 million tons are recoverable using surface mining methods. A more detailed discussion of the Company's coal reserves is set forth below in Item 2. Item 2. PROPERTIES, Coal Reserves, on page 8. Based upon limited information obtained from preliminary prospecting, drilling and coal seam analysis, the Company estimates that a substantial portion of this coal has a sulfur content of 1 percent or less, some of which is compliance coal. Sulfur content of 1 percent or less refers to percentage by weight, while "compliance coal" is coal which emits 1.2 pounds or less of sulfur dioxide per million BTU upon combustion without the aid of sulfur reduction technology. OPERATIONS MINGO LOGAN COAL COMPANY Mingo Logan Coal Company (Mingo Logan), an independent operating subsidiary of the Company, conducts its operations in Mingo County, West Virginia, on approximately 20,600 acres containing approximately 110 million recoverable tons of low-sulfur and compliance coal. Mingo Logan's operations consist of surface mining operations conducted by two independent contract miners, four underground mines operated by two other independent contract miners, and a longwall mine (Mountaineer Mine) operated by Mingo Logan. Mingo Logan's Black Bear preparation plant has a plant feed capacity of 1,600 tons per hour, and is connected to the Mountaineer Mine by a 2-mile overland conveyor. The Black Bear preparation plant is connected to the loadout on the Norfolk Southern Railway Company (Norfolk Southern) railroad by a second overland conveyor that is approximately seven-tenths of a mile in length. The preparation plant, loadout and conveyors are located on land leased from Pocahontas Land Corporation, an affiliate of Norfolk Southern. The Black Bear preparation plant and loadout have silo storage capacity of approximately 19,500 tons of raw coal and approximately 24,000 tons of clean coal, respectively. In addition, the loadout has ground storage capacity of approximately 100,000 tons. The loadout facility is capable of loading a 13,000-ton unit train in less than four hours. Mingo Logan operations produced approximately 7 million tons of coal during 1993. DAL-TEX COAL CORPORATION Dal-Tex, an independent operating subsidiary of the Company, conducts its operations on approximately 22,000 acres of coal lands located primarily in Logan County, West Virginia, containing approximately 214 million tons of recoverable reserves of low-sulfur and compliance coal. Dal-Tex's operations currently consist of two surface mines operated by a Dal-Tex subsidiary using mountaintop removal techniques and three deep mines, two operated by a Dal-Tex subsidiary and one operated by a contract miner. At the surface mines, two 51-cubic-yard shovels and other large excavators are used for overburden removal. Continuous miner units are utilized in the deep mine operations. The Dal-Tex operations include the Monclo preparation plant located on the CSX Transportation (CSXT) rail system which is capable of a raw coal feed of 2,000 tons per hour. This plant is capable of loading a 14,000-ton unit train in less than four hours. Approximately 2.8 million tons of coal were produced at all of the Dal-Tex operations during 1993. HOBET MINING, INC. Hobet, an independent operating subsidiary of the Company, operates two large surface mines in southern West Virginia. The Hobet 21 mine in Boone County, West Virginia, currently has reserves dedicated to it of approximately 62 million recoverable tons of coal, of which 42 million tons are recoverable by surface mining. This mine uses mountaintop removal techniques and modern surface mining equipment, including a 72-cubic-yard walking dragline and a 51-cubic-yard shovel. The mine's operations include the 850-ton-per-hour Beth Station preparation plant. The Company expects to expand the raw coal handling and blending capabilities of this plant by late 1994 or early 1995. A 5-mile overland conveyor belt system transports the coal from the mine to the Beth Station preparation plant where the coal is cleaned and loaded into railcars at the adjacent 125-car rail siding for shipment on the CSXT rail system. The Beth Station preparation plant has a storage capacity in silos of 5,000 tons of raw coal and 10,000 tons of clean coal. The Hobet 21 mine produced about 1.5 million marketable tons of coal during 1993. A new underground mine with an initial production rate of 250,000 tons per year is planned to be opened at the Hobet 21 mine in the third quarter of 1994. The Hobet 07 mine, located in Mingo and Logan Counties, West Virginia, currently has reserves dedicated to it of approximately 42 million recoverable tons of coal. This mine uses mountaintop removal techniques and modern surface mining equipment including a 72-cubic-yard walking dragline and two 27-cubic-yard shovels. The mine's operations include the 950-ton-per-hour Pine Creek preparation plant. This plant has the capability of loading a 10,000-ton unit train in less than eight hours. Coal is loaded into railcars on the facility's 100-car rail siding, which is served by the CSXT rail system. The Pine Creek preparation plant has a storage capacity in silos of 10,000 tons of raw coal and 15,000 tons of clean coal. This mine produced about .8 million marketable tons of coal during 1993. It is currently anticipated that operations at the Hobet 07 mine will be suspended by the end of the decade based on current coal price and mining cost projections. See the Outlook section of Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS beginning on page 13 below. COAL-MAC, INC. Coal-Mac, Inc. (Coal-Mac), another independent operating subsidiary of the Company, conducts mining operations in eastern Kentucky. Coal-Mac and other subsidiaries of the Company control approximately 51 million recoverable tons of coal reserves in Johnson, Martin, Pike, and Floyd Counties, Kentucky. Coal-Mac operates surface mines and independent contractors operate underground mines in Floyd County, Kentucky. Total production from Coal-Mac's surface and underground operations during 1993 was approximately 2.0 million tons of coal. TRANSPORTATION Coal from the mines of the Company's independent operating subsidiaries is transported by rail, truck and barge to domestic customers and to inland waterway and Atlantic seaboard transloading facilities for shipment to international customers. During 1993, approximately 74% of the coal sold by the Company was shipped to the customer by rail, 21% was shipped by barge and 5% was shipped by truck. Tri-State Terminals, Inc., an independent operating subsidiary of the Company, operates the Lockwood Dock situated on a 60-acre tract on the Big Sandy River approximately seven miles upstream from its confluence with the Ohio River. The Lockwood Dock is comprised of a truck receiving and coal storage facility, a 1,400-ton-per-hour crushing and blending facility and a barge loading facility capable of loading a 1,500-ton barge every 70 minutes. In addition, coal sold through this facility may be loaded into trucks for delivery to customers. During 1993, 3.6 million tons of coal were loaded and shipped from the Lockwood Dock. Of this amount, 3.2 million tons were loaded and shipped for the Company's account and .4 million tons were loaded and shipped for third parties for a fee. The Company owns a 17.5 percent interest in Dominion Terminal Associates (DTA), which leases and operates a ground storage-to-vessel coal transloading facility (the DTA Facility) in Newport News, Virginia. The DTA Facility has a throughput capacity of 20 million tons of coal per year and ground storage capacity of approximately 1.7 million tons. During 1993, DTA loaded through the DTA Facility approximately 1.0 million tons of coal for the Company's account. The DTA Facility serves international customers, as well as domestic coal users located on the eastern seaboard of the United States. For additional information concerning the Company's investment in DTA, see Note 4 to the Company's Consolidated Financial Statements on page 27 below, and incorporated by reference in this Item 1. EMPLOYEES As of March 1, 1994, the Company and its independent operating subsidiaries employed a total of 1,687 people (including 24 part-time employees), of whom 772 are represented by the UMWA. Hobet and the Dal-Tex Subsidiaries were signatories to the 1988 Wage Agreement, which expired by its terms on February 1, 1993. On February 2, 1993, a selective strike was commenced by the UMWA against another coal company, which strike later expanded to other coal companies. The operations of the Company's independent operating subsidiaries were not interrupted by that strike, but pursuant to an agreement (Assistance Agreement) among members of the BCOA, Hobet and the Dal-Tex Subsidiaries made payments for the benefit of BCOA members that were struck. The selective strike ended and obligations in respect of such strike under the Assistance Agreement also ended on March 2, 1993, when the UMWA and BCOA agreed to extend the 1988 Wage Agreement to May 3, 1993. However, on May 18, 1993, each of Hobet and the Dal-Tex Subsidiaries were struck by the UMWA. On December 16, 1993, union miners returned to work at the mines of Hobet and the Dal-Tex Subsidiaries following ratification of the Wage Agreement on December 14, 1993. The Wage Agreement provides for a total wage increase of $1.30 per hour over the first three years of the contract, changes in medical coverage providing for deductibles and copayments, more flexible work rules that will permit coal production to take place 24 hours a day and seven days a week, increases in employer contributions to an education and retraining fund, and employer contributions to fund the new Labor Management Positive Change Program and the new 1993 Benefit Fund created by the Wage Agreement. The contract provisions of the Wage Agreement applicable to wages, pensions and medical benefits are fixed for the first three years of the contract, but thereafter wages and pension benefits are subject to renegotiation at the UMWA's election and certain provisions of the medical plan are subject to renegotiation at either the UMWA's or the BCOA's election. The Labor Management Positive Change Program mandated by the Wage Agreement establishes a board comprised of union and management representatives to explore methods of increasing productivity and efficiency. In connection with the Wage Agreement, the UMWA and BCOA also entered into a Memorandum of Understanding that requires that certain jobs at mines of Ashland Coal's nonunion subsidiaries be offered to UMWA miners under the following conditions. At any existing, new or newly acquired operation of a nonunion subsidiary of Ashland Coal, the subsidiary must offer the first three of every five job openings for certain jobs to active and laid-off employees of any union subsidiary. The first two jobs must be filled from among the senior laid-off and active miners of any union subsidiary of the Company provided such miners have the ability to step in and perform the job at the time the job is awarded. The third job must be filled with the senior laid-off or active miner of any union subsidiary provided such miner has the ability to step in and perform the work of the job at the time the job is awarded and has actually performed the job within the last three years. The final two out of five jobs may be filled from any source at the sole discretion of the nonunion subsidiary's management. Similarly, Ashland Coal's nonunion coal mining subsidiaries must require certain of their lessees, licensees, contractors and subcontractors that are engaged after the date of execution of the Memorandum of Understanding to offer the first three of every five job openings for certain jobs to active and laid-off UMWA-represented employees at any Ashland Coal union subsidiary. Generally, this requirement applies only where both (i) the lessees, licensees, contractors and subcontractors produce and process coal for the nonunion subsidiaries and (ii) the coal is sold by the nonunion subsidiaries. Ashland Coal's union subsidiaries do not currently have any laid-off union workers. Finally, the Memorandum of Understanding prohibits Ashland Coal and its nonunion subsidiaries from engaging in any transaction, restructuring or reorganization for the purpose of evading obligations under the Memorandum of Understanding. For additional discussion, see Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS beginning below on page 11. The Company believes that the provisions of the Wage Agreement and the Memorandum of Understanding, taken as a whole, will not significantly change the costs experienced under the 1988 Wage Agreement. REGULATIONS AFFECTING COAL MINING Coal mining is subject to strict regulation by federal, state and local authorities, including, most significantly, with respect to permitting and environmental matters and health and safety matters. PERMITTING AND ENVIRONMENTAL MATTERS Numerous permits are required for mining operations. The Company believes all permits required to conduct present mining operations have been obtained. The Company believes that, upon the filing of the required information with the appropriate regulatory agencies, all permits necessary for continuing operations will be obtained. The federal Surface Mining Control and Reclamation Act of 1977 (SMCRA) was enacted to regulate certain surface mining of coal and the surface effects of underground mining. Kentucky and West Virginia have similar laws and regulations regulating surface and deep mining that impose, among other requirements, reclamation and environmental requirements and standards. The federal Clean Water Act affects coal mining operations by imposing effluent discharge restrictions on pollutants discharged into waters. Kentucky and West Virginia also have laws restricting discharges of pollutants into the waters of those states. In addition, the United States Environmental Protection Agency (EPA) has permitting requirements for storm water discharges from industrial facilities. These regulations require permits for some aspects of mining operations. Regular monitoring, as well as compliance with reporting requirements and performance standards, are preconditions for the issuance and renewal of permits governing the discharge of pollutants into waters. Further, as a result of a recent court decision, mining operations may be subject to Clean Water Act regulations for discharges into some ponds created to treat coal mining wastes. Previously, these ponds were not considered waters regulated by the Clean Water Act. Kentucky and West Virginia are also developing groundwater protection programs, but such programs have not been implemented and consequently the effect such programs may have on coal mining operations is unclear. The federal Resource Conservation and Recovery Act (RCRA) and implementing federal regulations exclude from the definition of hazardous waste all coal extraction, beneficiation and processing wastes. Additionally, other coal mining wastes which are subject to a SMCRA permit are exempt from RCRA permits and standards. Kentucky and West Virginia similarly exempt coal mine waste from their respective state hazardous waste laws and regulations. The federal Comprehensive Environmental Response, Compensation and Liability Act, as amended by the Superfund Amendments and Reauthorization Act, affects coal mining operations by imposing a cleanup requirement for threatened or actual releases of hazardous substances, other than the foregoing exempted hazardous waste, that may endanger public health or welfare or the environment. The federal Clean Air Act, as amended in 1990, imposes numerous requirements on various categories of emission sources. While the new statutory requirements do not directly impose new requirements on coal mining emission sources, it is possible that the EPA will implement the statute in a way that will impose additional regulatory requirements on industry sources including a duty to obtain an operating permit not previously required. The EPA previously published rules which do not require coal mines to include fugitive emissions in determining the applicability of the Clean Air Act's Prevention of Significant Deterioration Program. Although this rule was challenged, the rule was upheld and no appeal to the decision was filed. In addition, West Virginia state air regulations impose permitting obligations and performance standards on certain coal preparation plants and coal handling facilities such as crushers and screeners. HEALTH AND SAFETY MATTERS The federal Mine Safety and Health Act of 1977 imposes health and safety standards on all mining operations. Regulations are comprehensive and affect numerous aspects of mining operations, including training of mine personnel, mining procedures, blasting and the equipment used in mining operations. The Black Lung Benefits Reform Act of 1977 generally requires each coal mine operator to secure payment of federal and state black lung benefits to its employees through insurance, bonds or contributions to a state-controlled fund. The Black Lung Benefits Reform Act of 1977 also provides for the payment from a trust fund of benefits and medical expenses to employees for whom no benefits have been obtainable from their employer. This trust is financed by a tax on coal sales. The Coal Industry Retiree Health Benefit Act of 1992 (Benefit Act) addressed two underfunded trust funds which were to provide medical benefits for certain UMWA retirees. The Benefit Act provides for the funding of medical and death benefits for certain retired members of the UMWA through premiums to be paid by assigned operators (former employers), transfers of monies from an overfunded pension trust established for the benefit of retired UMWA members, and transfers from the Abandoned Mine Lands Fund, which is funded by a federal tax on coal production. This funding arrangement commenced February 1, 1993. Some former employers have filed suits challenging the constitutionality of the Benefit Act, but the eventual outcome of such litigation is uncertain. COMPLIANCE WITH REGULATORY REQUIREMENTS AND EXISTING ENVIRONMENTAL LIABILITY The Company's independent operating subsidiaries endeavor to conduct their operations in compliance with all applicable federal, state and local laws and regulations. However, because of the extensive and comprehensive regulatory requirements, violations during mining operations are not unusual in the industry. Mingo Logan and Dal-Tex are each a party to civil proceedings as a result of alleged failures to comply with mandatory federal or state health and safety regulations. Each of these proceedings involves a fatality and could result in the imposition of civil penalties. The Company believes that any adverse result, if incurred, would not have a material adverse effect on the Company's consolidated financial condition, results of operations or liquidity. Hobet, Sharples Coal Company, which is a subsidiary of Dal-Tex, Mingo Logan and other unrelated coal mining companies, individually, are parties to a civil proceeding with respect to the alleged failure of each of them to handle a respirable dust sampling cassette in accordance with regulations of the Mine Safety and Health Administration. Violations of federal and state health and safety regulations can result in civil and criminal penalties. To date, the monetary penalties assessed in respect of violations of these regulations have not been material and the Company does not anticipate that future assessments in respect of violations to date will be material to the Company's financial condition, results of operations or liquidity. Mingo Logan is a party to civil and administrative proceedings brought by owners of commercial surface property overlying part of Mingo Logan's Mountaineer Mine. These proceedings seek revocation of mining permits for the Mountaineer Mine and seek damages for alleged business disruptions and loss of a water well. It is unlikely that Mingo Logan's mining permits will be revoked as a result of these proceedings. It is impossible to predict the outcome of the damage claim at this stage of the proceedings, but any adverse result, if incurred, is not expected to have a material adverse effect on the Company's consolidated financial condition, results of operations or liquidity. The Company is not aware of any existing conditions on property in which it has an ownership or other interest that would give rise to material liability under federal, state and local environmental laws, regulations or ordinances. The Company believes that continued compliance with regulatory standards will not substantially affect its ability to compete with similarly situated coal mining companies. The cost of regulatory compliance, however, frequently increases the cost of mining coal and to this extent makes coal less competitive with alternative fuels. TRADEMARKS AND TRADENAMES Under an agreement executed in 1993, Ashland Oil, Inc. (Ashland Oil) granted the Company permission to continue using the Ashland name on a year to year basis after August 11, 1993, absent written notice from Ashland Oil to cease using the name at the end of the then applicable one year period. The Company also is permitted to use Ashland trademarks until July 1, 1994. If Ashland Oil's ownership in the Company ever falls below 35%, Ashland Oil may require the Company to remove the name Ashland from the Company's and its subsidiaries' names. RELIANCE ON MAJOR CUSTOMERS The Company's total sales to subsidiaries of American Electric Power Company and Cincinnati Gas & Electric Company accounted for approximately 20 and 16 percent, respectively, of the Company's total revenues in 1993. The loss of these customers could have a material adverse effect on the Company's business and results of operations. COMPETITION The coal industry is highly competitive, and the Company competes (principally in price, location and quality of coal) with a large number of other coal producers, some of which are substantially larger and have greater financial resources and larger reserve bases than the Company. Most long-term supply agreements and spot market orders are the result of competitive bidding. Coal also competes with other energy sources such as oil, natural gas, hydropower and nuclear energy for steam and electrical power generation. Over time, the cost and other factors, such as safety and environmental considerations, relating to these alternative fuels will affect the overall demand for coal as a fuel. ITEM 2. PROPERTIES As of December 31, 1993, the Company's subsidiaries controlled, primarily through long-term leases, approximately 130,604 and 114,581 acres of coal lands in West Virginia and eastern Kentucky, respectively. The Company's subsidiaries also control through ownership or long-term leases 917 acres of land in eastern Kentucky and West Virginia, which are used either for its coal processing facilities or are being held for possible future development. The Pine Creek, Beth Station and Black Bear preparation plants are located on properties held under leases which expire in 2030, 2022 and 2007 (with an optional 20-year extension), respectively. The Company's headquarters occupy approximately 52,000 square feet of leased space at 2205 Fifth Street Road, Huntington, West Virginia. The headquarters lease expires March 31, 1998. The descriptions of the Mingo Logan, Dal-Tex, Hobet and Coal-Mac mines set forth above in Item 1. BUSINESS are hereby incorporated into this Item 2. by reference. The Company's subsidiaries currently own or lease the equipment that is significant to their mining operations. Hobet leases equipment under leases that expire in 2003 and 1995. Hobet and Dal-Tex also utilize surface mining equipment leased pursuant to a sale and leaseback transaction entered into in January 1993. The lease term expires in January 1996. For further information about this 1993 transaction see Note 18 to the Company's Consolidated Financial Statements on page 36 below. The Company, through its subsidiaries, owns a 17.5 percent interest in DTA, which is the lessee and operator of a ground storage-to-vessel coal transloading facility at Newport News, Virginia (see Item 1. BUSINESS -- Transportation). COAL RESERVES The Company estimates that Company subsidiaries had, as of December 31, 1993, approximately 723 million recoverable tons of proven and probable coal reserves. Reserve totals vary from year to year for each Company subsidiary depending upon the amount of coal mined in any year, the acquisition and disposition of reserves in such year and exploration and development activity. The following table presents the Company's estimate of such reserves: RECOVERABLE COAL Substantially all of the coal reserves held by the Company's subsidiaries are controlled by leases which will not expire until the exhaustion of minable and merchantable coal. The remaining leases have primary terms expiring in various years ranging from 1994 to 2013, and most contain options to renew for stated periods. Royalties are paid to lessors either as a fixed price per ton or as a percentage of the gross sales price of the mined coal. The majority of the significant leases are on a percentage royalty basis. In certain cases a lease bonus is required, payable either at the time of execution of the lease or in annual installments following such execution. In most cases, the lease bonus amount is applied to reduce future production royalties. Subsidiaries of the Company own, lease or control 28,679 acres of coal lands upon which exploration has not been conducted. Federal and state legislation controlling air pollution affects the demand for certain types of coal by limiting the amount of sulfur dioxide which may be emitted as a result of fuel combustion and, thereby, encourages a greater demand for low-sulfur coal. Based upon limited information obtained from preliminary prospecting, drilling and coal seam analysis, the Company estimates that a substantial portion of the reserves held by Company subsidiaries consists of low-sulfur coal with a sulfur content of 1 percent or less, some of which is compliance coal. Most of the Company's reserves are primarily suitable for the steam coal markets. However, a substantial portion of the coal reserves at Mingo Logan may also be used as a high-volatile, low-sulfur metallurgical grade coal. The net book value, based on historical cost, of such mineral reserves at December 31, 1993, was $460 million, consisting of $15 million of prepaid royalties included in current assets, $54 million of prepaid royalties classified as an other asset and $391 million net book value of coal lands and mineral rights. Of this carrying value, approximately $31 million is attributable to certain reserves which are not currently in production and for which there are no current plans for significant production. In addition, as of December 31, 1993, future royalty commitments relating to these properties were approximately $3 million. See Note 6 to the Company's Consolidated Financial Statements beginning on Page 28 below and incorporated by reference in this Item 2. Consistent with industry practice, a limited investigation of title to coal properties is conducted prior to leasing. The titles of the lessors or grantors and the boundaries of leased properties are not completely verified until such time as the Company's independent operating subsidiaries prepare to mine such reserves. If defects in title or boundaries of undeveloped reserves are discovered in the future, control of and the right to mine such reserves could be adversely affected. ITEM 3. ITEM 3. LEGAL PROCEEDINGS There is a pending suit in Circuit Court for Mingo County, West Virginia, filed September 3, 1993, by the administrator of an estate of a deceased employee of Mingo Logan. The employee died in an accident involving the longwall mining equipment at the Mountaineer Mine. The suit is based on product liability, breach of warranty, and negligence claims against Mingo Logan and other unrelated defendants, including the equipment manufacturer, and alleges compensatory and punitive damages of $45 million. Mingo Logan denies responsibility for the accident and the Company believes that the claim will not have a material adverse effect on its financial condition, results of operations or liquidity. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There were no matters submitted to a vote of security holders of the Company through the solicitation of proxies or otherwise during the fourth quarter of 1993. ITEM X. EXECUTIVE OFFICERS OF THE REGISTRANT The following is a list of the Company's executive officers, their ages and their positions and offices held during the last five years (Senior Vice Presidents are listed alphabetically): WILLIAM C. PAYNE, 61, is Chairman of the Board of Directors, and President and Chief Executive Officer, and has served in such capacities since 1992 and 1987, respectively. He has served as a Director since 1987. C. HENRY BESTEN, JR., 46, is Senior Vice President, Marketing, and has served in this capacity since July 1990. From 1987 to 1990, he served as Administrative Vice President, Administration and Coal Resources. MARC R. SOLOCHEK, 48, is Senior Vice President and Chief Financial Officer and has served in these capacities since July 1990. From 1983 to 1990, he served as Administrative Vice President and Chief Financial Officer and from 1983 to 1992, he served as Treasurer. KENNETH G. WOODRING, 44, is Senior Vice President, Operations, and has served in this capacity since 1989. ROY F. LAYMAN, 48, is Administrative Vice President, Law and Human Resources, and Secretary, and has served in these capacities since April 1993. From 1987 to 1990, he served as Vice President, General Counsel and Secretary and from July 1990 to April 1993 he served as Administrative Vice President, General Counsel and Secretary. PART II. ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's par value $.01 Common Stock (Common Stock) is listed and traded on the New York Stock Exchange and also has unlisted trading privileges on the Chicago Stock Exchange (symbol: ACI). Information regarding the Company's Common Stock is shown in the following table. The Company paid its first quarterly dividend in the fourth quarter of 1988. The Company increased its dividend in the fourth quarter of 1989 and the third quarter of 1990. The Company expects to continue paying regular cash dividends, although there is no assurance as to the amount or payment of dividends in the future because they are dependent on the Company's future earnings, capital requirements and financial condition. In addition, the payment of dividends is subject to the restriction described in Note 7 to the Company's Consolidated Financial Statements below on Page 29. Information available as of February 16, 1994, indicates that there were 579 holders of record of the Company's Common Stock. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA FIVE-YEAR SELECTED FINANCIAL INFORMATION ASHLAND COAL, INC. AND SUBSIDIARIES ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS MANAGEMENT'S DISCUSSION AND ANALYSIS RESULTS OF OPERATIONS 1993 COMPARED TO 1992 Ashland Coal's earnings for the year ended December 31, 1993, were $45.4 million before adjustments for the cumulative effect of the changes in accounting required by the adoption of Statement of Financial Accounting Standards (SFAS) No. 106, EMPLOYERS' ACCOUNTING FOR POSTRETIREMENT BENEFITS OTHER THAN PENSIONS, and SFAS No. 109, ACCOUNTING FOR INCOME TAXES. This compares to net income of $35.7 million in 1992. After the cumulative effect of changes in accounting, net income for 1993 was $26.5 million. With the adoption of SFAS No. 106 effective January 1, 1993, Ashland Coal (the Company) immediately recognized an accumulated postretirement benefit obligation of $40.9 million ($25.3 million net of tax), which decreased income by the same amount. The adoption of SFAS No. 109, effective the same date, required the adjustment of the carrying value of certain assets, which had been acquired in prior business combinations, to their pretax amounts. That adjustment increased income by $10.5 million ($6.5 million net of tax). The net-of-tax amounts are reflected in the consolidated income statement as the cumulative effect of changes in accounting. Exclusive of the cumulative effect of changes in accounting, the combined effect of the adoption of SFAS No. 106 and SFAS No. 109 on income before income taxes and net income for 1993 was a decrease of $8.6 million and $5.3 million, respectively. In addition to the accounting changes discussed above, three other factors significantly affected earnings during 1993. First, there was an income tax benefit of $50.2 million principally as a result of the Company's election to deduct for federal tax purposes the amortization of goodwill associated with the April 1992 acquisition of Dal-Tex Coal Corporation. This amortization was not previously deductible, however the deduction is now permitted over 15 years as a result of the Omnibus Budget Reconciliation Act of 1993 (OBRA). The second factor was a special charge of $9.9 million ($6.0 million after tax) to increase the valuation allowance for certain prepaid royalties. The mineral reserves represented by those royalties are not conducive to large-scale, low-cost mining, and, given the Company's current expectations for future market prices for coal, the Company now believes that the recoverability of those royalties is doubtful. Finally, the seven-month strike by the United Mine Workers of America (UMWA) against Hobet Mining, Inc. and two subsidiaries of Dal-Tex adversely affected the operations of those companies and, therefore, consolidated net income. The strike ended December 16, 1993, with the ratification of a new five-year contract. Coal sales volume of 16.0 million tons and coal sales revenue of $484.4 million declined from 1992's levels by 3.0 million tons and $79.5 million, respectively. Sales volume and revenue were positively affected by the presence of Dal-Tex for the full year in 1993, as compared to nine months in 1992, and by increased production from the Mountaineer longwall mine of Mingo Logan Coal Company. These positive factors, however, were more than offset by the negative effects of the UMWA strike during the last three quarters of 1993. The average selling price increased $.65 per ton primarily because of strike-related higher selling prices in the spot market. The unit cost of coal sold increased $2.79 per ton because of the effects of the UMWA strike, the special charge relative to prepaid royalties, and the effects of the adoption of the new accounting standards. In addition, early in the year, Dal-Tex experienced a higher than normal level of equipment failures, and Mingo Logan's longwall mine operated in difficult mining conditions with resultant unfavorable costs. Selling, general, and administrative expenses increased $3.8 million primarily because of a full year's amortization of the carrying value of one of Dal-Tex's sales contracts, higher costs for salaries, payroll taxes, and benefits (including the effect of SFAS No. 106), and costs related to the investigation of a possible business combination with Arch Mineral Corporation. The Company and Arch terminated their discussions regarding such a combination in mid-February 1994. Interest expense increased $3.6 million over 1992 largely due to the discontinuation of the capitalization of construction period interest after the start-up of Mingo Logan's longwall equipment late in 1992. The income tax benefit recorded in 1993 was a result of OBRA and decreases in profitability coupled with higher percentage depletion relative to income. The Company's effective tax rate is sensitive to changes in profitability because of the effect of percentage depletion. 1992 COMPARED TO 1991 Ashland Coal's net income for the year ended December 31, 1992, was $35.7 million compared to $38.6 million in 1991, a decrease of $2.9 million, or 7.5 percent. Coal sales volume of 19.1 million tons and coal sales revenue of $563.9 million in 1992 were above 1991's levels by 4.8 million tons and $133.6 million, respectively. The acquisition of Dal-Tex on April 1, 1992, and expanded production from the mines at Mingo Logan were the major contributors to the increase in coal sales volume and revenue. Partially offsetting these contributions were declines in sales volume and revenue at Coal-Mac, Inc. The average selling price declined from 1991's level as the result of the lower average selling prices of the Dal-Tex sales agreements and weakness in the domestic spot and export markets, partially offset by an increase in the proportion of shipments to higher-priced domestic contract customers. The unit cost of coal sold increased slightly during 1992, reflecting less favorable mining conditions and consequent higher costs at the mines of Hobet. This increase was partially offset by the addition of low-cost production at Dal-Tex and the continued expansion of low-cost production at Mingo Logan. Selling, general, and administrative expenses increased $8.6 million, primarily due to $7.6 million in amortization of the carrying value of one of Dal-Tex's sales contracts. Interest expense increased $11.9 million over 1991 due to the higher level of debt resulting from the Dal-Tex acquisition and the development expenditures at Mingo Logan and due to lower amounts of construction period interest being capitalized. The effective tax rate for 1992 was significantly below 1991's rate. This decrease resulted from a decrease in profitability in 1992, the effects of the Dal-Tex acquisition, and higher percentage depletion at Mingo Logan. The acquisition of Dal-Tex had a significant beneficial impact on operating income, leading to a significant increase in percentage depletion. However, due to the interest expense incurred in funding the acquisition, income before income taxes was affected only moderately by the acquisition. BALANCE SHEET Cash equivalents declined from $37.0 million at December 31, 1992, to zero at the end of 1993. Late in 1992, Ashland Coal borrowed funds in excess of its immediate needs in order to improve liquidity in early 1993. These borrowings were repaid in February 1993. Subsequently, the Company again borrowed additional funds and maintained those funds as cash equivalents in order to be assured of adequate liquidity during the course of the strike by the UMWA. Those cash equivalents were utilized to repay borrowings at the conclusion of the strike. The balance of trade accounts receivable at December 31, 1993, declined $21.3 million from the balance at December 31, 1992. Ashland Coal's trade accounts receivable balance generally represents four to five weeks of coal sales, dependent upon the specific customer accounts and payment terms thereon. The balances of trade receivables at December 31, 1992, and December 31, 1993, reflect the levels of coal sales in December 1992 and December 1993, respectively. Coal sales in December 1993 were markedly lower because of the strike by the UMWA and its aftereffects. Inventories at December 31, 1993, were $2.2 million less than at December 31, 1992, principally as the result of lower inventories of coal. Coal inventories declined $4.0 million because stockpiles were drawn down during the strike. This decrease was partially offset, however, by an increase in supplies inventories of $1.8 million, primarily at Mingo Logan. The latter increase reflects a buildup during 1993 of parts and supplies in support of the fully developed longwall mine and, to a lesser extent, as a precaution against interruptions in the delivery of supplies during the strike. Because of the strike by the UMWA, prepaid royalties which are typically recovered in the normal course of mining each year were not fully recovered in 1993. This has resulted in temporarily higher current prepaid balances, but is not expected to affect the ultimate recoverability of these royalties. The balance of accounts payable declined $7.3 million from the balance at December 31, 1992, to $27.3 million at December 31, 1993. Purchases of goods and services were reduced during the strike, and deliveries of goods and services had not reached normal levels by the end of the year. Accrued expenses changed little largely because production had resumed at the struck mines, and accrued compensation was therefore at a normal level by the end of the year. The balance of the net deferred income tax liability at December 31, 1993, declined $86.6 million from the balance at December 31, 1992. This change arose principally as a result of tax law changes contained in OBRA (discussed above), which accounted for $50.2 million of the reduction, and the adoption of SFAS No. 106, which caused Ashland Coal to record a $15.5 million deferred tax asset related to the immediate recognition of the accumulated postretirement benefit obligation. In 1988, Ashland Coal and the holder of Ashland Coal's convertible Class C preferred stock entered into an agreement granting the holder the right to require, during the thirty-day period beginning August 18, 1993, Ashland Coal to purchase all the Class C shares. The holder did not exercise its put during the specified period, and all rights under the put have expired. The convertible Class C preferred stock has therefore been classified as an element of stockholders' equity in the December 31, 1993, balance sheet rather than outside stockholders' equity as was done at December 31, 1992. OUTLOOK The Company's 1994 results of operations will be adversely affected by the first-quarter aftereffects of the UMWA strike, which was settled late in 1993, and severe weather conditions. The severe winter weather experienced in early 1994 has had a significant adverse effect on the Company's mining and processing operations. In addition, the severe weather has adversely affected both rail and barge movements of coal. The combination of these factors will likely result in reduced volumes and increased costs in the first quarter of 1994. The Company expects that earnings for the first quarter will be approximately break-even. For the full year of 1994, Ashland Coal believes that average cost per ton will approximate the 1992 level. With higher sales volume than in 1993 and resultant lower fixed costs per ton, the Company expects operating income in 1994 to improve significantly over 1993's level. Since the settlement of the UMWA strike, spot market prices have fallen, but have remained above the level that prevailed prior to the strike. The combination of low utility inventories and severe weather is having a positive impact on current spot market prices. In addition, the demand for low-sulfur coal should continue to increase as the economy grows and as the effective date of the Clean Air Act amendments approaches. Sales to a major contract customer are expected to be above normal levels during 1994 as shortfalls in shipments that were scheduled for the strike-affected period are made up. The price on these contract sales is above the Company's average selling price. The Company has completed negotiations with two customers, including the Company's largest customer, concerning the price, extension of the term, and the quality and quantity of future deliveries under existing coal sales contracts with these customers. These new agreements will result in reduced coal sales revenues and cash flow in 1994. A substantial part of these decreases will be offset by additional sales volumes in later years. In addition, adjustments will be made in the rates of amortization of the carrying value of certain of these contracts, reducing amortization expense in 1994. Contracts with another major customer are expected to expire at the end of 1995, but could be renegotiated prior to then, based on current market prices. Because these contracts are priced above current market prices, these expirations will have a significant effect on earnings in 1996 and subsequent years. During 1993, export sales by Ashland Coal declined to 2.1 million tons from 3.9 million tons in 1992 because of weakness in the European economy and increased competition from both other fuels and other exporting countries. Because of strike-related factors in the domestic market, this decline had little effect on 1993's results of operations. The Company expects its export sales to show gradual growth from 1993 levels, but does not expect that export sales will have any significant effect on its results of operations. Also in 1993, the Company sold 1.6 million tons of metallurgical coal, which is used in the manufacture of steel. Although metallurgical coal ordinarily results in somewhat better profitability than similar sales of steam coal sold to electric utilities, Ashland Coal does not expect that sales of metallurgical coal will become a significant part of its total marketing strategy. Both export and metallurgical coal sales do, however, enhance Ashland Coal's market flexibility. The Company does not now expect that coal prices will be as high during the remainder of this decade as was anticipated in the mid-1980's, when the dragline development at Hobet 07 commenced. To compensate for these expected lower prices, it may be necessary, if costs at Hobet's 07 mine are not reduced, for Hobet to suspend operations at such mine by the end of the decade. In addition, costs are expected to be reduced by an expansion of the Hobet 21 mine. This expansion is expected to include the development of contract underground mines beginning in 1994, the construction of a raw coal handling and blending facility in 1994, and expansion of the preparation plant in 1995. The National Bituminous Coal Wage Agreement of 1993, which covers the UMWA employees of Hobet and of Dal-Tex's subsidiaries, provides for wage increases totaling $1.30 per hour over the first three years, changes in the health care plan intended to reduce costs, and improvements in work rules. Wage levels are subject to renegotiation after both the third and fourth years of the contract. In connection with the Agreement, a Memorandum of Understanding was entered into that provides for positions at mines of Ashland Coal's nonunion subsidiaries to be offered to UMWA miners under certain conditions. The Company believes that the provisions of the new Agreement and the Memorandum, taken as a whole, will not significantly change the costs experienced under the prior agreement. LIQUIDITY AND CAPITAL RESOURCES The following is a summary of cash provided by or used in each of the indicated types of activities during the past three years. Cash provided by operating activities before changes in operating assets and liabilities decreased in 1993 from 1992 primarily because of reduced sales volume resulting from the strike by the UMWA. Cash provided by operating activities before changes in operating assets and liabilities increased in 1992 from 1991 primarily because of increases in sales volume that resulted from the April 1992 acquisition of Dal-Tex and expanded operations at Mingo Logan. The reduction in 1993 from 1992 in cash used for changes in operating assets and liabilities primarily resulted from a reduction in accounts receivable balances during 1993, principally as a result of the UMWA strike. The significant increase in 1992 compared to 1991 in cash used for changes in operating assets and liabilities reflects higher accounts receivable balances, primarily because of the addition of Dal-Tex and the expansion of operations at Mingo Logan, and higher expenditures for prepaid royalties, primarily because of required payments under a lease held by Dal-Tex. Cash provided by investing activities in 1993 resulted from the sale and leaseback of certain mining equipment (discussed below). Cash used in investing activities in 1992 reflects the acquisition of Dal-Tex and construction activity at Mingo Logan. Cash used during 1991 for investing activities was primarily for construction activity at Mingo Logan. Cash used in financing activities in 1993 chiefly represents payments of $141.4 million on long-term borrowings from cash provided by the sale and leaseback of mining equipment, the liquidation of cash equivalents, and cash provided by operating activities. Cash provided by financing activities during 1992 and 1991 represents the proceeds of borrowings (and the sale of common stock in 1992) for the purpose of funding the 1992 Dal-Tex acquisition and capital expenditures not funded by cash provided by operating activities. The Company's capital expenditures during 1993 were $20.6 million, which was $76.6 million lower than in 1992. Expenditures for 1992 included $55 million related to the development of the Mingo Logan mine complex, which was completed in 1992. During 1993, the Company deferred some planned capital expenditures until 1994 to the extent possible in order to improve liquidity during the UMWA strike and in advance of the potential exercise of the put on convertible Class C preferred stock. Ashland Coal estimates that during 1994 capital expenditures will be approximately $65 million, including $11 million for the construction of a raw coal handling and blending facility at Hobet 21. On January 29, 1993, mining equipment valued at approximately $64 million being used by Dal-Tex and Hobet was sold and leased back under an operating lease. The sale and leaseback of this equipment gives Ashland Coal additional liquidity under its revolving credit agreement with little impact on financial results. The Company is no longer pursuing an agreement with a bank which would have allowed for sales of up to $35 million of trade accounts receivable at any given time. Ashland Coal has a revolving credit agreement with a group of banks providing for borrowings of up to $215 million, of which $50 million was borrowed at December 31, 1993. This commitment will be reduced in each calendar quarter until termination in 1997. The Company has $175 million of indebtedness under senior unsecured notes maturing in 1996 through 2006. Ashland Coal also periodically establishes uncommitted lines of credit with banks. These agreements generally provide for short-term borrowings at market rates. At December 31, 1993, there were $222.9 million of such agreements in effect with $56.3 million of indebtedness under these agreements. Of that amount, $19.3 million was classified as long-term debt, because Ashland Coal has the intent to maintain these borrowings on a long-term basis and the ability to do so through the use of the revolving credit agreement. The Company expects to repay the remaining $37 million of indebtedness under these lines of credit during 1994 and, accordingly, that amount was included in the current portion of long-term debt at December 31, 1993. The Company expects 1994 cash flow provided by operating activities to increase significantly from 1993 as a result of the conclusion of the UMWA strike and anticipated higher sales by Hobet and Dal-Tex during 1994. Ashland Coal believes that 1994 cash flow generated by operating activities will be adequate to fund anticipated capital expenditures and make the discretionary debt prepayments discussed above. Over the longer term, Ashland Coal believes that cash flow from operations will be adequate to fund anticipated capital expenditures, to make discretionary debt prepayments on indebtedness under lines of credit and the revolving credit agreement, and to pay scheduled debt maturities and other commitments when due. CONTINGENCIES Under the 1977 Surface Mining Control and Reclamation Act, a mine operator is responsible for postmining reclamation on every mine for at least five years after the mine is closed. Ashland Coal performs a substantial amount of reclamation of disturbed acreage as an integral part of its normal mining process. All such costs are expensed as incurred. The remaining costs of reclamation are estimated and accrued as mining progresses. The accrual for such reclamation (included in other long-term liabilities and in accrued expenses) was $2.5 million and $3.0 million at December 31, 1993 and 1992, respectively. In addition, the Company accrues the costs of removal at the conclusion of mining of roads, preparation plants, and other facilities and other costs (closing costs) over the lives of the various mines. Closing costs, in the aggregate, are estimated to be approximately $46.0 million. At December 31, 1993 and 1992, the accrual for closing costs, which is included in other long-term liabilities and in accrued expenses, was $4.7 million and $3.9 million, respectively. Ashland Coal is a party to numerous claims and lawsuits with respect to various matters, such as personal injury claims, claims for property damage, and claims by lessors, that are typical of the sorts of claims encountered in the coal industry. The Company provides for costs related to contingencies when a loss is probable and the amount is reasonably determinable. The Company estimates that its probable aggregate loss as a result of such claims is $4.6 million (included in other long-term liabilities) and believes that probable insurance recoveries of $3.9 million (included in other assets) related to these claims will be realized. The Company estimates that its reasonably possible aggregate losses from all currently pending litigation could be as much as $5.5 million (before tax) in excess of the probable loss previously recognized. However, the Company believes it is probable that substantially all of such losses, if any occur, will be insured. After conferring with counsel, it is the opinion of management that the ultimate resolution of these claims, to the extent not previously provided for, will not have a material adverse effect on the consolidated financial condition, results of operations, or liquidity of the Company. Ashland Coal has claims outstanding against a construction contractor for business interruption losses sustained by the Company when a coal silo failed and a second silo was unavailable during repairs. Recoveries under these claims are not expected to be material. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEX TO FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA REPORT OF INDEPENDENT AUDITORS To the Stockholders and Board of Directors Ashland Coal, Inc. We have audited the accompanying consolidated balance sheets of Ashland Coal, Inc. and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules 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 consolidated financial position of Ashland Coal, Inc. and subsidiaries at December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note 1 to the consolidated financial statements, effective January 1, 1993, the Company changed its methods of accounting for income taxes and for postretirement benefits other than pensions. /s/ ERNST & YOUNG Louisville, Kentucky January 28, 1994 CONSOLIDATED STATEMENTS OF INCOME ASHLAND COAL, INC. AND SUBSIDIARIES SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. CONSOLIDATED BALANCE SHEETS ASHLAND COAL, INC. AND SUBSIDIARIES SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY ASHLAND COAL, INC. AND SUBSIDIARIES THREE YEARS ENDED DECEMBER 31, 1993 SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. CONSOLIDATED STATEMENTS OF CASH FLOWS ASHLAND COAL, INC. AND SUBSIDIARIES SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ASHLAND COAL, INC. AND SUBSIDIARIES DECEMBER 31, 1993 1. ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of Ashland Coal, Inc. and its subsidiaries (the Company or Ashland Coal), which operate in the coal mining industry. All subsidiaries are wholly owned. Significant intercompany transactions and accounts have been eliminated in consolidation. Ashland Coal's 17.5% partnership interest in Dominion Terminal Associates is accounted for on the equity method in the consolidated balance sheet. Allocable costs of the partnership for coal loading and storage are included in costs and expenses in the statement of income. CHANGES IN ACCOUNTING METHODS Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 106, EMPLOYERS' ACCOUNTING FOR POSTRETIREMENT BENEFITS OTHER THAN PENSIONS. SFAS No. 106 requires the accrual method of accounting for postretirement health care and life insurance benefits based on actuarially determined costs to be recognized over the period the employee provides service to the Company. As of January 1, 1993, the Company recognized the full amount of its actuarially estimated accumulated postretirement benefit obligation (APBO) as of that date which had not been previously recognized. The APBO represents the present value of the estimated future benefits payable to current retirees and a pro rata portion of estimated benefits payable to active employees after retirement. The pretax charge to 1993 earnings was $40,856,000, which was $25,331,000 ($1.44 per share on a primary basis and $1.34 per share on a fully diluted basis) net of tax. The latter amount has been reflected in the consolidated statement of income as a cumulative effect of an accounting change. The incremental cost, excluding the cumulative effect adjustment, in 1993 for postretirement health and life insurance benefits under the new accounting method amounted to $6,341,000 before tax and $3,868,000 ($.22 per share on a primary basis and $.20 per share on a fully diluted basis) net of tax. In prior years, the Company expensed claims for such postretirement benefits as paid. The amount included in postretirement benefit expense for 1992 under the previous accounting method was $884,000. Also in 1992, $1,262,000 of interest expense was recognized in connection with the April 1, 1992, acquisition of Dal-Tex Coal Corporation (Dal-Tex) and its estimated $19,305,000 obligation for retiree health and life insurance benefits at acquisition, which was recorded in the purchase price allocation. In the absence of the accounting change, the Company would have recognized postretirement health and life insurance costs of $1,167,000 and related interest expense of $1,716,000 in 1993. Effective January 1, 1993, the Company adopted the provisions of SFAS No. 109, ACCOUNTING FOR INCOME TAXES. SFAS No. 109 requires a liability approach for measuring deferred taxes based on temporary differences between the financial statement and tax bases of assets and liabilities existing at each balance sheet date using enacted tax rates for years during which taxes are expected to be paid or recovered. Adoption of SFAS No. 109 required the adjustment of the carrying value of certain assets, which had been acquired in prior business combinations, to their pretax amounts. That adjustment increased 1993 income by $10,476,000, which was $6,495,000 ($.37 per share on a primary basis and $.34 per share on a fully diluted basis) net of tax. The latter amount has been reflected in the consolidated statement of income as a cumulative effect of an accounting change. Exclusive of the cumulative effect adjustment, the effect of adopting SFAS No. 109 on income before income taxes and 1. ACCOUNTING POLICIES (CONTINUED) net income for 1993 was a decrease of $2,267,000 and $1,383,000 ($.08 per share on a primary basis and $.07 per share on a fully diluted basis), respectively, as a result of increased depreciation and amortization expense on assets acquired in prior business combinations. INVENTORIES Inventories are comprised of the following: Coal inventories are stated at the lower of cost (determined by the first-in, first-out method) or market. Supplies inventories are valued at the lower of average cost or market. DEPRECIATION Depreciation is provided principally on the straight-line method over the estimated useful lives of the assets. EXPLORATION AND DEVELOPMENT COSTS Coal exploration costs are expensed as incurred. Development costs, which are recoverable, are capitalized and amortized by the units-of-production method over the estimated recoverable reserves. COAL ACQUISITION COSTS AND PREPAID ROYALTIES Coal lease rights obtained through acquisition of other companies are capitalized and amortized primarily by the units-of-production method over the estimated recoverable reserves. Rights to leased coal lands are often acquired through royalty payments. Where royalty payments represent prepayments recoupable against future production, they are capitalized, and amounts expected to be recouped within one year are classified as a current asset. As mining occurs on these leases, the prepayment is offset against earned royalties and is included in the cost of coal mined. The Company provides a valuation allowance for royalties estimated to be nonrecoupable. COAL SUPPLY AGREEMENTS Acquisition costs allocated to coal supply agreements (sales contracts) are capitalized and amortized to selling expense on the basis of coal to be shipped over the term of the contract. Accumulated amortization for sales contracts was $44,882,000 and $31,638,000 at December 31, 1993 and 1992, respectively. DEFERRED GAIN ON SALE AND LEASEBACK OF ASSETS Gain resulting from the sale and leaseback of assets is deferred and amortized over the term of the operating lease as a reduction of rental expense. REVENUE RECOGNITION Coal sales revenues include sales to customers of coal produced at Company operations and purchased from other companies. The Company recognizes revenue from coal sales at the time title passes to the customer. Revenues other than from coal sales are included in operating revenues and are recognized in income as services are performed. OTHER Cash equivalents (none at December 31, 1993, and $36,979,000 at December 31, 1992) represent highly liquid investments with a maturity of three months or less when purchased. Cash equivalents are recorded at cost, plus accrued interest, which approximates market. 1. ACCOUNTING POLICIES (CONTINUED) Interest costs on borrowed funds are capitalized for significant asset construction projects. Capitalized interest costs were $4,911,000 in 1992 and $6,497,000 in 1991. No interest was capitalized in 1993. Certain 1992 amounts included in the consolidated balance sheet have been reclassified to conform to 1993 classifications. 2. ACQUISITION On April 1, 1992, Ashland Coal acquired Dal-Tex for consideration of approximately $242,000,000, which included the issuance to the seller of 400,000 shares of Ashland Coal's common stock valued at $12,400,000. The cash portion was financed through bank borrowings and the issuance of 1,550,000 shares of common stock. This acquisition has been accounted for as a purchase, with the cost of the acquisition allocated to the assets acquired and liabilities assumed based on their respective estimated fair values at the date of acquisition. Such allocations were based on appraisals and Ashland Coal's evaluation of fair value. The results of operations of Dal-Tex have been included in Ashland Coal's consolidated financial statements since the acquisition date. 3. RELATED PARTIES The financial statements include transactions with Ashland Oil, Inc. (Ashland Oil), Saarbergwerke A.G. (Saarberg), and Carboex International, Ltd. (Carboex) and their affiliates. Ashland Oil owns 6,998,129 shares of the issued and outstanding common stock and Saarberg and Carboex own the issued and outstanding convertible Class B preferred stock and convertible Class C preferred stock, respectively. Revenues include sales of coal to Saarberg and miscellaneous items of income resulting from transactions with Ashland Oil. In addition, Ashland Coal receives certain services from and provides certain services to Ashland Oil for which fees are charged between the companies. Ashland Coal purchases fuel, oil, and other products for use in its mining operations from Ashland Oil. In 1991, Ashland Coal appointed Saarberg and Carboex as its exclusive agents for the purpose of selling metallurgical coal to the steel industry in Europe. Under the terms of the agreement, Ashland Coal pays a 2% commission on all such sales. Transactions with related parties are summarized below: Management believes that charges between Ashland Coal and Ashland Oil for services were reasonable and that the other transactions summarized above were concluded on terms equivalent to those prevailing among unaffiliated parties. 4. DOMINION TERMINAL ASSOCIATES Ashland Coal holds a 17.5% general partnership interest in Dominion Terminal Associates (DTA), which operates a ground storage-to-vessel coal transloading facility in Newport News, Virginia. DTA leases the facility from Peninsula Ports Authority of Virginia (PPAV) for amounts sufficient to meet debt service requirements. Financing is provided through $132,800,000 of tax-exempt bonds issued by PPAV which mature July 1, 2016. Under the terms of a throughput and handling agreement with DTA, each partner is charged its share of cash operating and debt service costs in exchange for the right to use its share of the facility's loading capacity and is required to make periodic cash advances to DTA to fund such costs. On a cumulative basis, costs exceeded cash advances by $6,497,000 and $6,044,000 at December 31, 1993 and 1992, respectively (included in other long-term liabilities). Costs and cash advances for the last three years follow: Future payments for fixed operating costs and debt service will approximate $3,300,000 annually through 2015 and $26,000,000 in 2016. 5. TAXES Significant components of the provision for income tax expense (benefit) are as follows: A reconciliation of the normal statutory federal income tax on Ashland Coal's pretax income with the Company's actual income tax expense (benefit) follows: Income tax benefit for 1993 includes a net $50,231,000 deferred tax benefit resulting from the enactment of the Omnibus Budget Reconciliation Act of 1993 (OBRA). OBRA increased the marginal tax rate on corporations by 1%, which resulted in Ashland Coal's recognizing an additional net deferred tax liability of $3,307,000 and a like amount of deferred income tax expense. The new law also permits the Company to elect to deduct the amortization of goodwill over 15 years. Such amortization 5. TAXES (CONTINUED) was not previously deductible. Ashland Coal has elected to deduct for federal tax purposes the amortization of goodwill associated with the April 1992 acquisition of Dal-Tex. As a result of this election, the Company recognized a $53,538,000 deferred tax asset and an equal deferred tax benefit. Significant components of the Company's deferred tax liabilities and assets that result from carryforwards and temporary differences between the financial statement basis and tax basis of assets and liabilities are summarized as follows: At December 31, 1993, the Company had $3,584,000 of U.S. net operating loss carryforwards (expiring $222,000 in 2003 and $3,362,000 in 2008) which may be applied against future taxable income. 6. PREPAID ROYALTIES Ashland Coal has entered into various noncancellable royalty lease agreements under which future minimum payments are approximately $25,000,000 annually in 1994 through 1998 and amounts aggregating $261,000,000 thereafter. Coal lands and mineral rights with a carrying value of $2,963,000, prepaid royalties with a carrying value of $27,788,000 (net of the valuation allowance described below), and future royalty commitments of $2,818,000 at December 31, 1993, represent amounts attributable to coal properties for which there are no immediate plans for significant production. Geological surveys performed by outside consultants indicate that there are sufficient reserves relative to these properties to permit recovery of Ashland Coal's investment. In 1993, Ashland Coal recorded a special charge of $9,900,000, which reduced net income $6,039,000 ($.34 per share on a primary basis and $.32 per share on a fully diluted basis), to increase the valuation allowance for prepaid royalties relative to certain properties. Because the reserves represented by those royalties are not conducive to large-scale, low-cost mining, the Company believes 6. PREPAID ROYALTIES (CONTINUED) that the recoverability of those royalties is doubtful, given the Company's current expectations for future market prices for coal. The valuation allowance for prepaid royalties was $22,062,000 and $10,634,000 at December 31, 1993 and 1992, respectively. 7. LONG-TERM DEBT AND FINANCING ARRANGEMENTS Long-term debt consists of the following: Ashland Coal has a revolving credit agreement with a group of banks providing for borrowings of up to $215,000,000. The rate of interest on borrowings under this agreement is, at Ashland Coal's option, a money market rate determined by a competitive bid process, the Continental Bank N.A. reference rate, or a rate based upon LIBOR. This commitment will be reduced in each calendar quarter until termination in 1997. The provisions of the revolving credit agreement require a facility fee of 1/4% per annum on the outstanding commitment. Ashland Coal periodically establishes uncommitted lines of credit with banks. These agreements generally provide for short-term borrowings at market rates. At December 31, 1993, there were $222,900,000 of such agreements in effect. Aggregate maturities of long-term debt are $37,260,000 in 1994, $66,715,000 in 1995, $24,727,000 in 1996, $25,000,000 in 1997, $25,000,000 in 1998, and $102,900,000 thereafter. Included in these maturities are discretionary prepayments of $37,000,000 in 1994, $66,705,000 in 1995, and $2,627,000 in 1996. Excluded from current maturities are $19,332,000 of borrowings under lines of credit with banks. These borrowings are classified as long-term debt since Ashland Coal has the intent to maintain these borrowings on a long-term basis and the ability to do so through the use of the revolving credit agreement. The credit agreements contain, among other covenants, provisions setting forth certain requirements for current ratio and consolidated net worth and restrictions on the payment of dividends and the creation of additional debt. At December 31, 1993, retained earnings of $46,824,000 were available for dividends. 8. ACCRUED BLACK LUNG BENEFITS Ashland Coal is liable under the federal Coal Mine Health and Safety Act of 1969, as amended, to provide for pneumoconiosis (black lung) benefits to eligible employees, former employees, and dependents with respect to claims filed by such persons on or after July 1, 1973. Ashland Coal is also liable under various states' statutes for black lung benefits. Ashland Coal currently provides for federal and state claims principally through a self-insurance program. Charges are being made to current operations in amounts sufficient to amortize the actuarially computed liability for black lung benefits over 8. ACCRUED BLACK LUNG BENEFITS (CONTINUED) 10-25 years at an assumed 8% after-tax investment return. The accrual for black lung benefits (included in other long-term liabilities) was $14,430,000 and $14,014,000 at December 31, 1993 and 1992, respectively. 9. ACCRUED POSTMINING RECLAMATION AND MINE CLOSING COSTS Under the 1977 Surface Mining Control and Reclamation Act, a mine operator is responsible for postmining reclamation on every mine for at least five years after the mine is closed. Ashland Coal performs a substantial amount of reclamation of disturbed acreage as an integral part of its normal mining process. All such costs are expensed as incurred. The remaining costs of reclamation are estimated and accrued as mining progresses. The accrual for such reclamation (included in other long-term liabilities and in accrued expenses) was $2,500,000 and $3,017,000 at December 31, 1993 and 1992, respectively. In addition, the Company accrues the costs of removal at the conclusion of mining of roads, preparation plants, and other facilities and other costs (closing costs) over the lives of the various mines. Closing costs, in the aggregate, are estimated to be approximately $46,000,000. At December 31, 1993 and 1992, the accrual for closing costs, which is included in other long-term liabilities and in accrued expenses, was $4,692,000 and $3,925,000, respectively. 10. ACCRUED EXPENSES Accrued expenses are comprised of the following: 11. CONVERTIBLE CLASS C PREFERRED STOCK Ashland Coal and Carboex entered into a put agreement in 1988 granting to Carboex the right to require Ashland Coal to purchase its 100 shares of Class C preferred stock for $37,500,000 to be paid over two years. Carboex could exercise its right during the thirty day period beginning August 18, 1993, but did not do so. These securities were recorded at their fair market value at date of issue, and the carrying value was increased to the 1993 present value of the redemption amount by periodic charges to retained earnings ($770,000 in 1993, $1,280,000 in 1992, and $1,232,000 in 1991). After the expiration of the put agreement, the Class C preferred stock was reclassified as an element of stockholders' equity. 12. CAPITAL STOCK Holders of shares of Class A, B, and C preferred stock are entitled to receive dividends at such times and in such amounts as shall be equal to the dividends payable on the number of shares of common stock into which each such share of preferred stock is convertible. In addition, holders of Class B and C preferred stock are entitled to receive cumulative dividends in preference to common stock of $4,200 per share per annum for the first five years from August 1988 and $2,800 for the next five years, with preference dividend amounts decreasing to zero at the end of fifteen years. Each share of Class A preferred stock (if issued) is convertible into 13,846 shares of common stock. 12. CAPITAL STOCK (CONTINUED) Each share of Class B and C preferred stock is convertible into shares of common stock as follows: Holders of Class B and C preferred stock, voting cumulatively and together as a class, have the right to elect one director for each 63 shares of such Class B and C preferred stock held by them, up to a maximum of three directors. The 1992 acquisition of Dal-Tex was funded in part by the private placement of 1,550,000 shares of Ashland Coal's common stock to accredited institutional investors and the issuance of 400,000 shares to the seller of Dal-Tex. On the sale of these shares, Ashland Coal realized $60,310,000 after underwriting and stock issuance expenses of $1,739,000. 13. EARNINGS PER SHARE Earnings per share of common stock are based on the weighted average number of common and common equivalent shares outstanding during each year. Shares of common stock issuable under the Company's stock incentive plan are treated as common stock equivalents when dilutive. Fully diluted earnings per share are based on conversion rights that become effective within 10 years of the respective balance sheet date. Computations of earnings per share, using the "two class" method, are as follows: 13. EARNINGS PER SHARE (CONTINUED) Weighted average shares for computing earnings per share were as follows: 14. STOCK INCENTIVE PLAN On August 8, 1988, the stockholders approved a stock incentive plan reserving 750,000 shares of Ashland Coal common stock for awards to officers and key employees. The plan provides for the granting of incentive stock options (qualified stock options), nonqualified stock options, stock appreciation rights (SARs) and restricted stock awards. Stock options generally become exercisable in full or in part one year from date of grant and are granted at a price equal to 100% of the fair market value of the stock on the date of grant. SARs entitle employees to surrender stock options and receive cash or stock in an amount equal to the excess of the market value of the optioned shares over their option price. Unexercised options and any accompanying SARs lapse ten years after the date of grant. Restricted stock awards may entitle employees to purchase shares at a nominal cost. Such awards entitle employees to vote shares acquired and to receive any dividends thereon, but such shares cannot be sold or transferred and are subject to forfeiture if employees terminate their employment prior to the prescribed period, which can be from one to five years. As of December 31, 1993, no SARs or restricted stock awards have been granted. Information regarding this plan follows: 15. EMPLOYEE BENEFIT PLANS DEFINED BENEFIT PENSION PLAN The Company has a noncontributory defined benefit pension plan covering certain of its salaried and nonunion hourly employees. Benefits for salaried employees generally are based on years of service and the employee's compensation during the three years prior to retirement. For hourly employees, the plan provides for a stated benefit for each year of service. Ashland Coal funds the plan in an amount not less than minimum statutory funding requirements nor more than the maximum amount that can be deducted for federal income tax purposes. Plan assets consist primarily of equity securities and fixed income securities. 15. EMPLOYEE BENEFIT PLANS (CONTINUED) The net pension expense of the plan included the following components: The following table sets forth the plan's funded status and amounts recognized in the consolidated balance sheet at December 31, 1993 and 1992: The assumptions used in computing the information above were as follows: MULTIEMPLOYER PENSION AND BENEFIT PLANS Under the labor contract with the United Mine Workers of America (UMWA), Ashland Coal made payments of $475,000 in 1993, $1,105,000 in 1992, and $669,000 in 1991 into a multiemployer defined benefit pension plan trust established for the benefit of union employees. Payments are based on hours worked. Under the Multiemployer Pension Plan Amendments Act of 1980, a contributor to a multiemployer pension plan may be liable, under certain circumstances, for its proportionate share of the plan's unfunded vested benefits (withdrawal liability). Ashland Coal has estimated its share of such amount to be $16,500,000 at December 31, 1993. Ashland Coal is not aware of any circumstances which would require it to reflect its share of unfunded vested pension benefits in its financial statements. The Coal Industry Retiree Health Benefit Act of 1992 (Benefit Act) provides for the funding of medical and death benefits for certain retired members of the UMWA through premiums to be paid by assigned operators (former employers), transfers of monies from an overfunded pension trust established for the benefit of retired UMWA members, and transfers from the Abandoned Mine Lands 15. EMPLOYEE BENEFIT PLANS (CONTINUED) Fund, which is funded by a federal tax on coal production. This funding arrangement commenced February 1, 1993. Some former employers, however, have filed suits challenging the constitutionality of the Benefit Act. Ashland Coal treats its obligation under the Benefit Act as a participation in a multiemployer plan and recognizes expense as premiums are paid. During 1993, Ashland Coal recognized $240,000 in expense relative to premiums paid pursuant to the Benefit Act. The Company believes that the amount of its obligation under the Benefit Act is not significant. Under the prior funding arrangement for retirees now covered by the Benefit Act, Ashland Coal paid $609,000 in 1993, $4,809,000 in 1992, and $2,606,000 in 1991 into two multiemployer benefit trusts. OTHER POSTRETIREMENT BENEFIT PLANS Ashland Coal and its subsidiaries currently provide certain postretirement health and life insurance coverage for eligible employees. Generally, covered employees who terminate employment after meeting the eligibility requirements for pension benefits are also eligible for postretirement coverage for themselves and their dependents. The salaried employee postretirement medical and dental plans are contributory, with retiree contributions adjusted periodically, and contain other cost-sharing features such as deductibles and coinsurance. The postretirement medical plan for retirees who were members of the UMWA is not contributory. The Company's current funding policy is to fund the cost of all postretirement health and life insurance benefits as they are paid. The net periodic postretirement benefit expense of these plans for 1993 included the following components: The following table sets forth the amounts recognized in the consolidated balance sheet at December 31, 1993, none of which have been funded: The discount rate used in determining the accumulated postretirement benefit obligation was 7% and 8.25% at December 31, 1993 and 1992, respectively. The assumed health care cost trend rate for 1994 is 13%, decreasing to 5% in the year 2010. The health care cost trend rate assumption has a significant effect on the amounts reported. For example, increasing the assumed health care cost trend rate by one percentage point in each year would increase the accumulated postretirement benefit obligation as of December 31, 1993, by $12,300,000, or 17.9%, and the net periodic postretirement benefit cost for 1993 by $2,000,000, or 21.7%. 15. EMPLOYEE BENEFIT PLANS (CONTINUED) OTHER PLANS Ashland Coal sponsors three savings plans which were established to assist eligible employees in providing for their future retirement needs. Ashland Coal's contributions to the plans were $1,464,000 in 1993, $1,135,000 in 1992, and $616,000 in 1991. In November 1992, the Financial Accounting Standards Board issued SFAS No. 112, EMPLOYERS' ACCOUNTING FOR POSTEMPLOYMENT BENEFITS, which requires that employers who provide benefits to former or inactive employees after employment but before retirement recognize the obligation for those benefits under certain conditions. Ashland Coal will adopt SFAS No. 112 in 1994. Ashland Coal does not believe that SFAS No. 112 will have a significant effect on the consolidated financial statements. 16. CONCENTRATION OF CREDIT RISK AND MAJOR CUSTOMERS Ashland Coal places its cash equivalents in investment grade short-term investments and limits the amount of credit exposure to any one commercial issuer. Ashland Coal markets its coal principally to electric utilities in the United States and Europe. As of December 31, 1993 and 1992, accounts receivable from electric utilities located in the United States totaled $31,609,000 and $49,908,000, respectively, and accounts receivable from electric utilities located in Europe totaled $2,491,000 and $10,738,000, respectively. Credit is extended based on an evaluation of the customer's financial condition, and collateral is not generally required. Credit losses are provided for in the financial statements and consistently have been minimal. Ashland Coal is committed under several long-term contracts to supply coal that meets certain quality requirements at specified prices. These prices are generally adjusted based on indices. Quantities sold under some of these contracts may vary from year to year within certain limits at the option of the customer. Sales (including spot sales) to major customers were as follows: In 1993, 1992, and 1991, Ashland Coal had export sales, principally to European customers, of $50,364,000, $93,832,000, and $95,229,000, respectively. 17. FAIR VALUES OF FINANCIAL INSTRUMENTS The following methods and assumptions were used by Ashland Coal in estimating its fair value disclosures for financial instruments: CASH AND CASH EQUIVALENTS: The carrying amount reported in the balance sheet for cash and cash equivalents approximates its fair value. LONG-TERM AND SHORT-TERM DEBT: The carrying amounts of Ashland Coal's borrowings under its revolving credit agreement and under lines of credit approximate their fair value. The fair values of Ashland Coal's senior notes are estimated using discounted cash flow analyses, based on Ashland Coal's current incremental borrowing rates for similar types of borrowing arrangements. 17. FAIR VALUES OF FINANCIAL INSTRUMENTS (CONTINUED) The carrying amounts and fair values of Ashland Coal's financial instruments at December 31, 1993, are as follows: 18. SALE AND LEASEBACK On January 29, 1993, Ashland Coal sold mining equipment valued at approximately $64,000,000 and leased back the equipment under an operating lease. The proceeds of this transaction were used to repay borrowings under Ashland Coal's revolving credit agreement. The lease has a term of three years and provides for minimum annual rental payments of $9,467,000 in 1994, $9,160,000 in 1995, and $2,242,000 in 1996. At the end of the lease term, the Company has the option to purchase the equipment for $43,172,000. Alternatively, the equipment may be sold by the lessor to a third party. In the event of such a sale, the Company will be required to make payment to the lessor in the event and to the extent that the proceeds are below $35,631,000. 19. COMMITMENTS AND CONTINGENCIES Ashland Coal leases office space, mining equipment, land, and various other properties under noncancellable long-term leases, expiring at various dates. Rental expense related to these operating leases amounted to $10,772,000 in 1993, $3,510,000 in 1992, and $4,371,000 in 1991. Minimum annual rentals due in future years under lease agreements in effect at January 1, 1994, are approximately $13,241,000 in 1994, $12,293,000 in 1995, $5,449,000 in 1996, $3,239,000 in 1997, $2,928,000 in 1998, and additional amounts thereafter aggregating $14,910,000 through 2011. Ashland Coal is a party to numerous claims and lawsuits with respect to various matters. The Company provides for costs related to contingencies when a loss is probable and the amount is reasonably determinable. The Company estimates that its probable aggregate loss as a result of such claims is $4,600,000 (included in other-long-term liabilities) and believes that probable insurance recoveries of $3,900,000 (included in other assets) related to these claims will be realized. The Company estimates that its reasonably possible aggregate losses from all currently pending litigation could be as much as $5,500,000 (before tax) in excess of the probable loss previously recognized. However, the Company believes it is probable that substantially all of such losses, if any occur, will be insured. After conferring with counsel, it is the opinion of management that the ultimate resolution of these claims, to the extent not previously provided for, will not have a material adverse effect on the consolidated financial condition, results of operations, or liquidity of the Company. Ashland Coal has claims outstanding against a construction contractor for business interruption losses sustained by the Company when a coal silo failed and a second silo was unavailable during repairs. Recoveries under these claims are not expected to be material. 20. QUARTERLY FINANCIAL INFORMATION (UNAUDITED) Quarterly financial data for 1993 and 1992 are summarized below. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE There have been no changes in accountants or disagreements with accountants with respect to accounting and financial disclosure during the two most recent fiscal years. PART III. ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT There is hereby incorporated by reference into this Annual Report on Form 10-K the information appearing under the subcaption "Nominees for Director" which appears under the caption "Election of Directors" beginning on Page 4 in the Company's 1994 Proxy Statement. See also the list of the Company's executive officers and related information under "Executive Officers of the Registrant" in Part I, Item X herein. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION There is hereby incorporated by reference into this Annual Report on Form 10-K the information appearing under the "Summary Compensation Table", the "Option Grants in Last Fiscal Year" table, the "Aggregated Option Exercises in Last Fiscal Year and FY-End Option Values" table, the "Long Term Incentive Plans Awards in Last Fiscal Year" table, the Other Compensation Plans section (including the Pension Plan Table), the Employment Contracts and Termination of Employment and Change in Control Arrangements section, the Compensation of Directors section, and the Compensation Committee Interlocks and Insider Participation section appearing on Pages 19 to 28 in the Company's 1994 Proxy Statement. No portion of the Personnel and Compensation Committee and Key Employee Stock Administration Committee Report on Executive Compensation for 1993 or the "Comparison of Cumulative Total Return" table is incorporated herein in reliance on Regulation S-K, Item 402(a)(8). ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT There is hereby incorporated by reference into this Annual Report on Form 10-K the information appearing under the caption "Security Ownership of Certain Beneficial Owners and Management" beginning on Page 9 of the Company's 1994 Proxy Statement. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS There is hereby incorporated by reference into this Annual Report on Form 10-K the information appearing under the subcaptions "Restated Shareholders Agreement" and "Registration Rights Agreement" on Pages 11 and 12 of the Company's 1994 Proxy Statement and the information appearing under the caption "Certain Relationships and Related Transactions" beginning on Page 28 of the Company's 1994 Proxy Statement. PART IV. ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) Documents filed as part of this Report (2) The following consolidated financial statement schedules of Ashland Coal, Inc. and subsidiaries are included in Item 14 at the page indicated: All other schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions or are inapplicable and, therefore, have been omitted. (3) Exhibits filed as part of this Report are as follows: Items 10.14, 10.15, 10.16, 10.17, 10.18, 10.20, 10.23 and 10.24 are executive compensation plans. Upon written or oral request to the Company's Secretary, a copy of any of the above exhibits will be furnished at cost. (b) Reports on Form 8-K A current Report on Form 8-K was filed on December 22, 1993 to report UMWA ratification of the Wage Agreement and the return of UMWA workers to the mines of Hobet and the Dal-Tex Subsidiaries. ASHLAND COAL, INC. AND SUBSIDIARIES SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT (IN THOUSANDS) ASHLAND COAL, INC. AND SUBSIDIARIES SCHEDULE VI -- ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (IN THOUSANDS) ASHLAND COAL, INC. AND SUBSIDIARIES SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS (IN THOUSANDS) ASHLAND COAL, INC. AND SUBSIDIARIES SCHEDULE X -- SUPPLEMENTARY INCOME STATEMENT INFORMATION (IN THOUSANDS) 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. ASHLAND COAL, INC. (Registrant) By: /s/ MARC R. SOLOCHEK ----------------------------------- Marc R. Solochek SENIOR VICE PRESIDENT AND CHIEF FINANCIAL OFFICER Date: March 30, 1994 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 indicated on March 30, 1994. ORIGINAL POWERS OF ATTORNEY AUTHORIZING WILLIAM C. PAYNE, MARC R. SOLOCHEK, AND ROY F. LAYMAN, AND EACH OF THEM, TO SIGN THIS ANNUAL REPORT ON FORM 10-K AND AMENDMENTS THERETO ON BEHALF OF THE ABOVE-NAMED PERSONS HAVE BEEN FILED WITH THE SECURITIES AND EXCHANGE COMMISSION AS EXHIBIT 25 TO THIS REPORT. EXHIBIT INDEX

1993 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULES Page Financial Statements Independent Auditors' Report................................31 Consolidated Balance Sheets, August 31, 1993 and 1992.......32 Consolidated Statements of Operations for each of the years in the three-year period ended August 31, 1993................34 Consolidated Statements of Cash Flows for each of the years in the three-year period ended August 31, 1993...............35 Consolidated Statements of Capital Shares and Equities for each of the years in the three-year period ended August 31, 1993.37 Notes to Consolidated Financial Statements...............38 Financial Statement Schedules Farmland Industries, Inc. and Subsidiaries for each of the years in the three-year period ended August 31, 1993: V--Property, Plant and Equipment.........................70 VI--Accumulated Depreciation and Amortization of..........73 Property, Plant and Equipment IX--Short-term Borrowings.................................76 X--Supplementary Income Statement Information............76 All other schedules are omitted as the required information is inapplicable or the information is presented in the consolidated financial statements or related notes. INDEPENDENT AUDITORS' REPORT The Board of Directors Farmland Industries, Inc.: We have audited the accompanying consolidated balance sheets of Farmland Industries, Inc. and subsidiaries as of August 31, 1993 and 1992, and the related consolidated statements of operations, cash flows and capital shares and equities for each of the years in the three-year period ended August 31, 1993. In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedules as listed in the accompanying index. These consolidated financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules 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 Farmland Industries, Inc. and subsidiaries as of August 31, 1993 and 1992, and the results of their operations and their cash flows for each of the years in the three-year period ended August 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. As discussed in note 7 to the consolidated financial statements, the Internal Revenue Service (IRS) has examined the Company's tax returns for the years ended August 31, 1984 and 1983, and has proposed certain adjustments. Should the IRS ultimately prevail, the federal and state income taxes and statutory interest thereon could be significant. Farmland believes it has meritorious positions with respect to such claims and, based upon the opinion of special tax counsel, management believes it is more likely than not that the courts will ultimately conclude that Farmland's treatment of such items was substantially, if not entirely, correct. The ultimate outcome of this matter can not presently be determined. Therefore, no provision for such income taxes and interest has been made in the accompanying consolidated financial statements. KPMG PEAT MARWICK Kansas City, Missouri October 29, 1993 FARMLAND INDUSTRIES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (continued) FARMLAND INDUSTRIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (1) Summary of Significant Accounting Policies Farmland is organized and operated as a cooperative and is intended to be a producer-driven and profitable ag supply to consumer foods cooperative system. Principles of Consolidation --The consolidated financial statements include the accounts of Farmland Industries, Inc. ("Farmland") and all its majority-owned subsidiaries (the "Company"). All significant intercompany accounts and transactions have been eliminated. Certain previously reported amounts have been reclassified to conform to the 1993 presentation. Investments --Investments in cooperatives are stated at cost plus the par value of equity certificates received as payment of patronage refunds less such equity certificates redeemed. Investments in companies owned 20% to 50% by Farmland are accounted for by the equity method. All other investments are stated at cost. Accounts Receivable --The Company uses the allowance method to account for uncollectible accounts and notes. Uncollectible accounts and notes receivable from members are reduced by offsets against the common stock of Farmland held by members prior to charging uncollectible accounts to operations. Inventories --Grain inventories are valued at market adjusted for net unrealized gains or losses on open commodity contracts. Crude oil, refined petroleum products, cattle and beef inventories are valued at the lower of last-in, first-out cost or market. Supplies are valued at cost. All other inventories are valued at the lower of first-in, first-out cost or market. To the extent practical, the Company hedges certain inventories, advance sales and purchase contracts with fixed prices and anticipated purchases of raw materials. Property, Plant and Equipment --Assets are stated at cost and depreciated principally on a straight-line basis over the estimated useful life of the individual asset (3 to 40 years). Leasehold improvements are amortized on a straight-line basis over the terms of the individual leases (15 to 21 years). Upon disposition of these assets any resulting gain or loss is included in income. Major repairs and maintenance costs are capitalized. Normal repairs and maintenance costs are charged to operations. Research and Development Costs --Total research and development costs for the Company for the years ended August 31, 1993, 1992 and 1991 were $3,303,000, $3,338,000 and $3,269,000, respectively. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Goodwill --The excess of cost over net assets of businesses purchased is being amortized on a straight-line basis over a period of 25 to 40 years. Federal Income Taxes --Farmland and its cooperative subsidiaries are subject to income taxes on all income not distributed to patrons as patronage refunds. Farmland and all its subsidiaries, except Farmland Foods, Inc. ("Foods") and National Beef Packing Company, L.P. ("NBPC") file consolidated federal and state income tax returns. Cash and Cash Equivalents --Investments with maturities of less than three months are included in "Cash and cash equivalents." (2) Acquisitions and Dispositions During 1993, Farmland and partners organized NBPC, a limited partnership. Farmland retained a 58% ownership interest in NBPC by investing $10,500,000 in cash. NBPC's purpose is to carry on the business of Idle Wild Foods, Inc. ("Idle Wild"). On April 15, 1993, NBPC acquired Idle Wild's beef packing plant and feedlot located in Liberal, Kansas. NBPC acquired these assets by assuming liabilities of Idle Wild with a fair market value of approximately $130,605,000, including bank loans which are nonrecourse to NBPC's partners. The acquisition has been accounted for as a purchase and, accordingly, the results of operations of NBPC have been included in the Company's consolidated financial statements from April 15, 1993. The liabilities assumed over the fair value of the net identifiable assets acquired ($16,086,000) has been recorded as goodwill and is being amortized on a straight-line basis over 25 years. Effective June 30, 1992, Farmland acquired substantially all the business and assets of Union Equity Co-Operative Exchange ("Union Equity") in exchange for 2,051,880 shares of Farmland common stock with a par value of $51,297,000 and Farmland's assumption of substantially all of Union Equity's liabilities. The acquisition has been accounted for as a purchase and, accordingly, the results of operations of Union Equity have been included in the Company's consolidated financial statements from June 30, 1992. The excess of the purchase price over the fair value of the net identifiable assets acquired ($20,976,000) has been recorded as goodwill and is being amortized on a straight-line basis over 25 years. To establish The Cooperative Finance Association ("CFA") as an independent finance association for its members, CFA purchased 10,113,000 shares of its voting common stock held by Farmland for a purchase price comprised of $1,541,000 in cash, equities of Farmland (with a par value of $2,406,000) held by CFA and a $6,166,000 subordinated promissory note payable to Farmland bearing interest of 5.3%. In addition, CFA: 1) purchased the lending operations and notes receivable of Farmland Financial Services Company ("FFSC"), a wholly-owned subsidiary of Farmland. The purchase price approximated the face amount of FFSC's notes receivable and consisted of $60,505,000 in cash and a $2,128,000 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) 6% subordinated promissory note payable; 2) repaid its operating loan to Farmland ($25,181,000); and, 3) proposed a recapitalization plan which limits the voting rights of any owner (including Farmland) to 20% or less regardless of the number of voting shares held. Farmland repaid $87,227,000 of its borrowings from National Bank for Cooperatives ("CoBank") with proceeds received from CFA. As a result of CFA's purchase of its stock, Farmland's voting percentage in CFA was reduced to 49%. Accordingly, CFA is not included in the consolidated balance sheet of the Company as of August 31, 1993. The following unaudited financial information, for the years ended August 31, 1993 and 1992, presents pro forma results of operations of the Company as if the disposition of CFA and the acquisitions of Union Equity and NBPC had occurred at the beginning of each period presented. The pro forma financial information includes adjustments for amortization of goodwill, additional depreciation expense and increased interest expense on debt assumed in the acquisitions. The pro forma financial information does not necessarily reflect the results of operations that would have occurred had the Company been a single entity which excluded CFA and included Union Equity and NBPC for the full years 1993 and 1992. August 31 (Unaudited) 1993 1992 (Amounts in Thousands) Net sales............................... $5,357,867 $5,441,303 Income (loss) before extraordinary item..$ (44,040) $ 47,225 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (3) Inventories Major components of inventories are as follows: August 31 1993 1992 (Amounts in Thousands) Grain.................................$ 91,990 $ 67,459 Beef.................................. 27,754 -0- Materials............................. 43,857 42,702 Supplies.............................. 41,388 38,445 Finished and in-process products...... 285,947 258,358 $490,936 $406,964 LIFO adjustment....................... 5,754 1,635 $496,690 $408,599 Earnings for the year ended August 31, 1993 have been reduced by $8,346,000 to recognize the write-down of certain crude oil and refined petroleum inventories to market. Inventories, for these products, stated under the last-in, first-out (LIFO) method at August 31, 1993 and 1992, were $84,088,000 and $92,094,000, respectively. Had the lower of first-in, first-out (FIFO) cost or market been used to value these products, inventories at August 31, 1993 and 1992 would have been lower by $5,754,000 and $1,635,000, respectively. The LIFO valuation method had the effect of increasing income before income taxes and patronage refunds by $4,119,000 in 1993, reducing such income by $1,953,000 in 1992 and increasing such income by $3,588,000 in 1991. Liquidation of prior year inventory layers in 1992 and 1991 reduced income before income taxes and patronage refunds in these years by $3,302,000 and $4,177,000, respectively. The carrying value of beef inventories stated under the LIFO method was $27,754,000 at August 31, 1993. The LIFO method of accounting for beef inventories had no effect on the carrying value of inventories or on the loss reported in 1993, because market value of these inventories was lower than LIFO or FIFO cost. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (4) Investments and Long-Term Receivables The Company's investments accounted for by the equity method consist principally of 50% equity interests in Farmland Hydro L.P., SF Phosphates Limited Company and Hyplains Beef L.C. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) On November 15, 1991, Farmland and Norsk Hydro a.s. ("Hydro") formed a joint venture company, Farmland Hydro, to manufacture phosphate fertilizer products for distribution to international markets. As part of the joint venture agreement, Farmland sold a 50% interest in its Green Bay, Florida phosphate fertilizer plant and certain phosphate rock reserves located in NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Hardee County, Florida to Hydro for an amount approximately equal to Farmland's carrying value of the assets. Subsequently, Farmland and Hydro contributed the assets to the joint venture. Farmland operates the plant under a management agreement with the joint venture and Hydro provides international marketing services. See note 15 of the notes to consolidated financial statements. Farmland and J. R. Simplot formed a joint venture (SF Phosphates, Limited Company) to operate a phosphate mine located in Vernal, Utah, a fertilizer plant located in Rock Springs, Wyoming, and a 96-mile pipeline that connects the mine with the fertilizer plant. The purchase of the mine, plant and pipeline from Chevron Corporation was completed in April 1992. Prior to August 31, 1993, CFA was a 99%-owned finance subsidiary of the Company. CFA provides specialized financial services for Farmland's local cooperative members. CFA operates on a fiscal year ending August 31. For the years ended August 31, 1993, 1992 and 1991, interest income of CFA amounting to $7,614,000, $7,840,000 and $7,382,000, respectively, has been included in sales and interest expense of $5,498,000, $6,248,000 and $5,202,000, respectively, has been included in cost of sales in the accompanying consolidated statements of operations. A condensed balance sheet of CFA as of August 31, 1992 and condensed statements of operations for the period ended August 30, 1993 and the years ended August 31, 1992 and 1991 are shown below. See note 2 of the notes to consolidated financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities," was issued by the Financial Accounting Standards Board ("FASB") in May 1993 and is effective for fiscal years beginning after December 15, 1993 (the Company's 1995 fiscal year). Statement 115 expands the use of fair value accounting and the reporting for certain investments in debt and equity securities. Management expects the adoption of Statement 115 will not have a significant impact on the Company's consolidated financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (5) Property, Plant and Equipment A summary of cost for property, plant and equipment is as follows: August 31 1993 1992 (Amounts in Thousands) Land and improvements.................$ 11,825 $ 11,437 Site improvements..................... 26,878 15,308 Buildings............................. 215,420 193,215 Machinery and equipment............... 655,117 593,014 Furniture and fixtures................ 45,405 37,850 Automotive equipment.................. 51,179 46,324 Mining properties..................... 26,786 26,569 Fertilizer properties................. 48,695 48,695 Construction in progress.............. 57,242 53,812 Leasehold improvements................ 15,796 10,215 Total.......................$1,154,343 $1,036,439 Mining properties represent phosphate rock reserves and construction and development costs of a mine in Hardee County, Florida and the surrounding area. The Company has deferred the development of this phosphate mine. See note 4 of the notes to consolidated financial statements. For the years ended August 31, 1993, 1992 and 1991, the Company capitalized construction period interest of $1,611,000, $330,000 and $328,000, respectively. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (6) Bank Loans, Subordinated Debt Certificates and Notes Payable The Company maintains various credit agreements with CoBank that allow the Company to borrow under terms as the Company and CoBank mutually agree upon. These facilities provide for both seasonal and term borrowings. At August 31, 1993, total credit lines available were approximately $508,900,000. Seasonal and term borrowings under these agreements at August 31, 1993 were $156,650,000 and $66,098,000, respectively, and $86,819,000 was used to support letters of credit issued on behalf of Farmland by CoBank. The agreements with CoBank stipulate that by February 15, 1994 the maximum credit available from CoBank to the Company shall be reduced to an amount not in excess of CoBank's then applicable lending limit to a single borrower. Under loan agreements with CoBank, the Company has pledged its investment in CoBank stock carried at $31,824,000. Under industrial revenue bonds and lease agreements, property, plant and equipment with a carrying value of $31,394,000 has been pledged. Under bank loan agreements of NBPC, all of its assets (carried at $152,745,000) are pledged to support its borrowings. Such borrowings of NBPC are nonrecourse to its partners. Farmland's loan agreements with CoBank contain provisions which require the Company to maintain consolidated working NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) capital of not less than $150,000,000 and to maintain consolidated net worth of not less than $425,000,000. In addition, the agreements require the Company to maintain funded indebtedness and senior funded indebtedness of not more than 52% and 43% of capitalization, respectively. All computations are based on consolidated financial data adjusted to exclude nonrecourse subsidiaries (any subsidiary for which Farmland is not directly or indirectly liable for any of such subsidiary's indebtedness). As computed under provisions of the agreement, at August 31, 1993, working capital was $210,744,000, net worth was $561,303,000, funded indebtedness was 45.14%, and senior funded indebtedness was 21.10% of capitalization. Borrowers from CoBank are required to maintain an investment in CoBank stock based on the average amount borrowed from CoBank during the previous five years. At August 31, 1993, the Company's investment in CoBank approximated the requirement. Farmland has credit facilities with various commercial banks. At August 31, 1993, Farmland had $215,000,000 of available credit from commercial banks under committed arrangements and $30,000,000 of credit available under uncommitted arrangements. Borrowings at August 31, 1993 under these committed and uncommitted credit facilities were $131,300,000 and $10,000,000, respectively. In addition, $18,237,000 was used at August 31, 1993 to support letters of credit issued by such banks on Farmland's behalf. Covenants of these arrangements are not more restrictive than Farmland's credit lines with CoBank. Subordinated debt certificates have been issued under several different indentures and therefore the terms of such securities are not identical. Farmland may redeem subordinated certificates of investments and capital investment certificates in advance of scheduled maturities. Farmland will redeem subordinated certificates of investments, capital investment certificates and subordinated monthly interest certificates upon death of the holder. Holders of certificates of investment and capital investment certificates have the right to exchange such securities after a minimum holding period for similar securities. The outstanding subordinated debt certificates are subordinated to senior indebtedness. At August 31, 1993, senior indebtedness included $449,454,000 for money borrowed, and other instruments (principally long-term operating leases) which provide for aggregate payments over ten years of approximately $116,250,000. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Bank loans, subordinated debt certificates and notes payable mature during the fiscal years ending August 31 in the following amounts: (Amounts in Thousands) 1994.......................................$ 31,947 1995....................................... 33,794 1996....................................... 94,075 1997....................................... 51,997 1998....................................... 73,643 1999 and after............................. 232,352 $517,808 (7) Income Taxes On July 28, 1983, Farmland sold the stock of Terra Resources, Inc. ("Terra"), a wholly-owned subsidiary engaged in oil and gas exploration and production operations, and exited its oil and gas exploration and production activities. The gain from the sale of Terra amounted to $237,200,000 for tax reporting purposes. During 1983, and prior to the sale of the Terra stock, Farmland received certain distributions from Terra totaling $24,800,000. For tax purposes, Farmland claimed intercorporate dividends-received deductions for the entire amount of such distributions. On March 24, 1993, the Internal Revenue Service ("IRS") issued a statutory notice to Farmland asserting deficiencies in federal income taxes (exclusive of statutory interest thereon) in the aggregate amount of $70,775,000. The asserted deficiencies relate primarily to the Company's tax treatment of the sale of the Terra stock and the distributions received from Terra prior to the sale. The IRS asserts that Farmland incorrectly treated the Terra sale gain as income against which certain patronage-sourced operating losses could be offset, and that, as a nonexempt cooperative, Farmland was not entitled to an intercorporate dividends-received deduction in respect of the 1983 distribution by Terra. It further asserts that Farmland incorrectly characterized gains for tax purposes aggregating approximately $14,600,000, and a loss of approximately $2,300,000, from the disposition of certain other assets. On June 11, 1993, Farmland filed a petition in the United States Tax Court contesting the asserted deficiencies in their entirety. A trial date has not yet been set. If the IRS ultimately prevails on all of the adjustments asserted in the statutory notice, Farmland would have additional federal and state income tax liabilities aggregating approximately $85,800,000 plus accumulating statutory interest thereon (through October 31, 1993, of approximately NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) $133,500,000). In addition, such adjustments would affect the computation of Farmland's taxable income for its 1989 tax year and, as a result, could increase Farmland's federal and state income taxes for that year by approximately $5,000,000 plus applicable statutory interest thereon. No provision has been made in the consolidated financial statements for federal or state income taxes (or interest thereon) in respect of the IRS claims described above. Farmland believes that it has meritorious positions with respect to all of these claims and will continue to vigorously pursue their favorable resolution through the pending litigation. In the opinion of Bryan Cave, Farmland's special tax counsel, it is more likely than not that the courts will ultimately conclude that (i) Farmland's treatment of the Terra sale gain was substantially, if not entirely, correct; and (ii) Farmland properly claimed a dividends-received deduction in respect of the 1983 distributions which it received from Terra prior to the sale of the Terra stock. Counsel has further advised, however, that none of the issues involved in these disputes is free from doubt, and that there can be no assurance that the courts will ultimately rule in favor of Farmland on any of these issues. Should the IRS ultimately prevail on all of its asserted claims, all claimed federal and state income taxes as well as accrued interest would become immediately due and payable, and would be charged to current operations. In such case, the Company would be required to renegotiate agreements with its banks to maintain compliance with various requirements of such agreements, including working capital and funded indebtedness provisions. However, no assurance can be given that such renegotiation would be successful. Alternatives could include other financing arrangements or the possible sale of assets. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Income tax expense (benefit) is comprised of the following: Year Ended August 31 1993 1992 1991 (Amounts in Thousands) Federal: Current..................$ (2,502) $ 6,600 $ 6,644 Deferred................. (2,944) 1,490 (205) $ (5,446) $ 8,090 $ 6,439 State: Current..................$ (468) $ 1,106 $ 1,064 Deferred................... (519) 262 (30) $ (987) $ 1,368 $ 1,034 $ (6,433) $ 9,458 $ 7,473 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) The current tax benefit for the year ended August 31, 1993 results from the carryback of nonpatronage-sourced losses to reduce the amount of federal and state income taxes paid during prior years. During the year ended August 31, 1992, all of Foods' nonmember-sourced loss carryforwards were utilized and deferred income taxes amounting to $1,294,000 were reinstated. During the year ended August 31, 1992, Farmland utilized nonmember-sourced loss carryforwards amounting to $3,168,000 to reduce income tax expense for financial reporting purposes by $1,267,000. Utilization of these loss carryforwards has been presented as an extraordinary item in the accompanying consolidated statement of operations for the year ended August 31, 1992. In connection with the acquisition of Union Equity, Farmland acquired member-sourced and nonmember-sourced loss carryforwards from Union Equity amounting to approximately $18,600,000 and $10,600,000, respectively. For the year ended August 31, 1992, Farmland was able to utilize member-sourced and nonmember-sourced loss carryforwards amounting to $18,600,000 and $2,800,000, respectively. The benefit of the utilization of the nonmember-sourced loss carryforward amounting to $1,134,000 has been recorded as a reduction of goodwill in the accompanying consolidated balance sheet as of August 31, 1992. See note 2 of the notes to consolidated financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) At August 31, 1993, Farmland has nonmember-sourced loss carryforwards amounting to approximately $7,597,000, which expire in 2006 and 2007. At August 31, 1993, Farmland and its consolidated subsidiaries have alternative minimum tax credit carryforwards of approximately $2,502,000. At August 31, 1993, Farmland has patronage-sourced loss carryforwards available to offset future patronage-sourced income of $8,155,000 which expire in 2008. Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," was issued by the FASB in February 1992 and is effective for fiscal years beginning after December 15, 1992 (the Company's 1994 fiscal year). Statement 109 requires a change from the deferred method currently used by the Company, to the asset and liability method of accounting for income taxes. Under the asset and liability method, deferred income taxes are recognized for the tax consequences of "temporary differences" by applying enacted statutory tax rates applicable to future years to differences between the financial statement carrying amounts and the tax basis of existing assets and liabilities. The Company has determined that implementation of Statement 109 in the first fiscal quarter of 1994 will not have a significant impact on its consolidated financial statements. (8) Minority Owners' Equity in Subsidiaries NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) During the year ended August 31, 1993, Farmland reduced its voting interest in CFA to 49%. See note 2 of the notes to consolidated financial statements. (9) Preferred Stock, Earned Surplus and Other Equities The 5-1/2% and 6% preferred stocks have preferential liquidation rights over the Series F preferred stock. Dividends on the 5-1/2% and 6% preferred stock are cumulative only to the extent earned each year. Series F preferred stock is nondividend bearing. Upon liquidation, holders of all preferred stock are entitled to the par value thereof and, with respect to the 5-1/2% and 6% preferred stock, any declared or unpaid earned dividends. (B) A summary of earned surplus and other equities is as follows: August 31 1993 1992 (Amounts in Thousands) Earned surplus................$123,974 $136,175 Nonmember capital.......... .. 104 104 Capital credits............... 38,105 35,765 Unallocated equity............ 6,021 25,877 Additional paid-in surplus.... 1,603 1,936 $169,807 $199,857 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Nonmember capital represents patronage refunds distributed in the form of book credits. Capital credits are issued: 1) for payment of the portion of patronage refunds distributed in equity to patrons who do not satisfy requirements for membership or associate membership; and, 2) upon conversion of an equal par value amount of common stock or associate member common stock held by persons who no longer meet qualifications for membership or associate membership in Farmland. During the year ended August 31, 1992, Farmland issued $11,110,000 of capital credits to owners of Foods in exchange for an equivalent par value of their ownership of Foods common stock and capital equity fund certificates. Unallocated equity represents the cumulative difference between the amount of member-sourced income determined for financial reporting purposes and the amount of member-sourced income for income tax reporting purposes. The difference in the two income amounts results principally from differences in timing between book expense and tax deductions. Additional paid-in surplus results from members donating Farmland equity to Farmland. None of the aforementioned equities are held by or for the account of Farmland or in any sinking or other special fund of Farmland and none have been pledged by Farmland. The bylaws of Farmland provide that the patronage refund payable for any year be reduced if immediately after the payment of such patronage refund, the amount of retained earnings (defined for this purpose as the sum of earned surplus and unallocated equity) would be less than 30% of the previous year-end balance of members' equity accounts (defined for this purpose as the sum of common stock, associate member common stock, capital credits, nonmember capital and patronage refunds payable in equities). The reduction of patronage refunds would be the lesser of 15% or the amount required to increase the balance of the retained earnings account to the required 30%. As of August 31, 1993, 1992 and 1991, retained earnings exceeded the required amount by approximately $3,874,000, $49,451,000 and $9,623,000, respectively. Farmland established a base capital plan in 1991. The plan's objective is to achieve proportionality between the dollar amount of business a member or associate member of Farmland ("Participant") transacts with Farmland and the par value of Farmland equity which the Participant should hold (hereinafter referred to as the Participants' "Base Capital Requirement"). This plan: 1) provides that the relationship between the par value of a Participant's actual investment in Farmland equity and the Participant's Base Capital Requirement shall influence the cash portion of any patronage refund paid to the Participant; and, 2) provides a method for redemption by Farmland of its NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) equities held by a Participant when the par value of the Participant's investment exceeds his Base Capital Requirement. The Base Capital Requirement shall be determined annually by the Farmland Board of Directors at its sole discretion. No patronage refunds were paid by Farmland for 1993. (10) Contingent Liabilities and Commitments The Company leases various equipment and real properties under long-term operating leases. For the years ended August 31, 1993, 1992 and 1991, rental expenses totaled $41,104,000, $43,300,000 and $43,029,000, respectively. Rental expense is reduced for mileage credits received on leased railroad cars ($1,939,000 in 1993, $663,000 in 1992 and $1,773,000 in 1991). The leases have various remaining terms ranging from over one year to 16 years. Some leases are renewable, at Farmland's option, for additional periods. The minimum amount Farmland must pay for these leases during the fiscal years ending August 31 are as follows: (Amounts in Thousands) 1994....................................$ 38,673 1995.................................... 29,370 1996.................................... 23,532 1997.................................... 21,603 1998.................................... 17,528 1999 and after.......................... 67,881 $198,587 Farmland and its subsidiaries are involved in various lawsuits incidental to the businesses. In the opinion of management, the ultimate resolution of these litigation issues will not have a material adverse effect on the Company's consolidated financial statements. The Company has certain throughput agreements, take-or-pay agreements, minimum quantity agreements, and minimum charge agreements for various raw material supplies and services through 1996. The Company's minimum obligations under such agreements are: $2,548,000 in 1994; $1,248,000 in 1995; and $924,000 in 1996. As a result of regulations by the Environmental Protection Agency, sulfur levels must be reduced in diesel fuels sold after September 30, 1993. To comply with these regulations, the Company has committed to approximately $44,000,000 of improvements to the Coffeyville refinery. As of August 31, 1993, approximately $31,451,000 has been spent. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (11) Employee Benefit Plans The Farmland Industries, Inc. Employee Retirement Plan ("the Plan") is a defined benefit plan covering substantially all employees of Farmland and its subsidiaries who meet minimum age and length-of-service requirements. Benefits payable under the Plan are based on years of service and the employee's average compensation during the highest four of the employee's last ten years of employment. The Company's funding policy is to make the maximum annual contribution that can be deducted for federal income tax purposes. Contributions are intended to provide not only for benefits attributed to service to date but also for those expected to be earned in the future. The assets of the Plan are maintained in a trust fund. The majority of the Plan's assets are invested in common stocks, corporate bonds, United States Government securities and short-term investment funds. Plan assets at August 31, 1993 and 1992 included Farmland subordinated debt certificates and Farmland demand loan certificates totalling $280,000 and $5,832,000, respectively. In connection with Farmland's acquisition of Union Equity, Union Equity's defined benefit plan's assets and actuarial liabilities were transferred to Farmland's retirement plan. The discount rate and the rate of increase in future compensation levels used in determining the actuarial present NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) value of the projected benefit obligations at August 31, 1993 were 8.5% and 5%, respectively (9% and 5% at August 31, 1992 and 1991, respectively). The expected long-term rates of return on assets at August 31, 1993, 1992 and 1991 were 8.5%, 9% and 9.5%, respectively. The Company provides life insurance benefits for retired employees through an insurance company. Any employee hired before January 1, 1988 who reaches normal retirement age while working for the Company is eligible for the benefit. Annual premiums for providing this employee benefit and for providing group life insurance for active employees are based on payments made by the insurance company during the year. Costs of life insurance provided for retired employees are not separable from costs of providing group life insurance for active employees. The Company recognizes costs for providing life insurance for retired and active employees by charging operations for the annual insurance premium paid. For the years ended August 31, 1993, 1992 and 1991, such insurance premiums were $1,178,000, $783,000 and $462,000, respectively. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) The Company will adopt FASB Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" during the first quarter of its 1994 fiscal year. Upon adoption, the cost for providing life insurance during an employee's retirement years will be accrued during the active service period of the employee. Previously unrecognized costs related to the service period already rendered (the transition obligation) will be recognized over 20 years. The annual cost of providing life insurance for retired employees, determined following Statement 106, is estimated to be $1,000,000. Statement of Financial Accounting Standards No. 112, "Employer's Accounting for Postemployment Benefits", was issued by the FASB in November 1992 and is effective for fiscal years beginning after December 15, 1993 (the Company's 1995 fiscal year). Statement 112 establishes standards of accounting and reporting for the estimated cost of benefits provided to former or inactive employees. Management expects that the adoption of Statement 112 will not have a significant impact on the Company's consolidated financial statements. An Annual Employee Variable Compensation Plan, a Long-Term Management Incentive Plan, and an Executive Deferred Compensation Plan have been established by the Company to meet the competitive salary programs of other companies, and to provide a method of compensation which is based on the Company's performance. Under the Company's Variable Compensation Plan, all regular salaried employees are eligible to receive an annual cash bonus that is based on the employee's position, income before extraordinary items of the Company, and income or other performance criteria of the individual's operating unit. Amounts accrued under this plan for the years ended August 31, 1993, 1992 and 1991 amounted to $-0-, $10,033,000 and $-0-, respectively. Distributions under this plan are made annually after the close of each fiscal year. Under the Long-Term Management Incentive Plan, the Company's executive management employees are paid cash bonus amounts determined by a formula which takes into account the level of management and the average annual net income of the Company over a three-year period. The current Long-Term Management Incentive Plan ends August 31, 1996. The Company's performance did not reach a level where incentive was earned under the Long-Term Management Incentive Plan that covered the three-year period ended August 31, 1993. As a result, operations in 1993 were credited by $2,463,000 to reverse provisions for management incentive awards previously charged against operations in 1992 and 1991 ($1,171,000 and $1,292,000, respectively). The Company's Executive Deferred Compensation Plan permits certain employees to defer part of their salary and/or part or all of their bonus compensation. The amount to be deferred and the period for deferral is specified by an election made NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) semi-annually. Payments of deferred amounts shall begin at the earlier of the end of the specified deferral period, retirement, disability or death. The employee's deferred account balance is credited annually with interest at the highest rate of interest paid by the Company on any subordinated debt certificate sold during the year. Payment of an employee's account balance shall, at the employee's election, be a lump sum or in ten annual installments. At August 31, 1993 and 1992, the Company's obligations under this plan amounted to $8,240,000 and $7,649,000, respectively. (12) Industry Segment Information The Company's business is conducted within three general operating areas: cooperative farm supply operations, cooperative marketing operations, and retail and service operations. As a farm supply cooperative, the Company engages in manufacturing and wholesale distribution of input products of agricultural production. The Company's principal farm supply products are petroleum, fertilizer and agricultural chemicals, and feed. Petroleum products include gasoline, distillate, diesel fuel, propane, lube oils, grease and automotive parts and accessories. Products in the fertilizer and agricultural chemicals area include nitrogen, phosphate and potash fertilizers, herbicides, insecticides and other farm chemicals. Feed products include a complete line of formulated feeds. Supply products are sold primarily at wholesale to local farm cooperatives. Marketing operations include pork and beef processing, marketing and the distribution of fresh meat products, ham, bacon, sausage, deli meats, Italian specialty meats and boxed beef, and the marketing and storage of grain. In 1993, export sales of grain totaled $570,171,000. The retail and service operations include convenience fuel and food stores, farm supply stores, finance company operations and services such as accounting, financial, management, environmental and safety, and transportation. See note 2 of the notes to consolidated financial statements. The operating income (loss) of each industry segment includes the revenue generated on transactions involving products within that industry segment less identifiable and allocated expenses. In computing operating income (loss) of industry segments none of the following items have been added or deducted: other income (deductions) or corporate expenses (included in the accompanying statements of operations as selling, general and administrative expenses), which cannot practicably be identified or allocated by industry segment. Operating income (loss) of industry segments for the years ended August 31, 1992 and 1991 have been restated for comparative purposes to include certain costs which were not identified to business segments in 1992 and 1991 but which were identified to business segments in 1993. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Corporate assets include cash, investments in other cooperatives, the corporate headquarters of Farmland and certain other assets. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (13) Significant Group Concentration of Credit Risk Farmland extends credit to its customers on terms no more favorable than standard terms of the industries it serves. A substantial portion of Farmland's receivables are concentrated in the agricultural industry. Collections on these receivables may be dependent upon economic returns from farm crop and livestock production. The Company's credit risks are continually received and management believes that adequate provisions have been made for doubtful accounts. Farmland maintains investments in and advances to cooperatives, cooperative banks and joint ventures from which it purchases products or services. A substantial portion of the business of these investees is dependent on the agribusiness economic sector. See note 4 of the notes to consolidated financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (14) Disclosures About Fair Value of Financial Instruments The estimated fair value of notes receivable has been determined by discounting future cash flows using a market interest rate. The estimated fair value of the subordinated debt certificates was calculated using the discount rate for subordinated debt certificates with similar maturities currently offered for sale. **** Investments in CoBank and other cooperatives' equities which have been purchased are carried at cost and securities received as patronage refunds are carried at par value, less provisions for permanent impairment. The Company believes it is not practicable to estimate the fair value of these securities because there is no established market for these securities and it is inappropriate to estimate future cash flows which are largely dependent on future patronage earnings of the cooperatives. (15) Related Party Transactions Farmland Hydro, L.P. and Hyplains Beef, L.C. (50% owned investees) and National Beef Packing Company, L.P. (a 58% owned NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) consolidated limited partnership) have credit agreements with various banks. Borrowings under these agreements are nonrecourse to the Company. Cash distributions by these entities to their owners are restricted by these credit agreements. In addition, Farmland advances funds and provides management and administrative services for these entities and, in certain instances, on terms less advantageous to Farmland than transactions conducted in the ordinary course of business. At August 31, 1993, Farmland's notes receivable from these entities amounted to $38,368,000. (16) Provision for Loss on Disposition of Assets The Board of Directors authorized management to proceed with negotiations to sell the Company's refinery at Coffeyville, Kansas. Based on terms of the transaction contemplated, a $20,022,000 provision for loss on the sale of the refinery has been included in the accompanying consolidated statement of operations for the year ended August 31, 1993. Accordingly, at August 31, 1993, the net carrying value of property, plant and equipment has been reduced by $17,622,000, and a liability of $2,400,000 has been recorded for completion of capital projects. The transaction is subject to certain conditions including negotiation of final definitive agreements. The Company entered discussions with a potential purchaser of a dragline. Based on these discussions, the Company estimates a loss of $6,155,000 from the sale. Accordingly, at August 31, 1993, the carrying value of the dragline has been written down by $6,155,000 and a provision for this loss is included in the Company's consolidated statement of operations for the year then ended. The carrying value of a pork processing plant at Iowa Falls, Iowa was written down by $3,253,000 to an estimated disposal value. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE No disagreement on any matter of accounting principles or practices or financial statement disclosure was reported. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The directors of Farmland are as follows: Directors are elected for a term of three years by the shareholders of Farmland at its annual meeting. The expiration dates for such three-year terms are sequenced so that about one-third of Farmland's Board of Directors is elected each year. H. D. Cleberg is serving as director-at-large; the remaining twenty-one directors were elected from nine geographically defined districts in Farmland's territory. The executive committee consists of Willard Engel, Robert Merkle, Otis Molz, Paul Ruedinger, Albert Shivley, and H. D. Cleberg. The audit committee consists of Willard Engel, Steven Erdman, Greg Pfenning, Vonn Richardson and Raymond Schmitz. The executive officers of Farmland are: Age as of August 31, Name 1993 Principal Occupation and Other Positions J. F. Berardi 50 Executive Vice President and Chief Financial Officer - Mr. Berardi joined Farmland March 1, 1992 to serve in his present position. Mr. Berardi served as Executive Vice President and Treasurer of Harcourt Brace Jovanovich, Inc., a diversified Fortune 200 company, and was a member of its Board of Directors from 1988 until 1990. From 1986 to 1989 Mr. Berardi served as Senior Vice President and Chief Financial Officer of Harcourt Brace Jovanovich, Inc. H. D. Cleberg 54 President and Chief Executive Officer - Mr. Cleberg has been with Farmland since 1968. He was appointed to his present position effective April 1991. From September 1990 to March 1991 he served as Senior Vice President and Chief Operating Officer. From April 1989 to August 1990 he served as Executive Vice President, Operations. From October 1987 to March 1989 he served as Vice President and General Manager, Fertilizer and Ag Chemicals Operations, and from July 1986 to September 1987 he served as President, Farmland Foods. Prior to July 1986 he held several executive management positions, most recently Vice President, Field Services and Operations Support. S. P. Dees 50 President and General Manager of Farmland Industrias, S.A. de C.V. - Mr. Dees was appointed to his present position in September 1993. From October 1990 to September 1993 he served as Executive Vice President, Administrative Group and General Counsel. Mr. Dees joined Farmland in October 1984, serving as Vice President and General Counsel, Law and Administration until September 1990. He was a partner in the law firm of Stinson, Mag and Fizzell, Kansas City, Missouri, from 1971 until his employment by Farmland. G. E. Evans 49 Senior Vice President, Agricultural Production Marketing/Processing - Mr. Evans has been with Farmland since 1971. He was appointed to his present position in January 1992. From April 1991 to January 1992 he served as Senior Vice President, Agricultural Inputs. He served as Executive Vice President, Agricultural Marketing from October 1990 to March 1991. He served as Executive Vice President, Operations from January 1990 to September 1990. He served as Vice President, Farmland Industries and President, Farmland Foods from October 1987 to December 1989. He served as Vice President and General Manager, Feed Operations from June 1986 to September 1987, and from May 1983 to June 1986 he served as Vice President, Feed Operations. R. W. Honse 50 Executive Vice President, Agricultural Inputs Operations - Mr. Honse has been with Farmland since September 1983. He was appointed to his present position in January 1992, and served as Executive Vice President, Agricultural Operations from October 1990 to January 1992. From April 1989 to September 1990, he served as Vice President and General Manager, Fertilizer and Agricultural Chemicals Operations. From July 1986 to March 1989 he served as General Manager of the Florida phosphate fertilizer complex. B. L. Sanders 52 Vice President and Corporate Secretary - Dr. Sanders has been with Farmland since 1968. He was appointed to his present position in September 1991. From April 1990 to September 1991 he served as Vice President, Strategic Planning and Development. From October 1987 to March 1990 he served as Vice President, Planning. From July 1986 to September 1987 he served as Director, Management Information Services. From July 1984 to June 1986 he served as Executive Director, Corporate Strategy and Research and from 1968 to June 1984, as Executive Director, Economic and Market Research. EXECUTIVE COMPENSATION An Annual Employee Variable Compensation Plan, a Long-Term Management Incentive Plan, and an Executive Deferred Compensation Plan have been established by the Company to meet the competitive salary programs of other companies, and to provide a method of compensation which is based on the Company's performance. Under the Company's Annual Employee Variable Compensation Plan, all regular salaried employees are eligible to receive an annual cash bonus that is based on the employee's position, income before extraordinary items of the Company, and income or other performance criteria of the individual's operating unit. Amounts accrued under this plan for the years ended August 31, 1993, 1992 and 1991 amounted to $-0-, $10,033,000 and $-0-, respectively. Distributions under this plan are made annually after the close of each fiscal year. Under the Long-Term Management Incentive Plan, the Company's executive management employees are paid cash bonus amounts determined by a formula which takes into account the level of management and the average annual net income of the Company over a three-year period. The current Long-Term Management Incentive Plan ends August 31, 1996. The Company's performance did not reach a level where incentive was earned under the Long-Term Management Incentive Plan that covered the three-year period ended August 31, 1993. As a result, operations in 1993 were credited by $2,463,000 to reverse provisions for management incentive awards previously charged against operations in 1992 and 1991 ($1,171,000 and $1,292,000, respectively). The Company's Executive Deferred Compensation Plan permits executive employees to defer part of their salary and/or part or all of their bonus compensation. The amount to be deferred and the period for deferral is specified by an election made semi-annually. Payments of deferred amounts shall begin at the earlier of the end of the specified deferral period, retirement, disability or death. The employee's deferred account balance is credited annually with interest at the highest rate of interest paid by the Company on any subordinated debt certificate sold during the year. Payment of an employee's account balance shall, at the employee's election, be a lump sum or in ten annual installments. Amounts accrued pursuant to the plan for the accounts of the named individuals during the fiscal years 1993, 1992 and 1991 are included in the cash compensation table. The Company established Farmland Industries, Inc. Employee Retirement Plan in 1986 for all employees whose customary employment is at the rate of at least 1000 hours per year. Participation in this plan is optional prior to age 34, but mandatory thereafter. Approximately 6,480 active and 6,900 inactive employees were participants in the plan on August 31, 1993. The plan is funded by employer and employee contributions to provide lifetime retirement income at normal retirement age 65, or a reduced income beginning as early as age 55. The Retirement Plan has been determined qualified under the Internal Revenue Code. The plan is administered by a committee appointed by the Board of Directors of Farmland, and all funds of the plan are held by a bank trustee in accordance with the terms of the trust agreement. It is the present intent to continue this plan indefinitely. Payments to participants in the plan are based upon length of participation and compensation (limited to $235,840 annually for any employee) reported to the plan for the four highest of the last ten years of employment. The plan also contains provisions for death and disability benefits. The Company made no contributions to the plan in 1993, 1992 and 1991. At August 31, 1993 (based upon the Plan's funded status as of May 31, 1993), the present value of the accumulated benefit obligation was $130,163,000 and the estimated fair value of plan assets was $212,647,000. In 1982, the Tax Equity and Fiscal Responsibility Act (TEFRA) imposed a maximum retirement benefit which may be paid by a qualified retirement plan. At the present time, that limit is $115,641. Subject to the $235,840 maximum limit on annual compensation which may be covered by a qualified pension plan, amounts included in the cash compensation table do not vary substantially from the compensation covered by the pension plan. CERTAIN TRANSACTIONS The Company transacts business in the ordinary course with its directors and with its local cooperative members with which the directors are associated on terms no more favorable than those available to its other local cooperative members. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT No person owns of record or is known to own beneficially more than five percent of Farmland's equity securities. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The Company transacts business in the ordinary course with its directors and with its local cooperative members with which the directors are associated on terms no more favorable than those available to its other local cooperative members. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (A) Listing of Financial Statements, Financial Statement Schedules and Exhibits (1) Financial Statements Independent Auditors' Report Consolidated Balance Sheets, August 31, 1993 and Consolidated Statements of Operations for each of the years in the three-year period ended August 31, 1993 Consolidated Statements of Cash Flows for each of the years in the three-year period ended August 31, 1993 Consolidated Statements of Capital Shares and Equities for each of the years in the three-year period ended August 31, 1993 Notes to Consolidated Financial Statements (2) Financial Statement Schedules Farmland Industries, Inc. and Subsidiaries for each of the years in the three-year period ended August 31, 1993: V--Property, Plant and Equipment VI--Accumulated Depreciation and Amortization of Property, Plant and Equipment IX--Short-term Borrowings X--Supplementary Income Statement Information All other schedules are omitted as the required information is inapplicable or the information is presented in the consolidated financial statements or related notes. (3) Exhibits Articles of Incorporation and Bylaws: 3.A Articles of Incorporation and Bylaws of Farmland Industries, Inc. effective August 30, 1990. (Incorporated by Reference - Form SE, filed November 21, 1990) Instruments Defining the Rights of Owners of the Debt Securities Being Registered: 4.A(1) Trust Indenture dated November 20, 1981, as amended January 4, 1982, including specimen of Demand Loan Certificates. (Incorporated by Reference - Form S-1, No.2-75071, effective January 7, 1982) 4.A(2) Trust Indenture dated November 8, 1984, as amended January 3, 1985, including specimen of 20-year Subordinated Capital Investment Certificates. (Incorporated by Reference - Form S-1, No.2-94400, effective December 31, 1984) 4.A(2)(1) Amendment Number 2, dated December 3, 1991, to Trust Indenture dated November 8, 1984 as amended January 3, 1985, covering Farmland Industries, Inc.'s 20-Year Subordinated Capital Investment Certificates (Incorporated by Reference - Form SE, filed December 3-2, 1991) 4.A(3) Trust Indenture dated November 8, 1984, as amended January 3, 1985, including specimen of 10-year Subordinated Capital Investment Certificates. (Incorporated by Reference - Form S-1, No.2-94400, effective December 31, 1984) 4.A(3)(1) Amendment Number 2, dated December 3, 1991, to Trust Indenture dated November 8, 1984 as amended January 3, 1985, covering Farmland Industries, Inc.'s 10-Year Subordinated Capital Investment Certificates. (Incorporated by Reference - Form SE, filed December 3-3, 1991) 4.A(4) Trust Indenture dated November 8, 1984, as amended January 3, 1985, including specimen of 5-year Subordinated Capital Investment Certificates. (Incorporated by Reference - Form S-1, No.2-94400, effective December 31, 1984) 4.A(4)(1) Amendment Number 2, dated December 3, 1991, to Trust Indenture dated November 8, 1984 as amended January 3, 1985, covering Farmland Industries, Inc.'s 5-Year Subordinated Capital Investment Certificates. (Incorporated by Reference - Form SE, filed December 3-4, 1991) 4.A(5) Trust Indenture dated November 8, 1984, as amended January 3, 1985 and November 20, 1985, including specimen of 10-year Subordinated Monthly Income Capital Investment Certificates. (Incorporated by Reference - Form S-1, No. 2-94400, effective December 31, 1984) 4.A(6) Trust Indenture dated November 11, 1985 including specimen of the 5-year Subordinated Monthly Income Capital Investment Certificates. (Incorporated by Reference - Form S-1, No. 33-1970, effective December 31, 1985) Instruments Defining Rights of Owners of Indebtedness not Registered: 4.B(1) National Bank for Cooperatives Master Loan Agreement for Farmland Industries, Inc., dated April 23, 1993. (Incorporated by Reference - Form 10-Q, filed July 14, 1993) 4.B(2) List identifying contents of all omitted schedules referenced in and not filed with, the National Bank for Cooperatives Master Loan Agreement for Farmland Industries, Inc. (Incorporated by Reference - Form 10-Q, filed July 14, 1993) Material Contracts: Lease Contracts: 10.A(1) The First National Bank of Chicago, not individually but solely as Trustee for FNBC Leasing Corporation, the First Chicago Leasing Corporation, The Boatmen's National Bank of St. Louis, Firstier Bank, N.A., and Norwest Bank Minnesota, National Association and Farmland Industries, Inc. consummated a leveraged lease in the amount of $73,153,000 dated September 6, 1991. (Incorporated by Reference - Form SE, filed December 3-1, 1991.) 10.A(2) Iowa-Des Moines National Bank as Trustee for Citicorp Lescaman as Owner-Participant and Farmland Industries, Inc. consummated a leveraged lease in the amount of $18,774,476 dated June 15, 1975. (Incorporated by Reference - Form S-1, No.2-57765, effective January 10, 1977) 10.A(3) The First National Bank of Commerce as Trustee for General Electric Credit Corporation as Beneficiary and Farmland Industries, Inc. consummated a leveraged lease in the amount of $51,909,257.90 dated March 17, 1977. (Incorporated by Reference - Form S-1, No.2-60372, effective December 22, 1977) Management Remunerative Plans Filed Pursuant to Item 14C of this Report. 10.(iii)(A)Annual Employee Variable Compensation Plan (September 1, 1993 - August 31, 1994) 10.(iii)(A)Farmland Industries, Inc. Management Long-Term Incentive Plan (Effective September 1993) 10.(iii)(A)Farmland Industries, Inc. Executive Deferred Compensation Plan (Incorporated by Reference - Form SE, filed November 23, 1987) 22. Subsidiaries of the Registrant Farmland Foods, Inc., a 99%-owned subsidiary, was incorporated under the laws of the State of Kansas. Farmland Foods, Inc. has been included in the consolidated financial statements filed in this registration. Farmland Insurance Agency, a wholly-owned subsidiary, was incorporated under the laws of the State of Missouri. Farmland Insurance Agency has been included in the consolidated financial statements filed in this registration. Farmers Chemical Company, a wholly-owned subsidiary, was incorporated under the laws of the State of Kansas. Farmers Chemical Company has been included in the consolidated financial statements filed in this registration. Farmland Securities Company, a wholly-owned subsidiary, was incorporated under the laws of the State of Delaware. Farmland Securities Company has been included in the consolidated financial statements filed in this registration. Cooperative Service Company, a wholly-owned subsidiary, was incorporated under the laws of the State of Nebraska. Cooperative Service Company has been included in the consolidated financial statements filed in this registration. Double Circle Farm Supply Company, a wholly-owned subsidiary, was incorporated under the laws of the State of Nevada. Double Circle Farm Supply Company has been included in the consolidated financial statements filed in this registration. National Beef Packing Company, L.P., a 58%-owned subsidiary, was incorporated under the laws of the State of Delaware. National Beef Packing Company has been included in the consolidated financial statements included in this registration. Farmland Financial Services Company, a wholly-owned subsidiary, was incorporated under the laws of the State of Kansas. Farmland Financial Services Company has been included in the consolidated financial statements included in this registration. Farmland Transportation, Inc., a wholly-owned subsidiary, was incorporated under the laws of the State of Missouri. Farmland Transportation, Inc. has been included in the consolidated financial statements included in this registration. Environmental and Safety Services, Inc., a wholly-owned subsidiary, was incorporated under the laws of the State of Missouri. Environmental and Safety Services, Inc. has been included in the consolidated financial statements included in this registration. Penterra, Inc., a 81%-owned subsidiary, was incorporated under the laws of the State of Kansas. Penterra, Inc. has been included in the consolidated financial statements included in this registration. Farmland Industries, Ltd., a wholly-owned subsidiary, was incorporated under the laws of the United States Virgin Islands. Farmland Industries, Ltd. has been included in the consolidated financial statements included in this registration. Heartland Data Services, Inc., a wholly-owned subsidiary, was incorporated under the laws of the State of Kansas. Heartland Data Services, Inc. has been included in the consolidated financial statements included in this registration. Yuma Feeder Pig, Inc., a 72%-owned subsidiary, was incorporated under the laws of the state of Colorado. Yuma Feeder Pig, Inc. has been included in the consolidated financial statements included in this registration. Equity Country, Inc., a wholly-owned subsidiary, was incorporated under the laws of the State of Delaware. Equity Country, Inc. has been included in the consolidated financial statements included in this registration. Equity Export Oil and Gas Company, Inc., a wholly-owned subsidiary, was incorporated under the laws of the State of Oklahoma. Equity Export Oil and Gas Company, Inc. has been included in the consolidated financial statements included in this registration. Uneco Investor Services, Inc., a wholly-owned subsidiary, was incorporated under the laws of the State of Delaware. Uneco Investor Services, Inc. has been included in the consolidated financial statements included in this registration. 24. Power of Attorney (B) Reports on Form 8-K A Form 8-K was filed September 15, 1993, pursuant to Item 2 of the Form 8-K, as a result of the disposition of The Cooperative Finance Association. Financial statements filed with the Form 8-K: a) Unaudited pro forma statements of operations for the year ended August 31, 1992 and the nine months ended May 31, 1993; b) Unaudited pro forma balance sheet as of May 31, 1993; and c) Notes to unaudited pro forma financial statements. (C) Exhibits The exhibits required by Item 601 of Regulation S-K are filed herewith or have been filed with the Securities and Exchange Commission and are incorporated by reference as part of this Form 10-K. See Item 14(A)(3). (D) Financial Statement Schedules required by Regulation are filed herewith: See Item 14(A)(2). SIGNATURES PURSUANT TO THE REQUIREMENTS OF THE SECURITIES ACT, FARMLAND INDUSTRIES, INC. HAS DULY CAUSED THIS FORM 10-K TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED IN THE CITY OF KANSAS CITY, STATE OF MISSOURI ON NOVEMBER 29, 1993. FARMLAND INDUSTRIES, INC. BY H. D. Cleberg H. D. Cleberg President and Chief Executive Officer BY John F. Berardi John F. Berardi Executive Vice President and Chief Financial Officer Pursuant to the requirements of the Securities Act of 1933, this Form 10-K has been signed for the following persons on the date indicated pursuant to valid Power of Attorney executed on October 21, 1993. Signature Title Date ALBERT J. SHIVLEY Chairman of Board, Director November 29, 1993 Albert J. Shivley Vice Chairman of Board, OTIS H. MOLZ Director November 29, 1993 Otis H. Molz LYMAN ADAMS Director November 29, 1993 Lyman Adams RONALD J. AMUNDSON Director November 29, 1993 Ronald J. Amundson BAXTER ANKERSTJERNE Director November 29, 1993 Baxter Ankerstjerne JODY BEZNER Director November 29, 1993 Jody Bezner RICHARD L. DETTEN Director November 29, 1993 Richard L. Detten WILLARD ENGEL Director November 29, 1993 Willard Engel STEVEN ERDMAN Director November 29, 1993 Steven Erdman BEN GRIFFITH Director November 29, 1993 Ben Griffith GAIL D. HALL Director November 29, 1993 Gail D. Hall BARRY JENSEN Director November 29, 1993 Barry Jensen ROBERT MERKLE Director November 29, 1993 Robert Merkle GREG PFENNING Director November 29, 1993 Greg Pfenning VONN RICHARDSON Director November 29, 1993 Vonn Richardson MONTE ROMOHR Director November 29, 1993 Monte Romohr PAUL RUEDINGER Director November 29, 1993 Paul Ruedinger RAYMOND J. SCHMITZ Director November 29, 1993 Raymond J. Schmitz DALE STENERSON Director November 29, 1993 Dale Stenerson THEODORE J. WEHRBEIN Director November 29, 1993 Theodore J. Wehrbein ROBERT ZINKULA Director November 29, 1993 Robert Zinkula

1993 Item 1. Description of Business Incorporated by reference, Annual Report to Shareholders for the year ended December 31, 1993, pages 17, 29, 55 and 56. Insurance Regulation. Like other insurance companies, the Registrant's subsidiaries are subject to regulation and supervision by the Florida Insurance Department, as well as other insurance departments of each jurisdiction in which they are licensed to do business. These supervisory agencies have broad administrative powers relating to the granting and revocation of licenses to transact business, the licensing of agents, the approval of policy forms, reserve requirements and the form and content of required financial statements. As to its investments, each of the Registrant's insurance subsidiaries must meet the standards and tests established by the National Association of Insurance Commissioners (NAIC) and, in particular, the investment laws and regulations of the Florida Insurance Department. The insurance companies are also subject to laws in most states that require solvent insurance companies to pay guaranty fund assessments to protect the interests of policyholders of insolvent insurance companies. In December, 1991, the NAIC adopted two new reserve requirements (the Asset Valuation Reserve or "AVR" and the Interest Maintenance Reserve or "IMR") to replace the former Mandatory Securities Valuation Reserve or "MSVR." These reserves are generally required by state insurance regulatory authorities to be established as a liability on a life insurer's statutory financial statements beginning with the 1992 annual statement, but do not affect financial statements of the Registrant prepared in accordance with generally accepted accounting principles. AVR establishes a statutory reserve for mortgage loans and investments in real estate, as well as for the types of investments (i.e., fixed maturities and common and preferred stock) that have been subject to the MSVR. AVR generally captures all realized and unrealized gains and losses on such assets, other than those resulting from changes in interest rates. IMR captures the net gains that are realized upon the sale of fixed income securities (bonds, preferred stocks, mortgage-backed securities and mortgage loans) and that result from changes in the overall level of interest rates, and amortizes these net realized gains into income over the remaining life of each investment sold, thus limiting the ability of an insurer to enhance statutory surplus by taking gains on fixed income securities. The implementation of the IMR and AVR has not had a material impact on the Registrant's life insurance subsidiary's surplus nor on its ability to pay dividends to the Registrant. In recent years, the NAIC has approved several regulatory initiatives designed to decrease the risk of insolvency of insurance companies in general. These initiatives include the implementation of a risk-based capital formula for determining adequate levels of capital and surplus and further restrictions on an insurance company's ability to pay dividends to its shareholders. Florida has adopted the risk-based capital requirements and has recently revised its dividend limitation policy. Under NAIC's risk-based capital (RBC)initiatives, life insurance companies must calculate and report information under a risk-based capital formula, beginning with their year-end 1993 statutory financial statements. (Property/Casualty companies must implement a different risk-based capital formula in their 1994 year-end statutory filings). This RBC information is intended to permit insurance regulators to identify and require remedial action for inadequately capitalized insurance companies. The NAIC initiatives provide for four levels of potential involvement by state regulators for inadequately capitalized insurance companies, ranging from regulatory control of the insurance company to a requirement for the insurance company to submit a plan to improve its capital. The life insurance subsidiary's surplus exceeds the authorized control level risk-based capital by approximately $80 million. Holdings in common stock require considerably more risk-based capital similar monies been invested in bonds. However, investment decisions are driven principally by long-term economic considerations and not altered to produce more attractive risk-based capital results. The subsidiary believes that over the long-term, the total return on equities outperforms that on debt security investments. It sells options against select holdings in the equity portfolio to generate realized investment gains and further enhance current yield and total return. Such net gains totaled $1.8 million in 1993. Another NAIC Model Act provision limits dividends that may be paid in any calendar year without regulatory approval to the lesser of (i) 10% of the insurer's statutory surplus at the prior year-end, or (ii) the statutory net gain from operations of the insurer (excluding realized capital gains and losses) for the prior calendar year. The NAIC has determined that it will not grant accreditation to any state insurance regulatory authority in a state that has not enacted statutes "substantially similar" to the NAIC Model Act regulating the payment of dividends by insurers. Under current Florida law, without prior approval from the Florida Commissioner of Insurance and conditional that insurers maintain at least 115 percent of required risk- based capital after the payment of dividends, the maximum allowable dividend in 1994 is $16 million. In accordance with the rules and practices of the NAIC and in accordance with state law, every insurance company is examined generally once each three years by examiners from its state of domicile and from several of the other states where it is licensed to do business. The most recent examinations for all the Registrant's insurance subsidiaries were for the year ending December 31, 1992. Item 2. Item 2. Properties Incorporated by reference, Annual Report to Shareholders for the year ended December 31, 1993, page 17. Item 3. Item 3. Legal Proceedings Incorporated by reference, Annual Report to Shareholders for the year ended December 31, 1993, page 54. Item 4. Item 4. Submission of Matters to a Vote of Security Holders No reportable events PART II Item 5. Item 5. Market for the Registrant's Common Stock and Related Security Holder Matters Incorporated by reference, Annual Report to Shareholders for the year ended December 31, 1993, page 18. The Registrant has been informed that holders of more than 90% of the voting stock of the Registrant have entered into an Agreement (the "No Transfer Agreement") prohibiting the parties thereto from transferring shares of voting stock held by them except under certain circumstances. The excepted transfers include: (i) transfers pursuant to an offer which has been approved or recommended by the Board of Directors of the Registrant, (ii) transfers pursuant to the written consent of holders of a majority of the shares of voting stock subject to the No Transfer Agreement and, (iii) transfers to the Registrant pursuant to the Exchange Agreement referred to in Item 12. The No Transfer Agreement has an initial term ending on November 10, 1996, renewable for two additional five-year terms by vote of the holders of a majority of the voting stock subject thereto prior to the expiration of each successive term. The restrictions on transfer of voting stock imposed by the No Transfer Agreement are in addition to, and not in lieu of, restrictions on such transfers imposed by the Articles of Incorporation of the Registrant. Item 6. Item 6. Selected Financial Data Incorporated by reference, Annual Report to Shareholders for the year ended December 31, 1993, pages 23-24. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Incorporated by reference, Annual Report to Shareholders for the year ended December 31, 1993, pages 25-33. Item 8. Item 8. Financial Statements and Supplementary Data Incorporated by reference, Annual Report to Shareholders for the year ended December 31, 1993, pages 35-57. Item 9. Item 9. Changes in and Disagreements on Accounting and Financial Disclosure No reportable events PART III Item 10. Item 10. Directors and Executive Officers of the Registrant The directors of the Registrant and the year originally elected are: Wilford C. Lyon, Jr.* 1980 Kendall G. Bryan* 1982 Jacob F. Bryan, IV* 1980 Carter B. Bryan 1984 Boyd E. Lyon, Sr.* 1980 William G. Howard 1993 G. Howard Bryan 1980 George M. Baldwin 1980 Patricia H. Doane 1992 Lucy B. Gooding 1980 Michael C. Lyon 1991 *Executive officer of the Registrant The annual terms of all directors will expire April 13, 1994. Carter B. Bryan, age 49, is employed by the Registrant's subsidiary as a territorial manager. G. Howard Bryan and Patrica H. Doane, ages 79 and 58, respectively, are retired vice presidents of the Registrant's principal subsidiary and are not otherwise employed. George M. Baldwin, and Lucy B. Gooding, ages 78 and 91, respectively, are not otherwise employed. Michael C. Lyon and William G. Howard are 43 and 42, and are vice presidents of the principal subsidiary of the Registrant. See below for information regarding the positions and offices of directors who are executive officers of the Registrant and for family relationships between such directors and officers. The names, ages and positions of the executive officers of the Registrant as of February 8, 1994, are listed below. The principal business experience during the past five years for each person listed has been as an officer of the Registrant. Name Age Position and Business Experience Wilford C. Lyon,Jr. 58 Chairman of the Board of Directors and Chief Executive Officer - 1984 Jacob F. Bryan, IV 50 President - 1984 Boyd E. Lyon, Sr. 54 Vice President, Treasurer and Chief Financial Officer - 1984 Kendall G. Bryan 47 Vice President and Chief Operating Officer - 1984 Guy Marvin III 53 Assistant Secretary and General Counsel - 1980 David A. Skup 41 Vice President and Internal Auditor - 1984 Each officer of the Registrant is elected at the annual meeting of the Board of Directors and holds office until the next annual meeting (to be held in 1994 on April 13). Wilford C. Lyon, Jr. and Boyd E. Lyon, Sr. are brothers, and are also cousins of Michael C. Lyon. Jacob F. Bryan, IV, Kendall G. Bryan and Carter B. Bryan are brothers, and nephews of G. Howard Bryan. Patricia Howard Doane and William G. Howard are cousins. Section 16(a) of the Securities Exchange Act of 1934 requires the Registrant's directors and executive officers, and persons who own more than 10% of a registered class of the Registrant's equity securities, to file with the Securities and Exchange Commission initial reports of ownership and reports of changes in ownership of Common Stock and other equity securities of the Registrant. Officers, directors and greater than 10% shareholders are required by SEC regulation to furnish the Registrant with copies of all Section 16(a) forms they file. To the Registrant's knowledge, based solely on review of the copies of reports furnished to the Registrant and written representations that no other reports were required, during the year ended December 31, 1993 all Section 16(a) filing requirements applicable to its officers, directors and greater than 10% beneficial owners were complied with. Item 11. Item 11. Executive Compensation (a) (b)(2)(i)(ii)(iii) The following table provides information concerning the annual compensation for the Registrant's Chief Executive Officer (CEO) and the four most highly compensated executive officers other than the CEO as of Decemeber 31, 1993. G. Howard Bryan who retired in October, 1993, as an executive officer also is included. SUMMARY COMPENSATION TABLE |--------- ANNUAL COMPENSATION -------| Other Name and Principal Annual Position Year Salary Bonus Compensation Wilford C. Lyon, Jr. 1993 345,748 0 0 Chairman of the Board & 1992 364,922 0 0 Chief Executive Officer 1991 339,170 20,239 0 Jacob F. Bryan IV 1993 297,151 0 0 President 1992 309,481 0 0 Director 1991 272,037 14,712 0 Boyd E. Lyon, Sr. 1993 240,977 0 0 Vice President 1992 249,668 0 0 Treasurer & Director 1991 225,106 13,476 0 Kendall G. Bryan 1993 229,054 0 0 Vice President 1992 244,959 0 0 Secretary & Director 1991 223,836 12,163 0 Guy Marvin, III 1993 162,906 0 0 Assistant Secretary & 1992 176,298 0 0 General Counsel 1991 175,077 8,260 0 G. Howard Bryan 1993 162,649 0 0 Vice President 1992 175,644 0 0 Secretary & Director 1991 165,914 15,563 0 |-- Long-Term Compensation --| |----- Awards ----| Payouts Restricted All Name and Principal Stock Options LTIP Other Position Year Awards SAR's Payouts Compensation Wilford C. Lyon, Jr. 1993 0 0 0 27,535 Chairman of the Board & 1992 0 0 0 27,134 Chief Executive Officer 1991 0 0 0 26,483 Jacob F. Bryan IV 1993 0 0 0 19,365 President 1992 0 0 0 19,137 Director 1991 0 0 0 18,752 Boyd E. Lyon, Sr. 1993 0 0 0 29,991 Vice President 1992 0 0 0 29,541 Treasurer & Director 1991 0 0 0 28,708 Kendall G. Bryan 1993 0 0 0 15,872 Vice President 1992 0 0 0 15,754 Secretary & Director 1991 0 0 0 15,652 Guy Marvin, III 1993 0 0 0 9,736 Assistant Secretary & 1992 0 0 0 9,655 General Counsel 1991 0 0 0 9,519 G. Howard Bryan 1993 0 0 0 91,944 Vice President 1992 0 0 0 90,661 Secretary & Director 1991 0 0 0 84,734 Amounts reported as All Other Compensation represent premiums paid by the Registrant for insurance policies issued in connection with a Deferred Death Benefit Plan for Key Personnel. (f)(1)(i) The following table shows estimated annual benefits payable pursuant to the Registrant's defined benefit plan, under which benefits are determined primarily by final compensation and years of service. Pension Plan Table Years of Service Remuneration 15 20 25 30 35 $125,000 $41,498 $55,330 $ 69,162 $ 82,995 $ 96,828 150,000 50,310 67,080 83,850 100,620 115,641(2) 175,000 59,122 78,830 98,538 115,641(2) 115,641 200,000 67,935 90,580 113,225 115,641 115,641 225,000 74,711(1) 99,615(1) 115,641(2) 115,641 115,641 250,000 74,711 99,615 115,641 115,641 115,641 300,000 74,711 99,615 115,641 115,641 115,641 400,000 74,711 99,615 115,641 115,641 115,641 450,000 74,711 99,615 115,641 115,641 115,641 500,000 74,711 99,615 115,641 115,641 115,641 (1) Limited by maximum five year average (2) Limited by maximum annual benefit limit (ii)(A)The Plan uses the average of an individual highest consecutive five years of earnings as a basis upon which to calculate benefits. Since earnings which can be credited under a defined benefit plan are limited, there is an effective limit on what this five year average can be. Tax limits have been as follows: 1989 200,000 1990 209,200 1991 222,220 1992 228,860 1993 235,840 This provides a maximum five year average of $219,224. Each year a maximum limitation is placed on the benefits which can be received from a plan. For 1993 this limit was $115,641. For purposes of tax calculations, an individual is assumed to have retired on December 31, 1993 at age 65. Amounts are annual income, straight life basis. (B) The years of service for named executive officers are: Wilford C. Lyon, Jr., 35; Jacob F. Bryan IV, 27; Boyd E. Lyon, Sr., 32; Kendall G. Bryan, 24; Guy Marvin, III, 14 and G. Howard Bryan, 60. (C) Under the plan, eligible employees are entitled to annual pension benefits beginning at normal retirement age (65 to 67 depending on participants' year of birth) equal to the sum of: (1) 1.6% of average earnings of the highest five years multiplied by number of years of service not to exceed 35 years; and (2) .75% of average earnings in excess of Social Security wages multiplied by number of years of service, not to exceed 35 years. (g) All directors who are not employees of the Registrant or one of its subsidiaries receive $1,000 for each board meeting that the director attends, $250 for each telephone meeting the director participates in and $250 for each committee meeting of the Board that the non-employee director attends. (j)(2)The Registrant uses the Hay point-factor job evaluation system which applies to all employees, including the Chief Executive Officer and executive officers. Each year the CEO selects members of the Board of Directors to evaluate his performance. During the last fiscal year, these members were Jacob F. Bryan, IV, Boyd E. Lyon, Sr. and Kendall G. Bryan. Overall increases, which are tied to performance evaluations and the evaluation system, are approved by the full Board. The CEO evaluates all other named executive officers. For the year 1993, the salaries of the CEO and the other named executive officers were reduced 5%-7%. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management (a)The principal holders of voting securities (Voting Common Stock, Par Value $1.00) of the Registrant as of February 8, 1994 are: Name and Address of Amount and Nature of Percent Beneficial Owner Beneficial Ownership of Class George M. Baldwin 1,033,288(1) 16.9% 2929 Murray Road Orange Park, Florida James L. Baldwin 1,033,088(1) 16.9 2753 Haver Hill Ct. Clearwater, FL Frederick E. Williams 1,032,888(1) 16.9 109 North Street Neptune Beach, Florida and John G. Grimsley 50 North Laura Street Jacksonville, FL Lucy B. Gooding 981,612 16.1 2970 St. Johns Avenue Jacksonville, Florida Jacob F. Bryan IV 865,598(2) 14.2 5249 Yacht Club Road Jacksonville, Florida Julia Olive Craig Brooke 834,516(2) 13.7 467 Ortega Blvd. Jacksonville, Florida G. Howard Bryan 829,612(2) 13.6 1596 Lancaster Terrace Jacksonville, Florida Boyd E. Lyon, Sr. 349,922(4) 5.7 129 Middleton Place Ponte Vedra Beach, Florida Catherine H. Stanley 344,446 5.6 7650 Hollyridge Road Jacksonville, Florida (b)The following table shows as to each class of equity securities of the Registrant, the number of shares owned beneficially, directly or indirectly, by each director and named executive offices, and by all directors and officers of the Registrant as a group as of February 8, 1994. In some instances more than one beneficial owner is listed for the same securities. Shares held beneficially by spouses or relatives of such officers and directors may be included. Amount and Nature of Beneficial Ownership and Title of Class Percent of Class Name of Common Common Beneficial Owner Voting Nonvoting Voting Nonvoting George M. Baldwin 1,033,288(1) 16.9% Lucy B. Gooding 981,612 1,222,340 16.1 17.3 Jacob F. Bryan IV 865,598(2) 1,075,594(3) 14.2 15.2 G. Howard Bryan 829,612(2) 1,032,396(3) 13.6 14.6 Boyd E. Lyon, Sr. 349,922(4) 5.7 Wilford C. Lyon, Jr. 176,357(5) 2.9 Patricia H. Doane 92,102 620 1.5 Michael C. Lyon 49,531 100 .8 Carter B. Bryan 36,400 32,642 .6 .5 Kendall G. Bryan 35,200 13,877 .6 .2 William G. Howard 2,474 David A. Skup 420 All directors and officers as a group 3,526,084 2,371,373 57.8 33.6 (1) Includes 1,032,888 shares held of record by a trust under the will of Grace D. Coburn,deceased. Frederick E. Williams and John G. Grimsley are trustees. George M. Baldwin and James L. Baldwin are beneficiaries of the trust. (2) Includes all the shares of three trusts aggregating 812,412 shares of voting common stock of which Jacob F. Bryan IV, G. Howard Bryan and Julia Olive Craig Brooke are beneficiaries and/or trustees. (3) Includes all the shares of three trusts aggregating 1,006,616 shares of nonvoting common stock of which Jacob F. Bryan IV, G. Howard Bryan and Julia Olive Craig Brooke are beneficiaries and/or trustees. (4) Includes all the shares of three trusts aggregating 113,600 shares of voting common stock of which Boyd E. Lyon, Sr. is a trustee, and two trusts aggregating 101,760 shares of voting common stock held by the Registrant's retirement plans of which Boyd E. Lyon, Sr. is a trustee. (5) Includes all the shares of three trusts aggregating 113,600 shares of voting common stock of which Wilford C. Lyon, Jr. is a trustee. The Registrant has entered into "Exchange Agreements" with holders of more than 90% of the outstanding shares of voting common stock of the Registrant ("Voting Stock") pursuant to which such holders may, at any time on or prior to December 31, 2006, exchange shares of voting stock for an equal number of shares of nonvoting common stock of the Registrant without payment of any additional consideration. All of the principal shareholders, officers and directors listed above are parties to these agreements. Item 13. Item 13. Certain Relationships and Related Transactions (a)The Registrant's subsidiary, The Independent Life and Accident Insurance Company ("Independent Life"), employs Carter B. Bryan as a manager of its general agency insurance operations, and in 1993 compensated Mr. Bryan $40,715 in salaries associated with his position. In addition, Mr. Bryan received commissions on personal insurance sales and overwrites from the sales of other agents he manages. Much of these operations involved the sale of Independent Life's small employer group insurance products, a line of business Independent Life has taken steps to withdraw from effective June 30, 1994. Independent Marketing Group, Inc. and Independent Life have worked closely to find replacement coverage for all terminated policyholders with another insurance carrier. (b)The commissions and overwrites described above are paid to Independent Marketing Group, Inc., an entity owned by Mr. Bryan and his wife. The Registrant believes that $263,329 paid to this entity in 1993 by the Registrant exceeds five percent of the entity's gross revenues for the year. Independent Marketing Group, Inc., markets products of Independent Life and other insurance companies. Independent Life supplies office space to Mr. Bryan, which is used both by Mr. Bryan in his employment as manager of its general agency insurance operations and by Independent Marketing Group, Inc. Part IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a)(1) Financial Statements Consolidated Balance Sheets, December 31, 1993 and 1992, incorporated by reference, Annual Report to Shareholders for the year ended December 31, 1993, pages 35-36. Consolidated Statements of Operations for years ended December 31, 1993, 1992 and 1991, incorporated by reference, Annual Report to Shareholders for the year ended December 31, 1993, page 37. Consolidated Statements of Cash Flows for years ended December 31, 1993, 1992 and 1991, incorporated by reference, Annual Report to Shareholders for year ended December 31, 1993, page 38. Consolidated Statements of Shareholders' Equity for years ended December 31, 1993, 1992 and 1991, incorporated by reference, Annual Report to Shareholders for the year ended December 31, 1993, page 39. Notes to Consolidated Financial Statements for the three years ended December 31, 1993, incorporated by reference, Annual Report to Shareholders for year ended December 31, 1993, pages 40-56. (2) Financial Statement Schedules Consolidated Summary of Investments - Other Than Investments in Affiliates (Schedule I), incorporated by reference, Annual Report to Shareholders for the year ended December 31, 1993, page 45. Condensed Financial Information of the Registrant (Schedule III) Supplementary Insurance Information (Schedule V) Reinsurance (Schedule VI) All other financial statements and schedules are omitted because of the absence of conditions under which they are required or because the required information is included elsewhere herein. (3) Exhibits (3) Articles of incorporation currently in effect incorporated by reference as filed as an exhibit with the Registrants 1989 Form 10-K under Item 14(3)(c) and by-laws of the Registrant currently in effect incorporated by reference as filed December 20, 1990, with report Form 8-K. (4) Instruments defining rights of security holders incorporated by reference as filed as an exhibit with the Registrant's Registration Statement No. 2-69530 on Form S-14 which became effective November 20, 1980, and as included or amended in articles of incorporation. (10)Material contracts - (1) Deferred Death Benefit Plan for Key Personnel of the Registrant and its subsidiaries incorporated by reference as previously filed as an exhibit with the Registrant's Form 10-K, December 31, 1981. (2) Medical Reimbursement Plan covering benefits of certain employees of the Registrant or its affiliates incorporated by reference as previously filed as an exhibit with the Registrant's Form 10-K, December 31, 1990. (3) Independent Life Invest Plan - 401(K) incorporated by reference as previously filed with the Registrant's Form S-8, Registration No. 33-35785. (5) The Registrant's Exchange Agreement incorporated by reference as previously filed as an exhibit with the Registrant's Form 10-K, December 31, 1990. (13) Portions of the Annual Report to Shareholders for the year ended December 31, 1993. (22)The Registrant's subsidiaries include the following companies and their wholly owned subsidiaries,all of which are incorporated under the laws of the state of Florida: (A)The Independent Life and Accident Insurance Company (B)Independent Fire Insurance Company (C)Herald Fire Insurance Company (D)Thomas Jefferson Insurance Company (E)Independent Investment Advisory Services, Inc (F)Independent Real Estate Management Corporation (G)Independent Property & Casualty Insurance Company (24)Consent of Independent Certified Public Accountants (b) There were no reports on Form 8-K filed for the three months ended December 31, 1993. (c) The Registrant previously filed exhibits listed above in Item 14 (a)(3)-(3),(4) and (10). (d) The following pages include the Financial Statement Schedules of the Registrant required by Regulation S-X which are excluded from the Annual Report to Shareholders. INDEPENDENT INSURANCE GROUP, INC. CONDENSED FINANCIAL INFORMATION OF THE REGISTRANT BALANCE SHEETS DECEMBER 31, 1993 AND 1992 (000 OMITTED) ASSETS 1993 1992 Cash $ 556 $ 199 Short-term investments 2,497 10 Investment in subsidiaries - continuing operations 307,196 331,056 Investment in subsidiaries - discontinued operations - 11,671 Real estate - net 6,899 7,237 Income taxes receivable 11,052 12,003 Other assets 4,053 257 Total $332,253 $362,433 LIABILITIES AND SHAREHOLDERS' EQUITY Notes payable $ 6,800 $ 8,000 Due to subsidiaries - federal income taxes 9,522 12,310 Other liabilities 8 417 Total liabilities 16,330 20,727 Shareholders' equity: Voting common stock 6,100 6,267 Nonvoting common stock 8,606 8,439 Additional paid-in capital 6,378 6,378 Net unrealized gain on equity securities held by subsidiaries 25,393 11,756 Retained earnings 293,997 333,417 Treasury stock - at cost - nonvoting common stock, 1,542 shares (24,551) (24,551) Total shareholders'equity 315,923 341,706 Total $332,253 $362,433 See notes to consolidated financial statements SCHEDULE III INDEPENDENT INSURANCE GROUP, INC. CONDENSED FINANCIAL INFORMATION OF THE REGISTRANT STATEMENTS OF INCOME AND RETAINED EARNINGS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (000 OMITTED) 1993 1992 1991 Revenues: Interest income $ 352 $ 94 $ 418 Other income 1,435 2,185 1,848 Total 1,787 2,279 2,266 Costs and Expenses: Interest expense 330 1,019 2,241 Professional services 293 133 377 Real estate expenses 350 381 389 Taxes, licenses and fees (51) 183 (1,366) Other expenses 422 568 167 Total 1,344 2,284 1,808 Income (loss) before income taxes and equity in income of consolidated subsidiaries 443 (5) 458 Provision (credit) for income taxes 123 (1) 156 Income (loss) before equity in income of consolidated subsidiaries 320 (4) 302 Equity in income (loss) of consolidated subsidiaries- continuing operations (including $2,150, $7,600 and $17,450 of dividends received from subsidiaries) (43,885) (16,990) 26,670 Equity in income of subsidiaries discontinued operations (including $173, $600 and $369 of dividends received) 465 1,906 1,670 Gain on disposition of discontinued operations 6,904 - - Cumulative effect of change in accounting principles (66) - - Net income (loss) (36,262) (15,088) 28,642 Retained Earnings, Beginning of Year 333,417 360,089 342,900 Less: Dividends to shareholders ($.24,$.88 and $.87 per share) 3,159 11,584 11,453 Retained earnings, end of year $ 293,996 $ 333,417 $ 360,089 SCHEDULE III INDEPENDENT INSURANCE GROUP, INC. CONDENSED FINANCIAL INFORMATION OF THE REGISTRANT STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (000 OMITTED) 1993 1992 1991 Operating Activities: Net income (loss) $(36,262) $(15,088) $ 28,642 Adjustments to reconcile net income to net cash provided by operating activities: Change in - Accounts receivable (2,545) 20,852 8,803 Other assets and other liabilities (4,446) 305 (34) Liability for income taxes (3,260) (10,662) (4,154) Equity in (income) of consolidated subsidiaries- continuing operations 43,885 16,990 (26,670) Equity in (income) of consolidated subsidiaries- discontinued operations (465) (1,906) (1,670) Gain from discontinued operations (net of taxes) (6,904) - - Dividends received from consolidated subsidiaries- continuing operations 2,150 7,600 17,450 Dividends received from subsidiaries - discontinued operations 173 600 369 Depreciation of property and equipment 378 340 359 Cumulative effect of changes in accounting principles 66 - - Net cash provided (used) by operating activities (7,230) 19,031 23,095 Investing Activities: Sales, maturities or payments from investments and loans - - 84 Purchases of investments and loans granted (2,127) (9) - Cash from sale of discontinued operations 22,573 - - Investment in subsidiary (8,500) (2,150) (800) Net cash provided (used) by investing activites 11,946 (2,159) (716) Financing Activities: Reductions in mortgage loans payable - (8,135) (162) Additions to notes payable 4,000 13,092 Reductions in notes payable (5,200) (10,018) (10,849) Dividends to shareholders (3,159) (11,584) (11,453) Net cash used by financing activities (4,359) (16,645) (22,464) Increase (Decrease) in Cash 357 227 (85) Cash, Beginning of Year 199 (28) 57 Cash, End of Year $ 556 $ 199 $ (28) See notes to condensed financial statements. Schedule III INDEPENDENT INSURANCE GROUP, INC. CONDENSED FINANCIAL INFORMATION OF THE REGISTRANT NOTES TO CONDENSED FINANCIAL STATEMENTS The accompanying condensed financial statements should be read in conjunction with the consolidated financial statements and notes thereto of Independent Insurance Group, Inc. and its wholly owned subsidiaries. Notes payable at December 31 consists of the following (000 omitted): 1993 1992 4.00% 180-day note $ 3,000 - 4.02% 90-day note - $ 8,000 6.25% Bank term loan 3,800 - The Company also has available another $24,000,000 short-term line of credit with two banks which can be terminated at any time by the banks. As of December 31, 1993, none of this line of credit was utilized. SCHEDULE V INDEPENDENT INSURANCE GROUP, INC. AND SUBSIDIARIES SUPPLEMENTARY INSURANCE INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (000 OMITTED) COLUMN B COLUMN C COLUMN D COLUMN E Other Policy Deferred Reserves Claims and Policy Losses, Claims Unearned Benefits Segment Acq. Costs & Loss Expenses Premiums Payable Year Ended December 31, 1993 Life $159,842 $754,960 $ 2,457 Property and casualty 3,491 40,478 39,387 Accident and health 33,387 64,524 Other Total $196,720 $859,962 $41,844 - Year Ended December 31, 1992 Life $157,616 $752,875 $ 4,236 Property and casualty 16,062 72,129 75,369 Accident and health 33,750 71,994 Other Total $207,428 $896,998 $79,605 - Year Ended December 31, 1991 Life $153,011 $743,105 $ 1,736 Property and casualty 21,579 34,014 67,280 Accident and health 33,423 71,789 Other Total $208,013 $848,908 $69,016 - COLUMN F COLUMN G COLUMN H Benefits, Net Claims, Losses Premium Investment & Settlement Segment Revenue Income* Expenses Year Ended December 31, 1993 Life $177,102 $62,063 $ 99,385 Property and casualty 100,136 6,422 77,282 Accident and health 94,441 5,142 37,161 Other 79 Total $371,679 $73,706 $213,828 Year Ended December 31, 1992 Life $174,100 $64,108 $102,014 Property and casualty 151,482 12,380 150,962 Accident and health 101,426 5,550 45,469 Other 30 Total $427,008 $82,068 $298,445 Year Ended December 31, 1991 Life $175,800 $69,396 $103,952 Property and casualty 164,085 13,459 95,686 Accident and health 103,950 6,029 51,788 Other 49 Total $443,835 $88,933 $251,426 COLUMN I COLUMN J COLUMN K Amortization of Deferred Pol Other Acquisition Operating Premiums Segment Costs Expenses# Written Year Ended December 31, 1993 Life $24,831 $105,724 Property and casualty 19,724 53,338 $52,764 Accident and health 5,926 49,030 94,441 Other 2,609 Total $50,481 $210,701 Year Ended December 31, 1992 Life $23,235 $104,027 Property and casualty 20,944 52,548 $132,370 Accident and health 5,864 56,390 101,426 Other 1,735 Total $50,043 $214,700 Year Ended December 31, 1991 Life $21,421 $102,338 Property and casualty 19,800 58,825 $164,639 Accident and health 5,980 48,965 103,950 Other 1,998 Total $47,201 $212,126 *The allocation of net investment income to life and accident and health is based on the raio of the mean liabilities (primarily, policy reserves and claims payable) attributed to life and to accident and health to total mean liabilities. Property and casualty net investment income is directly allocated. Other net investment income is that of noninsurance subsidiaries. #Expenses not directly identifiable to any line of business are allocated on bases considered reasonable under the circumstances. SCHEDULE VI INDEPENDENT INSURANCE GROUP, INC. AND SUBSIDIARIES REINSURANCE FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (OOO OMITTED) COLUMN A COLUMN B COLUMN C COLUMN D COLUMN E COLUMN F Percentage Ceded to Assumed of Amount Gross Other From Other Net Assumed Year Ended December 31, 1993 Life insurance in force* $ 7,733 $ 237 $ 2 $ 7,498 .03 % Insurance Premiums: Life $179,921 $ 2,841 $ 22 $177,102 (.01)% Property and casualty 182,279 85,629 3,486 100,136 3.48 % Accident and health 95,533 1,101 9 94,441 (.01)% Total $457,733 $89,571 $ 3,517 $371,679 .95 % Year Ended December 31, 1992 Life insurance in force* $ 7,719 $ 247 $ 4 $ 7,476 .05 % Insurance Premiums: Life $176,418 $ 2,318 $ $174,100 (.02)% Property and casualty 211,994 61,627 1,115 151,482 .74 % Accident and health 102,187 761 101,426 (.01)% Total $490,599 $64,706 $ 1,115 $427,008 .25 % Year Ended December 31, 1991 Life insurance in force* $ 7,387 $ 261 $ 10 $ 7,136 .14% Insurance Premiums: Life 177,948 $ 2,302 $ 154 $175,800 .09 % Property and casualty 179,245 16,269 1,109 164,085 .68 % Accident and health 104,356 427 21 103,950 .02 % Total $461,549 $ 18,998 $ 1,284 $443,835 .29% EXHIBIT 24 Consent of Independent Auditors We consent to the incorporation by reference in this Annual Report (Form 10-K) of Independent Insurance Group, Inc. of our report dated March 11, 1994, included in the 1993 Annual Report to Shareholders of Independent Insurance Group, Inc. Our audits also included the financial statement schedules of Independent Insurance Group, Inc. listed in Item 14(a). These schedules are the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. We also consent to the incorporation by reference in the Registration Statement (Form S-8 No. 33-35785) pertaining to the Independent Life Invest Plan of our report dated March 11, 1994, with respect to the consolidated financial statements incorporated herein by reference and our report included in the preceding paragraph with respect to the financial statement schedules included in the Annual Report (Form 10-K) of Independent Insurance Group, Inc. Ernst & Young Jacksonville, Florida March 29, 1994 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. (Registrant) INDEPENDENT INSURANCE GROUP, INC. Wilford C. Lyon, Jr. March 29, 1994 BY Wilford C. Lyon, Jr., Chairman of the Board and Chief Executive Officer Jacob F. Bryan, IV March 29, 1994 BY Jacob F. Bryan, IV, President and Director 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 dates indicated. Boyd E. Lyon, Sr. March 29, 1994 BY Boyd E. Lyon, Sr., Director, Treasurer (Chief Financial and Accounting Officer) Kendall G. Bryan March 29, 1994 BY Kendall G. Bryan, Director William G. Howard March 29, 1994 BY William G. Howard, Director Michael C. Lyon March 29, 1994 BY Michael C. Lyon, Director

1993 Item 1. BUSINESS ORGANIZATION Indianapolis Power & Light Company (IPL) is an operating public utility incorporated under the laws of the State of Indiana on October 27, 1926. IPL is a subsidiary of IPALCO Enterprises, Inc. (IPALCO). IPALCO is a holding company incorporated under the laws of the State of Indiana on September 14, 1983. All common stock of IPL is owned by IPALCO. GENERAL IPL is engaged primarily in generating, transmitting, distributing and selling electric energy in the City of Indianapolis and neighboring cities, towns, communities, and adjacent rural areas, all within the State of Indiana, the most distant point being about forty miles from Indianapolis. It also produces, distributes and sells steam within a limited area in such city. There have been no changes in the services rendered, or in the markets or methods of distribution, since the beginning of the fiscal year. IPL intends to do business of the same general character as that in which it is now engaged. No private or municipally-owned electric public utility companies are competing with IPL in the territory it serves. IPL operates under indeterminate permits subject to the jurisdiction of the Indiana Utility Regulatory Commission (IURC). Such permits are subject to revocation by the IURC for cause. The Public Service Commission Act of Indiana (the PSC Act), which provides for the issuance of such permits, also provides that if the PSC Act is repealed, indeterminate permits will cease and a utility will again come into possession of such franchises as were surrendered at the time of the issue of the permit, but in no event shall such reinstated franchise be terminated within less than five years from the date of repeal of the PSC Act. The electric utility business is affected by the various seasonal weather patterns throughout the year and, therefore, the operating revenues and associated operating expenses are not generated evenly by months during the year. IPL's electric system is directly interconnected with the electric systems of Indiana Michigan Power Company, PSI Energy, Inc., Southern Indiana Gas and Electric Company, Wabash Valley Power Association and Hoosier Energy Rural Electric Cooperative, Inc. Also, IPL and 28 other electric utilities, known as the East Central Area Reliability Group (the Group), are cooperating under an agreement which provides for coordinated planning of generating and transmission facilities and the operation of such facilities to provide maximum reliability of bulk power supply in the nine- state region served by the Group. In 1993, approximately 99.7% of the total kilowatthours sold by IPL were generated from coal, .2% from middle distillate fuel oil and .1% from secondary steam purchased from the Indianapolis Resource Recovery Project. In addition to use in oil-fired generating units, fuel oil is used for start up and flame stabilization in coal-fired generating units as well as for coal thawing and coal handling. IPL's long-term coal contracts provide for the supply of the major portion of its burn requirements through the year 1999, assuming environmental regulations can be met. The long-term coal agreements are with six suppliers and the coal is produced entirely in the State of Indiana (these six suppliers are located in the following counties: Clay, Daviess, Greene, Knox, Pike, Sullivan and Warrick, and are not affiliates of IPL). See Exhibits listed under Part IV Item 14(a)3(10). It is presently believed that all coal used by IPL will be mined by others. IPL normally carries a 70-day supply of coal and fuel oil to offset unforeseen occurrences such as labor disputes, equipment breakdowns, power sales to other utilities, etc. When strikes are anticipated in the coal industry, IPL increases its stockpile to an approximate 103-day supply. The combined cost of coal and fuel oil used in the generation of electric energy for 1993 averaged 1.151 cents per kilowatthour or $24.49 per equivalent ton of coal, compared with the 1992 average fuel cost for electric generation of 1.146 cents per kilowatthour or $24.55 per equivalent ton of coal. Fuel costs are expected to experience only moderate changes in the near future due to increased supplier productivity, the stabilizing of coal prices and a low dependency on oil. However, an acceleration of inflation and/or changes in laws, regulations or ordinances which impact the mining industry or place more restrictive environmental controls on utilities could have a detrimental effect on such prices. IPL has a long-term contract to purchase steam for use in its steam distribution system with Ogden Martin Systems of Indianapolis, Inc. (Ogden Martin). Ogden Martin owns and operates the Indianapolis Resource Recovery Project which is a waste-to- energy facility located in Marion County, Indiana. During 1993, IPL's steam system purchased 49.4% of its total therm requirement from Ogden Martin. Additionally, 33.3% of its 1993 one-hour peak load was met with steam purchased from Ogden Martin. IPL also purchased 3.2 million secondary therms which represent Ogden Martin send-out in excess of the IPL steam system requirements. Such secondary steam is used to produce electricity at the IPL Perry K and Perry W facilities. CONSTRUCTION The cost of IPL's construction program during 1993, 1992 and 1991 was $149.3 million, $115.3 million and $96.3 million, respectively, including Allowances for Funds Used During Construction (AFUDC) of $3.6 million, $3.2 million and $1.6 million, respectively. IPL's construction program is reviewed periodically and is updated to reflect among other things the changes in economic conditions, revised load forecasts and cost escalations under construction contracts. The most recent projections indicate that IPL will need about 800 megawatts (MW) of additional energy resources by the year 2000. IPL plans to meet this need through the combination of the use of Demand Side Management, power purchases, peaking turbines and base-load generation. During 1992, IPL entered into a five-year firm power purchase agreement with Indiana Michigan Power Company (IMP), which will supply additional capacity for the near-term requirements. IPL receives 200 MW of capacity. IPL can also elect to extend the agreement through November 1999. See Item 7, "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS" under "Capital Requirements" for additional information regarding the IMP agreement. IPL's construction program for the five-year period 1994- 1998, is estimated to cost $1.0 billion including AFUDC. The estimated cost of the program by year (in millions) is $234.4 in 1994; $191.9 in 1995; $116.6 in 1996; $221.4 in 1997; and $251.8 in 1998. It includes $113.7 million for four 80 MW combustion turbines with in-service dates of 1994, 1995, 1998 and 1999, respectively, and $217.2 million for base-load capacity with in- service dates of 2000 and 2002, or beyond. The forecast also includes $284.4 million for additions, improvements and extensions to transmission and distribution lines, substations, power factor and voltage regulating equipment, distribution transformers and street lighting distribution. With respect to the expenditures for pollution control facilities to comply with the Clean Air Act and with respect to the regulatory authority of the IURC as it relates to the integrated resource plan, see "REGULATORY MATTERS" and Item 7, "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS". FINANCING IPL's 1994-1998 long-term financing program anticipates sales of debt and equity securities totaling $447.7 million. The timing and amounts of such activities are contingent upon the timing and cost of any new capacity, as well as market conditions and other factors near the dates of the required financings. In addition to the sale of new securities, IPL has authority from the IURC to redeem and replace certain of its existing securities should favorable market conditions arise. Such action, if considered, may result in additional financing in the form of long-term debt. (With respect to restrictions on the issuance of certain securities, see Item 7, "LIQUIDITY AND CAPITAL RESOURCES".) EMPLOYEE RELATIONS As of December 31, 1993, IPL had 2,276 employees of whom 1,155 were represented by the International Brotherhood of Electrical Workers, AFL-CIO (IBEW) and 411 were represented by the Electric Utility Workers Union (EUWU), an unaffiliated labor organization. In December 1993, the membership of the IBEW ratified a new labor agreement which remains in effect until December 16, 1996. The agreement provides for general pay adjustments of 4% in 1993, 3.5% in both 1994 and 1995, and changes in pension and health care coverage. In March, 1992, the membership of the EUWU ratified a new labor agreement which remains in effect until February 27, 1995. The agreement provides for general pay adjustments of 4.5% in both 1992 and 1993, and 3% in 1994, as well as changes in health care coverage. REGULATORY MATTERS IPL is subject to regulation by the IURC as to its services and facilities, valuation of property, the construction, purchase or lease of electric generating facilities, classification of accounts, rates of depreciation, rates and charges, issuance of securities (other than evidences of indebtedness payable less than twelve months after the date of issue), the acquisition and sale of public utility properties or securities, and certain other matters. In addition, IPL is subject to the jurisdiction of the Federal Energy Regulatory Commission, in respect of short-term borrowings not regulated by the IURC, the transmission of electric energy in interstate commerce, the classification of its accounts and the acquisition and sale of utility property in certain circumstances as provided by the Federal Power Act. IPL is also subject to federal, state, and local environmental laws and regulations, particularly as to generating station discharges affecting air and water quality. The impact of such regulations on the capital and operating costs of IPL has been and will continue to be substantial. IPL's 1994-1998 construction program includes $335 million in environmental costs, including AFUDC, of which approximately $207 million pertains to the Clean Air Act. Accordingly, IPL has developed a plan to reduce sulfur dioxide and nitrogen oxide emissions from several generating units. This plan has been approved by the IURC. Annual costs for all air, solid waste, and water environmental compliance measures are $106 million and $112 million in 1994 and 1995, respectively. Item 2. Item 2. PROPERTIES IPL owns and operates five primarily coal-fired generating plants, three of which are used for total electric generation and two of which are used for a combination of electric and steam generation. In relation to electric generation, there exists a total gross nameplate rating of 2,885 MW, a winter capability of 2,862 MW and a summer capability of 2,829 MW. All figures are net of station use. In relation to steam generation, there exists a gross capacity of 2,290 Mlbs. per hour. Total Electric Stations: H. T. Pritchard plant (Pritchard), 25 miles southwest of Indianapolis (six units in service - one in 1949, 1950, 1951, two in 1953 and one in 1956) with 367 MW nameplate rating and net winter and summer capabilities of 344 MW and 341 MW, respectively. E. W. Stout plant (Stout) located in southwest part of Marion County (five units in service - one each in 1941, 1947, 1958, 1961 and 1973) with 771 MW nameplate rating and net winter and summer capabilities of 798 MW and 767 MW, respectively. Petersburg plant (Petersburg), located in Pike County, Indiana (four units in service - one each in 1967, 1969, 1977 and 1986) with 1,716 MW nameplate rating and net winter and summer capabilities of 1,690 MW and 1,690 MW, respectively. Combination Electric and Steam Stations: C.C. Perry Section K plant (Perry K), in the city of Indianapolis with 20 MW nameplate rating (net winter capability 20 MW, summer 19 MW) for electric and a gross capacity of 1,990 Mlbs. per hour for steam. C.C. Perry Section W plant (Perry W), in the city of Indianapolis with 11 MW nameplate rating (net winter capability 10 MW, summer 12 MW) for electric and a gross capacity of 300 Mlbs. per hour for steam. Net electrical generation during 1993, at the Petersburg, Stout and Pritchard stations accounted for about 74.9%, 19.6% and 5.5%, respectively, of IPL's total net generation. All steam generation by IPL for the steam system was produced by the Perry K and Perry W stations. Included in the above totals are three gas turbine units at the Stout station added in 1973 with a combined nameplate rating of 64 MW, one diesel unit each at Pritchard and Stout stations, and three diesel units at Petersburg station, all added in 1967. Each diesel unit has a nameplate rating of 3 MW. IPL's transmission system includes 454 circuit miles of 345,000 volt lines, 353 circuit miles of 138,000 volt lines and 275 miles of 34,500 volt lines. Distribution facilities include 4,686 pole miles and 19,785 wire miles of overhead lines. Underground distribution and service facilities include 436 miles of conduit and 4,900 wire miles of conductor. Underground street lighting facilities include 110 miles of conduit and 668 wire miles of conductor. Also included in the system are 74 bulk power substations and 85 distribution substations. Steam distribution properties include 22 miles of mains with 286 services. Other properties include coal and other minerals, underlying 798 acres in Sullivan County and coal underlying about 6,215 acres in Pike and Gibson Counties, Indiana. Additional land, approximately 4,722 acres in Morgan County, and approximately 884 acres in Switzerland County has been purchased for future plant sites. Item 3. Item 3. LEGAL PROCEEDINGS On March 16, 1993, Smith Cogeneration of Indiana, Inc., and its affiliates (Smith) filed a petition with the Indiana Utility Regulatory Commission (IURC) requesting that IPL be ordered to enter into a power sales agreement to purchase power from Smith's proposed 240 megawatt plant. On September 24, 1993, IPL filed a motion for summary adjudication of Smith's petition. This motion is currently pending, has been fully briefed and no further proceedings have been scheduled in this matter. In June 1993, IPL received a Notice of Violation from the Indianapolis Air Pollution Control Section (IAPCS) regarding fugitive dust emissions at its Perry K Generating Station. IPL met with IAPCS to discuss four alleged violations over a span of 15 months. Each violation was subject to a fine of up to $2,500. IPL agreed to a settlement in the amount of $3,500 for all violations, but settlement has not yet been finalized. On August 18, 1993, the IURC entered an order in Cause No. 39437, approving IPL's Environmental Compliance Plan to comply with the Clean Air Act Amendments of 1990. The estimated cost of IPL's Environmental Compliance Plan is approximately $250 million before including allowance for funds used during construction. A primary part of IPL's Plan, scrubbing IPL's Petersburg 1 and 2 coal-fired units by 1996 to enable IPL to continue to burn high sulfur coal, was opposed by the Office of Utility Consumer Counselor (OUCC), the Citizens Action Coalition, and the Industrial Intervenors Group (IIG). OUCC and IIG are in the process of appealing the Commission's order to the Indiana Court of Appeals. In October 1993, IPL received a Findings of Violation from EPA, Region V, regarding IPL's compliance with the thermal limitations of the NPDES (water discharge) permit under which IPL operates its Petersburg Generating Station. On February 20, 1992, IPL filed an application for renewal of that permit but the application has not been acted upon by the Indiana Department of Environmental Management. Although unclear to IPL, EPA's action seems to have resulted from its misinterpretation of data IPL supplied to EPA in response to the latter's Clean Water Act information request that preceded issuance of the Findings of Violation. IPL believes it continues to be in compliance with the requirements of the permit and has made continuing efforts to meet with EPA to discuss the matter. If IPL is found to be in violation of its permit, it could be subject to maximum fines of $25,000 per day per violation. Item 4. Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. EXECUTIVE OFFICERS OF THE REGISTRANT AT FEBRUARY 22, 1994 Name, age (at December 31, 1993), and positions and offices held for the past five years: From To John R. Hodowal (48) Chairman of the Board February, 1990 Chief Executive Officer May, 1989 Executive Vice President April, 1987 May, 1989 Ramon L. Humke (61) President and Chief Operating Officer February, 1990 President and Chief Executive Officer of Ameritech Services and Senior Vice President of Ameritech Bell Group September, 1989 February, 1990 President and Chief Executive Officer of Indiana Bell Telephone Company October, 1983 September, 1989 John R. Brehm (40) Senior Vice President - Finance and Information Services May, 1991 Senior Vice President - Financial Services May, 1989 May, 1991 Treasurer August, 1987 May, 1989 Robert W. Rawlings (52) Senior Vice President - Electric Production May, 1991 Vice President - Electric Production May, 1989 May, 1991 Vice President - Engineering and Construction April, 1986 May, 1989 From To Gerald D. Waltz (54) Senior Vice President - Business Development May, 1991 Senior Vice President - Engineering and Operations April, 1986 May, 1991 Max Califar (40) Vice President - Human Resources December, 1992 Treasurer May, 1989 December, 1992 Assistant Controller July, 1987 May, 1989 Stephen J. Plunkett (45) Controller May, 1991 Assistant Controller May, 1989 May, 1991 PART II Item 5. Item 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED SECURITY HOLDER MATTERS All common stock of IPL is owned by Enterprises and is not publicly traded on any stock exchange. Aggregate quarterly dividends paid on the common stock during 1993 and 1992 were as follows (in thousands): 1993 1992 First Quarter $18,445 $17,648 Second Quarter 19,209 18,399 Third Quarter 19,209 18,400 Fourth Quarter 19,209 18,443 The IPL Board of Directors at its meeting on February 22, 1994, declared a regular quarterly dividend on common stock of $19,979,921.98 in total, payable April 15, 1994. Dividend Restrictions So long as any of the several series of bonds of IPL issued under the Mortgage and Deed of Trust, dated as of May 1, 1940, as supplemented and modified, executed by IPL to American National Bank and Trust Company of Chicago, as Trustee, remain outstanding, IPL is restricted in the declaration and payment of dividends, or other distribution on shares of its capital stock of any class, or in the purchase or redemption of such shares, to the aggregate of its net income, as defined in Section 47 of such Mortgage, after December 31, 1939, available for dividends. The amount which these Mortgage provisions would have permitted IPL to declare and pay as dividends at December 31, 1993 exceeded retained earnings at that date. Such restrictions do not apply to the declaration or payment of dividends upon any shares of capital stock of any class to an amount in the aggregate not in excess of $1,107,155, or to the application to purchase or redemption of any shares of capital stock of any class of amounts not to exceed in the aggregate the net proceeds received by IPL from the sale of any shares of its capital stock of any class subsequent to December 31, 1939. Item 7. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS LIQUIDITY AND CAPITAL RESOURCES On a national basis, competition for wholesale and retail sales within the electric utility industry has been increasing. In Indiana, competition has been primarily focused on the wholesale power markets. Existing Indiana law provides for public utilities to have an exclusive permit at the retail level. The impact of continuing competitive pressures on IPL's wholesale and retail electric and steam markets cannot be determined at this time. Rate Matters Environmental Compliance Plan IPL is subject to the new air quality provisions specified in the federal Clean Air Act Amendments of 1990 and related regulations (the Act). During 1993, IPL obtained an order from the Indiana Utility Regulatory Commission (IURC) approving its environmental compliance plan, together with the costs and expenses associated therewith, which provides for the installation of sulfur dioxide and nitrogen oxide emissions abatement equipment and the installation of continuous emission monitoring systems to meet the requirements of both Phase I and Phase II of the Act - See "Capital Requirements". Certain intervenors in the hearing before the IURC have requested a transcript preparatory to an appeal of that order which appeal has not yet been perfected. As required by the Act, IPL filed its proposed compliance plan with the Environmental Protection Agency in February 1993. As provided in the Act, effective January 1, 1995, IPL is scheduled to receive annual emission "allowances" for certain of its generating units. Each allowance would permit the emission of one ton of sulfur dioxide. IPL presently expects that annual sulfur dioxide emissions will not exceed annual allowances provided to IPL under the Act. Allowances not required in the operation of IPL facilities may be reserved for future periods or sold. The value of such unused allowances that may be available to IPL for use in future periods or for sale is subject to a developing market and is unknown at this time. The IURC Order provides for the deferral of net gains and losses resulting from any sale of emission allowances for future amortization to cost of service on a basis to be determined in the next general retail electric rate proceeding. Demand Side Management Program On September 8, 1993, IPL obtained an order from the IURC approving a Stipulation of Settlement Agreement between IPL, the Office of Utility Consumer Counsel, Citizens Action Coalition of Indiana, Inc., an industrial group, the Trustees of Indiana University and the Indiana Alliance for Fair Competition relating to IPL's Demand Side Management Program (DSM). The order provides for the deferral and subsequent recovery in rates of certain approved DSM costs. The order also provides for the recording of a return on deferred costs until recognized in rates. Postretirement Benefits On December 30, 1992, the IURC issued an order authorizing Indiana utilities to account for postretirement benefits on the basis required by the Statement of Financial Accounting Standard No. 106 -- Accounting for Postretirement Benefits other than Pensions (SFAS 106). Generally, SFAS 106 requires the use of an accrual basis accounting method for determining annual costs of postretirement benefits. Prior to 1993, IPL used a pay-as-you-go method to account for such costs. IPL was required to adopt SFAS 106 effective January 1, 1993. Additionally, the order authorized the deferral of SFAS 106 costs in excess of such costs determined on a pay-as-you-go and the recording of a resulting regulatory asset. The order further provides for the recovery in rates of such costs in a subsequent general rate proceeding on an individual company basis in an amount to be determined in each such proceeding. IPL is deferring as a regulatory asset the non-construction related SFAS 106 costs associated with its electric business. IPL is expensing its non- construction related SFAS 106 costs associated with its steam business. Regulatory Asset Deferrals Balance sheet deferrals of regulatory assets for DSM, postretirement benefits, income taxes and other such costs amounted to $33.1 million in 1993. Future deferrals for such items are expected to increase due to SFAS 106, and DSM and related carrying charges until IPL's next retail electric rate order. Future Rate Relief IPL presently anticipates that it will petition the IURC to increase its electric rates and charges during 1994. A final IURC order on such a request may not occur until 1995. IPL's last authorized increase in electric rates and charges occurred in August, 1986. Steam Rate Order The IURC authorized IPL to increase its steam system rates and charges over a six-year period beginning January 13, 1993. Accordingly, IPL implemented new steam tariffs effective on that date which were designed to produce estimated additional annual steam operating revenues as follows: Capital Requirements The capital requirements of IPL are primarily driven by the need for facilities to ensure customer service reliability and environmental compliance and by the impact of maturing long-term debt. Forecasted Demand & Energy From 1994 to 1998, annual peak demand is forecasted to experience a compound 1.5% increase, while retail kilowatthour (KWH) sales are anticipated to increase at a 2.0% compound growth rate. Both compound growth rates are computed assuming normal weather conditions and include the effects of DSM. IPL expects a reduction of about 120 megawatts (MW) of annual peak demand by the year 2000 as a result of DSM programs. Integrated Resource Plan Sales growth projections indicate a need for about 800 MW of additional capacity resources by the year 2000. These resource requirements can be met in a variety of ways including, but not limited to, a combination of the use of DSM, power purchases, peaking turbines and base-load generation. IPL continues to review its integrated resource plan to consider the appropriateness of all resource options to meet capacity requirements over the decade of the 1990's and beyond. IPL has a well-defined, near-term integrated resource plan and is considering all reasonable options to meet its long-term capacity requirements. The following discussion makes certain assumptions regarding IPL's plans to meet these requirements. In order to maintain adequate summer capacity reserve margins in the near-term, IPL entered into a five-year firm power purchase agreement with Indiana Michigan Power Company (IMP), which expires March 31, 1997. Under this agreement, IPL is receiving 200 MW of capacity. The agreement provides for monthly capacity payments by IPL of $1.2 million through March 31, 1997. IPL can terminate the agreement, should the ability to recover future demand charges through rates be disallowed. IPL and IMP will also exchange 50 MW of seasonal power over the 1995-1998 period. IPL plans to add two 80 MW combustion turbines with in-service dates in 1994 and 1995. Under Indiana law, IPL must obtain from the IURC a certificate of "public convenience and necessity" (Certificate) prior to purchasing or commencing construction of any new electric generation facility. IPL received Certificates from the IURC for construction of these combustion turbines during 1992. IPL is considering a variety of options to meet its long-term capacity requirements through the year 2000 including DSM, utility and nonutility power purchases, additional peaking turbines and base- load generating units. Presently, IPL plans to add two additional 80 MW combustion turbines with in-service dates in 1998 and 1999. IPL also has options to extend the 200 MW firm power purchase agreement with IMP through December 31, 1997 and subsequently through November 30, 1999, with capacity payments of $1.2 million per month and $1.55 million per month, respectively. Under a recent agreement, IPL has an option to purchase up to 250 MW from PSI Energy over the 1996 to 2000 period. IPL is also evaluating the installation, on a joint ownership basis, of two 426 MW base-load generating units to be placed in service in 2000 and 2002, respectively, or beyond. Of the total 852 MW, IPL proposes to own 400 MW, with other partners owning the remaining 452 MW. There is no assurance that IPL will be able to ultimately reach a joint ownership agreement with any other party. IPL has not applied for Certificates for the additional combustion turbines or the base load unit. Environmental Compliance Construction Requests IPL estimates that the capital cost of complying with the Act through 1997 will be approximately $240 million, including Allowance for Funds Used During Construction (AFUDC), of which $33.0 million has been expended prior to 1994. IPL further estimates that, subsequent to December 31, 1997, no significant capital expenditures will be required to bring generating units into compliance with the Act until the year 2010 or beyond. Cost of Construction Program The cost of IPL's construction program during 1993, 1992 and 1991 was $149.3 million, $115.3 million and $96.3 million, including AFUDC of $3.6 million, $3.2 million and $1.6 million, respectively. IPL estimates the cost of the construction program for the five years, 1994-1998, to be approximately $1.0 billion including AFUDC of $73.1 million. This program is subject to continuing review and is revised from time to time in light of changes in the actual customer demand for electric energy, IPL's financial condition and construction cost escalations. In addition to costs of environmental compliance, the five-year construction program includes $113.7 million for the four 80 MW combustion turbines and $217.2 million for the base-load capacity, mentioned above. Additional expenditures will be incurred beyond 1998 for the capacity with in- service dates subsequent to 1998. Transmission and substation facilities relating to the planned base-load capacity amount to $29.0 million in the five-year construction program. Expenditures for the new capacity are contingent upon the review of other long-term and near-term options previously discussed and subsequent receipt of the necessary Certificates. Retirement of Long-term Debt and Equity Securities During 1993, 1992 and 1991, IPL retired long-term debt, including sinking fund payments, of $96.9 million, $75.0 million and $96.4 million, respectively, which required replacement with other debt securities at a lower cost. IPL will retire $7.5 million, $15.0 million, $11.25 million and $18.75 million of maturing long-term debt during 1994, 1996, 1997 and 1998, respectively, which may require replacement in whole or in part with other debt or equity securities. In addition, other existing higher rate debt may be refinanced depending upon market conditions. Financing Financing Requirements During the three-year period ended December 31, 1993, IPL's permanent financing totaled $275.3 million in long-term debt. The net proceeds of these securities were used, along with internal funds, to retire existing long-term debt. All of IPL's construction expenditures during this three-year period were funded with internally generated cash and short-term debt. IPL's permanent financing requirements for the five-year period, 1994-1998, are forecasted to include additional sales of debt and equity securities totaling $447.7 million. This amount is highly contingent on the timing and cost of any new capacity. The timing, number and dollar amounts of such financings will depend on market conditions and other factors, including required regulatory approvals. In addition to the sale of new securities, IPL has authority from the IURC to redeem and replace certain of its existing securities, should favorable market conditions dictate. Internally generated funds supplemented by temporary short-term borrowings are forecasted to provide the remaining funds required for the five-year construction program. Uncertainties which could affect this forecast include the impact of inflation on operating expenses, the actual degree of growth in KWH sales, the level of interchange sales with other utilities and the receipt of Certificates required for new electric generation facilities. Mortgage Restrictions IPL is limited in its ability to issue certain securities by restrictions under its Mortgage and Deed of Trust (Mortgage) and its Amended Articles of Incorporation (Articles). The restriction under the Articles requires that the net income of IPL, as specified therein, shall be at least one and one-half times the total interest on the funded debt and the pro forma dividend requirements on the outstanding preferred stock and on any preferred stock proposed to be issued, before any additional preferred stock can be issued. The Mortgage restriction requires that net earnings as calculated thereunder be two and one-half times the annual interest requirements before additional bonds can be authenticated on the basis of property additions. Based on IPL's net earnings for the twelve months ended December 31, 1993, the ratios under the Articles and the Mortgage are 3.28 and 7.33, respectively. IPL believes these requirements will not restrict any anticipated future financings. RESULTS OF OPERATIONS 1993 vs. 1992 Income applicable to common stock increased by $9.7 million in 1993 compared to 1992. The following discussion highlights the factors contributing to the increase. Operations Utility operating income increased $8.1 million in 1993 compared to 1992. Contributing to this increase was an increase in electric operating revenues of $30.1 million, due to increases in retail sales of $25.9 million, wholesale sales of $2.8 million and miscellaneous electric revenue of $1.4 million. Retail electric sales were higher due to increased retail KWH sales of $31.1 million and decreased fuel cost recoveries of $5.2 million. The increase in retail KWH sales this year resulted primarily from the return to normal weather conditions in 1993 as compared to the abnormally mild summer weather conditions in 1992. During 1992, cooling degree days were 26.5 percent below normal. Wholesale sales were higher as a result of increased energy requirements of other utilities, who were also affected by the mild summer during 1992. The continuing health of the Indianapolis economy also contributed to the growth in KWH sales, particularly in the large industrial class. Fuel costs increased $3.3 million due to increases in fuel consumption of $9.6 million, partially offset by decreased unit costs of coal and oil of $.5 million and deferred fuel costs of $5.8 million. Power purchased increased $11.6 million due to increased capacity payments of $7.2 million to IMP in accordance with a five-year power purchase agreement, and by increased purchases of energy as a result of the near normal weather conditions in 1993 as compared to 1992. Maintenance expenses increased $4.9 million. This increase reflects higher unit overhaul and outage expenses in 1993, partially offset by decreased distribution maintenance expenses as a result of a severe storm in 1992 that cost $3.9 million. Amortization of the deferred return--rate phase-in plan, decreased due to the completion in August 1992 of the five-year amortization period. Taxes other than income taxes decreased $1.7 million as a result of lower property assessments. Income taxes - net, increased $4.3 million as a result of the increase in pretax utility operating income and a one percentage point increase in the federal income tax rate. Other Income And Deductions Other - net, increased $1.6 million as a result of a $1.5 million contribution to customer energy assistance programs expensed last year. Interest Charges Interest on long-term debt decreased $1.3 million as a result of refinancing six series of IPL's First Mortgage Bonds as follows: the 10 1/4% Series, First Mortgage Bonds in October 1993 (replaced with the 5.50% Series, First Mortgage Bonds); the 5.80% Series, First Mortgage Bonds in October, 1993 (replaced with the 5.40% Series, First Mortgage Bonds); the 6.90% and the 6.60% Series, First Mortgage Bonds (replaced with the 6.10% Series, First Mortgage Bonds); and the 9.30% and 9 1/2% Series, First Mortgage Bonds in September 1992 (replaced with the 7 3/8% Series, First Mortgage Bonds). The allowance for borrowed funds used during construction increased due primarily to an increased construction base. Other interest charges increased $1.1 million due to higher notes payable balances carried during 1993. 1992 vs. 1991 Income applicable to common stock decreased by $10.8 million in 1992 compared to 1991. The following discussion highlights the factors contributing to the decrease. Operations Utility operating income decreased $15.6 million in 1992 compared to 1991. Contributing to this decrease were lower electric operating revenues of $16.7 million, due to lower retail electric sales of $13.9 million, lower wholesale sales of $1.8 million and lower miscellaneous electric revenue of $1.0 million. Retail electric sales were lower due to decreased retail KWH sales of $10.6 million and decreased fuel cost recoveries of $3.3 million. The decrease in retail KWH sales in 1992 resulted primarily from unusual weather conditions in both 1992 and 1991. Abnormally mild summer weather conditions in 1992 resulted in lower KWH sales, while the unusually hot weather during the summer of 1991 significantly increased KWH sales in that year. During 1992, cooling degree days were 48 percent lower than 1991 and 26.5 percent below normal. Wholesale sales were lower as a result of decreased energy requirements of other utilities, who were also affected by the mild summer. Fuel costs decreased $7.4 million due to decreases in fuel consumption of $4.3 million, decreased unit costs of coal and oil of $2.0 million and deferred fuel costs of $1.1 million. Other operating expenses increased $2.9 million due primarily to an increase in administrative and general expenses of $1.4 million (primarily as a result of increased salaries and group insurance costs), and a $2.0 million expense related to the FAC Agreement. Power purchased increased $3.9 million due to capacity payments of $5.4 million to IMP in accordance with a five-year power purchase agreement, partially offset by decreased purchases of energy as a result of the mild summer weather. Maintenance expenses increased $2.0 million, reflecting transmission and distribution system repair expenses as a result of a severe storm in June that cost a total of $3.9 million. These expenses were partially offset by decreased unit overhaul expenses in 1992, compared to 1991. Amortization of the deferred return--rate phase-in plan, decreased due to the completion in August 1992, of the five-year amortization period. Taxes other than income taxes increased $2.7 million as a result of increased property assessments and higher property tax rates. Income taxes-net, decreased $3.0 million primarily due to the decrease in pretax utility operating income. Other Income And Deductions Allowance for equity funds used during construction increased $1.3 million due to an increased construction base in 1992. Other - net, decreased $3.9 million due to decreased interest and dividend income earned by IPL of $2.4 million, and as a result of a $1.5 million contribution to customer energy assistance programs expensed in 1992. IPL received interest and dividend income in 1991 from investments, special deposits and other sources which did not occur this year. Income taxes - net, decreased $1.1 million as a result of decreased pretax operating income of the unregulated subsidiaries, decreased IPL interest and dividend income and the increased contribution expense previously mentioned. Interest Charges Interest and other charges - net, decreased $6.4 million primarily due to decreased interest on long-term debt of $3.8 million. This decrease is the result of refinancing four series of IPL's First Mortgage Bonds as follows: the 12% Series, First Mortgage Bonds in August 1991 (replaced with the long-term note at a floating interest rate that approximates tax-exempt Commercial Paper Rates); the 9 7/8% Series, First Mortgage Bonds in November 1991 (replaced with the 8% Series, First Mortgage Bonds); and the 9.30% and 9 1/2% Series, First Mortgage Bonds in September 1992 (replaced with the 7 3/8% Series, First Mortgage Bonds). The allowance for borrowed funds used during construction increased due primarily to an increased construction base. Other interest charges decreased $1.4 million due to lower interest rates during 1992. Factors having a bearing on 1994 earnings compared to 1993 will include the impact of economic conditions, weather conditions, an increased level of construction expenditures, an increase in monthly capacity payments and the implementation of new steam system tariff rates. Authorized electric operating income for 1994 as determined by the IURC is approximately $144.0 million. (IPL earned $141.2 million during 1993 and $133.4 million during 1992.) Affecting 1994 earnings will be the cost of the IMP purchases mentioned previously. Annual capacity payments will increase by $1.8 million. The overall effect these factors will have on 1994 earnings cannot be accurately determined at this time. Item 8. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEPENDENT AUDITORS' REPORT Indianapolis Power & Light Company: We have audited the accompanying balance sheets and statements of capitalization of Indianapolis Power & Light Company as of December 31, 1993 and 1992, and the related statements of income, retained earnings, and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on the financial statements and financial statement schedules 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, such financial statements present fairly, in all material respects, the financial position of Indianapolis Power & Light Company as of December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Notes 1 and 9 to the financial statements, the Company changed its method of accounting for income taxes and postretirement benefits other than pensions effective January 1, 1993. /s/ Deloitte & Touche Deloitte & Touche Indianapolis, Indiana January 21, 1994 INDIANAPOLIS POWER & LIGHT COMPANY Notes to Financial Statements For the Years Ended December 31, 1993, 1992 and 1991 - --------------------------------------------------------------------------- 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: All the outstanding common stock of Indianapolis Power & Light Company (IPL) is owned by IPALCO Enterprises, Inc. At December 31, 1993 and 1992, IPL had a receivable, which is due on demand, for advances made to IPALCO. System of Accounts--The accounts of IPL are maintained in accordance with the system of accounts prescribed by the Indiana Utility Regulatory Commission (IURC), which system substantially conforms to that prescribed by the Federal Energy Regulatory Commission. Revenues--Revenues are recorded as billed to customers on a monthly cycle billing basis. Revenue is not accrued for energy delivered but unbilled at the end of the year. A fuel adjustment charge provision, which is established after public hearing, is applicable to substantially all the rate schedules of IPL, and permits the billing or crediting of fuel costs above or below the levels included in such rate schedules. Under current IURC practice, future fuel adjustment revenues may be temporarily reduced should actual operating expenses be less than or income levels be above amounts authorized by the IURC. Authorized Annual Operating Income--In an IURC order dated May 6, 1992, IPL's maximum authorized annual electric operating income, for purposes of quarterly earnings tests, was established at approximately $147 million through July 31, 1992, declining ratably to approximately $144 million at July 31, 1993. This level will be maintained until IPL's next general electric rate order. Additionally, through the date of IPL's next general electric rate order, IPL is required to file upward and downward adjustments in fuel cost credits and charges on a quarterly basis. As provided in an order dated December 21, 1992, IPL's authorized annual steam net operating income is $6.2 million, plus any cumulative annual underearnings occurring during the five-year period subsequent to the implementation of the new rate tariffs. Deferred Fuel Expense--Fuel costs recoverable in subsequent periods under the fuel adjustment charge provision are deferred. Allowance For Funds Used During Construction (AFUDC)--In accordance with the prescribed uniform system of accounts, IPL capitalizes an allowance for the net cost of funds (interest on borrowed and a reasonable rate on equity funds) used for construction purposes during the period of construction with a corresponding credit to income. IPL capitalized amounts using pre-tax composite rates of 8.0%, 9.5% and 9.6% during 1993, 1992 and 1991, respectively. Utility Plant and Depreciation--Utility plant is stated at original cost as defined for regulatory purposes. The cost of additions to utility plant and replacements of retirement units of property, as distinct from renewals of minor items which are charged to maintenance, are charged to plant accounts. Units of property replaced or abandoned in the ordinary course of business are retired from the plant accounts at cost; such amounts plus removal costs, less salvage, are charged to accumulated depreciation. AFUDC is capitalized and depreciated over the life of the related facility. Depreciation was computed by the straight-line method based on the functional rates and averaged 3.4% during each of the years 1993, 1992 and 1991. Statements of Cash Flows - Cash Equivalents--IPL considers all highly liquid investments purchased with original maturities of 90 days or less to be cash equivalents. Unamortized Deferred Return - Rate Phase-in Plan--IPL deferred the pre- tax debt and equity costs relating to its investment in plant which did not earn a cash return during the first year of a two-year, two-step retail electric rate phase-in plan authorized August 6, 1986. This deferred return and the related income taxes were amortized to cost of service over a five-year period commencing with the August 8, 1987 implementation of the second step of the phase-in plan. The deferred return was fully amortized in August, 1992. Unamortized Petersburg Unit 4 Carrying Charges--IPL has deferred certain post in-service date carrying charges of its investment in Petersburg Unit 4 (Unit 4). These carrying charges include both AFUDC on and depreciation of Unit 4 costs from the April 28, 1986 in-service date through the August 6, 1986 IURC rate order date in which IPL's investment in Unit 4 was included in rate base. Subsequent to April 28, 1986, IPL has capitalized interest on these deferred carrying charges. In addition, IPL has capitalized $7.0 million of additional allowance for earnings on shareholders' investment for rate-making purposes but not for financial reporting purposes. As provided in the rate order, the total amount of deferred carrying charges will be included in IPL's next general electric rate case. Unamortized Redemption Premiums and Expenses on Debt and Preferred Stock--In accordance with regulatory treatment, IPL defers non-sinking fund debt redemption premiums and expenses, and amortizes such costs over the life of the original debt or, in the case of preferred stock redemption premiums, over twenty years. Other Regulatory Assets--At December 31, 1993 and 1992, IPL has deferred certain costs and expenses which are recoverable in future rates as follows: Income Taxes--Deferred taxes are provided for all significant timing differences between book and taxable income. Such differences include the use of accelerated depreciation methods for tax purposes, the use of different book and tax depreciable lives, rates and in-service dates, and the accelerated tax amortization of pollution control facilities. Investment tax credits which reduced Federal income taxes in the years they arose have been deferred and are being amortized to income over the useful lives of the properties in accordance with regulatory treatment. Effective January 1, 1993, IPL adopted Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes," on a prospective basis. This statement requires the current recognition of income tax expense for (a) the amount of income taxes payable or refundable for the current year, and (b) for deferred tax liabilities and assets for the future tax consequences of events that have been recognized in IPL's financial statements or income tax returns. The effects of income taxes are measured based on enacted laws and rates. Substantially all of the adjustments required by SFAS 109 were recorded to deferred tax balance sheet accounts, with the offsetting adjustments to regulatory assets and liabilities. The adoption of this standard did not have a material impact on IPL's cash flows or results of operations due to the effect of rate regulation. Employee Benefit Plans--Substantially all employees of IPL are covered by a non-contributory, defined benefit pension plan which is funded through two trusts. Additionally, a select group of management employees of IPL are covered under a funded supplemental retirement plan. Collectively, these two plans are referred to as Plans. Benefits are based on each individual employee's years of service and compensation. IPL's funding policy is to contribute annually not less than the minimum required by applicable law, nor more than the maximum amount which can be deducted for Federal income tax purposes. IPL also sponsors the Employees' Thrift Plan of Indianapolis Power & Light Company (Thrift Plan), a defined contribution plan covering substantially all employees of IPL. Employees elect to make contributions to the plan based on a percentage of their annual base compensation. IPL matches each employee's contributions in amounts up to, but not exceeding four percent of the employee's annual base compensation. Reclassification--Certain amounts from prior years' financial statements have been reclassified to conform to the current year presentation. 2. UTILITY PLANT IN SERVICE: The original cost of utility plant in service at December 31, segregated by functional classifications, follows: Substantially all of IPL's property is subject to the lien of the indentures securing IPL's First Mortgage Bonds. 3. DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS The following disclosure of the estimated fair value of financial instruments is made in accordance with the requirements of SFAS No. 107, "Disclosures about Fair Value of Financial Instruments". The estimated fair value amounts have been determined by IPL, using available market information and appropriate valuation methodologies. However, considerable judgment is necessarily required in interpreting market data to develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amounts that IPL could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies may have an effect on the estimated fair value amounts. Cash, cash equivalents and notes payable--The carrying amount approximates fair value due to the short maturity of these instruments. Long-term debt, including current maturities and sinking fund requirements--Interest rates that are currently available to IPL for issuance of debt with similar terms and remaining maturities are used to estimate fair value. At December 31, 1993 and 1992 the carrying amount of IPL's long-term debt, including current maturities and sinking fund requirements, and the approximate fair value are as follows: 4. CAPITAL STOCK: Common Stock: There were no changes in IPL common stock during 1993, 1992 and 1991. Restrictions on the payment of cash dividends or other distributions on common stock and on the purchase or redemption of such shares are contained in the indenture securing IPL's First Mortgage Bonds. All of the retained earnings at December 31, 1993, were free of such restrictions. Cumulative Preferred Stock: Preferred stock shareholders are entitled to two votes per share, and if four full quarterly dividends are in default, they are entitled to elect the smallest number of Directors to constitute a majority. 5. LONG-TERM DEBT: The 9 5/8% Series due 2012, 10 5/8% Series due 2014, 6.10% Series due 2016, 5.40% Series due 2017, and 5.50% Series due 2023 were each issued to the City of Petersburg, Indiana (City) by IPL to secure the loan of proceeds received from a like amount of tax-exempt Pollution Control Revenue Bonds issued by the City for the purpose of financing pollution control facilities at IPL's Petersburg Generating Station. On August 6, 1992, IPL issued $80 million of First Mortgage Bonds, 7 3/8% series, due 2007. The net proceeds from this issue were used to redeem on September 1, 1992, IPL's First Mortgage Bonds, 9.3% series, due 2006 and 9 1/2% series, due 2016, at the prices of $104.17 and $107.13, respectively, plus accrued interest. On April 13, 1993, IPL issued a First Mortgage Bond, 6.10% Series, due 2016, in the principal amount of $41.85 million, in connection with the issuance of the same amount of Pollution Control Refunding Revenue Bonds by the City of Petersburg, Indiana. The net proceeds, along with other IPL funds were used to redeem on June 1, 1993, IPL's $19.65 million First Mortgage Bonds, 6.90% Series, due 2006, and IPL's $22.2 million First Mortgage Bonds, 6.60% Series, due 2008, at the prices of $100 and $101, respectively, plus accrued interest. On October 14, 1993, IPL issued a First Mortgage Bond, 5.40% Series, due 2017, in the principal amount of $24.65 million, in connection with the issuance of the same amount of Pollution Control Refunding Revenue Bonds by the City of Petersburg, Indiana. The net proceeds, along with other IPL funds, were used to redeem on November 15, 1993, IPL's $24.65 million First Mortgage Bonds, 5.80% Series, due 2007, at the price of $100 plus accrued interest. Also, on October 14, 1993, IPL issued a First Mortgage Bond, 5.50% Series, due 2023, in the principal amount of $30.0 million, in connection with the issuance of the same amount of Pollution Control Refunding Revenue Bonds by the City of Petersburg, Indiana. The net proceeds, along with other IPL funds, were used to redeem on November 15, 1993, IPL's $30.0 million First Mortgage Bonds, 10 1/4% Series, due 2013, at the price of $103 plus accrued interest. IPL has a 30-year unsecured promissory note which was issued to the City of Petersburg, Indiana, in connection with the issuance of $40 million of Pollution Control Refunding Revenue Bonds, due 2021, by the City of Petersburg. This note and the related bonds provide for a floating interest rate that approximates tax-exempt Commercial Paper Rates. The average interest rate on this note was 2.40% for 1993 and 3.00% for 1992. At the option of IPL, the bonds can be converted to First Mortgage Bonds which would bear interest at a fixed rate. Maturities and sinking fund requirements on long-term debt for the five years subsequent to December 31, 1993, are as follows: 6. LINES OF CREDIT: IPL has lines of credit with banks of $100 million at December 31, 1993, to provide loans for interim financing. These lines of credit, based on separate formal and informal agreements, have expiration dates ranging from January 31, 1994 to November 30, 1994 and require the payment of commitment fees. At December 31, 1993, these credit lines were unused. Lines of credit supporting commercial paper were $90 million at December 31, 1993. 7. INCOME TAXES: Federal and State income taxes charged to income are as follows: The provision for Federal income taxes (including net investment tax credit adjustments) is less than the amount computed by applying the statutory tax rate to pre-tax income. The reasons for the difference, stated as a percentage of pre-tax income, are as follows: The significant items comprising IPL's net deferred tax liability recognized in the balance sheet as of December 31, 1993 are as follows: 8. RATE MATTERS Steam Rate Order By an order dated January 13, 1993, the IURC authorized IPL to increase its steam system rates and charges over a six-year period. Accordingly, IPL implemented new steam tariffs designed to produce estimated additional annual steam operating revenues as follows: Environmental Compliance Plan On August 18, 1993, IPL obtained an Order from the IURC approving its Environmental Compliance Plan, together with the costs and expenses associated therewith, which provides for the installation of sulfur dioxide and nitrogen oxide emissions abatement equipment and the installation of continuous emission monitoring systems to meet the requirements of both Phase I and Phase II of the Federal Clean Air Act Amendments of 1990. The order provides for the deferral of net gains and losses resulting from any sale of emission allowances for future amortization to cost of service on a basis to be determined in the next general electric rate proceeding. Demand Side Management Program IPL obtained an Order from the IURC approving a Stipulation of Settlement Agreement between IPL, the Office of Utility Consumer Counsel, Citizens Action Coalition of Indiana, Inc., an industrial group, the Trustees of Indiana University and the Indiana Alliance for Fair Competition relating to the Company's Demand Side Management Program (DSM). The order provides for the deferral and subsequent recovery in rates of certain approved DSM costs. The order also provides for the recording of a return on deferred costs until recognized in rates. 9. EMPLOYEE BENEFIT PLANS AND OTHER POST-RETIREMENT BENEFITS: IPL's contributions to the Thrift Plan, net of amounts allocated to related parties were $3.1 million, $3.1 million and $2.8 million in 1993, 1992 and 1991, respectively. Net pension cost including amounts charged to construction for 1993, 1992 and 1991 are comprised of the following components: A summary of the Plans' funding status, and the amount recognized in the balance sheets at December 31, 1993 and 1992, follows: As of the October 31, 1993 valuation date, approximately 10.5% of the Plans' assets were in equity securities, with the remainder in fixed income securities. IPL also provides certain postretirement health care and life insurance benefits for employees who retire from active service on or after attaining age 55 and have rendered at least 10 years of service. On January 1, 1993, IPL adopted the provisions of SFAS No. 106 -- Employers' Accounting for Postretirement Benefits Other than Pensions (SFAS 106). Generally, SFAS 106 requires the use of an accrual basis accounting method for determining annual costs of postretirement benefits. The January 1, 1993 transition obligation of $122.4 million is being amortized over a 20 year period. Prior to 1993, the cost of such benefits was recognized when incurred and amounted to $3.5 million and $2.8 million in 1992 and 1991, respectively. Net postretirement benefit cost, including amounts charged to construction for 1993 is comprised of the following components: A summary of the retiree health care and life insurance plan's funding status, and the amount recognized in the consolidated balance sheet at December 31, 1993 follows: IPL is expensing its non-construction related SFAS 106 costs associated with its steam business. The SFAS 106 costs, net of amounts paid and capitalized for construction, associated with IPL's electric business is being deferred as a regulatory asset on the balance sheet, as authorized by an order of the IURC on December 30, 1992, which provided for deferral of SFAS 106 costs in excess of such costs determined on a cash basis. A request for recovery in rates of these costs will be included in IPL's next general electric rate petition. The assumed health care cost trend rate used in measuring the accumulated postretirement benefit obligation is 12.6 % for 1994, gradually declining to 5.0% in 2003. A one-percentage point increase in the assumed health care cost trend rate for each year would increase the accumulated postretirement benefit obligation as of December 31, 1993 by approximately $24.3 million and the combined service cost and interest cost for 1993 by approximately $3.4 million. Plan assets consist of the cash surrender value of life insurance policies on certain retired employees. The expected long-term rate of return on plan assets is 8 percent. Assumptions used in determining the accumulated benefit obligation for the pension plans for 1993, 1992 and 1991 and for the accumulated postretirement benefit obligation for 1993 were: 10. COMMITMENTS AND CONTINGENCIES: In 1994, IPL anticipates the cost of its construction program to be approximately $234 million. IPL will comply with the provisions of "The Clean Air Act Amendments of 1990" (the Act) through the installation of SO2 scrubbers and NOx facilities. The cost of complying with the Act from 1994 through 1997, including AFUDC, is estimated to be approximately $207 million, of which $80 million is anticipated in 1994. During 1993, expenditures for compliance with the Act were $13.7 million. IPL has a five-year firm power purchase agreement with Indiana Michigan Power Company (IMP) for 100 megawatts (MW) of capacity effective April 1992, with the purchase of an additional 100 MW (for a total of 200 MW) beginning in April 1993. The agreement provides for monthly capacity payments by IPL of $.6 million from April 1992 through March 1993, increasing to a monthly amount of $1.2 million which began in April 1993 and continue through March 31, 1997. The agreement further provides that IPL can elect to extend purchases through December 31, 1997, and subsequently through November 30, 1999, with capacity payments of $1.2 million per month and $1.55 million per month, respectively. IPL can terminate the agreement, should the ability to recover future demand charges through rates be disallowed. Capacity payments in 1993 and 1992 under this agreement totaled $12.6 million and $5.4 million, respectively. In October 1993, IPL received a Findings of Violation regarding compliance with the thermal limits of the National Pollutant Discharge Elimination System permit for its Petersburg Generating Station. IPL expects to meet with the Environmental Protection Agency in early 1994 to resolve this matter. IPL believes it has met all the requirements of its permit, but if IPL's position is found erroneous, IPL could be subject to fines of up to $25,000 per day of violation. IPL is involved in litigation arising in the normal course of business. While the results of such litigation cannot be predicted with certainty, management, based upon advice of counsel, believes that the final outcome will not have a material adverse effect on the financial position and results of operations. 11. QUARTERLY RESULTS (UNAUDITED): Operating results for the years ended December 31, 1993 and 1992 by quarter, are as follows (in thousands): The quarterly figures reflect seasonal and weather-related fluctuations which are normal to IPL's operations. Weather conditions in 1993 reflected near normal conditions, while weather conditions in 1992 were considerably moderate. The quarter ended June 30, 1992, includes a $3.9 million expense as a result of severe storm damage to IPL's transmission and distribution systems, and a $2.8 million expense in connection with the settlement of disputes regarding fuel adjustment issues. Item 9. Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III Items 10, 11, 12 Indianapolis Power & Light Company has filed with the and 13 Securities and Exchange Commission a definitive information statement pursuant to Regulation 14C. This document will incorporate by reference the information required by these items, except for the information regarding executive officers which is set forth in Part I, following Item 4 hereof under the heading "EXECUTIVE OFFICERS OF THE REGISTRANT." PART IV Item 14 Item 14 (a). DOCUMENT LIST The Financial Statements and Supplemental Schedules under this Item 14 (a) 1 and 2 filed in this Form 10-K are those of Indianapolis Power & Light Company. 1. Financial Statements Included in Part II of this report: Independent Auditors' Report Statements of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991 Statements of Income for the Years Ended December 31, 1993, 1992 and 1991 Balance Sheets, December 31, 1993 and 1992 Statements of Capitalization December 31, 1993 and 1992 Statements of Retained Earnings for the Years Ended December 31, 1993, 1992 and 1991 Notes to Financial Statements 2. Supplementary Data and Financial Statement Schedules Included in Part IV of this report: For each of the years ended December 31, 1993, 1992 and 1991 Schedule V - Utility Property, Plant, and Equipment Schedule VI - Accumulated Depreciation of Utility Property, Plant, and Equipment Schedule IX - Short-Term Borrowings Schedule X - Supplemental Income Statement Information The schedules, other than those listed above, are omitted because of the absence of the conditions under which they are required or because the information is furnished in the financial statements or notes thereto. 3. Exhibits Required by Securities and Exchange Commission Regulation S-K Copies of the documents listed below which are identified with an asterisk (*) are incorporated herein by reference and made part hereof and have heretofore been classified as basic documents under Rule 24(b) of the SEC Rules of Practice. (3) Articles of Incorporation and By-Laws * --Copy of Amended Articles of Incorporation of IPL. (Form 8-K dated May 19, 1982.) * --Copy of Amended Articles of Incorporation including Articles of Amendment dated April 17, 1991. (Form 10-Q for quarter ended March 31, 1991.) * --Copy of Amended By-Laws dated August 23, 1993. (Form 10-Q for quarter ended September 30, 1993.) (4) Instruments defining the rights of security holders, including indentures * --Copy of Mortgage and Deed of Trust, dated as of May 1, 1940, between IPL and American National Bank and Trust Company of Chicago, Trustee, as supplemented and modified by 33 Supplemental Indentures. Exhibits D in File No. 2-4396; B-1 in File No. 2-6210; 7-C File No. 2-7944; 7-D in File No. 2-72944; 7-E in File No. 2-8106; 7-F in File No. 2-8749; 7-G in File No. 2-8749; 4-Q in File No. 2-10052; 2-I in File No. 2-12488; 2-J in File No. 2-13903; 2-K in File No. 2-22553; 2-L in File No. 2-24581; 2-M in File No. 2-26156; 4-D in File No. 2-26884; 2-D in File No. 2-38332; Exhibit A to Form 8-K for October 1970; Exhibit 2-F in File No. 2-47162; 2-F in File No. 2-50260; 2-G in File No. 2-50260; 2-F in File No. 2-53541, 2E in File No. 2-55154; 2E in File no. 2-60819; 2F in File No. 2-60819; 2-G in File No. 2-60819; Exhibit A to Form 10-Q for the quarter ended 9-30-78 File No. 1-3132; 13-4 in File No. 2-73213; Exhibit 4 in File No. 2-93092. Twenty-eighth, Twenty-ninth and Thirtieth Supplemental Indentures. (Form 10-K dated for the year ended December 31, 1985.) * --Copy of Thirty-First Supplemental Indenture dated as of October 1, 1986. (Form 10-K for the year ended December 31, 1986.) * --Copy of Thirty-Second Supplemental Indenture dated as of June 1, 1989. (Form 10-K for year ended 12-31-89.) * --Copy of Thirty-Third Supplemental Indenture dated as of August 1, 1989. (Form 10-K for year ended 12-31-89.) Exhibits Required by Securities and Exchange Commission Regulation S-K (Continued) * --Copy of Thirty-Fourth Supplemental Indenture dated as of October 15, 1991. (Form 10-K for year ended 12-31-91.) * --Copy of Thirty-Fifth Supplemental Indenture dated as of August 1, 1992. (Form 10-K for year ended 12-31-92.) * --Copy of Thirty-Sixth Supplemental Indenture dated as of April 1, 1993. (Form 10-Q for quarter ended 9-30-93.) * --Copy of Thirty-Seventh Supplemental Indenture dated as of October 1, 1993. (Form 10-Q for quarter ended 9-30-93.) * --Copy of Thirty-Eighth Supplemental Indenture dated as of October 1, 1993. (Form 10-Q for quarter ended 9-30-93.) * --Copy of Thirty-Ninth Supplemental Indenture dated as of February 1, 1994. (Form 8-K, dated 1-25-94.) * --Copy of Fortieth Supplemental Indenture dated as of February 1, 1994. (Form 8-K, dated 1-25-94.) (10) Material Contracts * --Copy of Amended Coal Supply Agreement between IPL and Peabody Coal Company dated as of January 1, 1982. (Form 10-K for the year ended 12-31-82.) * --Copy of Coal Supply Agreement between IPL and Peabody Coal Company effective as of January 1, 1992 and dated April 7, 1993. (Form 10-Q for quarter ended 3-31-93.) * --Copy of Amendment to Coal Supply Agreement dated July 15. 1985, between IPL and Black Beauty Coal Company, Inc. (Form 10-K for year ended 12-31-86.) * --Copy of Coal Supply Agreement dated December 26,1984, between IPL and AMAX Coal Company. (Form 10-K for year ended 12-31-84.) * --Copy of Amendment to Coal Supply Agreement dated February 27, 1987, between IPL and Black Beauty Coal Company, Inc. (Form 10-K for year ended 12-31-87.) * --Copy of Transportation Contract dated September 28,1987, between IPL and Consolidated Rail Corporation. (Form 10-K for year ended 12-31-87.) * --Copy of Amendment No. 1 to Transportation Contract between IPL and Consolidated Rail Corporation dated November 1, 1988. (Form 10-Q for quarterly period ended June 30, 1989.) Exhibits Required by Securities and Exchange Commission Regulation S-K (Continued) * --Copy of Amendments No. 2 and 3 to Transportation Contract between IPL and Consolidated Rail Corporation dated August 1, 1989 and August 2, 1989, respectively. (Form 10-Q for quarterly period ended September 30, 1989.) * --Copy of Amendment No. 4 to Transportation Contract between IPL and Consolidated Rail Corporation dated July 30, 1990. (Form 10-Q for quarterly period ended September 30, 1990.) * --Copy of Coal Supply Agreement dated September 23, 1988, between IPL and Shand Mining, Inc. (Form 10-K for year ended 12-31-88.) * --Copy of Coal Supply Agreement dated March 29, 1988, between IPL and Coal, Inc. (Form 10-K for year ended 12-31-88.) * --Copy of First Amendment to Coal Supply Agreement between IPL and Coal, Inc. dated July 17, 1989. (Form 10-K for year ended 12-31-89.) * --Copy of Coal Supply Agreement between IPL and Triad Mining of Indiana, Inc. and Marine Coal Sales Company. (Form 10-Q for quarterly period ended March 31, 1991.) --Directors' and Officers' Liability Insurance Policy No. DO392B1A93 effective June 30, 1993, to June 1, 1994. * --Certificate of the Resolution amending the Unfunded Deferred Compensation Plan for IPL Directors dated February 22, 1983. (Form 10-K for year ended 12-31-82.) * --Copy of the Resolution amending the Unfunded Deferred Compensation Plan for IPL Directors effective January 1, 1992. (Form 10-K for year ended 12-31-92.) --Copy of the Resolution amending the Unfunded Deferred Compensation Plan for IPL Directors effective January 1, 1994. --Copy of the resolution adopting the Unfunded Deferred Compensation Plan for IPL Officers effective January 1, 1994. * --Eighth Amendment to and Complete Restatement of the IPL Unfunded Supplemental Retirement Plan for a Select Group of Management Employees effective November 1, 1988. (Form 10-K for year ended 12-31-88.) * --Copy of IPL Supplemental Retirement Plan and Trust Agreement for a Select Group of Management Employees (As Amended and Restated Effective January 1, 1992). (Form 10-K for year ended 12-31-92.) Exhibits Required by Securities and Exchange Commission Regulation S-K (Continued) --Copy of IPL Supplemental Retirement Plan and Trust Agreement For a Select Group of Management Employees (As Amended and Restated Effective May 1, 1993). --Copy of First Amendment to the Indianapolis Power & Light Company Supplemental Retirement Plan and Trust Agreement For A Select Group of Management Employees (As Last Amended and Restated Effective May 1, 1993). --Management Performance Program for 1993. * --Interconnection Agreement, dated December 30, 1960, between IPL and Indiana & Michigan Electric Company as modified. (Exhibits 4-A in File No. 2-24581; 5-F in File No. 2-28756; 5-R in File No. 2-43038; 5-S in File No. 2-47162 and 5-L in File No. 2-53541.) * --Modification 14 to Interconnection Agreement between IPL and Indiana & Michigan Electric Company. (Form 10-K for year ended 12-31-82.) * --Modification 15 to Interconnection Agreement dated September 1, 1985, between IPL and Indiana & Michigan Electric Company. (Form 10-K for year ended 12-31-88.) * --Modification 16 to Interconnection Agreement dated September 1, 1991, between IPL and Indiana Michigan Power Company (formerly Indiana & Michigan Electric Company). (Form 10-K for year ended 12-31-91.) * --Interconnection Agreement, dated May 1, 1962, between IPL and Public Service of Indiana, Inc. as supplemented. (Exhibits 4-B in File No. 2-24581; 5-L in File No. 2-38332; 5-N in File No. 2-41916; 5-P in File No. 2-41916; 5-B in File No. 2-60819 and Forms 10-K for years ended 12-31-82 and 12-31-87.) * --Ninth Supplemental Agreement dated May 1, 1992, to Interconnection Agreement between IPL and PSI Energy, Inc. (Form 10-K for year ended 12-31-92.) * --Facilities Agreement effective in 1968 among Indianapolis Power & Light Company, Public Service Company of Indiana, Inc. and Indiana & Michigan Electric Company. (Exhibit 5-G in File No. 2-28756.) * --Facilities Agreement dated August 16, 1977, between IPL and Public Service Company of Indiana, Inc. (Form 10-K for year ended 12-31-81.) Exhibits Required by Securities and Exchange Commission Regulation S-K (Continued) * --Amendment No. 1 dated June 1, 1981, to Facilities Agreement between IPL and Public Service Company of Indiana, Inc. (Form 10-K for year ended 12-31-81.) * --Amendment No. 2 dated October 1, 1984, to Facilities Agreement between IPL and Public Service of Indiana, Inc. (Form 10-K for year ended 12-31-86.) * --East Central Area Reliability Agreement dated August 1, 1967, between IPL and 23 other electric utility companies as supplemented. (Exhibits 5-I in File No. 2-38332 and 5-J in File No. 2-38332.) * --Interconnection Agreement dated December 2, 1969, between IPL and Southern Indiana Gas and Electric Company as modified. (Exhibits 5-K in File No. 2-38332 and 5-Q in File No. 2-43038.) * --Modification 2, Modification 3, and Modification 4 to Interconnection Agreement between IPL and Southern Indiana Gas and Electric Company. (Form 10-K for year ended 12-31-80.) * --Modification 5 and Modification 6 to Interconnection Agreement between IPL and Southern Indiana Gas and Electric Company. (Form 10-K for year ended 12-31-81.) * --Modification 7 to Interconnection Agreement between IPL and Southern Indiana Gas and Electric Company. (Form 10-K for year ended 12-31-82.) * --Modification 8 to Interconnection Agreement between IPL and Southern Indiana Gas and Electric Company. (Form 10-K for year ended 12-31-89.) * --Interconnection Agreement dated December 1, 1981, between IPL and Hoosier Energy Rural Electric Cooperative, Inc. (Form 10-K for year ended 12-31-81.) * --Modification 1 to Interconnection Agreement between IPL and Hoosier Energy Rural Electric Cooperative, Inc. (Form 10-K for year ended 12-31-82.) * --Modification 2 to Interconnection Agreement between IPL and Hoosier Energy Rural Electric Cooperative, Inc. (Form 10-K for year ended 12-31-83.) Exhibits Required by Securities and Exchange Commission Regulation S-K (Continued) * --Modification 3 to Interconnection Agreement between IPL and Hoosier Energy Rural Electric Cooperative, Inc. (Form 10-K for year ended 12-31-89.) * --Interconnection Agreement, dated October 7, 1987, between IPL and Wabash Valley Power Association. (Form 10-K for year ended 12-31-87.) (23) Consents of Experts and Counsel --Independent Auditors' Consent (99) Additional Exhibits * --Agreement, dated as of October 27, 1993, by and among IPALCO Enterprises, Inc., Indianapolis Power & Light Company, PSI Resources, Inc., PSI Energy, Inc. The Cincinnati Gas & Electric Company, CINergy Corp., James E. Rogers, John R. Hodowal and Ramon L. Humke. (Form 10-Q for quarterly period ended 9-30-93.) Item 14 (b). REPORTS ON FORM 8-K A report on Form 8-K, dated January 25, 1994, reporting Item 5, "Other Events", and Item 7, "Exhibits", with respect to financial results for the fiscal year ending 1993, and the 39th and 40th Supplemental Indentures. 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. INDIANAPOLIS POWER & LIGHT COMPANY By John R. Hodowal ----------------------------------- (John R. Hodowal, Chairman of the Board and Chief Executive Officer) Date February 22, 1994 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 dates indicated. Signature Title Date --------- ----- ---- (i) Principal Executive Officer: /s/ John R. Hodowal Chairman of the Board February 22, 1994 ---------------------- and Chief Executive (John R. Hodowal) Officer (ii) Principal Financial Officer: /s/ John R. Brehm Senior Vice President February 22, 1994 ---------------------- Finance and Information (John R. Brehm) Services (iii) Principal Accounting Officer: /s/ Stephen J. Plunkett Controller February 22, 1994 ------------------------ (Stephen J. Plunkett) (iv) A majority of the Board of Directors of Indianapolis Power & Light Company: /s/ Joseph D. Barnette, Jr. Director February 22, 1994 ---------------------------- (Joseph D. Barnette, Jr.) /s/ Robert A. Borns Director February 22, 1994 ---------------------------- (Robert A. Borns) SIGNATURES (Continued) /s/ Mitchell E. Daniels, Jr. Director February 22, 1994 ---------------------------- (Mitchell E. Daniels, Jr.) /s/ Rexford C. Early Director February 22, 1994 ---------------------------- (Rexford C. Early) /s/ Otto N. Frenzel III Director February 22, 1994 ---------------------------- (Otto N. Frenzel III) /s/ Max L. Gibson Director February 22, 1994 ---------------------------- (Max L. Gibson) /s/ Edwin J. Goss Director February 22, 1994 ---------------------------- (Edwin J. Goss) /s/ Dr. Earl B. Herr, Jr. Director February 22, 1994 ---------------------------- (Dr. Earl B. Herr, Jr.) /s/ John R. Hodowal Director February 22, 1994 ---------------------------- (John R. Hodowal) /s/ Ramon L. Humke Director February 22, 1994 ---------------------------- (Ramon L. Humke) /s/ Sam H. Jones Director February 22, 1994 ---------------------------- (Sam H. Jones) /s/ Andre B. Lacy Director February 22, 1994 ---------------------------- (Andre B. Lacy) /s/ L. Ben Lytle Director February 22, 1994 ---------------------------- (L. Ben Lytle) /s/ Michael S. Maurer Director February 22, 1994 ---------------------------- (Michael S. Maurer) SIGNATURES (Continued) /s/ Thomas M. Miller Director February 22, 1994 ---------------------------- (Thomas M. Miller) /s/ Sallie W. Rowland Director February 22, 1994 ---------------------------- (Sallie W. Rowland) /s/ Thomas H. Sams Director February 22, 1994 ---------------------------- (Thomas H. Sams) /s/ Zane G. Todd Director February 22, 1994 ---------------------------- (Zane G. Todd)

1993 ITEM 1. BUSINESS THE COMPANY Kirby Corporation (the "Company") was incorporated January 31, 1969 in Nevada as a subsidiary of Kirby Petroleum Co. Pursuant to the plan of liquidation of Kirby Industries, Inc. ("Industries"), Kirby Petroleum Co., which was then a wholly owned subsidiary of Industries, transferred to the Company in 1975 substantially all of its nonproducing oil and gas acreage, royalty interests and interests in oil and gas limited partnerships. The Company became publicly owned on September 30, 1976, when its common stock was distributed pro rata to the stockholders of Industries in connection with the liquidation of Industries. In September, 1984, the Company changed its name from "Kirby Exploration Company" to "Kirby Exploration Company, Inc." and in April, 1990, the name was changed from "Kirby Exploration Company, Inc." to "Kirby Corporation." Unless the context otherwise requires, all references herein to the Company include the Company and its subsidiaries. The Company's principal executive office is located at 1775 St. James Place, Suite 300, Houston, Texas 77056, and its telephone number is (713) 629-9370. The Company's mailing address is P.O. Box 1745, Houston, Texas 77251-1745. BUSINESS AND PROPERTY The Company and its subsidiaries conduct operations in three business segments: marine transportation, diesel repair and insurance. The Company's marine transportation segment is conducted through three divisions, organized around the markets they serve: the Inland Chemical Division, engaged in the inland transportation of industrial chemicals and agricultural chemicals by tank barge; the Inland Refined Products Division, engaged in the inland transportation of refined petroleum products by tank barge; and the Offshore Division, engaged in the offshore transportation of petroleum products by tank barge and tank ship and dry bulk, container, palletized cargo by barge and break-bulk and container ship. The Company's marine transportation divisions are strictly providers of transportation services and do not presently assume ownership of any of the products they transport. The Company's diesel repair segment is engaged in the overhaul and repair of diesel engines and related parts sales in two distinct markets: the marine market, serving vessels powered by large diesel engines utilized in the various inland and offshore marine industries; and the locomotive market, serving the shortline and industrial railroad markets. The Company's insurance segment is engaged primarily in the writing of property and casualty insurance in the Commonwealth of Puerto Rico through a 70% owned subsidiary. The Company and its subsidiaries have approximately 2,050 employees with approximately 150 in the Commonwealth of Puerto Rico and the balance in the United States. The following table sets forth by industry segment the combined gross revenues, operating profits (before general corporate expenses, interest expense and income taxes) and identifiable assets (including goodwill) attributable to the continuing principal activities of the Company for the periods indicated (in thousands): MARINE TRANSPORTATION The Company is engaged in marine transportation as a provider of service for both the inland and offshore markets. As of March 14, 1994, the equipment owned or operated by the Company's three marine transportation divisions was composed of 400 inland tank barges, 10 inland dry cargo barges, 123 inland towing vessels, six offshore tank ships, two offshore tank barges, six offshore dry cargo barges, four offshore break-bulk and container ships and nine offshore tugboats with the following specifications and capacities: - --------------- (*) Includes four barges and five tugboats owned by Dixie Fuels Limited and one barge and tugboat owned by Dixie Fuels II, Limited, partnerships in which a subsidiary of the Company owns a 35% and 50% interest, respectively. The following table sets forth the approximate marine transportation revenue and percentage of such revenue derived from the three divisions for the periods indicated (dollars in thousands): INLAND TANK BARGE INDUSTRY The Company's Inland Chemical Division and Inland Refined Products Division operate in the United States inland tank barge industry, which provides marine transportation of liquid bulk cargos for customers along the United States inland waterway system. Among the most significant segments of this industry are the transportation of industrial and agricultural chemicals, refined petroleum products and crude oil. The Company operates in each of these segments. The use of marine transportation by the petroleum and petrochemical industry is a major reason for the location of domestic refineries and petrochemical facilities on navigable inland waterways and along the Gulf Coast. Much of the United States farm belt is likewise situated within access to the inland waterway system, relying on marine transportation of farm products including agricultural chemicals. Although no official industry statistics are maintained, the Company believes that the total number of tank barges that operate in the inland waters of the United States has declined from an estimate of approximately 4,200 in 1981 to approximately 2,900 in 1993. The Company believes this decrease is primarily attributable to the following reasons: increasing age of the domestic tank barge fleet resulting in scraping; rates inadequate to justify new construction; reduction in financial incentives to construct new equipment; and an increase in regulations that mandate expensive equipment modification which some owners are unwilling or unable to undertake given current rate levels and the age of the fleet. Although well maintained tank barges can be efficiently operated for more than 30 years, the cost of hull work for required annual Coast Guard certifications, as well as general safety and environmental concerns, force operators to periodically reassess their ability to recover maintenance costs. Previously, tax and financing incentives to operators and investors to construct tank barges, including short life depreciation, investment tax credits and government guaranteed financing, led to the growth in the supply of domestic tank barges to a peak of approximately 4,200 in 1981. These tax incentives have since been eliminated and government financing programs have since been curtailed. The supply of tank barges resulting from the earlier programs is slowly aligning with demand for tank barge services, primarily through attrition, as discussed above. While the United States tank barge fleet has decreased in size, domestic production of petrochemicals, a major component of the industry's revenues, has increased between 1982 and 1993 by approximately 48%. Growth in the economy and the continued substitution of plastics and synthetics in a wide variety of products have been major factors behind the increase of capacity in the petrochemical industry. Texas and Louisiana, which are within the Company's areas of operations, currently account for more than 78% of the total United States production of petrochemicals. COMPETITION IN THE INLAND TANK BARGE INDUSTRY The Company operates in the highly competitive marine transportation market for commodities transported on the major inland rivers and tributaries and the Gulf Intracoastal Waterway. The industry has become increasingly concentrated within recent years as smaller and/or economically weaker companies have gone out of business or have been acquired by stronger or larger companies. Competition has historically been based primarily on price; however, shipping customers, through increased emphasis on safety, the environment, quality and a greater reliance on a "single source" supply of services, are more frequently requiring that their supplier of inland tank barge services have the capability to handle a variety of tank barge requirements, and offer flexibility, safety, environmental responsibility and quality of service consistent with the customer's own operations. The Company's direct competitors are primarily noncaptive marine transportation companies. "Captive" companies are those companies that are owned by major oil and/or petrochemical companies which, although competing in the inland barge market to varying extents, primarily transport cargos for their own account. Although industry statistics are not categorized by individual firms, the Company believes it is the largest inland tank barge carrier based on its number of barges and barrels of available capacity. While the Company competes primarily with other barge companies, it also competes with companies owning crude oil and refined products pipelines, and, to a lesser extent, rail tank cars and tank trucks in some areas and markets. The Company believes that inland marine transportation of bulk liquid products enjoys a substantial cost advantage over rail and truck transportation. The Company also believes that crude oil and refined products pipelines, although sometimes a less expensive form of transportation than barges, are not as adaptable to diverse products and are generally limited to fixed point-to-point distribution of commodities in high volumes over extended periods of time. INLAND CHEMICAL DIVISION The Company's Inland Chemical Division provides transportation services for three distinct markets: industrial chemicals, agricultural chemicals and barge fleeting services. Collectively, the Division operates a fleet of 285 inland tank barges, 84 towboats and two bowboats. Industrial Chemicals. Dixie Carriers, Inc. ("Dixie"), a subsidiary of the Company, and its subsidiaries, Dixie Marine, Inc. ("Dixie Marine") and TPT Transportation Company ("TPT Transportation"), and Chotin Carriers, Inc. ("Chotin"), a subsidiary of the Company, provide service to the industrial chemical industry through intraplant movements of petrochemical feedstock and the transportation of industrial processed chemicals and lube oils to industry users. Operating a fleet of 216 inland tank barges, 56 towboats and two bowboats, the fleet operates primarily along the Gulf Intracoastal Waterway, the Mississippi River and its tributaries and the Houston Ship Channel. The business is conducted under contracts with customers with whom the Company has long-term relationships, as well as under short-term and spot contracts. Currently, approximately 76% of the industrial chemical revenues are derived from term contracts and 24% from the spot market. All of the inland tank barges used in the transportation of industrial chemicals are of double hull construction for increased environmental protection and, where applicable, are capable of controlling vapor emissions to meet occupational health and safety regulations and air quality concerns. Chotin was acquired on June 1, 1992 by means of a merger of Scott Chotin, Inc. ("Scott Chotin") with and into Chotin. TPT Transportation acquired the assets of TPT, a marine transportation division of Ashland Oil, Inc. on March 3, 1993. See "Note 2" to the financial statements included under Item 8 elsewhere herein for further disclosure on the Chotin merger and the TPT Transportation asset purchase. Dixie's and Dixie Marine's headquarters are located in Houston, Texas and Chotin's and TPT Transportation's headquarters are in Baton Rouge, Louisiana. Agricultural Chemicals. Brent Transportation Corporation ("Brent Transportation"), a subsidiary of Dixie, operates 69 inland tank barges, including 11 cryogenic anhydrous ammonia barges, and 17 towboats primarily in transportation of agricultural chemicals, including anhydrous ammonia, to points along the Mississippi River and its tributaries and the Gulf Intracoastal Waterway. Brent Transportation's assets were acquired effective April 1, 1989, in connection with the purchase of certain assets of Brent Towing Company, Inc., and related affiliates ("Brent"), which had been engaged in the transportation of agricultural chemicals and other liquid cargos since 1961. Brent Transportation conducts its business with customers with whom it has long-term relationships and, to a lesser extent, under short-term contracts. Brent Transportation's headquarters are in Greenville, Mississippi. The Company believes that Brent Transportation has the largest inland barge fleet that primarily transports agricultural chemicals. Barge Fleeting Services. Western Towing Company ("Western"), a subsidiary of Dixie, owns 11 towboats and operates what the Company believes to be the largest commercial barge fleeting service (provision of temporary barge storage facilities) in the Port of Houston, at Bolivar Peninsula and in the Port of Freeport, Texas. Western's towboats are engaged primarily in shifting (distribution and gathering of barges) in the Houston-Galveston area. INLAND REFINED PRODUCTS DIVISION The Company's Inland Refined Products Division provides transportation services for the refined products and harbor services markets. Collectively, the Division operates a fleet of 115 inland tank barges, 26 towboats, seven harbor tugboats and four bowboats. Refined Products. Sabine Transportation Company ("Sabine Transportation"), a subsidiary of the Company, and OMR Transportation Company ("OMR Transportation"), a subsidiary of Dixie, provide service from Gulf Coast refineries through movements of primarily gasoline, diesel fuel and jet fuel to waterfront terminals on the Gulf Intracoastal Waterway and the Mississippi River and its tributaries. Many of Sabine Transportation's barges are split-product barges which maximize shipping alternatives for customers by allowing for the efficient transportation of smaller individual volumes of petroleum products and providing a means to carry up to four grades of products in the same barge. In addition, by consolidating the product requirements of several customers in split-product equipment, the Refined Products Division is able to offer quantity discounted rates to customers who are carrying small quantities of product. Currently, approximately 36% of the Inland Refined Products Division's revenues are derived from long-term contracts and 64% from the spot market. The Inland Refined Products Division was formed with the acquisition by Sabine Transportation of certain assets of Sabine Towing & Transportation, Inc. ("Sabine") on March 13, 1992 and the acquisition by OMR Transportation of certain of the assets of Ole Man River Towing, Inc. and related entities ("Ole Man River") on April 2, 1992. The Inland Refined Products Division was expanded on December 21, 1993 with the acquisition by OMR Transportation of 53 inland tank barges from Midland Enterprises Inc. and its wholly owned subsidiary, Chotin Transportation, Inc. ("Chotin Transportation"). See "Note 2" to the financial statements included under Item 8 elsewhere herein for further disclosures on the Sabine Transportation, OMR Transportation and Chotin Transportation asset purchases. Sabine Transportation's headquarters are in Port Arthur, Texas and OMR Transportation's headquarters are located in Vicksburg, Mississippi. Harbor Services. Sabine Transportation provides towing, docking and shifting services for vessels calling at the ports of Beaumont, Port Arthur and Orange, Texas and the port of Lake Charles, Louisiana. Operating seven harbor tugboats, the Company believes that this fleet holds a combined market share of approximately 55% in the ports which it serves. In addition, Sabine Transportation provides offshore ship assistance and drill-rig movements off the Texas and Louisiana coasts. OFFSHORE TRANSPORTATION INDUSTRY The Company's Offshore Division is engaged in U.S. flag offshore tank ship and tank barge operations, offshore dry bulk cargo barge operations and offshore container and break-bulk cargo barge and ship operations. The Division provides transportation of petroleum products, dry bulk, containers and palletized cargos, including United States Government preference agricultural commodities, worldwide with particular emphasis in the Gulf of Mexico, along the Atlantic Seaboard, Caribbean Basin ports and South American, West African and Northern European ports. COMPETITION IN THE OFFSHORE TRANSPORTATION INDUSTRY The offshore marine transportation market, like the inland transportation market, is highly competitive. The Company operates predominantly in United States domestic trade which is subject to the Jones Act, a federal law that limits participation between domestic ports within the United States and its territories to U.S. flag vessels. For a discussion of the Jones Act, see "Governmental Regulations" below. The Company's direct competitors are primarily captive and noncaptive operators of U.S. flag ocean-going barges, container and break-bulk ships and tank ships. Competition is based upon price, service and equipment availability. There are a limited number of vessels meeting the requirements of the Jones Act which are currently eligible to engage in domestic United States marine transportation. OFFSHORE DIVISION Offshore Tank Ship and Tank Barge Operations. Sabine Transportation operates a fleet of six owned U.S. flag single skin tank ships, that transport petroleum products primarily domestically in the Gulf of Mexico, along the East Coast and internationally to ports in the Caribbean Basin. Currently, four of Sabine Transportation's tank ships are chartered to various oil companies for the transportation of their products and two operate in the spot market, transporting petroleum products as cargo offers. Classified as "handy size," the tank ships have deadweight capacities ranging between 28,000 and 35,000 tons with a total capacity of 1,538,000 barrels. As discussed under "Environmental Regulations" below, the Oil Pollution Act of 1990 ("OPA") has placed a number of stringent requirements on tank ship owners and operators, including the phasing out of all single hull vessels beginning in 1995, depending on vessel size and age. In accordance with the OPA, Sabine Transportation's tank ships are scheduled to be retired from service as follows: one -- January 1, 1995; one -- January 1, 1996; one -- October 1, 1996; one -- October 30, 2000; one -- November 4, 2004; and one -- January 1, 2005. In order to stay in service beyond the retirement date, these tank ships would have to be either retrofitted with a double hull cargo section or used exclusively in foreign trade. In addition to the tank ships, the Company, through Dixie, owns and operates two ocean-going tank barge and tugboat units, one of which is single skin and one double skin. The single skin 157,000 barrel barge and tug unit and the double skin 165,000 barrel barge and tug unit provide service in the transportation of refined petroleum products between domestic ports along the Gulf of Mexico and along the Atlantic Seaboard. The single skin tank barge is scheduled to be removed from service in accordance with the OPA on January 1, 2005. The double skin tank barge meets all of the OPA construction requirements. Offshore Dry Bulk Cargo Operations. The Company's offshore dry bulk cargo operations are conducted through Dixie's wholly owned equipment and through two general partnerships, Dixie Fuels Limited ("Dixie Fuels") and Dixie Fuels II, Limited ("Dixie Fuels II"), in which a subsidiary of Dixie owns a 35% and 50% interest, respectively. Dixie and Dixie Fuels transport dry bulk cargos, such as coal, limestone, cement, fertilizer, flour, raw sugar and grain, as well as containers between domestic ports along the Gulf of Mexico, the East Coast and West Coast, and to ports in the Caribbean Basin with occasional movements to West Africa and other international ports as cargo offers. Management believes that Dixie, including the operations of Dixie Fuels and Dixie Fuels II, is the second largest domestic offshore dry bulk barge carrier in terms of deadweight capacity. Dixie owns one ocean-going dry bulk barge and tugboat unit that is engaged in transportation of dry bulk commodities primarily between domestic ports along the Gulf of Mexico and along the Atlantic Seaboard. Dixie, as general partner, also manages the operations of Dixie Fuels, which operates a fleet of four ocean-going dry bulk barges, four ocean-going tugboats and one shifting tugboat. The remaining 65% of Dixie Fuels is owned by Electric Fuels Corporation ("EFC"), an affiliate of Florida Power Corporation ("Florida Power"). Dixie Fuels operates primarily under long-term contracts of affreightment, including a contract that expires in the year 2002 with EFC to transport coal across the Gulf of Mexico to Florida Power's facility at Crystal River, Florida. Dixie Fuels also has a 12-year contract, which commenced in 1989, with Holnam, Inc. ("Holnam") to transport Holnam's limestone requirements from a facility adjacent to the Florida Power facility at Crystal River to Holnam's plant in Theodore, Alabama. The Holnam contract provides cargo for a portion of the return voyage for the vessels that carry coal to Florida Power's Crystal River facility. Dixie Fuels is also engaged in the transportation of coal, fertilizer and other bulk cargos on a short-term basis between domestic ports and of grain from domestic ports to points primarily in the Caribbean Basin. Dixie also manages the operations of Dixie Fuels II, which operates an ocean-going dry bulk barge and tug unit. The remaining 50% of Dixie Fuels II is owned by EFC. Dixie Fuels II is engaged in the transportation of dry bulk cargo and containers between domestic ports, ports in the Caribbean Basin and international ports as cargo offers. Since May, 1993, Dixie Fuels II's barge and tug unit has been engaged in the international transportation of preference agricultural aid cargos for the United States Government. Offshore Break-bulk and Container Cargo Operations. In May, 1993, the Company completed the acquisition of AFRAM Lines (USA) Co., Ltd. ("AFRAM Lines") by means of a merger of AFRAM Lines with and into AFRAM Carriers, Inc. ("AFRAM"). AFRAM is engaged in the worldwide transportation of dry bulk, container and palletized cargos, primarily for departments and agencies of the United States Government. AFRAM's fleet of three U.S. flag break-bulk and container ships specialize in the transportation of United States Government military and preference aid cargos. See "Note 2" to the financial statements included under Item 8 elsewhere herein for further disclosures on the AFRAM merger. In addition, for a discussion of preference aid cargos, see "Governmental Regulations" below. AFRAM's headquarters are located in Houston, Texas. In early March, 1994, the Company, through its subsidiary, Americas Marine Express, Inc. ("Americas Marine"), began all-water marine transportation services between Memphis, Tennessee and Mexico, Guatemala, Honduras and El Salvador. The new transportation service utilizes a chartered river/ocean vessel that offers direct sailing between the locations. The new service provides exporters and importers in the north, central and mid-south states with a direct shipping alternative between Memphis and Mexico and Central America on a fourteen day round trip basis. The direct all-water liner service accepts 20 foot and 40 foot containers, including refrigerated and tank containers, as well as other cargo on a space available basis. The Company is of the opinion that the liner service offers container shippers to the interior of the United States a lower transportation cost alternative, predictable delivery time, a consistent product flow to their customers and other benefits inherent in a direct all-water liner service. CONTRACTS AND CUSTOMERS The majority of the marine transportation contracts are for terms of one to five years. Currently, the three marine transportation divisions of the Company operate under long-term contracts with Agricultural Minerals Corporation, Chevron Chemical Company, EFC, Holnam, Monsanto Chemical Company, Odfjell Tank Ships (USA) Inc. and Shell Oil Company, among many others. While these companies have generally been customers of the Company's marine transportation divisions for several years and management anticipates a continuing relationship, there is no assurance that any individual contract will be renewed. No single customer of the Company's marine transportation segment accounted for more than 10% of the Company's revenue in 1993, 1992 or 1991. EMPLOYEES The Company's three marine transportation divisions have approximately 1,725 employees, of which approximately 1,425 are vessel crew members. Approximately 39% of the 1,425 vessel crew members are subject to various collective bargaining agreements with various labor organizations. No one collective bargaining agreement covers more than 10% of the 1,425 vessel crew members. PROPERTIES The principal office of Dixie is located in Houston, Texas, in facilities under a lease that expires in 1996. The marine transportation operating divisions are located on the Gulf Intracoastal Canal at Belle Chasse, Louisiana, a suburb of New Orleans; in Houston, Texas, near the Houston Ship Channel; in Greenville, Mississippi and in Vicksburg, Mississippi. The Greenville location is leased and the Belle Chasse, Houston and Vicksburg locations are owned. Western's facilities are located on a 10.24-acre tract of land owned by Dixie lying between the San Jacinto River and Old River Lake near Houston, Texas. The principal office of Chotin and TPT Transportation is located in Baton Rouge, Louisiana in owned facilities. The principal office and operating units of Sabine Transportation are located in Port Arthur, Texas on 30 acres of owned waterfront property along the Sabine-Neches Waterway. The principal office of AFRAM is located in Houston, Texas in leased facilities. The principal office of Americas Marine is located in Memphis, Tennessee in leased facilities. GOVERNMENTAL REGULATIONS General. The Company's transportation operations are subject to regulation by the United States Coast Guard, federal laws, state laws and certain international conventions. The transportation of cargos in bulk are exempt from economic regulations under the Interstate Commerce Act. Therefore, with the exception of AFRAM and Americas Marine, the rates charged by the Company for the transportation of such bulk cargos are negotiated between the Company and its customers and are not set by tariff. AFRAM and Americas Marine generally operate under published tariffs. AFRAM also bids for United States Government cargo. The majority of the Company's tank barges, all offshore barges and all ships are inspected by the United States Coast Guard and carry certificates of inspection. The Company's inland and offshore towing vessels are not subject to United States Coast Guard inspection requirements; however, the Company's offshore tugboats and offshore dry bulk and tank barges are built to American Bureau of Shipping ("ABS") classification standards. These offshore vessels are inspected periodically by the ABS to maintain the vessels in class. The crew employed by the Company aboard vessels, including captains, pilots, engineers, able-bodied seamen and tankermen, are licensed by the United States Coast Guard. The Company is required by various governmental agencies to obtain licenses, certificates and permits for its vessels depending upon such factors as the cargo transported, the waters in which the vessel operates, the age of the vessels and other factors. The Company is of the opinion that the Company's vessels have obtained and can maintain all required licenses, certificates and permits required by such governmental agencies. The Company believes that safety concerns highlighted by the highly publicized barge collision with the railroad bridge near Mobile, Alabama in September, 1993 will result in additional regulations being imposed on the barge industry in the form of personnel licensing and navigation equipment requirements. Generally, the Company endorses the anticipated additional regulations and believes it is currently operating to standards at least the equal of such anticipated additional regulations. Jones Act. The Jones Act is a federal law that restricts domestic marine transportation in the United States to vessels built and registered in the United States. Furthermore, the Jones Act requires that the vessels be manned by United States citizens and owned by United States citizens. For corporations, 75% of the corporations' beneficial stockholders must be United States citizens. The Company presently meets all of the requirements of the Jones Act for its owned vessels. Compliance with the United States ownership requirements of the Jones Act is very important to the operations of the Company and the loss of the Jones Act status could have a significant negative effect to the Company. The Company monitors the citizenship requirements under the Jones Act of its employees and beneficial stockholders and will take any remedial action necessary to insure compliance with the Jones Act requirements. The requirements that the Company's vessels be United States built, manned by United States citizens and the crewing requirements of the Coast Guard significantly increase the capital and labor costs of U.S. flag vessels when compared with foreign flag vessels. The Company's business would be adversely affected if the Jones Act were to be modified so as to permit foreign competition. During the past several years, the Jones Act and cargo preference laws, see "Preference Cargo" below, have come under attack by interests seeking to facilitate foreign flag competition for cargos reserved for U.S. flag vessels under the Jones Act and cargo preference laws. These efforts have been consistently defeated by large margins in the United States Congress. The Company believes that continued efforts will be made to gain access to such trade and if such access is successful, it could have an adverse effect on the Company. Construction and Operating Differential Subsidies. The Merchant Marine Act of 1970 permits deferral of taxes on earnings deposited into capital construction funds. Such funds and interest earned from such funds can be used for the construction of or acquisition of U.S. flag vessels. In addition, to encourage U.S. flag vessels to engage in foreign trade, the Merchant Marine Act provides for direct subsidies to equalize the disparity between costs of U.S. flag operations and construction and the costs of foreign operations and construction. The Company does not receive either of these subsidies on any of its vessels. Preference Cargo. The Merchant Marine Act of 1936, as amended, requires that preference be given to U.S. flag vessels in the transportation of certain United States Government impelled cargos (cargos shipped either by the United States Government or by a foreign nation, with the aid or guarantee of the United States Government). Currently, 75% of the Government directed foreign aid and agricultural assistance programs, which includes grains and other food concessions, are required to be transported in U.S. flag vessels. Such programs currently benefit the Company's offshore break-bulk ships and dry bulk barge and tug units, some of which work primarily in this trade. The transportation of such cargo accounted for approximately 10% of the Company's transportation revenues in 1993, 1% in 1992 and 2% in 1991. The transportation of United States military cargo is also classified as a preference cargo, which requires the use of U.S. flag vessels, if available. The Company's AFRAM break-bulk ships have from time to time been chartered by the Military Sealift Command ("MSC"). Charters to MSC accounted for 2% of the Company's 1993 transportation revenues. The chartering by the MSC depends upon the requirements of the United States military for marine transportation of cargos, and, therefore, depends in part on world conditions and United States foreign policy. Currently, none of the Company's vessels are chartered to the MSC. The preference cargo law is often opposed by agricultural interests which perceive they would benefit from the ability to transport preference cargos aboard foreign flag vessels. Like the Jones Act, the Company is of the opinion that continued efforts will be made to significantly reduce, or remove completely, the requirement that 75% of such cargos be transported in U.S. flag vessels. Any reduction in this percentage could have an adverse effect on the Company's operations and, therefore, the Company will continue to participate in efforts to preserve the present preference cargo requirements. User Fees. Federal legislation requires that inland marine transportation companies pay a waterway user fee in the form of a tax based on propulsion fuel used by vessels engaged in trade along the inland waterways that are maintained by the United States Corps of Engineers. Such user fees are designed to help defray the cost associated with replacing major components of the inland waterway system such as locks, dams and to build new waterway projects. A significant portion of the inland waterways on which the Company's vessels operate are maintained by the Corps of Engineers. The Company presently pays a waterway tax of 23.4 cents per gallon, reflecting a 4.3 cents per gallon increase imposed during October, 1993 and a 2 cents per gallon increase imposed in January, 1994. In mid-February, 1993, President Clinton announced his economic plan which included a proposal to raise the user tax by an additional $1.00 per gallon, such user tax to be phased in until taking full effect in 1997. The Company and marine transportation and shipping groups vigorously protested the user tax proposal, stating that such a rate increase could significantly reduce the ability of the Company's customers to be internationally competitive and would place the inland river transportation system at a competitive disadvantage to other modes of transportation. These efforts were successful in defeating the $1.00 per gallon proposal as, in October, 1993, President Clinton signed into law the 1993 budget which included a 4.3 cents per gallon increase in the waterway user tax, increasing the total tax to 21.4 cents per gallon. In January, 1994, an additional 2 cents per gallon was phased in, the result of prior legislation. Currently, an additional 2 cents per gallon is scheduled to be phased in effective January 1, 1995, with the user tax rate reaching an ultimate rate of 25.4 cents per gallon. There can be no assurance that additional user fees, above the presently planned amounts, may not be imposed in the future. ENVIRONMENTAL REGULATIONS The Company's operations are affected by various regulations and legislation enacted for protection of the environment by the United States Government, as well as many coastal and inland waterway states. Water Pollution Regulations. The Federal Water Pollution Act of 1972, as amended by the Clean Water Act of 1977, the OPA, and the Comprehensive Environmental Response, Compensation and Liability Act of 1981 impose strict prohibitions against the discharge of oil and its derivatives or hazardous substances into the navigable waters of the United States. These acts impose civil and criminal penalties for any prohibited discharges and impose substantial liability for cleanup of these discharges and any associated damages. Certain states also have water pollution laws that prohibit discharges into waters that traverse the state or adjoin the state and impose civil and criminal penalties and liabilities similar in nature to those imposed under federal laws. The OPA and various state laws of similar intent, substantially increased over historic levels statutory strict exposure of owners and operators of vessels for oil spills, both in terms of limit of liability and scope of damages. The Company considers its most significant pollution liability exposure to be the carriage of persistent oils (crude oil, asphalt, # 5 oil, # 6 oil, lube oil and other black oil). The Company restricts the carriage of persistent oil in inland equipment to double skin barges only. Currently, the only persistent oil carried in the Company's offshore fleet is in a Sabine Transportation single skin tank ship which ceases operation at year-end 1994. One of the most important requirements under OPA is the requirement that all newly constructed tank ships or tank barges engaged in the transportation of oil and petroleum products in the United States must be double hulled and all existing single hull tank ships or tank barges be retrofitted with double hulls or phased out of domestic service between January 1, 1995 and 2015, in order to comply with the new standards. See "Offshore Division -- Offshore Tank Ships and Tank Barge Operations" for a discussion of the effects of OPA on the Company's offshore equipment. As a result of several recent highly publicized oil spills, federal or state legislators could impose additional licensing, certification or equipment requirements on marine vessel operations. Generally, the Company believes that it is in a good position to accommodate any reasonably foreseeable regulatory changes and that it will not incur significant additional costs. The Company manages its exposure to losses from potential discharges of pollutants through the use of well maintained and equipped vessels, the safety and environmental programs of the Company and the Company's insurance program. In addition, the Company uses double skin barges in the transportation of more hazardous substances. There can be no assurance, however, that any new regulations or requirements or any discharge of pollutants by the Company will not have an adverse effect on the Company. Financial Responsibility Requirement. Commencing with the Federal Water Pollution Control Act of 1972, as amended, vessels over three hundred gross tons operating in United States waters have been required to maintain evidence of financial ability to satisfy statutory liabilities for water pollution. This evidence is in the form of a Certificate of Financial Responsibility ("CFR") issued by the United States Coast Guard. The majority of the Company's tank barges and all the tank ships are subject to this CFR requirement and the Company has fully complied since inception of the requirement. The OPA amended the CFR requirements principally by expanding the scope of liability subject to the requirements and by significantly increasing the financial ability requirements. The United States Coast Guard promulgated a Notice of Proposed Rulemaking on September 26, 1991 that would implement the new financial responsibility requirements of OPA. The proposed rule, if implemented in present form, would eliminate the ability of the Company to utilize its insurance, which greatly exceeds the financial responsibility requirements, as a means of satisfying the financial ability requirement under OPA. Under the proposed rule the Company would be required to demonstrate net worth and working capital equal to the maximum statutory limit of liability under OPA and the Comprehensive Environmental Response, Compensation and Liability Act of 1981. The Company believes it will be able to satisfy the more stringent CFR requirements currently proposed. The Company is also of the opinion that such proposed regulations are unnecessarily stringent and that a majority of domestic and foreign vessel operators subject to the proposed regulation will be unable to comply. Clean Air Regulations. The Federal Clean Air Act of 1979 requires states to draft State Implementation Plans ("SIPs") designed to reduce atmospheric pollution to levels mandated by this act. Several SIPs provide for the regulation of barge loading and degassing emissions. The implementation of these regulations will require a reduction of hydrocarbon emissions released in the atmosphere during the loading of most petroleum products and the degassing and cleaning of barges for maintenance or change of cargo. These new regulations will require operators who operate in these states to install vapor control equipment on their barges. The Company expects that future toxic emission regulations will be developed and will apply this same technology to many chemicals that are handled by barge. Most of the Company's barges engaged in the transportation of petrochemicals, chemicals and refined products are already equipped with vapor control systems. Although a risk exists that new regulations could require significant capital expenditures by the Company and otherwise increase the Company's costs, the Company believes that, based upon the regulations that have been proposed thus far, no material capital expenditures beyond those currently contemplated by the Company or increase in costs are likely to be required. Contingency Plan Requirement. Commencing August 8, 1993, OPA and several state statutes of similar intent require the majority of the vessels operated by the Company to maintain approved oil spill contingency plans as a condition of operation. The Company has submitted plans that it believes comply with requirements, but approval has not yet been granted. Occupational Health Regulations. The Company's vessel operations are primarily regulated by the United States Coast Guard for occupational health standards. The Company's shore personnel are subject to the United States Occupational Safety and Health Administration regulations. The Coast Guard has promulgated regulations that address the exposure to benzene vapors, which require the Company, as well as other operators, to perform extensive monitoring, medical testing and record keeping of seamen engaged in the handling of benzene transported aboard vessels. It is expected that these regulations may serve as a prototype for similar health regulations relating to the carriage of other hazardous liquid cargos. The Company believes that it is in compliance with the provisions of the regulations that have been adopted and does not believe that the adoption of any further regulations will impose additional material requirements on the Company. There can be no assurance, however, that claims will not be made against the Company for work related illness or injury or that the further adoption of health regulations will not adversely affect the Company. Insurance. The Company's marine transportation operations are subject to the hazards associated with operating heavy equipment carrying large volumes of cargo in a marine environment. These hazards include the risk of loss of or damage to the Company's vessels, damage to third parties from impact, fire or explosion as a result of collision, loss or contamination of cargo, personal injury of employees, pollution and other environmental damages. The Company maintains insurance coverage against these hazards. Risk of loss of or damage to the Company's vessels is insured through hull insurance policies currently insuring approximately $500 million in hull values. Vessel operating liabilities, such as collision, cargo, environmental and personal injury, are insured primarily through the Company's participation in protection and indemnity mutual insurance associations under which the protection against such hazards is in excess of $1 billion for each incident, except in the case of oil pollution, which is limited to $500 million for each incident, but is limited to $700 million for each incident in the case of the Company's tank ships and ocean-going tank barges. However, because it is mutual insurance, the Company is exposed to funding requirements and coverage shortfalls in the event claims by the Company or other members exceed available funds and reinsurance. Environmental Protection. The Company has a number of programs that were implemented to further its commitment to environmental responsibility in its operations. One such program is environmental audits of barge cleaning vendors, principally directed at management of cargo residues and barge cleaning wastes. Another program is the participation by the Company in the Chemical Manufacturer's Association Responsi- ble Care program and the American Petroleum Institute STEP program, both of which are oriented to continuously reducing the chemical and petroleum industries' impact on the environment, including the distribution services area. Safety. The Company manages its exposure to the hazards incident to its business through safety, training and preventive maintenance efforts. The Company places considerable emphasis on safety through a program oriented towards extensive monitoring of safety performance for the purpose of identifying trends and initiating corrective action, and for the purpose of rewarding personnel achieving superior safety performance. The Company believes that its safety performance consistently places it among the industry leaders, which is evidenced by what it believes are lower insurance costs (as a percentage of revenue) and a lower injury level than many of its competitors. Quality. The Company is totally committed to the concept of quality in its business philosophy. Through Quality Project Teams and Quality Steering Committees, the Company's quality commitment is carried throughout the marine transportation organization. Such committees are dedicated to directing attention to the continuous improvement of the business processes, focusing efforts on achieving customer satisfaction the first time, every time and carefully monitoring statistical measures of the Company's progress in meeting its quality objectives. The Company's commitment to quality has been expanded in recent years to include the installation and maintenance of Quality Assurance Systems in compliance with the International Quality Standard, ISO 9002 ("ISO"). During 1993, Dixie's offshore operations and Dixie's inland operations were awarded ISO certifications by ABS Quality Evaluations, a leading registrar of quality systems. Dixie's offshore operation was the first U.S. flag offshore vessel operator to achieve this distinction, while Dixie's inland operation was the second inland marine transportation company to be recognized in the United States. At present, the balance of the Company's marine transportation operations are working toward certification during 1994 and 1995. Achieving ISO certification demonstrates the Company's total commitment to quality throughout the organization. The benefits of implementing these Quality Assurance Systems are significant for the Company's marine transportation operations since such Quality Assurance Systems provide additional internal controls that improve operating efficiency. Through documentation, problems are easier to identify and correct, training is streamlined and favorable operational practices are easier to identify and install company-wide. In addition, the Company's commitment to safety and environmental protection is further enhanced. DIESEL REPAIR The Company is presently engaged in the overhaul and repair of diesel engines and related parts sales through two operating subsidiaries: Marine Systems, Inc. ("Marine Systems") and Rail Systems, Inc. ("Rail Systems"). As a provider of diesel repair services for customers in the marine and rail industries, the Company's diesel repair segment is divided into the marine and locomotive markets. MARINE DIESEL REPAIR Through Marine Systems, the Company is engaged in the overhaul and repair of marine diesel engines, reduction gear repair, line boring, block welding services and related parts sales for customers in the marine industry. The marine diesel repair industry services tugs and towboats powered by large diesel engines utilized in the inland and offshore barge industries. It also services marine equipment in the offshore petroleum exploration and well service industry, the offshore commercial fishing industry and vessels owned by the United States Government. Marine Systems operates through four divisions providing in-house and in-field repair capabilities. These four divisions are: Gulf Coast (based in Houma, Louisiana); East Coast (based in Chesapeake, Virginia); Midwest (based in East Alton, Illinois); and West Coast (based in National City, California, with service facilities in Seattle, Washington and the Pacific Basin). All four of Marine Systems' divisions are nonexclusive authorized service centers for the Electromotive Division of General Motors Corporation ("EMD") selling parts and service. Marine Systems is positioned through the location of its divisions to serve all of the marine industry of the United States. Marine Systems' Gulf Coast and Midwest divisions concentrate on larger diesel engines, including those manufactured by EMD, that are more commonly used in the inland and offshore barge and oil service industries. The East Coast division overhauls and repairs the larger EMD engines used by the military and commercial customers from Connecticut to Miami. The West Coast division concentrates on large EMD engines used by the offshore commercial fishing industry, the military, commercial business in the Pacific Northwest and customers in Alaska. Marine Systems' emphasis is on service to its customers and can send its crews from any of its locations to service customers' equipment anywhere in the world. During 1993, Marine Systems enhanced its long-term opportunities with the addition of two distributorship agreements. Under a long-term agreement with Paxman Diesels, Ltd. of Colchester, England, a manufacturer of diesel engines, Marine Systems will sell engine parts and other authorized repair services. Paxman engines are used primarily by the United States Coast Guard in its patrol boats. In addition, during 1993, Marine Systems signed a long-term agreement with Falk Corporation, a marine reduction gear manufacturer, whereby Marine Systems will sell parts and offer authorized repair services. The following table sets forth the revenues of Marine Systems for the periods indicated (dollars in thousands): MARINE CUSTOMERS Major customers of Marine Systems include inland and offshore dry bulk and tank barge operators, oil service companies, petrochemical companies, offshore fishing companies, other marine transportation entities and the United States Coast Guard, Navy and Army. Marine Systems also provides services to the Company's fleet, which accounted for approximately 6% of Marine Systems' total 1993 revenues; however, such revenues are eliminated in consolidation, and not included in the table above. No single customer of Marine Systems accounted for more than 10% of the Company's revenues in 1993, 1992 or 1991. Since Marine Systems' business can be cyclical and is linked to the relative health of the diesel power tug and towboat industry, the offshore supply boat industry, the military and the offshore commercial fishing industry, there is no assurance that its present gross revenues can be maintained in the future. The results of the diesel repair service industry are largely tied to the industries it serves, and, therefore, have been somewhat influenced by the cycles of such industries. MARINE COMPETITIVE CONDITIONS Marine Systems' primary competitors are 10 to 15 independent diesel repair companies. While price is a major determinant in the competitive process, reputation, consistent quality and expeditious service, experienced personnel, access to parts inventories and market presence are significant factors. A substantial portion of Marine Systems' business is obtained by competitive bids. Many of the parts sold by Marine Systems are generally available from other distributors, however, Marine Systems is one of a limited number of distributors of EMD parts. Although the Company believes it is unlikely, termination of Marine Systems' relationship with the supplier could adversely affect its business. LOCOMOTIVE DIESEL REPAIR Through Rail Systems, the Company is engaged in the overhaul and repair of locomotive diesel engines and sale of replacement parts for locomotives serving the shortline and industrial railroads within the continental United States. In October, 1993, EMD, the world's largest manufacturer of diesel-electric locomotives, awarded an exclusive United States rail distributorship to Rail Systems to provide replacement parts, service and support to these important and expanding markets. The operations of Rail Systems commenced in January, 1994. Rail Systems has an office and service facility in Nashville, Tennessee. The service facility is primarily a parts warehouse. Service to the actual locomotives are completed at sites convenient for the customer by Rail Systems' service crews. LOCOMOTIVE CUSTOMERS Shortline railroads have been a growing component of the United States railroad industry since deregulation of the railroads in the 1970's. Generally shortline railroads have been created through the divestiture of branch routes from the major railroad systems. These short routes provide switching and short haul of freight, with an emphasized need for responsive and reliable service. Currently, about 500 shortline railroads in the United States operate approximately 2,400 EMD engines. Approximately 280 United States industrial users operate approximately 1,300 EMD engines. Generally, the EMD engines operated by the shortline and industrial users are older and, therefore, require more maintenance. LOCOMOTIVE COMPETITIVE CONDITIONS As an exclusive United States distributor for EMD parts, Rail Systems will provide all EMD parts sales to these markets, as well as provide rebuilt and service work. Currently, other than Rail Systems, there are three primary companies providing service for the shortline and industrial locomotives. In addition, the industrial companies in some cases, provide their own service. EMPLOYEES Marine Systems and Rail Systems have approximately 120 employees. PROPERTIES The principal office of Marine Systems is located in Houma, Louisiana. Parts and service facilities are located in Houma, Louisiana; in Chesapeake, Virginia; in East Alton, Illinois; in National City, California; and in Seattle, Washington. The Chesapeake, East Alton, National City and Seattle locations are on leased property and the Houma location is situated on approximately four acres of owned land. The principal office and service facility of Rail Systems is located in leased facilities in Nashville, Tennessee. INSURANCE The Company is engaged in the writing of property and casualty insurance primarily through Universal Insurance Company ("Universal"), a corporation located in the Commonwealth of Puerto Rico. Since its formation in 1972, Universal has evolved primarily from an automobile physical damage insurer to a full service property and casualty insurer, with emphasis on the property insurance lines. Universal is ranked third among Puerto Rican insurance companies in terms of policyholders' surplus and admitted assets, and has achieved an A+ (Superior) rating from A. M. Best Company, a leading insurance rating agency, for ten consecutive years. On September 25, 1992, Universal merged with Eastern America Insurance Company ("Eastern America"), a property and casualty insurance company in Puerto Rico, with Universal being the surviving entity. As of December 31, 1993, the Company owned approximately 70% of Universal's voting common stock with the remaining approximately 30% owned by Eastern America Financial Group, Inc. ("Eastern America Group"), the former parent of Eastern America. The Company owns 100% of the non-voting common and preferred stocks of Universal. In accordance with a shareholder agreement among Universal, the Company and Eastern America Group, through options and redemption rights, Universal has the right to purchase the Company's interest in Universal over a period of up to 12 years, the result of which would be Eastern America Group becoming the owner of 100% of Universal's stock. To date, Universal has redeemed from the Company 44,933 shares of Class B common stock for a total redemption price of $8,000,000. Of the total redemptions to date, $7,000,000, or 39,128 shares, were redeemed in July, 1993 and $1,000,000, or 5,805 shares, were redeemed in December, 1992. INSURANCE OPERATION Universal writes a broad range of property and casualty insurance. Universal, however, is primarily a property insurer, generating approximately 66% of its 1993 premiums written from property lines. Universal's principal property insurance line is automobile physical damage, specifically the vehicle single-interest risk line, which insures lending institutions against the risk of loss of the unpaid balance of their automobile loans with respect to financed vehicles. Vehicle single-interest premiums accounted for 25% of Universal's consolidated premiums written in 1993. Universal's insurance business is generated primarily through independent agents and brokers in Puerto Rico. While no one agent, other than the Eastern America Insurance Agency, an affiliate of Eastern America Group, accounted for more than 5% of premiums written in 1993, Universal could be adversely affected if it were to lose several of its higher producing agents. Universal maintains an extensive program of reinsurance of the risks that it insures, primarily under arrangements with reinsurers in London and the United States. Property lines are reinsured under quota share agreements up to $5,000,000. Casualty claims above $500,000 are reinsured up to $4,000,000. Ocean marine and surety lines are reinsured under various pro rata and excess treaties up to $500,000 and $4,000,000, respectively. Catastrophe automobile physical damage, fire and allied lines and marine coverage affords recovery of losses over $500,000, $1,500,000 and $250,000 up to $15,000,000, $64,000,000 and $3,000,000, respectively. Because Universal's business is written in Puerto Rico, Universal's insurance risk is not as diversified as the risk of a carrier that covers a broader geographical area. A natural catastrophe could cause property damage to a large number of Universal's policyholders, which would result in significantly increased losses to Universal. However, the Company believes that Universal's reinsurance program will limit its net exposure in any such catastrophe. Property damage from Hurricane Hugo in September, 1989 attributable to Universal was approximately $34,000,000; however, the net impact was $1,450,000 after deducting the reinsurance recoverables. At December 31, 1993, Universal had investments of $122,412,000, consisting primarily of short-term and available-for-sale securities. At such date, approximately 97% of that portfolio was invested in United States Government instruments due to their safety and to the favorable Puerto Rican tax treatment of such securities. Universal's insurance business is governed by the Insurance Code of the Commonwealth of Puerto Rico and in accordance with the regulations issued by the Commissioner of Insurance of the Commonwealth of Puerto Rico. REINSURANCE OPERATION Prior to 1991, the Company participated in the international reinsurance market through Mariner Reinsurance Company Limited ("Mariner"), a wholly owned subsidiary of the Company, and through Universal. From 1972 through 1990, Mariner was engaged in the pro rata and excess of loss reinsurance business dealing principally with brokers in London. This reinsurance consisted of certain property and casualty reinsurance lines whereby Mariner participated in the reinsurance of certain Lloyd's underwriters, British insurance companies, and other foreign insurance companies. In addition, Mariner reinsured certain treaties of Universal. Effective January 1, 1987, Mariner ceased writing any new or renewal reinsurance and Mariner's business portfolio was assumed by Universal; however, in 1989, two reinsurance contracts were transferred back to Mariner. Effective January 1, 1991, Universal ceased accepting new participation in the international reinsurance market and the entire reinsurance business portfolio was assumed by Mariner. During the 1992 year, Mariner, based on certain delayed and certain timely loss advices, increased its loss reserves. See "Note 5" to the financial statements included under Item 8 elsewhere herein for further disclosures on the increase in the Mariner reserves. With the 1990 year being the final year for participation in the reinsurance market, neither Mariner nor Universal was involved in any subsequent catastrophes such as Hurricane Andrew. Neither Universal nor Mariner does business with any of the Company's other subsidiaries, nor is there any connection, other than common ownership. The Company is currently pursuing strategies to withdraw from the runoff of Mariner's reinsurance business at the earliest possible date. Such strategies include the possible commutation of Mariner's open book of reinsurance business in exchange for a portion of, or all of, Mariner's assets. As of December 31, 1993, the Company had net equity in Mariner of approximately $1,500,000. CAPTIVE INSURANCE OPERATION Effective January 1, 1994, the Company established a captive insurance company, Oceanic Insurance Limited ("Oceanic"). The captive will insure only risks of the Company and its domestic subsidiaries. EMPLOYEES Universal has approximately 150 employees, all in the Commonwealth of Puerto Rico. Mariner's and Oceanic's activities are handled by the Company's employees and by agents in Bermuda. PROPERTIES Universal's office is located in San Juan, Puerto Rico. The office is leased with an expiration date of January 31, 1998. ITEM 2. ITEM 2. PROPERTIES The information appearing in Item 1 is incorporated herein by reference. The Company and Dixie currently occupy leased office space at 1775 St. James Place, Suite 300, Houston, Texas under a lease that expires in 1996. The Company believes that its facilities are adequate for its needs and additional facilities would be readily available. ITEM 3. ITEM 3. LEGAL PROCEEDINGS See "Note 13" to the financial statements included under Item 8 elsewhere herein for a discussion of legal proceedings. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS During the fourth quarter of the fiscal year December 31, 1993, no matter was submitted to a vote of security holders through solicitation of proxies or otherwise. EXECUTIVE OFFICERS OF THE REGISTRANT The executive officers of the Company are as follows: No family relationship exists between the executive officers or between the executive officers and the directors. Officers are elected to hold office until the annual meeting of directors, which immediately follows the annual meeting of stockholders, or until their respective successors are elected and have qualified. George A. Peterkin, Jr. holds a degree in business administration, was elected a Director of the Company in 1973 and was employed as its President on October 1, 1976. He had served as a Director of Kirby Industries, Inc. since 1969 and as President of Industries since January, 1973. Prior to that, he was President of Dixie from 1953 through 1972. J. H. Pyne holds a degree in liberal arts from the University of North Carolina and has served as President of Dixie since July, 1984, was elected a Director of the Company in July, 1988, and was elected Executive Vice President of the Company in 1992. He also served in various operating and administrative capacities with Dixie from 1978 to 1984, including Executive Vice President from January to June, 1984. Prior to joining Dixie, he was employed by Northrop Services, Inc. and served as an officer in the United States Navy. Brian K. Harrington is a Certified Public Accountant and holds an M.B.A. degree from the University of Oregon. He has served as Treasurer and Principal Financial Officer of the Company and Dixie since May, 1989, Vice President since September, 1989 and Senior Vice President since 1993. Prior to joining the Company, he was engaged as a financial consultant with emphasis in the petrochemical distributing industry, providing services to Dixie and other companies. Prior to 1979, he was Vice President of Planning, Marketing and Development for Paktank Corporation. G. Stephen Holcomb holds a degree in business administration from Stephen F. Austin State University and has served the Company as Vice President, Controller, Assistant Treasurer and Assistant Secretary since January, 1989. He also served as Controller from January, 1987 to January, 1989, and as Assistant Controller and Assistant Secretary from 1976 through 1986. Prior to that, he was Assistant Controller of Kirby Industries, Inc. from 1973 to 1976. Prior to joining the Company, he was employed by Cooper Industries, Inc. Ronald C. Dansby holds a degree in business administration from the University of Houston and has served the Company as Vice President -- Inland Chemical Division since 1993. He also serves as President of Dixie Marine, joining the Company in connection with the acquisition of Alamo Inland Marine Co. ("Alamo") in 1989. He had served as President of Alamo since 1974. Prior to that, he was employed by Alamo Barge Lines and Monsanto Chemical Company from 1962 to 1973. Steven M. Bradshaw holds a M.B.A. degree from Harvard Business School and has served the Company as Vice President -- Inland Refined Products Division since 1993. He also serves as Executive Vice President -- Marketing of Dixie since 1990 and served in various operating and administrative capacities with Dixie from 1981 to 1990, including Vice President -- Sales from 1985 to 1990. Prior to joining Dixie, he was employed by the Ohio River Company and served as an officer in the United States Navy. Patrick L. Johnsen holds a degree in nautical science from California Maritime Academy and has served as Vice President -- Offshore since 1993. Prior to joining the Company in August, 1993, he served in senior seagoing and shoreside capacities with Mobil Shipping and Transportation, including Chartering and United States Fleet Manager. Prior to joining Mobil in 1978, he was employed at sea by various shipping companies, including Sabine. Dorman L. Strahan attended Nicholls State University and has served the Company as Vice President -- Diesel Repair since 1993. He also serves as President of Marine Systems since 1986 and President of Rail Systems since 1993. After joining the Company in 1982 in connection with the acquisition of Marine Systems, he served as Vice President of Marine Systems until 1985. Mark R. Buese holds a degree in business administration from Loyola University and has served the Company as Vice President -- Administration since 1993. He also serves as Vice President of Dixie since 1985 and served in various sales, operating and administrative capacities with Dixie from 1978 through 1985, including President of Western. Jack M. Sims holds a degree in business administration from the University of Miami and has served the Company as Vice President -- Human Resources since 1993. Prior to joining the Company in March, 1993, he served as Vice President - -- Human Resources for Virginia Indonesia Company from 1982 through 1992, Manager -- Employee Relations for Houston Oil and Minerals Corporation from 1977 through 1981 and in various professional and managerial positions with Shell Oil Company from 1967 through 1977. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's common stock is traded on the American Stock Exchange under the symbol KEX. The following table sets forth the high and low sales prices for the common stock for the periods indicated as reported by The Wall Street Journal. As of March 14, 1994, the Company had 28,275,133 outstanding shares held by approximately 2,300 stockholders of record. On September 5, 1989, the Company paid a cash dividend of $.10 per share of common stock to stockholders of record as of August 14, 1989. A similar dividend was paid in 1988. The Company does not have an established dividend policy. Decisions regarding the payment of future dividends will be made by the Board of Directors based on the facts and circumstances that exist at that time. Prior to 1988, the Company had not paid any cash dividends on its common stock since it became a publicly held company in 1976. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The comparative selected financial data of the Company and consolidated subsidiaries is presented for the five years ended December 31, 1993. The information should be read in conjunction with Management's Discussion and Analysis of Financial Condition and Results of Operations of the Company and the Financial Statements and Schedules included under Item 8 elsewhere herein (in thousands, except per share amounts): (Footnotes on following page) - --------------- (1) Comparability with prior periods is affected by the acquisitions of Alamo and Brent in the second quarter of 1989, the acquisition of Sabine in the first quarter of 1992, the acquisition of Ole Man River and merger with Scott Chotin in the second quarter of 1992, the merger with Eastern America in the third quarter of 1992, the acquisition of TPT in the first quarter of 1993, the merger with AFRAM Lines in the second quarter of 1993 and the acquisition of Chotin Transportation in the fourth quarter of 1993. (2) The extraordinary item for the years ended December 31, 1989 and 1990 represents the reduction in equivalent income taxes from utilization of financial net operating loss carryforwards. (3) Cumulative effect on prior years from the adoption of Statement of Financial Accounting Standards ("Accounting Standards") No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions," net of equivalent income taxes and Accounting Standards No. 109, "Accounting for Income Taxes." ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OF THE COMPANY RESULTS OF OPERATIONS The Company reported net earnings for the 1993 year of $22,829,000, or $.86 per share, compared with net earnings before the cumulative effect of changes in accounting principles for the 1992 year of $13,598,000, or $.60 per share, and net earnings of $13,298,000, or $.61 per share, for 1991. Net earnings for 1992 were $681,000, or $.03 per share. The Company adopted, effective January 1, 1992, Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions" and Accounting Standards No. 109, "Accounting for Income Taxes." Collectively, the recognition of the cumulative effect of the adoption of the Accounting Standards for all prior years reduced the Company's 1992 net earnings by $12,917,000, or $.57 per share. The adoption of both Accounting Standards also reduced the Company's 1992 operating earnings after taxes by $1,271,000, or $.06 per share. Accounting Standards No. 106 established a new accounting principle for the cost of retiree health care benefits. The cumulative effect on prior years for the change in accounting principle resulted in an expense after applicable income taxes of $2,258,000, or $.10 per share. In addition to the impact of the cumulative effect on prior years, the effect of adoption of Accounting Standards No. 106 reduced the Company's 1992 operating earnings after applicable income taxes by $355,000, or $.02 per share. Accounting Standards No. 109 required a change from the deferred method to the asset and liability method of accounting for income taxes. The cumulative effect on prior years for the change in accounting principle resulted in an expense of $10,659,000, or $.47 per share. The effect of the adoption of Accounting Standards No. 109 reduced the Company's 1992 operating earnings after taxes by $916,000, or $.04 per share. In 1993, the corporate federal income tax rate was increased from 34% to 35%. In accordance with Accounting Standards No. 109, the effect of the increase in the corporate federal income tax rate resulted in additional federal taxes of $1,131,000, or $.04 per share, for 1993. The adoption of the Accounting Standards had no effect on the Company's cash flow. The Company conducts operations in three business segments: marine transportation, diesel repair and property and casualty insurance. A discussion of each segment follows: MARINE TRANSPORTATION The Company's marine transportation revenues for the 1993 year totaled $283,747,000, reflecting a 49% increase when compared with $190,214,000 reported in 1992 and a 143% increase when compared with $117,003,000 reported in 1991. The 49% increase for the 1993 year reflects the operations of three marine transportation companies acquired during the 1992 year, one in March, one in April and one in June, and the operations of three marine transportation companies acquired during the 1993 year, TPT Transportation on March 3, AFRAM on May 14 and Chotin Transportation on December 21, all of which were accounted for under the purchase method of accounting. Collectively, the operations of TPT Transportation, AFRAM and Chotin Transportation generated revenues during 1993 of approximately $61,400,000 since their dates of acquisition. In addition, the revenues for each year reflect the new and existing equipment additions to both the inland and offshore fleets made during the years. The transportation segment's inland operations were curtailed to some degree during the 1993 third quarter by flooding in the upper Mississippi River and the closing of the Algiers Lock at New Orleans. Collectively, the pretax effect of the two events reduced the 1993 results by an estimated $2.4 million. Flooding in the upper Mississippi River closed the upper River to marine transportation movements from June 24 through August 22 and continued to disrupt deliveries even after that date. Movements north of Cairo, Illinois were curtailed substantially; several of the inland river towing units were stranded by the flood; and the segment's lower Mississippi River marine operations were rescheduled. The closing of the Algiers Lock for repair from July 1 through September 10 required the inland towing vessels to use alternate routes, which resulted in time delays. The Algiers Lock is situated along the main artery of the Intracoastal Waterway near New Orleans. As a provider of service for both the inland and offshore United States markets, the marine transportation segment is divided into three divisions organized around the markets they serve: the Inland Chemical Division, serving the inland industrial and agricultural chemical markets; the Inland Refined Products Division, serving the inland refined products market; and the Offshore Division, which serves the offshore petroleum products, container, dry bulk and palletized cargo markets. Movements of inland industrial chemicals for the petrochemical processing industry, handled by the segment's Inland Chemical Division, were intermittently weak during the 1993 year. In the latter part of the 1993 first quarter, the Inland Chemical Division's equipment utilization and rates reflected signs of improvement from the recessionary pressures which negatively influenced the market during all of 1992 as well as the second half of 1991. While the improvement continued through the 1993 second quarter, equipment utilization was somewhat lower during the 1993 third quarter and remained static during the balance of 1993. Budgetary constraints by petrochemical manufacturers have held back needed rate increases. Movements of liquid fertilizer and anhydrous ammonia have remained at high levels for the 1993, 1992 and 1991 years due to continued heavy usage of fertilizer products and consistent export sales. For the 1993 year, the movements of liquid fertilizer were conducted well past the normal fertilizer season, as fertilizer terminals which could not be reached during the flooding in the upper Mississippi River were supplied and the demand for fertilizer was enhanced due to flooding of the River farmlands. The Inland Refined Products Division, which moves inland refined products (gasoline, diesel fuel and jet fuel) reflected improvements during the 1993 year primarily due to a strong demand for gasoline and the resupplying of terminals in the upper Mississippi River flood areas. Such growth in demand benefitted equipment utilization and enabled modest rate increases. The Inland Refined Products Division, formed in 1992 with the acquisitions by Sabine Transportation and OMR Transportation, reflected weakness of demand during the 1992 year, as the peak driving season fell below expectations. Revenues from the Offshore Division improved significantly during the 1993 year, primarily from the merger with AFRAM Lines on May 14, 1993. Throughout 1993, the Division's dry bulk, container and palletized cargo vessels have remained in heavy demand, being taken out of service only for scheduled maintenance. The merger with AFRAM Lines has improved the Division's ability to transport cargos for United States Government aid programs and military use. The Offshore Division's liquid market, however, has shown price and demand weakness due to excess capacity in the offshore liquid market, particularly affecting spot prices. During 1993, certain equipment was idle due to lack of business. For the 1992 year, revenues from the Offshore Division were significantly enhanced with the addition of Sabine Transportation's six tank ships, all of which were fully booked, except for periods of scheduled maintenance. Each year includes gains from the disposition of primarily single skin barges and other surplus or obsolete transportation assets. Such gains totaled $525,000 for 1993, $494,000 for 1992 and $1,414,000 for 1991. Costs and expenses, excluding interest expense, for the marine transportation segment for the 1993 year increased to $242,553,000, an increase of 49% over the comparable 1992 expense of $162,973,000 and 140% over 1991 costs and expenses of $100,884,000. Most of the increases for both comparable periods reflect the costs and expenses, including depreciation, associated with the acquisitions and mergers consummated during the 1993 and 1992 years. In addition, the increases reflect higher equipment costs, employee health and welfare costs, general and administrative costs and inflationary increases in costs and expenses. The marine transportation pretax earnings for 1993 were $35,668,000, an increase of 63% over 1992 pretax earnings of $21,836,000 and 164% over 1991 pretax earnings of $13,507,000. DIESEL REPAIR The Company's diesel repair segment reported diesel repair revenues of $31,952,000 for 1993 reflecting an 11% decrease compared with $35,753,000 for 1992 and a 7% decrease compared with $34,288,000 for 1991. With diesel repair facilities in five locations nationwide that cater to specific markets, each location has been influenced by different economic or environmental conditions during the three comparable periods. The East Coast facility, catering to the military, has been slowed in 1993 and 1992 by United States military reductions and government budget restraints. The Midwest facility, which caters to the inland barge industry, has been hampered to some degree in 1993 and 1992 by the recession, however, the 1993 year was significantly affected by the flooding in the upper Mississippi River during the 1993 third quarter. Revenues from the segment's Midwest facility were reduced by an estimated $900,000, as customers affected by the flooding either curtailed or postponed scheduled repairs and overhauls and significantly curtailed parts purchases. The Gulf Coast facility, tied to the inland and offshore barge and oil service industries was hampered during 1992 by the recession, however, during 1993, business has remained relatively constant. The West Coast facilities, whose primary emphasis is the offshore tuna fishing industry, were negatively affected during 1993 and 1992 by deferred maintenance of equipment by their commercial fishing customers due to low tuna prices caused by the worldwide surplus of tuna. Diesel repair revenues increased by $6,000,000 in 1992 and $2,000,000 in 1991 due to the West Coast facility acquisition in July, 1991. Costs and expenses, excluding interest expense, for the diesel repair segment for 1993 totaled $30,121,000, compared with $33,328,000 for 1992 and $31,904,000 for 1991. The decrease of 10% for 1993 when compared with 1992 reflects the overall decline in revenues and its effect on the segment's profit margins. The increase for 1992 and 1991 reflects the growth of the segment's direct parts sales and overhaul and repair revenues. In addition, for the 1992 year, the increase in costs and expenses partially reflects the opening of the Seattle facility and the acquisition of the West Coast facility in 1991, which also increased the 1991 costs and expenses. The diesel repair segment's pretax earnings for 1993 were $1,577,000, a decrease of 30% compared with 1992 pretax earnings of $2,263,000 and 29% under 1991 pretax earnings of $2,213,000. PROPERTY AND CASUALTY INSURANCE The Company's property and casualty insurance segment, which is conducted primarily through Universal, reported premiums written of $80,993,000 for 1993, compared with $52,830,000 for 1992 and $36,481,000 for 1991. The 53% increase in premiums written during 1993 compared with 1992 reflected business generated from Eastern America's portfolio brought in with the merger of Eastern America with and into Universal in September, 1992, a new government policy, two vehicle single-interest portfolio transfers and the addition of vehicle single-interest business from two financial institutions, which was the result of an improvement in automobile sales during 1993. The 45% increase in premiums written during 1992 compared with 1991 reflected the increased emphasis in participation in the commercial multi-peril and double-interest lines of business, as premium volumes in the automobile single-interest line remained low due to depressed new automobile sales in Puerto Rico. Premiums written for the 1992 year also included $3 million of single-interest premiums associated with a portfolio transfer which occurred during the 1992 first quarter. In addition, the 1992 year reflected the merger of Eastern America with and into Universal. Premiums written in 1991 reflected the reduction in the automobile single-interest line, offset to some degree by increased participation in the commercial multiple-peril and automobile double-interest lines of business. Net premiums earned for 1993 totaled $48,243,000 compared with $29,552,000 for 1992 and $23,561,000 for 1991. The 63% increase in net premiums earned during 1993 compared with 1992 reflected the business generated from the Eastern America portfolio as well as a significant increase in the single-interest line of business during 1993. Net premiums earned for all three years were negatively affected by the high reinsurance costs for the commercial multiple-peril line associated with the ceding of a portion of the gross premium under the segment's reinsurance program. Due to the number of worldwide catastrophic events within the past few years, the cost of the segment's reinsurance program continued to substantially increase. Investment income is generated primarily from the segment's investment in United States Treasury securities, due to their investment safety and favorable Puerto Rico tax treatment. Investment income totaled $7,741,000 for 1993 compared with $6,454,000 for 1992 and $5,994,000 for 1991. The segment, prior to the decline in interest rates, procured a constant yield from the purchase of United States Treasury securities with fixed rates. Even though interest rates on investment securities have remained low since 1991, the insurance segment's investment portfolio has reflected excellent market performance during 1992 and 1993. In addition, the 1993 investment income reflected the full year effect of the merger with Eastern America. The investment portfolio of Eastern America at the date of the merger totaled approximately $21 million. In addition, the insurance segment recognized investment gains of $1,164,000 in 1993, $1,478,000 in 1992 and $853,000 in 1991. Losses, claims and settlement expenses for 1993 totaled $37,496,000 compared with $26,289,000 for 1992 and $18,103,000 for 1991. The 43% increase for 1993 compared with 1992 reflected the merger with Eastern America as well as the significant increase in business volume, particularly from the single-interest line. In addition, the 1992 year reflected an abnormal year for losses from the commercial multiple-peril line, which experienced high losses from specific events. The 1992 year also included a reserve of $2,500,000 recorded in Mariner, the Company's Bermuda reinsurance subsidiary, which participated in the writing of property and casualty lines of reinsurance from 1970 through 1990. During 1992, Mariner received certain delayed large loss advices, which resulted in the increase in its loss reserves. The 1990 year was the last year for participation in the reinsurance market. For the 1991 year, the insurance segment's loss experience was favorable, the result of a decrease in losses from the commercial multiple-peril and automobile single-interest lines. Management continues to review the runoff of the reinsurance business previously written by Mariner with the intent of seeking an expedient withdrawal from this business and closure of Mariner's activities, including consideration of commutation of Mariner's book of business. A commutation would entail the transfer of liability from known and incurred but not reported losses to a second party in exchange for a portion of, or all of, Mariner's assets. As of December 31, 1993, the Company had net equity in Mariner of approximately $1,500,000. Policy acquisition costs for 1993 totaled $11,085,000 compared with $8,649,000 for 1992 and $7,181,000 for 1991. Generally, policy acquisition costs for each year increased due to the higher commission rates associated with the property insurance lines. The results for the 1993 and 1992 year also reflected the merger with Eastern America. As of December 31, 1993 and 1992, the Company owned 70% and 75%, respectively, of the voting common stock of Universal, with the balance owned by Eastern America Group. The Company owned 100% of the non-voting common and preferred stocks. Minority interest expense for the 1993 year totaled $1,623,000. The Company's portion of the property and casualty insurance segment's pretax earnings totaled $4,539,000 for 1993, compared with $1,108,000 for 1992 and $4,891,000 for 1991. FINANCIAL CONDITION, CAPITAL RESOURCES AND LIQUIDITY In October, 1990, the Board of Directors approved the authorization to purchase 2,000,000 shares of common stock. Currently, approximately 1,700,000 shares remain under the repurchase authorization. The Company is authorized to purchase the common stock on the American Stock Exchange and in private negotiated transactions. When repurchasing common shares, the Company is subject to price, trading volume and other market considerations. Shares repurchased may be used for reissuance upon the exercise of stock options and other purposes. The purchase of additional shares depends on numerous conditions, including the price of the common stock, capital investment opportunities and other factors. From 1988 through January, 1991, the Company purchased approximately 2,300,000 shares of common stock at an average price of $5.71 per share. The Company and Dixie have separate revolving credit agreements with an established line of credit of $50,000,000 each. Proceeds under the credit agreements, which provide for interest rates, based at the Company's option, on the prime rate, Eurodollar rate or CD rates, can be used for general corporate purposes, the purchase of new or existing equipment or for business acquisitions. As of March 14, 1994, the Company and Dixie had $33,600,000 and $33,900,000, respectively, available for takedown under the credit agreements. The Company and Dixie entered into the separate credit agreements in April, 1993 providing for aggregate borrowings of up to $30,000,000 and $50,000,000, respectively. In August, 1993, the Company's line of credit was increased to $50,000,000. In March, 1992, Dixie entered into a $20,000,000 acquisition credit facility with Texas Commerce Bank National Association which provided the transportation segment with in-place financing for possible future acquisitions. On June 1, 1992, the acquisition credit facility was activated with the merger of Scott Chotin into a subsidiary of the Company and in August, 1992, the acquisition credit facility was retired. In August, 1992, Dixie sold $50,000,000 of 8.22% notes, due June 30, 2002, in a private placement. Proceeds from these notes were used to retire the $20,000,000 acquisition credit facility with Texas Commerce Bank National Association and the retirement of two $5,000,000, 10% subordinated promissory notes originally issued as part of the purchase in 1989 of the assets of Brent, with the balance of the proceeds used to reduce the amount outstanding under Dixie's $50,000,000 revolving credit agreement. In May, 1993, the Company called for redemption on June 4, 1993, the entire $50,000,000 aggregate principal amount of its 7 1/4% Convertible Subordinated Debentures due 2014 ("Debentures") issued in October, 1989 at a redemption price of 105.075% of the principal amount of the Debentures, plus accrued interest on the principal of the Debentures from April 1, 1993 to the date fixed for redemption. Prior to, or on May 27, 1993, the fifth business day prior to the date set for redemption under the Debentures, the holders of the entire $50,000,000 of Debentures elected to convert such Debentures into common stock of the Company at a conversion price of $11.125 per share. The conversion of the Debentures increased the issued and outstanding common stock of the Company by 4,494,382 shares. Business Acquisitions and Developments Following the Company's stated strategy of acquiring businesses to complement its existing operations, the Company has been actively engaged in the acquisition of, or merger with, companies during the 1991, 1992 and 1993 years. In May, 1991, Brent Transportation purchased for $2,550,000 in cash all of the operating assets of International Barges, Inc. The assets consist of three cryogenic inland tank barges currently operating under a term contract transporting industrial anhydrous ammonia. The acquisition incorporates the handling of industrial anhydrous ammonia with Brent Transportation's established market position in the transporting of anhydrous ammonia for use in agriculture. In July, 1991, Marine Systems purchased the operating assets of Steve Ewing's Diesel Service, Inc., a National City, California based company engaged in the repair and overhaul of marine diesel engines and related parts sales. The acquired assets, consisting of inventory and fixed assets, are operated under the name of Ewing Marine Systems, Inc. The acquisition expanded the diesel repair segment's markets to the West Coast and the Pacific Basin and enables the segment to offer nationwide service to its customers. On March 13, 1992, the Company completed the purchase of Sabine for $36,950,000 in cash. Sabine, located in Port Arthur, Texas, was engaged in coastal and inland marine transportation of petroleum products and in harbor tug services. The purchased properties included six U.S. flag tank ships, 33 owned and five leased inland tank barges, 11 owned and four leased towboats, three owned bowboats, eight owned tugboats, land and buildings. The Company has continued to use the assets of Sabine in the same business that Sabine conducted prior to the purchase. The purchase was financed through $9,950,000 of existing cash balances, borrowings of $9,000,000 under the transportation segment's bank revolving credit agreement, as well as an $18,000,000 bank term loan with a negative pledge of the assets acquired from Sabine. Based on audited information, assets acquired from Sabine had total revenues for the years ended December 31, 1990 and 1991 of $62,886,000 and $62,986,000, respectively. Operations of the assets acquired from Sabine are included as part of the Company's operations effective March 13, 1992, in accordance with the purchase method of accounting. On April 2, 1992, OMR Transportation completed the purchase of Ole Man River for $25,575,000 in cash. Ole Man River, located in Vicksburg, Mississippi, was engaged in inland marine tank barge transportation of petroleum products along the Mississippi River System and the Gulf Intracoastal Waterway. The purchased properties included 24 owned and two leased tank barges, eight owned towboats, land and buildings. The Company has continued to use the assets of Ole Man River in the same business that Ole Man River conducted prior to the purchase. The asset purchase was funded by borrowings under the transportation segment's bank revolving credit agreement. Based on audited information, Ole Man River had total revenues for the years ended December 31, 1990 and 1991 of $14,676,000 and $15,550,000, respectively. Operations of the assets acquired from Ole Man River are included as part of the Company's operations effective April 2, 1992, in accordance with the purchase method of accounting. On June 1, 1992, the Company completed the acquisition of Scott Chotin by means of a merger with and into a wholly owned subsidiary of the Company for an aggregate consideration of approximately $34,900,000. Pursuant to the Agreement and Plan of Merger, the Company issued 870,892 shares of common stock, valued at $12.625 per share, to certain Scott Chotin shareholders and paid the shareholders of Scott Chotin approximately $9,700,000 in cash in exchange for the working capital and all of the outstanding common stock of Scott Chotin, discharged existing debt of Scott Chotin of approximately $7,400,000 and paid to certain executives and shareholders of Scott Chotin $5,000,000 for agreements not to compete. In addition, the Company recorded a liability reserve for the issuance, over a three-year period after the closing, of up to 170,000 additional shares of the Company's stock contingent upon the resolution of certain potential liabilities resulting from operations of Scott Chotin prior to the merger. In June, 1993, the Company issued 22,500 shares under the contingent stock agreement. Scott Chotin, located in Mandeville, Louisiana, was engaged in inland marine tank barge transportation of industrial chemicals and asphalt along the Mississippi River System and the Gulf Intracoastal Waterway. Scott Chotin's inland fleet consisted of 29 owned tank barges, six of which operate in the asphalt trade, 10 owned dry cargo barges, eight owned towboats, land and buildings. The Company has continued to use the assets of Scott Chotin in the same business that Scott Chotin conducted prior to the merger. The cash portion of the merger was financed through existing cash balances, borrowings under a subsidiary of the Company's $20,000,000 acquisition line of credit, as well as a $16,000,000 bank term loan with a negative pledge of the assets. Based on audited information, Scott Chotin recorded total revenues for the years ended May 31, 1991 and 1992 of $20,894,000 and $18,817,000, respectively. Scott Chotin's operations are included as part of the Company's operations effective June 1, 1992, in accordance with the purchase method of accounting. On September 25, 1992, the Company completed the acquisition of Eastern America, a property and casualty insurance company in Puerto Rico, by means of a merger of Eastern America with and into the Company's insurance subsidiary, Universal, with Universal being the surviving entity. Presently, the Company owns approximately 70% of the voting common stock of Universal, with the remaining approximately 30% owned by Eastern America Group, the former parent of Eastern America. Through options and redemption rights included in the merger transaction, Eastern America Group could become the owner of up to 100% of Universal's stock over a period of up to 12 years. Based on audited information, Eastern America reported total revenues of $11,951,000 and $13,544,000 for the years ended December 31, 1990 and 1991, respectively. To date, Universal has redeemed a total 44,933 shares of its common stock from the Company at a price of $8,000,000. In July, 1993, Universal redeemed 39,128 shares for $7,000,000 and in December, 1992, Universal redeemed 5,805 shares for $1,000,000. Eastern America's operations are included as part of the Company's operations effective September 25, 1992, in accordance with the purchase method of accounting. On March 3, 1993, TPT Transportation completed the purchase of TPT, a marine transportation division of Ashland Oil, Inc., for approximately $24,400,000 in cash, subject to post-closing adjustments. TPT was engaged in the inland marine transportation of industrial chemicals and lube oil primarily from the Gulf Intracoastal Waterway to customers primarily on the upper Ohio River. TPT's inland fleet consisted of 61 owned and six leased double skin tank barges, four owned and one leased single skin tank barges and five owned towboats. Of the 72 barges, 32 are equipped with vapor control systems while 30 barges are dedicated to the transportation of lube oil, where vapor control equipment is not required. The Company has continued to use the assets of TPT in the same business that TPT conducted prior to the purchase. The asset purchase was financed under the transportation segment's bank revolving credit agreement. Based on unaudited information, TPT had total revenues for the fiscal year ended September 30, 1992, of $17 million. The asset purchase was accounted for in accordance with the purchase method of accounting effective March 3, 1993. On May 14, 1993, the Company completed the acquisition of AFRAM Lines by means of a merger with and into a wholly owned subsidiary of the Company, for an aggregate consideration of $16,725,000. In addition, the merger provides for an earnout provision not to exceed $3,000,000 in any one year and not to exceed a maximum of $10,000,000 over a four year period. The earnout provision will be recorded as incurred as an adjustment to the purchase price. As of December 31, 1993, a $2,250,000 earnout provision, which accrues from April 1 to March 31 of the following year, had been recorded. Under the terms of the merger, the Company issued 1,000,000 shares of its common stock in exchange for all of AFRAM Lines outstanding stock and paid certain executives and shareholders of AFRAM Lines agreements not to compete totaling $2,000,000. AFRAM Lines located in Houston, Texas, was engaged in the worldwide transportation of dry bulk, container and palletized cargos, primarily for Departments and Agencies of the United States Government. The Company has continued to use the assets of AFRAM Lines in the same business that AFRAM Lines conducted prior to the merger. AFRAM Lines fleet consisted of three U.S. flag container and break-bulk ships which specialize in the transportation of United States Government military and aid cargos. Based on audited information, AFRAM Lines recorded transportation revenues for the years ended June 30, 1992 and 1991 of $38,758,000 and $29,817,000, respectively. Unaudited historical transportation revenues for the year ended December 31, 1992 were $46,268,000. The merger, effective as of April 1, 1993, was accounted for in accordance with the purchase method of accounting. The financial results for the 1993 year include the net earnings from the operations from May 14, 1993, as the net earnings from April 1, 1993 to May 14, 1993, were recorded as a reduction of the purchase price. In May, 1993, Marine Systems enhanced its long-term opportunities with the addition of two distributorship agreements. Under a long-term agreement with Paxman Diesels, Ltd. of Colchester, England, a manufacturer of diesel engines, Marine Systems will sell engine parts and offer authorized repair services. In addition, in May, 1993, Marine Systems signed a long-term agreement with Falk Corporation, a marine reduction gear manufacturer, whereby Marine Systems will sell parts and offer authorized repair services. As an expansion of the diesel repair segment, the Company is engaged through Rail Systems in the overhaul and repair of locomotive diesel engines and sale of replacement parts for locomotives, serving shortline and industrial railroads within the continental United States. In October, 1993, EMD, the world's largest manufacturer of diesel-electric locomotives, awarded an exclusive shortline and industrial rail distributorship to Rail Systems to provide replacement parts, service and support to these important and expanding markets. The operations of Rail Systems commenced in January, 1994. On December 21, 1993, OMR Transportation completed the cash purchase of certain assets of Chotin Transportation. Chotin Transportation, located in Cincinnati, Ohio, was engaged in the inland marine transportation of refined products by tank barge primarily from the lower Mississippi River to the Ohio River under a long-term contract with a major oil company. The purchased properties included 50 single skin and three double skin inland tank barges and a transportation contract, which expires in the year 2000. The asset purchase was funded by borrowings under the transportation segment's bank revolving credit agreement. Operations of the assets acquired from Chotin Transportation are included as part of the Company's operations effective December 21, 1993, in accordance with the purchase method of accounting. In March, 1994, the Company through its subsidiary, Americas Marine, began all-water marine transportation services between Memphis, Tennessee and Mexico, Guatemala, Honduras and El Salvador. The new transportation service utilizes a chartered foreign flag river/ocean vessel which offers direct sailing between the locations. The new service provides exporters and importers in the north, central and mid-south states with a direct shipping alternative between the locations on a fourteen day round trip basis. The direct all-water liner service accepts 20 foot and 40 foot containers, including refrigerated and tank containers, as well as other cargo on a space available basis. Capital Expenditures The Company continued to enhance its existing operations through the acquisitions of existing equipment during the 1991, 1992 and 1993 years and construction of new equipment during the 1991 and 1992 years. During 1991, six new 29,000 barrel capacity double skin inland tank barges, which were constructed under a contract entered into in May, 1990, were placed in service. Three of the barges were placed into service in July, one in August and two in September. The six barges cost approximately $8,000,000, including enhancements after delivery. In March, 1991, an option was exercised to purchase six additional 29,000 barrel capacity double skin inland tank barges at a total purchase price including enhancements after delivery, of approximately $8,000,000. The first barge was placed in service in November, 1991, followed by one barge each month through March, 1992. The remaining barge was placed in service in May, 1992. Through a 50% partnership with EFC, one dry cargo barge and tug unit for use in the offshore market was purchased for approximately $5,500,000, with capitalized restorations and modifications to the barge and tug unit of approximately $7,500,000. The equipment was placed in service in May, 1991. In July, 1992, a 165,000 barrel double skin ocean-going tank barge and tug unit was purchased for approximately $9,200,000. The unit is currently working in the offshore refined products trade. In July, 1992, four existing inland towboats were purchased for a total purchase price of $1,650,000. The towboats are being used in the industrial chemical market. In July, 1992, the diesel repair segment expanded its market to the Pacific Northwest with the opening of a service facility in Seattle, Washington, serving both the inland and offshore marine industries. Emphasis is focused on the repair of diesel engines in the marine transportation industry and various governmental agencies. In August, 1992, a 17,000 barrel capacity pressure barge which was constructed under a contract entered into in September, 1991, was placed into service in the industrial chemical market. Cost of the barge was approximately $2,700,000. In October, 1993, three inland towboats were purchased for approximately $895,000. The towboats are being used in the refined products market. In addition to the new and existing transportation equipment mentioned above, during 1991, 1992 and 1993, the Company's transportation subsidiaries continued to add to their fleet through separate purchases of existing equipment. In 1991, two existing towboats and seven existing double skin inland tank barges were purchased for use in the industrial and agricultural chemical market. In 1992, four inland tank barges were purchased and renovated for use in the agricultural market and an inland towboat was purchased for use in the refined products market. In 1993, three existing double skin inland tank barges were purchased and renovated for use in the agricultural market and one inland towboat was purchased for use in the fleeting and shifting operation. Liquidity Within the past three years, the Company has generated significant cash flow from its operating segments to fund its capital expenditures, asset acquisitions, debt service and other operating requirements. During 1993, 1992 and 1991, the Company generated net cash provided by operating activities of $61,614,000, $38,372,000 and $26,498,000, respectively. During each year, inflation has had a relatively minor effect on the financial results of the Company. The marine transportation segment has long-term contracts which generally contain cost escalation clauses whereby certain costs, including fuel can be passed through to its customers, while the segment's short-term, or spot business, is based principally on current prices. In addition, the marine transportation assets acquired and accounted for using the purchase method of accounting were adjusted to a fair market value and, therefore, the cumulative long-term effect on inflation was reduced. The repair portion of the diesel repair segment is based on prevailing current market rates. For the property and casualty insurance segment, 97% of its investments were classified as available-for-sale or short-term investments, which consists primarily of United States Governmental instruments. Universal is subject to dividend restrictions under the stockholders' agreement between the Company, Universal and Eastern America Group. In addition, Universal is subject to industry guidelines and regulations with respect to the payment of dividends. The Company has no present plan to pay dividends on common stock in the near future. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The response to this item is submitted as a separate section of this report (see Item 14, page 60). ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE On October 20, 1992, the Company engaged the accounting firm of KPMG Peat Marwick to serve as the principal independent public accountant. The services of the accounting firm of Deloitte & Touche, who previously served as the Company's independent public accountant, were terminated effective October 20, 1992, except for the Company's subsidiary, Universal, which continues to be audited by Deloitte & Touche. The engagement of KPMG Peat Marwick to serve as the principal independent public accountant and the termination of Deloitte & Touche were approved by unanimous consent of the Company's Board of Directors upon the recommendation by the Company's Audit Committee. With respect to the audit for the year ended December 31, 1991 and the unaudited period to October 20, 1992, there have been no disagreements with Deloitte & Touche on any matters of accounting principles or practices, financial statement disclosure, or accounting scope or procedure. The report of Deloitte & Touche on the financial statements for the year ended December 31, 1991 contained no adverse opinion or disclaimer of opinion and was not qualified or modified as to uncertainty, audit scope or accounting principles. PART III ITEMS 10 THROUGH 13. The information for these items has been omitted inasmuch as the registrant will file a definitive proxy statement with the Commission pursuant to the Regulation 14A within 120 days of the close of the fiscal year ended December 31, 1993, except for the information regarding executive officers which is provided in a separate item caption, "Executive Officers of the Registrant," and is included as an unnumbered item following Item 4 in Part I of this Form 10-K. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Board of Directors and Stockholders of Kirby Corporation We have audited the accompanying consolidated statements of earnings, stockholders' equity and cash flows of Kirby Corporation and its subsidiaries for the year ended December 31, 1991. Our audit also included the financial statement schedules listed in Part IV, Item 14, for the year ended December 31, 1991. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on such financial statements and financial statement schedules based on our audit. We conducted our audit 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 audit provides a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the results of operations, changes in stockholders' equity and cash flows of Kirby Corporation and its subsidiaries for the year ended December 31, 1991 in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedules, when considered in relation to the consolidated financial statements for the year ended December 31, 1991, taken as a whole, present fairly in all material respects the information set forth therein. DELOITTE & TOUCHE Houston, Texas March 2, 1992, except for Note 2 as to which the date is March 18, 1992 INDEPENDENT AUDITORS' REPORT To the Board of Directors of Kirby Corporation: We have audited the accompanying consolidated balance sheets of Kirby Corporation and consolidated subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of earnings, stockholders' equity and cash flows for the years then ended. In connection with our audits of the consolidated financial statements, we have also audited the related financial statement schedules. These consolidated financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. The financial statements and financial statement schedules of Kirby Corporation and consolidated subsidiaries as of and for the year ended December 31, 1991 were audited by other auditors whose report thereon dated March 2, 1992, except for Note 2 to which the date is March 18, 1992, expressed an unqualified opinion on those statements. We did not audit the consolidated financial statements of Universal Insurance Company and its subsidiaries, a 70 percent owned subsidiary, which statements reflect total assets constituting 33 percent and 32 percent and total revenues constituting 14 percent and 16 percent in 1993 and 1992, respectively, of the related consolidated totals. Those statements and the amounts included in the related 1993 and 1992 financial statement schedules were audited by other auditors whose report has been furnished to us, and our opinion, insofar as it relates to the amounts included for Universal Insurance Company and its subsidiaries, is based solely on the report of the other auditors. 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 and the report of the other auditors provide a reasonable basis for our opinion. In our opinion, based on our audits and the report of other auditors, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Kirby Corporation and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for the years then ended in conformity with generally accepted accounting principles. Also, in our opinion, based on our audits and the report of the other auditors, the related financial statement schedules, when considered in relation to the 1993 and 1992 basic consolidated financial statements taken as a whole, present fairly, in all material respects the information set forth therein. As discussed in note 3 to the consolidated financial statements, the Company changed its method of accounting for investments in equity securities in 1993 to adopt the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities." As discussed in note 5 to the consolidated financial statements, the Company adopted the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts" in 1993. As discussed in note 7 to the consolidated financial statements, the Company changed its method of accounting for income taxes in 1992 to adopt the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." As discussed in note 10 to the consolidated financial statements, the Company adopted the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions" in 1992. KPMG PEAT MARWICK Houston, Texas February 21, 1994 KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES BALANCE SHEETS DECEMBER 31, 1992 AND 1993 ASSETS See accompanying notes to financial statements. KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES BALANCE SHEETS DECEMBER 31, 1992 AND 1993 LIABILITIES AND STOCKHOLDERS' EQUITY See accompanying notes to financial statements. KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES STATEMENTS OF EARNINGS FOR THE YEARS ENDED DECEMBER 31, 1991, 1992 AND 1993 See accompanying notes to financial statements. KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES STATEMENTS OF STOCKHOLDERS' EQUITY FOR THE YEARS ENDED DECEMBER 31, 1991, 1992 AND 1993 See accompanying notes to financial statements. KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 1991, 1992 AND 1993 See accompanying notes to financial statements. KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 1991, 1992 AND 1993 (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND OPERATIONS Principles of Consolidation. The consolidated financial statements include the accounts of Kirby Corporation and its subsidiaries ("the Company"). The assets and liabilities for the insurance operations have not been classified as current or noncurrent, in accordance with insurance practice. The Company's equity in certain partnerships is reflected in the accounts at its pro rata share of the assets, liabilities, revenues and expenses of the partnerships. The purchase price of certain subsidiaries exceeded the equity in net assets of the respective companies at dates of acquisition. The excess is being amortized over 10 to 25 year periods. All material intercompany accounts and transactions have been eliminated in consolidation. Certain reclassifications have been made to reflect current presentation of financial information. Operations. The Company is engaged in three industry segments as follows: Marine Transportation -- Marine transportation by United States flag vessels on the inland waterway system and in United States coastwise and foreign trade. The principal products transported include petrochemical feedstocks, processed chemicals, agricultural chemicals, refined petroleum products, coal, limestone, grain and sugar. Container and palletized cargo are also transported for United States Government aid programs and military. Diesel Repair -- Repair of diesel engines, reduction gear repair and sale of related parts and accessories, primarily for customers in the marine industry and beginning in 1994, for customers in the shortline and industrial railroad industry. Insurance -- Writing of property and casualty insurance in Puerto Rico. The insurance subsidiary operates under the provisions of the Insurance Code of the Commonwealth of Puerto Rico and is subject to regulations issued by the Commissioner of Insurance of the Commonwealth of Puerto Rico. General Accounting Policies: Accounting Principles. The consolidated financial statements have been prepared in accordance with generally accepted accounting principles. Cash Equivalents. Cash equivalents consist of short-term, highly liquid investments with maturities of three months or less at date of purchase. Depreciation. Property and equipment is depreciated on the straight-line method over the estimated useful lives of the assets as follows: marine transportation equipment, 6-22 years; buildings, 10-25 years; other equipment, 2-10 years; leasehold improvements, term of lease. Concentrations of Credit Risk. Financial instruments which potentially subject the Company to concentrations of credit risk are primarily trade accounts receivables. The Company's marine transportation customers include the major oil refineries. The diesel repair customers are offshore well service companies, inland and offshore marine transportation companies and the United States Government. The insurance segment customers include agents and customers who reside in Puerto Rico. In addition, credit risk exists through the placement of certificates of deposits with local financial institutions by the insurance segment. Marine Transportation, Diesel Repair and Other Accounting Policies: Property, Maintenance and Repairs. Property is recorded at cost. Improvements and betterments are capitalized as incurred. When property items are retired, sold, or otherwise disposed of, the related cost and accumulated depreciation are removed from the accounts with any gain or loss on the disposition included in operating income. Maintenance and repairs are charged to operating expenses as incurred on an annual basis. KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND OPERATIONS -- (CONTINUED) Taxes on Income. The Company follows the asset and liability method of accounting for income taxes. Under the asset and liability method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. In 1991, the provision for deferred income taxes represents the tax effect of differences in the timing of income and expense recognition for tax and financial reporting purposes. The Company files a consolidated federal income tax return with its domestic subsidiaries and Mariner Reinsurance Company Limited ("Mariner"). Insurance Accounting Policies: Investments. Fixed maturity investments held as of December 31, 1993 are primarily classified as available-for-sale securities and are reported at fair market value, with unrealized gains and losses reported in the accompanying balance sheet as unrealized net gains in value of investments. For 1992, the investment in fixed maturities consisted of an investment and a trading account. Investment account securities were recorded at cost, adjusted for the amortization of premiums and accretion of discounts and trading account securities were recorded at market value. The difference between the market value and the amortized cost of trading securities was presented in the accompanying balance sheets as unrealized net gains in value of investments. Short-term investments consisting of certificates of deposit, United States Treasury bills and United States Treasury notes maturing within one year from acquisition date, are recorded at amortized cost. Equity securities are recorded at market value. Reinsurance. By reinsuring certain levels of risk in various areas with reinsurers, the exposure of losses which may arise from catastrophes or other events which may cause unfavorable underwriting results are reduced. Amounts recoverable from reinsurance are estimated in a manner consistent with the claim liability associated with the reinsured policy. Deferred Policy Acquisition Costs. Deferred policy acquisition costs representing commissions paid to agents are deferred and amortized following the daily pro rata method over the terms of the policies in 1993 (monthly pro rata method in prior years), except for automobile physical damage single-interest policies, which are amortized following the sum-of-the years method. Deferred policy acquisition costs are written off when it is determined that future policy revenues are not adequate to cover related future losses and loss adjustments expenses. Earnings on investments are taken into account in determining whether this condition exists. No deficiencies have been determined in the periods presented. Accrued Losses, Claims and Settlement Expenses. Accrued losses, claims and settlement expenses include estimates based on individual claims outstanding and an estimated amount for losses incurred but not reported (IBNR) based on past experience. Unearned Premiums. Unearned premiums are deferred and amortized following the daily pro rata method over the terms of the policies in 1993 (monthly pro rata method in prior years), except for automobile physical damage single-interest policies, which are amortized to income following the sum-of-the-years method. Guarantee Fund Assessment. The Company's Puerto Rican property and casualty insurance subsidiary is a member of the Puerto Rico Insurance Guaranty Association and is required to participate in losses payable KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND OPERATIONS -- (CONTINUED) to policyholders under risks underwritten by insolvent associated members. Losses are estimated based on its share and accrued on a current basis. Changes In Accounting Principles: The Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts," which changes the accounting and disclosure requirements for reinsurance contracts entered into by ceding insurance companies. Effective December 31, 1993, the Company adopted SFAS No. 113, the effects of which are more fully described in Note 5, Insurance Disclosure. The FASB issued SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," which establishes standards of financial accounting and reporting for investments in equity securities that have readily determinable fair values and for all investments in debt securities. Effective December 31, 1993, the Company adopted SFAS No. 115, the effects of which are more fully described in Note 3, Investments. The FASB issued SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," which establishes a new accounting principle for the cost of retiree health care and other postretirement benefits. Effective January 1, 1992, the Company adopted SFAS No. 106, the effects of which are more fully described in Note 10, Retirement Plans. The FASB issued SFAS No. 109, "Accounting for Income Taxes," which requires a change from the deferred method of accounting for income taxes to the asset and liability method of accounting for income taxes. Effective January 1, 1992, the Company adopted SFAS No. 109, the effects of which are more fully described in Note 7, Taxes on Income. (2) ACQUISITIONS 1992 YEAR: On March 13, 1992, a subsidiary of the Company completed the purchase of certain assets of Sabine Towing & Transportation Co., Inc. ("Sabine"), a wholly owned subsidiary of Sequa Corporation, for $36,950,000 in cash. Sabine, located in Port Arthur, Texas was engaged in coastal and inland marine transportation of petroleum products and harbor tug services. The purchased properties included six United States flag tank ships, 33 owned and five leased inland tank barges, 11 owned and four leased inland towboats, three owned bowboats, eight owned harbor tugboats, land and buildings. The Company has continued to use the assets of Sabine in the same business that Sabine conducted prior to the purchase. The purchase was financed through $9,950,000 of existing cash balances, borrowings of $9,000,000 under the transportation segment's bank revolving credit agreement, as well as an $18,000,000 bank term loan with a negative pledge of the assets acquired from Sabine. Operations of the assets acquired from Sabine are included as part of the Company's operations effective March 13, 1992, in accordance with the purchase method of accounting. On April 2, 1992, a subsidiary of the Company completed the purchase of substantially all of the operating assets of Ole Man River Towing, Inc. and related entities ("Ole Man River") for $25,575,000 in cash. Ole Man River, located in Vicksburg, Mississippi, was engaged in inland marine tank barge transportation of petroleum products along the Mississippi River System and the Gulf Intracoastal Waterway. The purchased properties included 24 owned and two leased inland tank barges, eight owned inland towboats, land and buildings. The Company has continued to use the assets of Ole Man River in the same business that Ole Man River conducted prior to the purchase. The asset purchase was funded by borrowings under the transportation segment's bank revolving credit agreement. Operations of the assets acquired from Ole Man KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) (2) ACQUISITIONS -- (CONTINUED) River are included as part of the Company's operations effective April 2, 1992, in accordance with the purchase method of accounting. On June 1, 1992, the Company completed the acquisition of Scott Chotin, Inc. ("Scott Chotin") by means of a merger of Scott Chotin with and into a subsidiary of the Company for an aggregate consideration of approximately $34,900,000. Pursuant to the Agreement and Plan of Merger, the Company issued 870,892 shares of common stock, valued at $12.625 per share to certain Scott Chotin shareholders and paid the shareholders of Scott Chotin approximately $9,700,000 in cash in exchange for the working capital and all of the outstanding common stock of Scott Chotin, discharged existing debt of Scott Chotin of approximately $7,400,000 and paid to certain executives and shareholders of Scott Chotin $5,000,000 for agreements not to compete. In addition, the Company recorded a liability reserve for the issuance, over a three-year period after the closing, of up to 170,000 additional shares of the Company's common stock contingent upon the resolution of certain potential liabilities resulting from operations of Scott Chotin prior to the merger. In June, 1993, the Company issued 22,500 shares of common stock under the contingent stock agreement. Scott Chotin, located in Mandeville, Louisiana was engaged in inland marine tank barge transportation of industrial chemicals and asphalt along the Mississippi River System and the Gulf Intracoastal Waterway. Scott Chotin's inland fleet consisted of 29 owned tank barges, six of which operate in the asphalt trade, 10 owned dry cargo barges, eight owned towboats, land and buildings. The Company has continued to use the assets of Scott Chotin in the same business that Scott Chotin conducted prior to the purchase. The cash portion of the merger was financed through existing cash balances, borrowings under the transportation segment's $20,000,000 acquisition line of credit, as well as a $16,000,000 bank term loan with a negative pledge of the assets of Scott Chotin. Scott Chotin's operations are included as part of the Company's operations effective June 1, 1992, in accordance with the purchase method of accounting. On September 25, 1992, the Company completed the acquisition of Eastern America Insurance Company ("Eastern America"), a property and casualty insurance company in Puerto Rico, by means of a merger of Eastern America with and into the Company's insurance subsidiary, Universal Insurance Company ("Universal"), with Universal being the surviving entity. Presently, the Company owns approximately 70% of the voting common stock of Universal, with the remaining approximately 30% owned by Eastern America Financial Group, Inc. ("Eastern America Group"), the former parent of Eastern America. Through options and redemption rights included in the merger transaction, Eastern America Group could become the owner of up to 100% of Universal's stock over a period of up to 12 years. To date, Universal has redeemed a total 44,933 shares of their common stock from the Company at a price of $8,000,000. In July, 1993, Universal redeemed 39,128 shares for $7,000,000 and in December, 1992, Universal redeemed 5,805 shares for $1,000,000. Eastern America's operations are included as part of the Company's operations effective September 25, 1992, in accordance with the purchase method of accounting. 1993 YEAR: On March 3, 1993, a subsidiary of the Company completed the purchase of certain assets of TPT ("TPT"), a marine transportation division of Ashland Oil, Inc., for $24,400,000 in cash. TPT, located in Freedom, Pennsylvania, was engaged in the inland marine transportation of industrial chemicals and lube oils by tank barges predominantly from the Gulf Intracoastal Waterway to customers primarily on the upper Ohio River. The purchased properties included 61 owned and six leased double skin inland tank barges, four owned and one leased single skin inland tank barges and five owned inland towboats. The Company has continued to use the assets of TPT in the same business that TPT conducted prior to the purchase. The asset purchase was funded by borrowings under the transportation segment's bank revolving credit agreement. Based on unaudited information, the acquired assets of TPT had total revenues for the year ended September 30, 1992 of KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) (2) ACQUISITIONS -- (CONTINUED) $17,000,000. Operations of the assets acquired from TPT are included as part of the Company's operations effective March 3, 1993, in accordance with the purchase method of accounting. On May 14, 1993, the Company completed the acquisition of AFRAM Lines (USA) Co., Ltd. ("AFRAM Lines") by means of a merger of AFRAM Lines with a subsidiary of the Company for an aggregate consideration of $16,725,000. Additionally, the merger provides for an earnout provision not to exceed $3,000,000 in any one year and not to exceed a maximum of $10,000,000 over a four-year period. The earnout provision will be recorded as incurred as an adjustment to the purchase price. As of December 31, 1993, a $2,250,000 earnout provision, which accrues from April 1 to March 31 of the following year, had been recorded. Pursuant to the Agreement and Plan of Merger, the Company issued 1,000,000 shares of common stock, valued at $14.725 per share, in exchange for all of AFRAM Lines' outstanding stock and paid to certain executives and shareholders of AFRAM Lines $2,000,000 for agreements not to compete. AFRAM Lines, located in Houston, Texas, was engaged in the worldwide transportation of dry bulk, container and palletized cargos, primarily for Departments and Agencies of the United States Government. The Company has continued to use the assets of AFRAM Lines in the same business that AFRAM Lines conducted prior to the merger. AFRAM Lines' fleet consisted of three United States flag container and break-bulk ships which specialize in the transportation of United States Government aid and military cargos. The cash portion of the merger was financed through borrowings under the Company's bank revolving credit agreement. Pursuant to the Agreement and Plan of Merger, the effective date of the merger was April 1, 1993, and the merger was accounted for in accordance with the purchase method of accounting. The financial results for the 1993 year include the net earnings from the operations of AFRAM Lines from May 14, 1993, as the net earnings from April 1, 1993 to May 14, 1993, were recorded as a reduction of the purchase price. On December 21, 1993, a subsidiary of the Company completed the purchase of certain assets of Midland Enterprises Inc. and its wholly owned subsidiary, Chotin Transportation Company ("Chotin Transportation") for $14,950,000 in cash. Chotin Transportation, located in Cincinnati, Ohio, was engaged in the inland marine transportation of refined products by tank barge primarily from the lower Mississippi River to the Ohio River under a long-term contract with a major oil company. The Company has continued to use the assets of Chotin Transportation in the same business that Chotin Transportation conducted prior to the purchase. The purchased properties included 50 single skin and three double skin inland tank barges and the transportation contract, which expires in the year 2000. The asset purchase was funded by borrowings under the transportation segment's bank revolving credit agreement. Operations of the assets acquired from Chotin Transportation are included as part of the Company's operations effective December 21, 1993, in accordance with the purchase method of accounting. KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) (2) ACQUISITIONS -- (CONTINUED) The following unaudited pro forma financial information for the year ended December 31, 1991 is based on adjusted historical financial statements of the Company, Sabine, Ole Man River, Scott Chotin and Eastern America. The unaudited pro forma financial information for the year ended December 31, 1992 is based on adjusted historical financial statements of the Company, Sabine, Ole Man River, Scott Chotin, Eastern America and AFRAM Lines. The unaudited pro forma financial information for the year ended December 31, 1993 is based on adjusted historical financial statements of the Company and AFRAM Lines. The financial information assumes the acquisitions and mergers were completed as of the beginning of the periods indicated. The pro forma financial information is not necessarily indicative of the results of operations that would have been achieved had the asset purchases and mergers been consummated as of the periods indicated. In addition, the pro forma information is not necessarily indicative of the results of operations that may be obtained in the future. (3) INVESTMENTS With the adoption of SFAS No. 115 effective December 31, 1993 that established new criteria for the accounting and reporting of investments in debt and equity securities that have readily determinable fair value, management revaluated its investment strategy in accordance with the new provisions. Under the provisions of SFAS No. 115, investments are to be classified under one of three categories. Management determined that substantially all debt and equity securities held at December 31, 1993 qualify as available-for-sale securities. The adoption of SFAS No. 115 increased the carrying value of investment account securities by approximately $4,100,000 and stockholders' equity by $3,075,000, net of applicable deferred income taxes. SFAS No. 115 precludes restatement of prior year financial statements. KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) (3) INVESTMENTS -- (CONTINUED) A summary of the insurance subsidiaries' investments as of December 31, 1992 is as follows (in thousands): A summary of the insurance subsidiaries' investments as of December 31, 1993 is as follows (in thousands): KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) (3) INVESTMENTS -- (CONTINUED) A summary of the available-for-sale securities by maturities as of December 31, 1993 is as follows (in thousands): Short-term and all other investments primarily consist of United States Treasury obligations, certificates of deposits, commercial paper and banker's acceptances. The Company does not invest in high-yield securities judged to be below investment grade. Investment income for the years ended December 31, 1991, 1992 and 1993 is summarized as follows (in thousands): Realized net gains on investments for the years ended December 31, 1991, 1992 and 1993 are summarized as follows (in thousands): Changes in unrealized net gains (losses) in value of investments for the years ended December 31, 1991, 1992 and 1993 are summarized as follows (in thousands): KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) (4) PROPERTY AND EQUIPMENT The following is a summary of property and equipment and the related allowance for depreciation at December 31, 1992 and 1993 (in thousands): (5) INSURANCE DISCLOSURE The financial results of the Company's insurance subsidiaries, Universal, a property and casualty insurance subsidiary located in Puerto Rico, and Mariner, a wholly owned subsidiary located in Bermuda, are consolidated with the Company's other operations. KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) (5) INSURANCE DISCLOSURE -- (CONTINUED) As of December 31, 1992 and 1993, the Company owned 75% and 70% of Universal's voting common stock and 100% of Universal's non-voting common and preferred stocks, respectively (see Note 2). Condensed combined statements of earnings of the insurance subsidiaries which are reflected in the consolidated financial statements are as follows (in thousands): Policy acquisition costs deferred and amortized against earnings during the years ended December 31, 1991, 1992 and 1993 are summarized as follows (in thousands): In 1993, the insurance subsidiaries adopted SFAS No. 113, which specifies the accounting by insurance enterprises for the reinsurance of insurance contracts and eliminates the practice by insurance enterprises of reporting assets and liabilities relating to reinsured contracts net of the effects of reinsurance. The adoption of SFAS No. 113 increased the assets and liabilities by approximately $15,510,000 as of December 31, 1993. The transfer of risk provisions of SFAS No. 113 did not affect the accounting for reinsurance contracts presently in place. KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) (5) INSURANCE DISCLOSURE -- (CONTINUED) The insurance subsidiary participated in the international reinsurance market by assuming participations in risks originally undertaken by other underwriters. Effective January 1, 1991, the insurance subsidiary ceased accepting participations in the international reinsurance market. During 1992, the Company's Bermudian reinsurance subsidiary received certain delayed and certain timely large loss advises, the receipt of which caused the Company to increase the reinsurance subsidiary's loss reserves by $2,500,000 to cover both known and unknown losses. The Company is currently pursuing strategies to withdraw from the runoff of Mariner's reinsurance business at the earliest possible date. Such strategies include the possible commutation of Mariner's open book of reinsurance business in exchange for a portion of, or all of, Mariner's assets. As of December 31, 1993, the Company had net equity in Mariner of approximately $1,500,000. Net earnings and stockholders' equity of only the Company's Puerto Rican property and casualty insurance subsidiary as determined in accordance with Puerto Rican statutory accounting practices and generally accepted accounting principles for the years ended December 31, 1991, 1992 and 1993 are as follows (in thousands): The net assets of the insurance subsidiary available for transfer to the parent company are limited to the amount that its stockholders' equity, as determined in accordance with statutory accounting practices, exceeds minimum statutory capital requirements. (6) LONG-TERM DEBT Long-term debt at December 31, 1992 and 1993 consisted of the following (in thousands): KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) (6) LONG-TERM DEBT -- (CONTINUED) The aggregate payments due on the long-term debt in each of the next five years are as follows (in thousands): On May 4, 1993, the Company called for redemption on June 4, 1993, the entire $50,000,000 aggregate principal amount of its 7 1/4% Convertible Subordinated Debentures due 2014 ("Debentures") issued in October, 1989 at redemption price of 105.075% of the principal amount of the Debentures, plus accrued interest on the principal of the Debentures from April 1, 1993 to the date fixed for redemption. Prior to, or on May 27, 1993, the fifth business day prior to the date set for redemption, under the terms of the October, 1989 offering, the holders of the entire $50,000,000 of Debentures elected to convert such Debentures into common stock of the Company at a conversion price of $11.125 per share. The conversion of the Debentures increased the issued and outstanding Common Stock of the Company by 4,494,382 shares. The carrying amount and unamortized premium on the Debentures were accounted for as a decrease in stockholders' equity. On April 23, 1993, the Company and the Company's principal marine transportation subsidiary, entered into two separate revolving credit agreements (the "Credit Agreements") with Texas Commerce Bank National Association ("TCB"), as agent bank, providing for aggregate borrowings of up to $30,000,000 and $50,000,000, respectively, maturing on June 30, 1996. On August 12, 1993, the Company amended its Credit Agreement with TCB and increased the Company's provision for aggregate borrowings from $30,000,000 to $50,000,000. The Credit Agreements are unsecured; however, the Company's Credit Agreement contains a negative pledge with respect to the capital stock of certain subsidiaries of the Company and the marine transportation subsidiary's Credit Agreement contains a negative pledge with respect to certain scheduled assets. In addition, the Credit Agreements provide for the grant to TCB of a first priority lien on the capital stock or assets, as applicable, subject to the negative pledge, generally in the event of the occurrence and continuation of a default. Interest on the Credit Agreements, subject to an applicable margin ratio and type of loan, is floating prime rate or, at the Company and the marine transportation subsidiary's option, rates based on an Eurodollar interbank rate or certificate of deposit rate. Proceeds under the Credit Agreements may be used for general corporate purposes, the purchase of existing or new equipment or for possible business acquisitions. The Credit Agreements contain covenants that require the maintenance of certain financial ratios and certain other covenants that are substantially similar to the covenants contained in the marine transportation subsidiary's prior $60,000,000 revolving credit agreement, which was terminated in connection with the new Credit Agreements. These covenants cover, among other things, the disposal of capital stock of subsidiaries and assets outside the ordinary course of business. The Credit Agreements also contain usual and customary events of default. The Company and the marine transportation subsidiary were in compliance with the matters as of December 31, 1993. At December 31, 1993, the Company and the marine transportation subsidiary had $32,000,000 and $23,900,000 respectively, available for takedown under the Credit Agreements. On March 6, 1992, the Company entered into a $18,000,000 credit agreement with TCB which matures on March 6, 1997. The purchase of Sabine, on March 13, 1992, was financed with the $18,000,000 credit agreement, existing cash balances, and borrowings under the marine transportation subsidiary's credit agreement. The $18,000,000 credit agreement has a negative pledge of the assets acquired from Sabine. Principal payments of $667,000 are due quarterly up through December 31, 1996. Interest on the credit agreement, subject to an applicable margin ratio and type of loan, is floating prime rate, or at the Company's KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) (6) LONG-TERM DEBT -- (CONTINUED) option, rates based on a Eurodollar interbank rate or certificate of deposit rates. The remaining principal balance of $5,333,000 is fully due and payable on March 6, 1997, together with any unpaid interest accrued thereon. At December 31, 1993, $13,333,000 was outstanding under the loan agreement and the weighted average interest rate was 4.32%. On May 28, 1992, the Company entered into a $16,000,000 credit agreement with TCB which matures on June 1, 1997. The purchase of Scott Chotin, on June 1, 1992, was financed with the $16,000,000 credit agreement, existing cash balances, and borrowings under a $20,000,000 acquisition credit facility with TCB. The credit agreement has a negative pledge of the assets acquired from Scott Chotin. Principal payments of $571,000 are due quarterly up through March 31, 1997. Interest on the credit agreement, subject to an applicable margin ratio and type of loan, is floating prime rate, or at the Company's option, rates based on an Eurodollar interbank rate or certificate of deposit rates. The remaining principal balance of $5,143,000 is fully due and payable on June 1, 1997, together with any unpaid interest accrued thereon. At December 31, 1993, $12,571,000 was outstanding under the loan agreement and the weighted average interest rate was 4.57%. On August 13, 1992, the Company's transportation segment sold $50,000,000 of 8.22% senior notes due June 30, 2002, in a private placement. Proceeds from these notes were used to retire the $20,000,000 acquisition credit facility with TCB and the retirement of two $5,000,000, 10% subordinated promissory notes originally issued as part of the purchase of the assets of a marine transportation company on May 23, 1989, with the balance of the proceeds used to reduce the amount outstanding under the marine transportation subsidiary's credit agreement with TCB. Principal payments of $5,000,000, plus interest, are due annually through June 30, 2002. At December 31, 1993, $45,000,000 was outstanding under the senior notes. The Company is of the opinion that the terms of the outstanding debt represents the fair value of such debt as of December 31, 1993. (7) TAXES ON INCOME Earnings before taxes on income and details of the provision (benefit) for taxes on income for United States and Puerto Rico operations for the years ended December 31, 1991, 1992 and 1993 are as follows (in thousands): KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) (7) TAXES ON INCOME -- (CONTINUED) For the years ended December 31, 1992 and 1993, taxes on income were accounted for under the asset and liability method required by SFAS No. 109. The cumulative effect on prior years of the adoption of SFAS No. 109 decreased net earnings by $10,659,000, or $.47 per share, and is reported separately in the statement of earnings for the year ended December 31, 1992. In addition to the impact of the cumulative effect on prior years, the effect of the adoption of SFAS No. 109 decreased the net earnings for the 1992 year by $916,000, or $.04 per share. Prior year financial statements were not restated. Under SFAS No. 109, a change in tax rates is required to be recognized in income in the period that includes the enactment date. The 1993 Revenue Reconciliation Act included an increase in the corporate federal income tax rate from 34% to 35%, thereby requiring an increase in the Company's tax expense for the 1993 year of $1,131,000. Of the total tax adjustment, $779,000 applied to a one-time, non-cash, federal deferred tax charge for prior years and $352,000 reflects the 1% tax rate increase on earnings for the 1993 year. The Company's effective income tax rate for United States federal income taxes varied from the statutory tax rate for the years ended December 31, 1991, 1992 and 1993 due to the following: The Company's effective income tax rate for Puerto Rico income taxes varied from the statutory tax rate for the years ended December 31, 1991, 1992 and 1993 due to the following: The significant components of deferred United States taxes on income attributable to earnings from operations for the years ended December 31, 1992 and 1993 are as follows (in thousands): KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) (7) TAXES ON INCOME -- (CONTINUED) For the year ended December 31, 1991, the deferred income tax provision results from the timing differences in the recognition of income and expense for tax and financial reporting purposes. The sources and tax effect of the timing differences related to the United States operations for the year ended December 31, 1991 is as follows (in thousands): Deferred Puerto Rico income taxes arise from the recognition of certain income and expense items in different periods for income tax and for financial reporting purposes. Such items consist principally of deferred acquisition costs, salvage and subrogation recoveries, provision for doubtful accounts and accrual for guarantee fund assessments. The tax effects of temporary differences that give rise to significant portions of the current deferred tax assets and non-current deferred tax liabilities at December 31, 1992 and 1993 are as follows (in thousands): As of December 31, 1993, there was no valuation allowance. KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) (7) TAXES ON INCOME -- (CONTINUED) Subsequently recognized tax benefits relating to the valuation allowance for deferred tax assets as of December 31, 1992 were allocated as follows (in thousands): At December 31, 1993, the Company has alternative minimum tax credit carryforwards of approximately $7,397,000 which are available to reduce future federal regular income taxes, if any, over an indefinite period. (8) LEASES The Company and its subsidiaries currently lease various facilities and equipment under a number of cancelable and noncancelable operating leases. Total rental expense for the years ended December 31, 1991, 1992 and 1993 follows (in thousands): Rental commitments under noncancelable leases are as follows (in thousands): (9) STOCK OPTION PLANS The Company has three stock option plans, which were adopted in 1976, 1982 and 1989 for selected officers and other key employees. The 1976 Employee Plan, as amended, provided for the issuance until 1986 of incentive and non-qualified stock options to purchase up to 1,000,000 shares of common stock. The 1982 Employee Plan provided for the issuance until 1992 of incentive and non-qualified stock options to purchase up to 600,000 shares of common stock. The 1989 Employee Plan provides for the issuance of incentive and nonincentive stock options to purchase up to 600,000 shares of common stock. All three of the stock option plans authorize the granting of limited stock appreciation rights. KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) (9) STOCK OPTION PLANS -- (CONTINUED) Changes in options outstanding under the employee plans described above for the 1991, 1992 and 1993 years are summarized as follows: At December 31, 1993, 94,714 shares were available for future grants under the employee plans and 478,014 shares under the employee plans were issued with limited stock appreciation rights. The 1989 Director Stock Option Plan provides for the issuance of options to purchase up to 150,000 shares of common stock to the Company's directors, who are not employees of the Company. Stock options totaling 60,000 shares were granted to non-employee directors during the year ended December 31, 1989, at an option price of $7.5625 per share, and remain outstanding as of December 31, 1991, 1992 and 1993. During the year ended December 31, 1993, an additional 10,000 shares were granted at an option price of $18.625 per share and remain outstanding as of December 31, 1993. In July, 1993, the Board of Directors of the Company adopted, subject to stockholder approval at the 1994 Annual Meeting of Stockholders, the granting of 25,000 shares of non-qualified stock options to Robert G. Stone, Jr. at an option price of $18.625. Such price represents the fair market value of the Company's common stock on the date of grant. The grant serves as an incentive to retain the optionee as Chairman of the Board of the Company or as a member of the Board of Directors of the Company. In January, 1994, the Board of Directors of the Company adopted, subject to stockholder approval at the 1994 Annual Meeting of Stockholders, the 1994 Employee Stock Option Plan, providing for the issuance of options to key employees of the Company to purchase up to 1,000,000 shares of common stock. No options have been granted under the 1994 Employee Plan. In January, 1994, the Board of Directors of the Company adopted, subject to stockholders approval at the 1994 Annual Meeting of Stockholders, the 1994 Nonemployee Director Stock Option Plan, providing for the issuance of options to Directors of the Company, including Advisory Directors, to purchase up to 100,000 shares of common stock. The 1994 Nonemployee Director Stock Option Plan is intended as an incentive to KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) (9) STOCK OPTION PLANS -- (CONTINUED) attract and retain qualified, independent Directors. To date, 12,000 shares have been granted under the 1994 Director Plan, subject to shareholder approval at the 1994 Annual Meeting of Stockholders. Also, in January, 1994, the Board of Directors of the Company adopted, subject to stockholder approval at the 1994 Annual Meeting of Stockholders, an amendment to the 1989 Director Stock Option Plan. Such amendment would reduce the number of stock options automatically granted to future directors from 10,000 shares of the Company's common stock to 5,000 shares of the Company's common stock. (10) RETIREMENT PLANS The transportation subsidiaries sponsor defined benefit plans for certain ocean-going personnel. The plan benefits are based on an employee's years of service. The plans' assets primarily consist of fixed income securities and corporate stocks. Funding of the plans is based on actuarial computations that are designed to satisfy minimum funding requirements of applicable regulations and to achieve adequate funding of projected benefit obligations. Net periodic pension cost of the defined benefit plans as determined by using the projected unit credit actuarial method was $174,000, $908,000 and $1,080,000 in 1991, 1992 and 1993, respectively. The components of net periodic pension cost are as follows (in thousands): The funding status of the plans as of December 31, 1992 and 1993 was as follows (in thousands): KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) (10) RETIREMENT PLANS -- (CONTINUED) The Company, transportation subsidiaries and the diesel repair subsidiary sponsor defined contribution plans for all shore-based employees and certain ocean-going personnel. Maximum contributions to these plans equal the lesser of 15% of the aggregate compensation paid to all participating employees, or up to 20% of each subsidiary's earnings before federal income tax after certain adjustments for each fiscal year. The aggregate contributions to the plans were approximately $1,948,000, $2,124,000 and $1,484,000 in 1991, 1992 and 1993, respectively. The insurance subsidiary sponsors a qualified, non-contributory profit-sharing plan which provides retirement benefits to eligible employees. Voluntary contributions to the plan equal no less than 1% of the annual participant's compensation, as defined, plus a portion of the administration expenses of the plan during the first 10 years. The insurance subsidiary's contributions to the plan were approximately $227,000, $231,000 and $269,000 in 1991, 1992 and 1993, respectively. In addition to the Company's defined benefit pension plans, the Company sponsors an unfunded defined benefit health care plan that provides limited postretirement medical benefits to employees, who meet minimum age and service requirements, and eligible dependents. The plan is contributory, with retiree contributions adjusted annually. As discussed in Note 1, the Company adopted SFAS No. 106 effective January 1, 1992. The cumulative effect on prior years of the adoption of SFAS No. 106 decreased net earnings by $2,258,000, net of applicable income taxes of $1,163,000, or $.10 per share, and is reported separately in the statement of earnings for the year ended December 31, 1992. In addition to the impact of the cumulative effect on prior years, the effect of the adoption of SFAS No. 106 decreased the net earnings for the 1992 year by $355,000, net of applicable income taxes of $183,000 or $.02 per share. Prior year financial statements were not restated. The following table presents the plan's funded status reconciled with amounts recognized in the Company's consolidated balance sheet at December 31, 1993 (in thousands): The Company's unfunded defined benefit health care plan, which provides limited postretirement medical benefits, limits cost increases in the Company's contribution to 4% per year. For measurement purposes, a 4% annual rate of increase in the per capita cost of covered benefits (i.e., health care cost trend KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) (10) RETIREMENT PLANS -- (CONTINUED) rate) was assumed for future periods. Accordingly, health care cost trend rate assumption would have no effect on the amounts reported. The weighted average discount rate used in determining the accumulated postretirement benefit obligation was 7.25% at December 31, 1993. SFAS No. 112, "Employers' Accounting for Postemployment Benefits," issued in November, 1992, which is required to be applied in the first quarter of 1994, is not expected to have a material effect on the Company's financial statements. (11) EARNINGS PER SHARE OF COMMON STOCK Primary earnings per share of common stock for the year ended December 31, 1991, 1992 and 1993 were based on the weighted average number of common stock and common stock equivalent shares outstanding of 21,952,000, 22,607,000 and 26,527,000 respectively. Fully diluted earnings per share of common stock for the year ended December 31, 1991 assume the conversion of the 7 1/4% debentures (see Note 6) and the exercise of stock options using the treasury stock method. Net earnings for the computation were increased by the interest expense, net of federal income taxes, on the debentures. The weighted average number of shares used in the computation of fully diluted earnings per common share for 1991 was 26,454,000. (12) QUARTERLY RESULTS (UNAUDITED) The unaudited quarterly results for the year ended December 31, 1992 are as follows (in thousands, except per share amounts): KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) (12) QUARTERLY RESULTS (UNAUDITED) -- (CONTINUED) The unaudited quarterly results for the year ended December 31, 1992 have been restated for the effect of the adoption of SFAS No. 106, more fully described in Note 10 and the adoption of SFAS No. 109, more fully described in Note 7. The adoption of SFAS No. 106 and SFAS No. 109,, effective January 1, 1992, reduced the net earnings (loss) before the cumulative effect of the accounting changes for the four quarters of 1992 as follows (in thousands, except per share amounts): The unaudited quarterly results for the year ended December 31, 1993 are as follows (in thousands, except per share amounts): (13) CONTINGENCIES AND COMMITMENTS The Company's Puerto Rican insurance subsidiary has appealed to the Supreme Court of Puerto Rico, a July 5, 1989 Superior Court judgment of approximately $1,100,000, plus interest of approximately $1,935,000 as of December 31, 1993, resulting from a civil suit claiming damages. The Supreme Court of Puerto Rico decided during 1992 to review the case. Management is of the opinion, based on consultation with its legal counsel, that the judgment will be reversed or at least substantially reduced, however, reserves have been established for the entire amount of the judgment plus accrued interest. KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) (13) CONTINGENCIES AND COMMITMENTS -- (CONTINUED) There are various other suits and claims against the Company, none of which in the opinion of management will have a material effect on the Company. Management has recorded necessary reserves and believes that it has adequate insurance coverage or has meritorious defenses for the foregoing claims and contingencies. (14) INDUSTRY SEGMENT DATA The Company conducts operations in three industry segments as follows: Marine Transportation -- Marine transportation by United States flag vessels on the inland waterway system and in United States coastwise and foreign trade. The principal products transported include petrochemical feedstocks, processed chemicals, agricultural chemicals, refined petroleum products, coal, limestone, grain and sugar. Container and palletized cargo are also transported for United States Government aid programs and military. Diesel Repair -- Repair of diesel engines, reduction gear repair and sale of related parts and accessories, primarily for customers in the marine industry and beginning in 1994, for customers in the shortline and industrial railroad industry. Insurance -- Writing of property and casualty insurance in Puerto Rico. The following table sets forth by industry segment the combined gross revenues, operating profits (before general corporate expenses, interest expense and income taxes), identifiable assets (including goodwill), depreciation and amortization and capital expenditures attributable to the continuing principle activities of the Company for the years ended December 31, 1991, 1992 and 1993 (in thousands): (Table continued on following page) KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) (14) INDUSTRY SEGMENT DATA -- (CONTINUED) Identifiable assets are those assets that are used in the operation of each segment. General corporate assets are principally cash, short-term investments, accounts receivable, furniture and equipment. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENTS, SCHEDULES AND REPORTS ON FORM 8-K (a) 1. Financial Statements: Included in Part III of this report: Report of KPMG Peat Marwick, Independent Public Accountants, on the financial statements of Kirby Corporation and Consolidated Subsidiaries for the years ended December 31, 1992 and 1993. Report of Deloitte and Touche, Independent Public Accountants, on the financial statements of Kirby Corporation and Consolidated Subsidiaries for the year ended December 31, 1991. Balance Sheets, December 31, 1992 and 1993. Statements of Earnings, for the years ended December 31, 1991, 1992 and Statements of Stockholders' Equity, for the years ended December 31, 1991, 1992 and 1993 Statements of Cash Flows, for the years ended December 31, 1991, 1992 and 1993 Notes to Financial Statements, for the years ended December 31, 1991, 1992 and 1993 (a) 2. Financial Statement Schedules: Included in Part IV of this report: All other schedules are omitted as the required information is inapplicable or the information is presented in the consolidated financial statements or related notes. (a) 3. Exhibits - --------------- * Filed herewith + Management contract, compensatory plan or arrangement SCHEDULE V KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES PLANT, PROPERTY AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1991, 1992 AND 1993 SCHEDULE VI KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES ACCUMULATED DEPLETION, DEPRECIATION AND AMORTIZATION OF PLANT, PROPERTY AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1991, 1992 AND 1993 SCHEDULE X KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1991, 1992 AND 1993 SCHEDULE V KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES SUPPLEMENTAL INSURANCE INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1991, 1992 AND 1993 - --------------- (1) Reconciliation of net investment income to investment income amount reflected in the statements of earnings is as follows: (2) Included as part of selling, general and administrative expenses, taxes, other than on income, and depreciation and amortization in the statements of earnings. SCHEDULE VI KIRBY CORPORATION AND CONSOLIDATED SUBSIDIARIES REINSURANCE FOR THE YEARS ENDED DECEMBER 31, 1991, 1992 AND 1993 - --------------- * Reconciliation of total premiums to net premiums earned, the amount reflected in the statements of earnings is as follows. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. KIRBY CORPORATION (Registrant) By: BRIAN K. HARRINGTON Brian K. Harrington Senior Vice President Dated: March 14, 1994 Pursuant to the requirements of the Securities 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 dates indicated.

1993 Item 1. Business. - ------ -------- and Item 2. Item 2. Properties. - ------ ---------- GENERAL. Norfolk Southern Corporation (Norfolk Southern) was incorporated on July 23, 1980, under the laws of the Commonwealth of Virginia. On June l, 1982, Norfolk Southern acquired control of two major operating railroads, Norfolk and Western Railway Company (NW) and Southern Railway Company (Southern). In accordance with an Agreement of Merger and Reorganization dated as of July 31, 1980, and related Plans of Merger, and the approval of the transaction by the Interstate Commerce Commission (ICC), each issued share of NW's common stock was converted into one share of Norfolk Southern Common Stock and each issued share of Southern common stock was converted into 1.9 shares of Norfolk Southern Common Stock. The outstanding shares of Southern's preferred stock remained outstanding without change. Effective December 31, 1990, Norfolk Southern transferred all the common stock of NW to Southern, and Southern's name was changed to Norfolk Southern Railway Company (Norfolk Southern Railway). As of February 28, 1994, all the common stock of NW (100 percent voting control) is owned by Norfolk Southern Railway, and all the common stock of Norfolk Southern Railway and 7.1 percent of its preferred stock (resulting in 94.3 percent voting control) are owned directly by Norfolk Southern. On June 21, 1985, Norfolk Southern acquired control of North American Van Lines, Inc. and its subsidiaries (NAVL), a diversified motor carrier. In accordance with an Acquisition Agreement dated May 2, 1984, and the approval of the transaction by the ICC, Norfolk Southern acquired all the issued and outstanding common stock of NAVL from PepsiCo, Inc. During 1993, NAVL underwent a restructuring (see discussion on page 7 and in Note 3 of Notes to Consolidated Financial Statements on page 74) designed to enhance its opportunities to return to profitability. Unless indicated otherwise, Norfolk Southern and its subsidiaries are referred to collectively as NS. STOCK PURCHASE PROGRAMS. Norfolk Southern announced on November 24, 1987, that its Board of Directors had authorized the purchase of up to 20 million shares of Norfolk Southern's common stock through the end of 1990. This program was completed in November 1989. On October 24, 1989, the Board of Directors authorized the purchase of up to an additional 45 million shares of common stock. Purchases under these programs initially were made with internally generated cash. Beginning in May 1990, some purchases were financed with proceeds from the sale of short-term notes pursuant to the commercial paper program discussed below. On January 29, 1992, Norfolk Southern announced that, primarily related to issues surrounding the 1991 special charge (see Note 15 of Notes to Consolidated Financial Statements on page 85), the purchase program would continue, but at a slower pace and over a longer authorized period with purchases dependent on market conditions, the economy, cash needs and alternative investment opportunities. As of December 31, 1993, 33.6 million shares had been purchased pursuant to the current program resulting in a total of 53.6 million shares purchased and retired since 1987 at a cost of approximately $2.2 billion. If all 45 million shares are purchased under the current program, the number of outstanding shares of common stock will have been reduced by about one third since 1987. Purchases are made in regular brokerage transactions on the open market at prevailing market prices and otherwise in accordance with Securities and Exchange Commission regulations. In June 1989, Norfolk Southern announced that it intended to purchase up to 250,000 shares of Norfolk Southern Railway's $2.60 Cumulative Preferred Stock, Series A, during the subsequent two-year period. In May 1991, Norfolk Southern extended the previously announced stock purchase program through 1993. In March 1994, Norfolk Southern announced that it would continue purchasing up to 250,000 shares of the stock through 1996. From June 2, 1989, through December 31, 1993, Norfolk Southern had purchased 77,626 shares of the preferred stock at a total cost of approximately $2.67 million. COMMERCIAL PAPER PROGRAM AND DEBT ISSUANCE. In May 1990, Norfolk Southern established a commercial paper program principally to finance the purchase and retirement of its common stock. Commercial paper debt is due within one year, but a portion has been classified as long-term because Norfolk Southern has the ability and intends to refinance its commercial paper on a long-term basis, either by issuing additional commercial paper (supported by a revolving credit agreement) or by replacing commercial paper notes with long-term debt. The original $350 million credit agreement was replaced effective June 9, 1992, by a credit agreement expiring June 9, 1995, having a credit limit of $400 million. The agreement provides for interest on borrowings at prevailing short-term rates and contains customary financial covenants, including principally a minimum tangible net worth requirement of $3 billion and a restriction on the creation or assumption of certain liens. Norfolk Southern intends to replace the current credit agreement with a new agreement during the first half of 1994. It is expected that the new credit agreement will have a term of five years, a credit limit of $500 million and covenants similar to those included in the current agreement. In January 1991, Norfolk Southern filed with the Securities and Exchange Commission a shelf registration statement on Form S-3 covering the issuance of up to $750 million principal amount of unsecured debt securities. On March 13, 1991, Norfolk Southern issued and sold $250 million principal amount of its 9 percent Notes due March 1, 2021 (9% Notes). The 9% Notes are not redeemable prior to maturity and are not entitled to any sinking fund. Proceeds from the sale of the 9% Notes were used to purchase and retire shares of Norfolk Southern Common Stock and to retire short-term commercial paper debt issued to fund previous share purchases. On February 26, 1992, Norfolk Southern issued and sold $250 million principal amount of its 7-7/8 percent Notes due February 15, 2004 (7-7/8% Notes). The 7-7/8% Notes are not redeemable prior to maturity and are not entitled to any sinking fund. Proceeds from the sale of the 7-7/8% Notes were used to purchase and retire shares of Norfolk Southern Common Stock and to retire short-term commercial paper debt. RAILROAD OPERATIONS. As of December 31, 1993, NS' railroads operated 14,589 miles of road in the states of Alabama, Florida, Georgia, Illinois, Indiana, Iowa, Kentucky, Louisiana, Maryland, Michigan, Mississippi, Missouri, New York, North Carolina, Ohio, Pennsylvania, South Carolina, Tennessee, Virginia and West Virginia, and the Province of Ontario, Canada. Of this total, 12,761 miles are owned, 677 miles are leased and 1,151 miles are operated under trackage rights. Of the operated mileage, 11,870 miles are main line and 2,719 miles are branch line. In addition, NS' railroads operate approximately 11,266 miles of passing, industrial, yard and side tracks. NS' railroads have major leased lines in North Carolina and between Cincinnati, Oh., and Chattanooga, Tn. The North Carolina leases, covering approximately 300 miles, expire at the end of 1994, and NS' railroads are discussing possible renewals with the lessor. If these leases are not renewed, NS' railroads could be required to continue using the lines subject to conditions prescribed by the ICC or they might find it necessary ultimately to operate over an alternate route or routes. It is not expected that the resolution of this matter, whether resulting in renewal of the leases, continued use of the leased lines under prescribed conditions or operation over one or more alternate routes, will have a material effect on NS' consolidated financial position. The Cincinnati-Chattanooga lease, covering about 335 miles, expires in 2026, subject to an option to extend the lease for an additional 25 years at terms to be agreed upon. NS' lines carry raw materials, intermediate products and finished goods primarily in the Southeast and Midwest and to and from the rest of the United States and parts of Canada. These lines also transport overseas freight through several Atlantic and Gulf Coast ports. Atlantic ports served by NS include: Norfolk, Va.; Morehead City, N.C.; Charleston, S.C.; Savannah and Brunswick, Ga.; and Jacksonville, Fl. Gulf Coast ports served include: Mobile, Al., and New Orleans, La. The lines of NS' railroads reach most of the larger industrial and trading centers of the Southeast and Midwest, with the exception of those in central and southern Florida. Atlanta, Birmingham, New Orleans, Memphis, St. Louis, Kansas City (Missouri), Chicago, Detroit, Cincinnati, Buffalo, Norfolk, Charleston, Savannah and Jacksonville are among the leading centers originating and terminating freight traffic on the system. In addition to serving other established centers, its lines reach many industries, mines (in western Virginia, eastern Kentucky and southern West Virginia) and businesses located in smaller communities in its service area. The traffic corridors carrying the heaviest volumes of freight include those from the Appalachian coal fields of Virginia, West Virginia and Kentucky to Norfolk and Sandusky, Oh.; Buffalo to Chicago and Kansas City; Chicago to Jacksonville (via Cincinnati, Chattanooga and Atlanta); and Washington, D.C./Hagerstown, Md., to New Orleans (via Atlanta and Birmingham). Buffalo, Chicago, Hagerstown, Jacksonville, Kansas City, Memphis, New Orleans and St. Louis are major gateways for interterritorial system traffic. MOTOR CARRIER OPERATIONS. NAVL's principal transportation activity is the domestic, irregular route common and contract carriage of used household goods and special commodities between points in the United States. NAVL also operates as an intrastate carrier of property in 17 states. Prior to its restructuring in 1993, NAVL's domestic motor carrier business was organized into three primary divisions: Relocation Services (RS) specializing in residential relocation of household goods; High Value Products (HVP) specializing in office and industrial relocations and transporting exhibits; and Commercial Transport (CT) specializing in the transportation of truckload shipments of general commodities. In 1993, NAVL underwent a restructuring involving termination of the CT Division and sale of the operations of Tran-Star, Inc. (Tran-Star), NAVL's refrigerated trucking subsidiary. In 1993, NAVL discontinued CT's operations, transferred some parts of CT's business to other divisions and began selling CT's assets that are not needed in NAVL's other operations. The sale of Tran-Star's operations was completed on December 31, 1993. During 1993, the RS and HVP divisions conducted operations through agents at 707 locations in the United States. Agents are local moving and storage companies that provide NAVL with such services as solicitation, packing and warehousing in connection with the movement of household goods and specialized products. NAVL's domestic operations are expected to be conducted principally through the RS and HVP divisions in 1994 and thereafter. Customized Logistics Services (CLS) was established in 1993 as an operating unit of the HVP Division. CLS' business is to focus NAVL's resources to respond to a variety of customer needs for integrated logistics services. The services include emergency parts order fulfillment, time definite transportation, and returns and merchandise recycling services. NAVL's foreign operations are conducted through the RS and HVP Divisions and through foreign subsidiaries, including North American Van Lines Canada, Ltd. The latter subsidiary provides motor carrier service for the transportation of used household goods and specialized commodities between most points in Canada through a network of approximately 182 agent locations. NAVL's international operations consist primarily of forwarding used household goods to and from the United States and between foreign countries through a network of approximately 350 foreign agents and representatives. NAVL's international operations are structured to align them with the services provided by its domestic operating divisions. All international household goods operations and related subsidiaries in Alaska, Canada and Panama are assigned to the RS Division. The remaining international operations, which include subsidiaries in the United States, Germany and the United Kingdom, are involved in the transportation of selected general and specialized commodities and are assigned to the HVP Division. The RS Division successfully completed its negotiations in the first quarter of 1992 to form a joint venture company known as UTS Europe Holding BV (UTS). The new entity, which is headquartered in Amsterdam, Netherlands, has been handling intra-European movement of household goods since March 1, 1992. NAVL has a 40 percent interest in UTS which is comprised of approximately 70 individual shareholders in 65 locations throughout Europe. To date, national and regional organizations have been formed under the UTS banner in Germany and the Netherlands (founding members), with an 8 percent and 5 percent interest in UTS, respectively. In addition, the United Kingdom (8 percent interest in UTS), Belgium (5 percent interest) and the Scandinavian countries (5 percent interest) have also formed under the UTS banner. TRIPLE CROWN OPERATIONS. Until April 1993, Norfolk Southern's intermodal subsidiary, Triple Crown Services, Inc. (TCS), offered intermodal service using RoadRailer (Registered Trademark) (RT) equipment and domestic containers. RoadRailer(RT) units are enclosed vans which can be pulled over highways in tractor- trailer configuration and over the rails by locomotives. On April 1, 1993, the business, name and operations of TCS were transferred to Triple Crown Services Company (TCSC), a partnership formed by subsidiaries of Norfolk Southern and Consolidated Rail Corporation (CR). RoadRailer(RT) equipment owned or leased by TCS (which was renamed TCS Leasing, Inc.) is operated by TCSC. Because NS indirectly owns only 50 percent of TCSC (an affiliate of CR also owns 50 percent), the revenues of TCSC are not consolidated with the results of NS. TCSC offers door-to-door intermodal service using RoadRailer(RT) equipment and domestic containers in the corridors previously served by TCS, as well as service to the New York and New Jersey markets via CR. Major traffic corridors include those between New York and Chicago, Chicago and Atlanta and Atlanta and New York. TRANSPORTATION OPERATING REVENUES. NS' total transportation operating revenues were $4.5 billion in 1993. These revenues were received for the transportation of revenue freight: 262.3 million tons by rail and 3.2 million tons by motor carrier. Of the rail tonnage, approximately 210.4 million tons originated on line, approximately 222.8 million tons terminated on line (including 177.1 million tons of local traffic -- originating and terminating on line) and approximately 6.2 million tons was overhead traffic (neither originating nor terminating on line). Revenue and revenue ton mile (one ton of freight moved one mile) contributions by principal transportation operating revenue sources for the period 1989 through 1993 are set forth in the following table: COAL TRAFFIC - The commodity group moving in largest tonnage volume over NS' railroads is coal, coke and iron ore, most of which is bituminous coal. NS' railroads originated 112.1 million tons of coal, coke and iron ore in 1993 and handled a total of 118.0 million tons. Originated tonnage decreased 5 percent from 118.0 million tons in 1992, and total tons handled decreased 5 percent from 124.4 million tons. Revenues from coal, coke and iron ore, which accounted for 27 percent of NS' total transportation operating revenues and 36 percent of total revenue ton miles in 1993, were $1.21 billion, a decrease of 6 percent from $1.30 billion in 1992. The following table shows total coal tonnage originated on NS' lines, received from connections and handled for the five years ended December 31, 1993: Of the 109.8 million tons of coal originating on NS railroad lines in 1993, the approximate breakdown is as follows: 37.9 million tons from West Virginia, 37.6 million tons came from Virginia, 22.9 million tons from Kentucky, 7.6 million tons from Alabama, 1.7 million tons from Tennessee, 1.1 million tons from Illinois, and 1.0 million tons from Indiana. Of this NS-origin coal, approximately 25.3 million tons moved for export, principally through NS pier facilities at Norfolk (Lamberts Point), Va.; 20.1 million tons moved to domestic and Canadian steel industries; 55.6 million tons of steam coal moved to electric utilities; and 8.8 million tons moved to other industrial and miscellaneous users. NS' railroads moved 9.7 million tons of originated coal to various docks on the Ohio River for further movement by barge and 5.1 million tons to various Lake Erie ports. Other than coal moving for export, virtually all coal tonnage handled by NS' railroads was terminated in states situated east of the Mississippi River. Total NS coal tonnage handled through all system ports in 1993 was 42.4 million. Of this total, 65 percent moved through the pier facilities at Lamberts Point. In 1993, total tonnage handled at Lamberts Point, including coastwise traffic, was 27.6 million tons, a 20 percent decrease from the 34.7 million tons handled in 1992. The quantities of NS coal handled for export only through Lamberts Point for the five years ended December 31, 1993, were as follows: The recession in Europe and high stockpiles of coal overseas continued to affect NS' railroads' export coal shipments in 1993, as did the UMWA strike at several mines served by NS. Domestic coal was essentially flat, compared with 1992, although the market for utility coals increased slightly because of the hot weather in our service region and continued spot tonnage purchases. Increased shipments to steel producers were attributed to strike-related problems encountered by suppliers served by other carriers; the industrial market stayed even with the previous year. MERCHANDISE RAIL TRAFFIC - The merchandise traffic group consists of Intermodal and five major commodity groupings (Paper/Forest; Chemicals; Automotive; Agriculture; and Metals/Construction). Total NS railroad merchandise revenues increased in 1993 to $2.41 billion, a 2 percent increase over 1992. Railroad merchandise carloads handled in 1993 were 2.82 million, compared with 2.66 million handled in 1992, an increase of 6 percent. Intermodal results reflect the effect of the formation, in April 1993, of Triple Crown Services Company (TCSC), a partnership between NS and Conrail subsidiaries (see also page 8). This partnership provides RoadRailer(RT) and domestic container services previously offered by a wholly owned NS subsidiary. Because NS owns only 50 percent of TCSC, its revenues are not consolidated, and NS' 1993 intermodal revenues include only revenues for rail service provided by NS to the partnership. Excluding this partnership effect, intermodal revenues would have increased 10 percent, and merchandise revenues would have increased 5 percent. In 1993, 97.8 million tons of merchandise freight, or approximately 68 percent of total rail merchandise tonnage handled by NS, originated on line. The balance of NS' railroad merchandise traffic was received from connecting carriers (mostly railroads, with some intermodal, water and highway as well), usually at interterritorial gateways. The principal interchange points for NS- received traffic included Chicago, Memphis, New Orleans, Cincinnati, Kansas City, Detroit, Hagerstown, St. Louis/East St. Louis, and Louisville. The economy improved in 1993, but the pace of recovery was still below the average of post-war recoveries. All merchandise commodity groups showed improvement over 1992. The biggest gains were in Intermodal, up $34.1 million (adjusted for the effect of the TCSC partnership with Conrail); Automotive, up $28.0 million; Metals/ Construction, up $19.8 million and Agriculture, up $18.3 million. There were smaller gains in Paper/Forest and Chemicals. PAPER/FOREST traffic (including paper, paperboard, wood pulp, pulpwood, wood chips, lumber, kaolin clay and waste paper) accounted for 11 percent of NS' total transportation operating revenues and 13 percent of total revenue ton miles during 1993. Compared with 1992, Paper/Forest revenues increased 1 percent and revenue ton miles increased 3 percent. Weak domestic and overseas demand for paper depressed NS shipments for much of the year. Lumber, however, posted a 4 percent gain in revenue due to a strong recovery in housing construction. Moderate growth, somewhat higher than industry production, is expected over the next few years due to growth in market share. CHEMICALS traffic (including petroleum products, plastics, fertilizers, nonmetallic minerals, sulfur, chloral-alkali chemicals, rubber, miscellaneous chemicals and waste/hazardous chemicals) accounted for 11 percent of NS' total transportation operating revenues and 13 percent of total revenue ton miles during 1993. Compared with 1992, NS' total revenue for chemicals was up 0.3 percent and revenue ton miles increased 3 percent. The lower gain in revenue was due to a change in the mix of traffic. Gains in general chemicals and plastics were offset by weakness in movements of export fertilizer due to sluggish conditions overseas. Stronger growth is expected in 1994 and beyond, paced by additional rail-truck distribution facilities for bulk chemicals. While environmental concerns could adversely affect production of pesticides and chlorine, increased environmental awareness is likely to have a positive impact on movements of recyclables, hazardous wastes and alternative fuels such as ethanol. AUTOMOTIVE traffic (including motor vehicles, vehicle parts, miscellaneous transportation and ordnance, and tires) accounted for 10 percent of NS' total transportation operating revenues and 4 percent of revenue ton miles during 1993. Compared with 1992, NS Automotive revenues increased 7 percent and revenue ton miles increased 14 percent. The gain was due to strong demand for vehicles produced at plants served by NS. NS' largest customer, Ford Motor Company, produced the top-selling automobile and truck in 1993. In addition, NS benefited from a full year of production at the Ford/Nissan plant located near Avon Lake, Oh. Successful marketing efforts, such as an innovative program with GM for just-in-time movement of auto parts, also contributed to the gain. Further growth in Automotive is expected in 1994 and beyond, as U.S. automotive production is anticipated to increase for the next few years. Within this growing market, NS will pursue innovative marketing programs and aggressive industrial development. From 1994 to 1997, operations will begin at three new or expanded automotive assembly plants located on NS--the second Toyota Plant at Georgetown, Ky., in 1994; BMW at Greer, S.C., in 1995; and Mercedes- Benz at Tuscaloosa, Al., in 1997. The retooling of GM's Wentzville, Mo., and Doraville, Ga., plants for van production should also increase traffic. AGRICULTURE traffic (including grains and soybeans, feed and feed ingredients, sweeteners, beverages, consumer products, and various other agricultural and food commodities) accounted for 7 percent of NS' total transportation operating revenues and 12 percent of total revenue ton miles during 1993. Compared with 1992, agricultural revenues increased 6 percent and revenue ton miles increased 8 percent. In the early part of the year, NS benefited from a record harvest, that continued well into 1993. During the summer, the flood in the Midwest diverted traffic to rail that formerly moved by barge. In the fall, good crop conditions in NS' sourcing areas and poor conditions elsewhere produced strong NS traffic gains. Although the special conditions present during 1993 are not likely to recur in 1994, a small increase in agriculture revenue is expected, driven by growth in poultry production in the Southeast, a prime NS feed grain market. METALS/CONSTRUCTION traffic (including aluminum ore, iron and steel, aluminum products, scrap metal, machinery, sand and gravel, cement, brick, miscellaneous construction, and nonhazardous waste) accounted for 7 percent of NS' total transportation operating revenues and 9 percent of total revenue ton miles during 1993. Compared with 1992, NS' total revenues for Metals/Construction were up 7 percent and revenue ton miles were up 13 percent. Most of the revenue gain was in shipments of iron and steel, where strong industry production and new plants located on NS' lines boosted revenue $10 million. Shipments of construction commodities were also strong due to a recovery in housing. Further gains are expected over the next few years. NS has initiatives under way intended to win back truck business in aluminum, and several new movements of municipal solid waste are expected. INTERMODAL traffic (including trailers, containers, and Triple Crown) accounted for 8 percent of NS' total transportation operating revenues and 11 percent of total revenue ton miles during 1993. Compared with 1992, intermodal revenues increased 9 percent, and revenue ton miles increased 9 percent. Intermodal growth in 1993 was led by a 21 percent increase in Triple Crown activity due to strong automotive shipments and expansion of service to the Northeast through the partnership with Conrail. Container revenues were up 6 percent, a smaller increase than previous years due to less international traffic caused by the continuing recession in Europe and Japan. Trailer revenue was up 11 percent, boosted by gains from haulage arrangements with truckload carriers. Strong growth is expected in 1994 and for the next several years. TCSC should continue to grow as service is expanded to additional markets. Container growth is expected to improve as recoveries overseas produce steady growth in international shipments. Trailer business also is expected to grow, as leading truckload carriers, such as Schneider National and J.B. Hunt, use rail for the long-haul portion of their shipments. OTHER INTERMODAL primarily consists of drayage from or to rail points and is exclusively related to Triple Crown activity (see discussion of new partnership on page 12). The figures shown for 1993 reflect the results of NS' wholly owned subsidiary which performed RoadRailer(RT) services only for the first three months of 1993 (up to the inception of the TCSC partnership). MOTOR CARRIER TRAFFIC - NAVL's traffic volume decreased during 1993; total revenues from operations were $714.2 million, down 13.9 percent from 1992, including a 16.2 percent decrease resulting from NAVL's restructuring. NAVL's expenses decreased 11.5 percent in 1993, also resulting from the restructuring. NAVL's domestic motor carrier operations are conducted primarily through its RS and HVP divisions. In 1993, total domestic shipments for these divisions, including the CT Division through June 25, 1993, numbered 550,207, down 12.8 percent from 1992, resulting from the restructuring. Further comments about each division follow. Domestic shipments of used household goods transported by the RS Division fall into three market categories. Approximately 50 percent of the domestic shipment volume comes from the sale of moving services to individual consumers. Another 35 percent comes from corporations and other businesses that pay for the relocation of their employees. The remaining 15 percent is derived from military, government and other sources. Total domestic RS Division shipments in 1993 represented 21 percent of the NAVL domestic motor carrier shipments transported by the three primary divisions. Total domestic revenues from this division were down 2 percent, compared with 1992, and represented 38 percent of total revenues from operations. The HVP Division specializes in providing transportation services in less-than-truckload (LTL) and truckload (TL) quantities to manufacturers of sensitive products. These products are divided into the following categories: office furniture and equipment, exhibits and displays, electronic equipment, industrial machinery, commercial relocation, LTL furniture and selected general commodities. Total HVP Division shipments transported in 1993, including TL and LTL, represented 43 percent of the NAVL domestic motor carrier shipments transported by the three primary divisions. Revenues from this division were up 15 percent from 1992 levels and represented 33 percent of total revenues from operations. The operations of the CT Division were discontinued in 1993. Total CT Division shipments transported in 1993 represented 36 percent of NAVL's total domestic motor carrier shipments transported for the entire year by the three primary divisions. Revenues from this division were down 50 percent from 1992 levels and represented 19 percent of total revenues from operations. FOREIGN OPERATIONS include NAVL's Canadian subsidiary, North American Van Lines Canada, Ltd., as well as operating subsidiaries in England, Germany and Panama. Foreign operations involving the transportation of household goods and selected general and specialized commodities generated revenues of $69.5 million in 1993, down 10 percent from 1992. Revenues from foreign operations represented 10 percent of NAVL's total revenue. RAIL OPERATING STATISTICS. The following table sets forth certain statistics relating to NS' railroad operations during the periods indicated: FREIGHT RATES. In the pricing of freight services, NS' railroads continued in 1993 to increase reliance on private contracts which, coupled with traffic that has been exempted from regulation by the ICC (e.g., boxcar and intermodal traffic), presently account for over 80 percent of freight operating revenues. Thus, a major portion of NS' railroads' freight business is not economically regulated by the government. In general, market forces have been substituted for government regulation and now are the primary determinant of rail service prices. In 1993, the ICC found NS' railroads "revenue adequate" based on results for the year 1992. A railroad is "revenue adequate" under the Interstate Commerce Act when its return on net investment exceeds the rail industry's cost of capital. The condition of "revenue adequacy" determines whether a railroad can take advantage of a provision in the Interstate Commerce Act allowing freedom to increase regulated rates by a specific percentage. However, with the decreasing importance of regulated tariff traffic to NS' railroads, the ICC's "revenue adequacy" findings have less impact than formerly. Pricing and service flexibility afforded by the Motor Carrier Act of 1980 and the Household Goods Transportation Act of 1980 has resulted in NAVL's increased emphasis on innovative pricing action in order to remain competitive. Since 1980, NAVL has increasingly operated as a contract carrier. As of December 31, 1993, domestic contract carriage agreements accounted for the following percentage of shipments: RS Division, 31.9 percent and HVP Division, 72.7 percent; the CT Division was discontinued in June of 1993. PASSENGER OPERATIONS. Regularly scheduled passenger operations on NS' lines consist of Amtrak trains operating between Alexandria and New Orleans, and between Charlotte and Selma, N.C. Former Amtrak operations between East St. Louis and Centralia, Il., were discontinued by Amtrak November 3, 1993. Commuter trains continued operations on the NS line between Manassas and Alexandria under contract with two transportation commissions of the Commonwealth of Virginia, providing for reimbursement of related expenses incurred by NS. During 1993, a lease of the Chicago to Manhattan, Il., line to the Commuter Rail Division of the Regional Transportation Authority of Northeast Illinois replaced a purchase of service agreement by which NS had provided commuter rail service for the Authority. OTHER RAILWAY OPERATIONS. Revenues from switching, demurrage and miscellaneous services amounted to $121.5 million, or approximately 3 percent of total transportation operating revenues, during 1993 and $121.7 million, or approximately 3 percent of total transportation operating revenues, in 1992. NONCARRIER OPERATIONS. Norfolk Southern's noncarrier subsidiaries engage principally in the acquisition and subsequent leasing of coal, oil, gas and timberlands, the development of commercial real estate and the leasing or sale of rail property and equipment. In 1993, no such noncarrier subsidiary or industry segment grouping of noncarrier subsidiaries met the requirements for a reportable business segment set forth in Statement of Financial Accounting Standards No. 14. In January 1994, certain Norfolk Southern subsidiaries purchased rights with respect to an estimated 210 million recoverable tons of coal located primarily in eastern Kentucky and southern West Virginia. The cash purchase price for the acquisition was $71 million. These coal reserves have been leased to various producers who are to operate and mine the properties under long-term leases providing royalty income to NS. The average age of the freight car fleet at December 31, 1993, was 20.8 years. During 1993, NS retired 5,576 freight cars. As of December 31, 1993, the average age of the locomotive fleet was 14.6 years. During 1993, NS retired 37 locomotives, the average age of which was 24.7 years. Since 1989, NS has rebodied over 14,000 coal cars. As a result, the remaining serviceability of the freight car fleet is greater than is indicated by the percentage of freight cars built in earlier years. NS continues freight car and locomotive maintenance programs to ensure the highest standards of safety, reliability, customer satisfaction and equipment marketability. In recent years, as illustrated in the table below, the bad order ratio has risen or remained fairly stable primarily due to the storage of certain types of cars which are not in high demand. Funds were not spent to repair cars for which present and future customers' needs could be adequately met without such repair programs. Also, NS' own standards of what constitutes a "serviceable" car have risen, and NS continues a rational disposition program for underutilized, unserviceable and overage cars. TRACKAGE - All NS trackage is standard gauge, and the rail in approximately 95 percent of the main line trackage (including first, second, third and branch main tracks, all excluding trackage rights) is heavyweight rail ranging from 90 to 155 pounds per yard. Of the 23,512 miles of track maintained by NS as of December 31, 1993, 15,621 were laid with welded rail. The density of traffic on NS running tracks (main line trackage plus passing tracks) during 1993 was as follows: MICROWAVE SYSTEM - The NS microwave system, consisting of 6,584 radio path miles, 374 active stations and 7 passive repeater stations, provides communication services between Norfolk, Buffalo, Detroit, Fort Wayne, Chicago, Kansas City, St. Louis, Washington, D.C., Atlanta, New Orleans, Jacksonville, Memphis, Cincinnati and most operating locations between these cities. The microwave system provides approximately 2,152,600 individual voice channel miles of circuits, and NS began a conversion of the system from analog to digital technology in 1993. Conversion is under way on all microwave facilities between St. Louis, Mo., and Danville, Ky.; the process is also under way between Roanoke and Norfolk, Va. The microwave communication system is used principally for voice communications, VHF radio control circuits, data and facsimile transmissions, traffic control operations, AEI data transmissions, and relay of intelligence from defective equipment detectors. Extension of microwave communications to low density or operations support facilities is accomplished via microwave interface to buried fiber-optic or copper cables. TRAFFIC CONTROL - Of a total of 13,438 road miles operated by NS, excluding trackage rights over foreign lines, 5,274 road miles are governed by centralized traffic control systems and 2,734 road miles are equipped for automatic block system operation. COMPUTERS - Data processing facilities connect the yards, terminals, transportation offices, rolling stock repair points, sales offices and other key locations on NS to the central computer complex in Atlanta, Ga. System operating and traffic data are compiled and stored to provide customers with information on their shipments throughout the system. Data processing facilities are capable of providing current information on the location of every train and each car on line, as well as related waybill and other train and car movement data. Additionally, this facility affords substantial capacity for, and is utilized to assist management in the performance of, a wide variety of functions and services, including payroll, car and revenue accounting, billing, material management activities and controls, and special studies. OTHER - NS has extensive facilities for support of railroad operations, including freight depots, car construction shops, maintenance shops, office buildings, and signals and communications facilities. MOTOR CARRIER PROPERTY. REAL ESTATE - NAVL owns and leases real estate in support of its operations. Principal real estate holdings include NAVL's headquarters complex and warehouse and vehicle maintenance facilities in Fort Wayne, Indiana, vehicle maintenance facilities in Fontana, California, and terminal facilities in Grand Rapids, Michigan, and Great Falls, Montana. NAVL also leases facilities throughout the United States for sales offices, maintenance facilities and for warehouse, terminal and distribution center operations. EQUIPMENT - NAVL relies extensively on independent contractors (owner-operators) who supply the power equipment (tractors) used to pull NAVL trailers. Agents also provide a substantial portion of NAVL's equipment needs, particularly for the transportation of household goods, by furnishing tractors and trailers on either a permanent or an intermittent lease basis. As of December 31, 1993, agents and owner-operators together supplied 4,280 tractors, representing 71 percent of the U.S. power equipment operated in NAVL service. Also as of December 31, 1993, NAVL owned 6,981 trailer units, representing 73 percent of the U.S. trailer fleet in NAVL service. The remaining 27 percent was provided mainly by agents and owner-operators. Agents also provided 1,145 straight trucks, or 97 percent of such units in NAVL service. NAVL has an extensive program for the repair and maintenance of its trailer equipment. In 1993, work orders on approximately 18,574 trailers were completed at NAVL's facility in Fort Wayne. As of December 31, 1993, the average age of trailer equipment in the NAVL fleet was 6.7 years. COMPUTERS - NAVL relies extensively on data processing facilities for shipment planning and dispatch functions as well as shipment tracing. Data processing capabilities are also utilized in revenue processing functions, driver and agent account settlement activity, and internal accounting and record keeping service. In 1993, NAVL continued implementation of WORLDTRAC(Trademark), a satellite-based mobile communications and position-reporting system. The system allows NAVL, through computers installed in cabs, to communicate instantaneously with fleet drivers while enroute to optimize customer service and to insure customer retention. The ability to locate a driver and communicate instantly has resulted in improved equipment utilization. As of December 31, 1993, satellite units were in place on approximately 1,710 tractors throughout the NAVL fleet. This is a substantial decrease from 1992 due to the discontinuation of the CT Division's operations. ENCUMBRANCES. A substantial portion of NS' properties is subject to liens securing, as of December 31, 1993 and 1992, approximately $125.9 million and $148.5 million of mortgage debt, respectively. In addition, certain equipment is subject to the prior lien of equipment financing obligations amounting to approximately $551.4 million as of December 31, 1993, and $593.7 million at December 31, 1992. Many of the tractors utilized in NAVL service are purchased by NAVL from manufacturers and resold to agents and owner-operators under a NAVL-sponsored financing program. At December 31, 1993, NAVL had $27.1 million in such tractor contracts receivable. This program allows NAVL to generate the funds necessary to purchase the tractors and to resell them under favorable financing terms. The equipment is sold under conditional sales contracts with the agents and owner- operators. CAPITAL EXPENDITURES. During the five calendar years ended December 31, 1993, NS' capital expenditures for road, equipment and other property were as follows: NS' capital spending and maintenance programs are and have been designed to assure the Corporation's ability to provide safe, efficient and reliable transportation services. For 1994, NS is planning $634 million of capital spending, of which $627 million will be for railway projects and $7 million for motor carrier property. NS anticipates new equipment financing of approximately $72 million in 1994. Looking further ahead, rail capital spending is likely to increase moderately over the next few years. The proposed construction of a $100 million coal ground storage facility in Isle of Wight County, Va., may affect capital spending in future years. However, because of delays in the permitting process and reduced demand for export coal, any significant spending on this project is not expected until after 1994. In addition to boosting capacity, this new facility should further increase the efficiency of coal transportation service and reduce the need for new coal hopper cars. A substantial portion of future capital spending is expected to be funded through internally generated cash, although debt financing will continue as the primary funding source for equipment acquisitions. In January 1994, NS spent $71 million for coal reserves (see discussion on page 18). ENVIRONMENTAL MATTERS. Compliance with federal, state and local laws and regulations relating to the protection of the environment is a principal NS goal. To date, such compliance has not affected materially NS' capital additions, earnings, liquidity or competitive position. Costs for environmental protection for 1993 were approximately $32.9 million, of which $28.9 million were operating expenses and $4.0 million were capitalized. Such NS expenditures historically have been associated with the cleanup of real estate used for operating and nonoperating purposes, solid/hazardous waste handling and disposal, water pollution control, asbestos removal projects and removal/remediation work related to underground tanks. To promote achievement of NS' environmental objectives and to assure continuous improvement in its programs, environmental engineers perform ongoing analyses of all identified sites, and -- after consulting with counsel -- any necessary adjustments to initial liability estimates are recorded (and expensed or capitalized, as appropriate). Evaluations of other sites are ongoing. NS also has established an Environmental Policy Council, composed of senior managers, to prescribe and direct its environmental initiatives and undertake environmental awareness programs through which NS employees will receive training. Certain NS rail subsidiaries have received notices from the Environmental Protection Agency that they are potentially responsible parties under the Comprehensive Environmental Response, Compensation and Liability Act (CERCLA) which generally imposes joint and several liability for cleanup costs. State agencies also have notified certain NS rail subsidiaries that they may be potentially responsible for environmental damages, and in several instances they have agreed voluntarily to initiate cleanup. For CERCLA sites and all other known environmental incidents where loss or liability is probable, NS has recorded an estimated liability. The amount of that liability, which includes estimated costs of remediation (and any associated restoration) on a site-by-site basis, is expected to be paid over several years. Although the estimated liability usually is expensed in the year it is recorded, certain expenditures relating to real estate development projects have been capitalized. Claims, if any, against third parties for recovery of remediation costs incurred by NS are reflected as receivables in the balance sheet and not netted against the associated NS liability. Estimates of a company's potential financial exposure even for known environmental claims or incidents are necessarily imprecise because of the widely varying costs of available remediation techniques, the difficulty of determining in advance the nature and extent of contamination and each potential participant's share of an estimated loss, and evolving statutory and regulatory standards governing liability. The risk of incurring environmental liability -- for acts and omissions, both past and current -- is inherent in railroad operations. Moreover, some of the commodities, particularly those classified as hazardous materials, in NS' traffic mix can pose special risks, which NS and its subsidiaries work diligently to minimize. In addition, several NS subsidiaries have land holdings that may be leased (and operated by others) or held for sale. Because certain conditions may exist on these properties for which NS ultimately may bear some financial responsibility, there can be no assurance that NS will not incur liabilities or costs, the amount and materiality of which, to a single accounting period or in the aggregate, cannot be estimated reliably now, related to environmental problems that are latent or undiscovered. However, based on its assessments of the facts and circumstances now known and after consulting with its legal counsel, Management believes that it has recorded appropriate estimates of liability for those environmental matters of which NS is aware. At year end, a grand jury investigation was under way regarding possible violations of certain environmental statutes in 1989 at Moberly Yard, Moberly, Mo. A more detailed report of this incident, including information concerning its resolution since year end, is set forth under the heading "Item 3. Item 3. Legal Proceedings - ------ ----------------- New Orleans, Louisiana - Tank Car Fire. A number of lawsuits have been filed as a result of a tank car fire which occurred in New Orleans, La., on September 9, 1987, and resulted in the evacuation of many residents of the surrounding area. Plaintiffs allege that they were injured and sustained other economic loss when a chemical called butadiene leaked from a tank car under the control of either CSX Transportation, Inc., or New Orleans Terminal Company (a subsidiary of Norfolk Southern Railway) or both. In addition to the rail defendants, defendants in one or more of the suits include the City of New Orleans, the owner of the tank car (General American Transportation Corporation), the loader of the tank car (GATX Terminals Corporation), and the shipper (Mitsui & Co. (USA Inc.)). The suits, which are pending in the Civil District Court for the parish of Orleans, seek damages ranging from $10,000 to $20,000,000,000. Management, after consulting with its legal counsel, is of the opinion that ultimate liability will not materially affect the consolidated financial position of NS. This matter has been reported previously by Norfolk Southern in Part II, Item 1, of its Form 10-Q Reports for the quarters ending September 30, 1987, and March 31, 1990; and in Part I, Item 3, of its Form 10-K Annual Reports for 1987, 1988, 1989, 1990, 1991 and 1992. Moberly, Missouri - Burial of Paint and Solvent. On or about May 16 and May 23, 1991, respectively, certain employees and NW were served with subpoenas duces tecum requiring production of various documents and information, all related to a federal grand jury's investigation of possible violations of certain environmental statutes in 1989 at Moberly Yard, Moberly, Mo. A search warrant also was served on NW at Moberly, and various company records were seized. A second subpoena duces tecum was served on September 19, 1991, concerning the relationship between Norfolk Southern Corporation and NW. The investigation resulted from employees' having buried containers of paint and one container of solvent. NW management first learned of the incident in June 1990 from the Missouri Department of Natural Resources ("DNR"). Promptly thereafter, NW initiated appropriate remediation efforts and notified the National Response Center. The burial of paint and solvent violated long-standing NW policy and instructions. NW cooperated fully with the DNR; at year end 1993, the grand jury's investigation was continuing. The paint and paint cans (along with the single drum which contained a solvent and appears not to have leaked) and any associated contaminated dirt have been excavated and properly disposed of under the DNR's direction. On February 23, 1994, NW settled this matter with the federal and state governments by pleading guilty to a single violation of the federal Resource Conservation and Recovery Act and by making or committing to make penalty and restitution payments of up to $4,400,000. Of that amount, $1.7 million is to purchase equipment for state environmental enforcement purposes and, in line with NW's suggestion, $1.0 million is for the Katy Trail State Park which was damaged severely in the 1993 Missouri River flood. In addition, NW made certain commitments with respect to an organization-wide environmental awareness program. Management believes the February 23 settlements conclude this matter and expects to make no further reports about it. This matter has been reported previously by Norfolk Southern in Part II, Item 1, of its Form 10-Q Report for the quarter ending June 30, 1991, and in Part I, Item 3, of its Form 10-K Annual Reports for 1991 and 1992. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. - ------ ---------------------------------------------------- There were no matters submitted to a vote of security holders during the fourth quarter of 1993. Executive Officers of the Registrant. - ------------------------------------- Norfolk Southern's officers are elected annually by the Board of Directors at its first meeting held after the annual meeting of stockholders, and they hold office until their successors are elected. There are no family relationships among the officers, nor any arrangement or understanding between any officer and any other person pursuant to which the officer was selected. The following table sets forth certain information, as of March 1, 1994, relating to these officers: Business Experience during Name, Age, Present Position past 5 Years - --------------------------- ------------------------------------ David R. Goode, 53, Present position since September Chairman, President and 1992. Served as President from Chief Executive Officer October 1991 to September 1992, Executive Vice President- Administration from January to October 1991 and prior thereto as Vice President-Taxation. John R. Turbyfill, 62, Present position since June 1993. Vice Chairman Served prior thereto as Executive Vice President-Finance. R. Alan Brogan, 53, Executive Present position since December Vice President-Transportation 1992. Served as Vice President- Logistics and President-North Quality Management from April American Van Lines, Inc. 1991 to December 1992, Vice President-Material Management and Property Services from July 1990 to April 1991, and prior thereto as Vice President-Material Management. Paul R. Rudder, 61, Present position since March Executive Vice President- 1990. Served as Senior Vice Operations President-Operations from October 1989 to March 1990, and prior thereto as Vice President- Engineering. John S. Shannon, 63, Executive Present position since June 1982. Vice President-Law Thomas C. Sheller, 63, Present position since October Executive Vice President- 1991. Served prior thereto as Administration Vice President-Personnel and Labor Relations. Business Experience during Name, Age, Present Position past 5 Years - --------------------------- ------------------------------------ D. Henry Watts, 62, Executive Present position since July 1986. Vice President-Marketing Henry C. Wolf, 51, Executive Present position since June 1993. Vice President-Finance Served as Vice President-Taxation from January 1991 to June 1993, and prior thereto as Assistant Vice President-Tax Counsel. Stephen C. Tobias, 49, Senior Present position since October Vice President-Operations 1993. Served as Vice President- Strategic Planning from December 1992 to October 1993, Vice President-Transportation from October 1989 to December 1992, and prior thereto as General Manager-Western Lines. William B. Bales, 59, Vice Present position since August 1993. President-Coal Marketing Served prior thereto as Vice President-Coal and Ore Traffic. James C. Bishop, Jr., 57, Present position since August Vice President-Law 1989. Served prior thereto as Senior General Solicitor. John F. Corcoran, 53, Vice- Present position since March 1992. President-Public Affairs Served prior thereto as Assistant Vice President-Public Affairs. Thomas L. Finkbiner, 41, Present position since August 1993. Vice President-Intermodal Served as Senior Assistant Vice President-International and Intermodal from April to August 1993, and prior thereto as Assistant Vice President- International and Intermodal. James L. Granum, 57, Vice- Present position since March 1992. President-Public Affairs Served prior thereto as Assistant Vice President-Public Affairs. James A. Hixon, 40, Vice Present position since June 1993. President-Taxation Served as Assistant Vice President-Tax Counsel from January 1991 to June 1993, and prior thereto as General Tax Attorney. Business Experience during Name, Age, Present Position past 5 Years - --------------------------- ------------------------------------ Harold C. Mauney, Jr., 55, Present position since December Vice President-Quality 1992. Served as Assistant Vice Management President-Quality Management from April 1991 to December 1992, and prior thereto as General Manager- Intermodal Transportation Services. Donald W. Mayberry, 50, Present position since October 1987. Vice President-Mechanical James W. McClellan, 54, Vice Present position since October President-Strategic Planning 1993. Served as Assistant Vice President-Corporate Planning from March 1992 to October 1993, and prior thereto as Director- Corporate Development. Kathryn B. McQuade, 37, Present position since December Vice President-Internal Audit 1992. Served as Director-Income Tax Administration from May 1991 to December 1992, and prior thereto as Director-Federal Income Tax Administration. Charles W. Moorman, 42, Vice Present position since October President-Information 1993. Served as Vice President- Technology Employee Relations from December 1992 to October 1993, Vice President-Personnel and Labor Relations from February to December 1992, Assistant Vice President-Stations, Terminals and Transportation Planning from March 1991 to February 1992, Senior Director Transportation Planning from March 1990 to March 1991, and prior thereto as Director, Transportation Planning. Phillip R. Ogden, 53, Vice Present position since December President-Engineering 1992. Served as Assistant Vice President-Maintenance from November 1990 to December 1992, Chief Engineer-Line Maintenance North from February 1989 to November 1990, and prior thereto as Chief Engineer-Program Maintenance. Business Experience during Name, Age, Present Position past 5 Years - --------------------------- ------------------------------------ L. I. Prillaman, Jr., 50, Present position since December Vice President-Properties 1992. Served as Vice President and Controller from May 1988 to December 1992 and prior thereto as Vice President-Accounting. Magda A. Ratajski, 43, Vice Present position since July 1984. President-Public Relations John P. Rathbone, 42, Vice Present position since December President and Controller 1992. Served as Assistant Vice President-Internal Audit from January 1990 to December 1992, and prior thereto as Director- Internal Audit. William J. Romig, 49, Vice Present position since April 1992. President and Treasurer Served prior thereto as Assistant Vice President-Finance. Donald W. Seale, 41, Vice Present position since August 1993. President-Merchandise Served as Assistant Vice Marketing President-Sales and Service from May 1992 to August 1993, Director- Metals, Waste and Construction from March 1990 to May 1992, and prior thereto as Director- Marketing Development. Powell F. Sigmon, 54, Vice Present position since October President-Safety, Environ- 1993. Served as Assistant Vice mental and Research President-Mechanical (Car) from Development January 1991 to October 1993, and prior thereto as General Manager- Mechanical Facilities. Donald E. Middleton, 63, Present position since June 1982. Corporate Secretary PART II Item 5. Item 5. Market for Registrant's Common Stock and Related - ------- ------------------------------------------------ Stockholder Matters. ------------------- NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES STOCK PRICE AND DIVIDEND INFORMATION The common stock of Norfolk Southern Corporation, owned by 51,884 stockholders of record as of December 31, 1993, is traded on the New York Stock Exchange with the symbol NSC. The following table shows the high and low sales prices and dividends per share, by quarter, for 1993 and 1992. Item 6. Item 6. Selected Financial Data. - ------- ----------------------- Item 6. Selected Financial Data. (continued) - ------- ----------------------- Item 6. Selected Financial Data. (continued) - ------- ----------------------- Item 6. Selected Financial Data. (continued) - ------- ----------------------- Item 7. Item 7. Management's Discussion and Analysis of Financial - ------- ------------------------------------------------- Condition and Results of Operations. ----------------------------------- See pages 48 - 61 for "Management's Discussion and Analysis of Financial Condition and Results of Operations." Item 8. Item 8. Financial Statements and Supplementary Data. - ------- ------------------------------------------- Item 8. Financial Statements and Supplementary Data. (continued) - ------- ------------------------------------------- The Index to Financial Statement Schedules appears in Item 14 on page 42. The financial statements and related documents for Norfolk Southern Corporation and Subsidiaries are as follows: Index to Financial Statements: Page ----------------------------- ---- Consolidated Statements of Income Years ended December 31, 1993, 1992 and 1991 62-63 Consolidated Balance Sheets As of December 31, 1993 and 1992 64 Consolidated Statements of Cash Flows Years ended December 31, 1993, 1992 and 1991 65-66 Consolidated Statements of Changes in Stockholders' Equity Years ended December 31, 1993, 1992 and 1991 67 Notes to Consolidated Financial Statements 68-87 Independent Auditors' Report 88 Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting - ------- ----------------------------------------------------------- and Financial Disclosure. ------------------------ None. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant. - ------- -------------------------------------------------- Item 11. Item 11. Executive Compensation. - ------- ---------------------- Item 12. Item 12. Security Ownership of Certain Beneficial Owners - ------- ----------------------------------------------- and Management. -------------- and Item 13. Item 13. Certain Relationships and Related Transactions. - ------- ---------------------------------------------- In accordance with General Instruction G(3), the information called for by Part III is incorporated herein by reference from Norfolk Southern's definitive Proxy Statement, to be dated April 4, 1994, for the Norfolk Southern Annual Meeting of Stockholders to be held on May 12, 1994, which definitive Proxy Statement will be filed electronically with the Commission pursuant to Regulation 14A. The information regarding executive officers called for by Item 401 of Regulation S-K is included in Part I beginning on page 30 under "Executive Officers of the Registrant." PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on - ------- ------------------------------------------------------- Form 8-K. -------- (a) The following documents are filed as part of this report: 1. Financial Statement Schedules: The following consolidated financial statement schedules should be read in connection with the consolidated financial statements: Index to Consolidated Financial Statement Schedules Page --------------------------------------------------- ---- Schedule V - Property, Plant and Equipment 89 Schedule VI - Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment 90 Schedule VII - Guarantees of Securities of Other Issuers 91 Schedule VIII - Valuation and Qualifying Accounts 92-93 Schedule IX - Short-Term Borrowings 94 Schedule X - Supplementary Income Statement Information 95 Schedules other than those listed above are omitted for the reasons that they are not required, are not applicable or the information is included in the consolidated financial statements or related notes. 2. Exhibits Exhibit Number Description - ------- ------------------------------------------------- 3 Articles of Incorporation and Bylaws - 3(a) The Restated Articles of Incorporation of Norfolk Southern are incorporated herein by reference from Exhibit 1 of Norfolk Southern's Form 10-Q report for the quarter ended September 30, 1989. 3(b) The Bylaws of Norfolk Southern, as last amended January 25, 1994, are incorporated herein by reference from Exhibit 4 of Norfolk Southern's Registration Statement on Form S-8, filed electronically on January 26, 1994. Item 14. Exhibits, Financial Statement Schedules, and Reports on - ------- ------------------------------------------------------- Form 8-K. (continued) -------- Exhibit Number Description - ------- ------------------------------------------------- 4 Instruments Defining the Rights of Security Holders, Including Indentures - In accordance with Item 601(b)(4)(iii) of Regulation S-K, copies of instruments of Norfolk Southern and its subsidiaries with respect to the rights of holders of long-term debt are not filed herewith, or incorporated by reference, but will be furnished to the Commission upon request. 10 Material Contracts - (a) The Agreement of Merger and Reorganization dated as of July 31, 1980, among NWS Enterprises, Inc. (name changed to Norfolk Southern Corporation by Certificate of Amendment issued by the State Corporation Commission of Virginia on November 2, 1981), NW, Norfolk and Western Railroad Company of Virginia, Southern Railway Company (name changed to Norfolk Southern Railway Company by Certificate of Amendment issued by the State Corporation Commission of Virginia as of December 31, 1990), and Southern Railroad Company of Virginia and the related Plans of Merger (Exhibits B and C to the Agreement) are incorporated herein by reference from Appendix A to NW's and Southern's definitive Proxy Statements dated October 1, 1980, for NW's and Southern's Special Meetings of Stockholders held on November 7, 1980. (b) The lease between The Cincinnati, New Orleans and Texas Pacific Railway Company, a subsidiary of Norfolk Southern Railway, as lessee, and the Trustees of the Cincinnati Southern Railway, as lessor, dated as of October 11, 1881, is incorporated herein by reference from Exhibit 5 of Southern's 1980 Annual Report on Form 10-K. The Supplementary Agreement to the lease, dated as of January 1, 1987, is incorporated herein by reference from Exhibit 10(b) of Southern's 1987 Annual Report on Form 10-K. Item 14. Exhibits, Financial Statement Schedules, and Reports on - ------- ------------------------------------------------------- Form 8-K. (continued) -------- Exhibit Number Description - ------- ------------------------------------------------- (c) The lease between The North Carolina Railroad Company, as lessor, and Norfolk Southern Railway, as lessee, dated as of January 1, 1896, is incorporated herein by reference from Exhibit 6 of Southern's 1980 Annual Report on Form 10-K. (d) The lease between Atlantic and North Carolina Railroad Company (The North Carolina Railroad Company, successor by merger, September 29, 1989), as lessor, and Atlantic and East Carolina Railway Company, a subsidiary of Norfolk Southern Railway, as lessee, dated as of April 20, 1939, is incorporated herein by reference from Exhibit 7 of Southern's 1980 Annual Report on Form 10-K. Management Compensation Plans ----------------------------- (e) The Norfolk Southern Corporation Management Incentive Plan is incorporated herein by reference from Exhibit 10(h) of Norfolk Southern's 1987 Annual Report on Form 10-K. (f) The Norfolk Southern Corporation Long-Term Incentive Plan is incorporated herein by reference from Appendix A to Norfolk Southern's definitive Proxy Statement dated April 3, 1989, for the Norfolk Southern Annual Meeting of Stockholders held May 11, 1989. (g) A copy of the Norfolk Southern Corporation Officers' Deferred Compensation Plan as amended effective January 1, 1994. (h) A copy of the Directors' Deferred Fee Plan of Norfolk Southern Corporation as amended effective January 1, 1994. (i) The Norfolk Southern Corporation Directors' Restricted Stock Plan effective January 26, 1994, is incorporated herein by reference from Exhibit 99 to Norfolk Southern's Form S-8 filed electronically on January 26, 1994. Item 14. Exhibits, Financial Statement Schedules, and Reports on - ------- ------------------------------------------------------- Form 8-K. (continued) -------- Exhibit Number Description - ------- ------------------------------------------------- (j) The Excess Benefit Plan of Norfolk Southern Corporation and Participating Subsidiary Companies is incorporated herein by reference from Exhibit 10(k) of Norfolk Southern's 1988 Annual Report on Form 10-K. (k) The Directors' Pension Plan of Norfolk Southern Corporation is incorporated herein by reference from Exhibit 10(l) of Norfolk Southern's 1989 Annual Report on Form 10-K. 11 Computation of Earnings Per Share 12 Computation of Ratio of Earnings to Fixed Charges 21 Subsidiaries of the Registrant. 23 Consents of Experts and Counsel - Consent of Independent Auditors. (b) Reports on Form 8-K. No reports on Form 8-K were filed for the three months ended December 31, 1993. (c) Exhibits. The Exhibits required by Item 601 of Regulation S-K as listed in Item 14(a)2 are filed herewith or incorporated herein by reference. (d) Financial Statement Schedules. Financial statement schedules and separate financial statements specified by this Item are included in Item 14(a)1 or are otherwise not required or are not applicable. POWER OF ATTORNEY ----------------- Each person whose signature appears below under "SIGNATURES" hereby authorizes Henry C. Wolf and John S. Shannon, or either of them, to execute in the name of each such person, and to file, any amendment to this report and hereby appoints Henry C. Wolf and John S. Shannon, or either of them, as attorneys-in-fact to sign on his or her behalf, individually and in each capacity stated below, and to file, any and all amendments to this report. SIGNATURES ---------- Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Norfolk Southern Corporation has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on this 22nd day of March, 1994. NORFOLK SOUTHERN CORPORATION By /s/ David R. Goode ----------------------------------------- (David R. Goode, Chairman, President and Chief Executive Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below on this 22nd day of March, 1994, by the following persons on behalf of Norfolk Southern Corporation and in the capacities indicated. Signature Title --------- ----- /s/ David R. Goode - ------------------------------ Chairman, President and Chief (David R. Goode) Executive Officer and Director (Principal Executive Officer) /s/ Henry C. Wolf - ------------------------------ Executive Vice President-Finance (Henry C. Wolf) (Principal Financial Officer) /s/ John P. Rathbone - ------------------------------ Vice President and Controller (John P. Rathbone) (Principal Accounting Officer) /s/ Gerald L. Baliles - ------------------------------ Director (Gerald L. Baliles) Signature Title --------- ----- /s/ Gene R. Carter - ------------------------------ Director (Gene R. Carter) /s/ L. E. Coleman - ------------------------------ Director (L. E. Coleman) - ------------------------------ Director (William J. Crowe, Jr.) /s/ T. Marshall Hahn, Jr. - ------------------------------ Director (T. Marshall Hahn, Jr.) /s/ Landon Hilliard - ------------------------------ Director (Landon Hilliard) /s/ E. B. Leisenring, Jr. - ------------------------------ Director (E. B. Leisenring, Jr.) /s/ Arnold B. McKinnon - ------------------------------ Director (Arnold B. McKinnon) /s/ Robert E. McNair - ------------------------------ Director (Robert E. McNair) /s/ Jane Margaret O'Brien - ------------------------------ Director (Jane Margaret O'Brien) /s/ Harold W. Pote - ------------------------------ Director (Harold W. Pote) (ITEM 7) NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis should be read in conjunction with the Consolidated Financial Statements and Notes beginning on page 62 and the Ten-Year Financial Review on page 35. The Condensed Summary provides a brief overview of results of operations, and the text beginning under "Results of Operations" is a more detailed analytical discussion. CONDENSED SUMMARY OF RESULTS OF OPERATIONS 1993 Compared with 1992 - ----------------------- Net income was $772.0 million in 1993, a substantial increase over the $557.7 million reported in 1992. Earnings per share were $5.54 compared with $3.94 in 1992. Results for 1993 were significantly affected by required accounting changes (see Note 1 on page 68) and by an increase in the federal income tax rate (see Note 2 on page 70). Excluding the impact of the accounting changes and the federal tax rate increase related to prior years, 1993 earnings would have been $594.9 million, or $4.27 per share, a $37.2 million, or 7%, increase over 1992. Total transportation operating revenues decreased 3%, compared with 1992. Railway operating revenues declined 1%, primarily as a result of lower coal traffic levels and a reduced share of certain intermodal revenues after formation of a partnership with Consolidated Rail Corporation (Conrail). Motor carrier operating revenues declined 14%, due to a restructuring of NAVL (see Note 3 on page 74), which resulted in the disposition of two of its businesses. Total transportation operating expenses declined 3%, largely a result of the restructuring of NAVL. Nonoperating income reflected in the Consolidated Statements of Income as "Other income-net" rose $39.0 million due principally to gains from property and stock sales (see Note 4 on page 74). 1992 Compared with 1991 - ----------------------- Net income was $557.7 million in 1992, a significant increase over the $29.7 million reported in 1991. Earnings per share were $3.94, compared with $0.20 in 1991. Earnings in 1991 were adversely affected by a $680 million special charge. Excluding the impact of the special charge in 1991, 1992 earnings increased by $30.3 million, or 6%, compared with 1991. Total transportation operating revenues were up 3%, compared with 1991; railway operating revenues were up 3% despite a decline in coal traffic, and motor carrier operating revenues increased 4%. Total railway operating expenses were down less than half of 1%, compared with 1991 (excluding the special charge). Motor carrier operating expenses increased 9% and resulted in an operating loss of $39.7 million. Nonoperating income declined $33.5 million, reflecting lower interest income on less cash available to invest, lower interest rates and reduced gains on investment-related transactions (see Note 4 on page 74). Interest expense on debt was up 9% due to new debt issues (see Note 8 on page 76). RESULTS OF OPERATIONS Railway Operating Revenues - -------------------------- Railway operating revenues were $3.75 billion in 1993, compared with $3.78 billion in 1992 and $3.65 billion in 1991. The following table presents a three-year comparison of revenues by market group and reflects (in Intermodal) the effect of the formation in April 1993 of Triple Crown Services Company (TCSC), a partnership between NS and Conrail subsidiaries. This partnership provides RoadRailer(RT) and domestic container services previously offered by a wholly owned NS subsidiary. Because NS owns only 50% of TCSC, its revenues are not consolidated, and NS' intermodal revenues include only revenues for rail service provided by NS to the partnership. Excluding this partnership effect, intermodal revenues would have increased 10%, and total railway operating revenues would have increased 1%. NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations Most NS rail traffic, particularly coal traffic, moves under contractually negotiated rates as opposed to the typically higher regulated tariff rates. In 1993, 91% of NS origin coal moved under contract, compared with 88% in 1992 and 90% in 1991. Traffic volume increased for all market groups except coal. The large reduction in revenue per unit/mix was due principally to the effect of the TCSC partnership described above. The remaining reduction in the average revenue per car was largely due to new business that was short- haul and lowered the overall average. NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations COAL (which includes coke and iron ore) traffic volume in 1993 decreased 6%, and revenues, which represented 32% of total railway operating revenues, were down 6% from 1992. Coal accounted for about 97% of this market group's volume, and 95% of coal shipments originated on NS' lines. As shown in the following table, small tonnage gains in utility and steel coal were more than offset by declines in export coal, down 22%, compared with 1992. The export coal market continues to be weak. The recession in Europe deepened as the year progressed. Additionally, stockpiles remain at high levels in the United Kingdom, and two Italian coal-fired generating stations that closed in 1992 remained closed for all of 1993. The UMWA strike, which was settled in December 1993, also had an adverse effect on the export market, as some U.S. producers deferred export shipments to take advantage of higher domestic spot market prices. Although the strike was not widespread at mines served by NS, it idled four operations that are heavily oriented toward export shipments. NS' export coal business is expected to remain somewhat depressed in 1994. Expanded coal output and export capacity by foreign producers may make this market very competitive, especially for steam coal. Export coal opportunities for NS are expected to continue to be greatest in Europe, and moderate growth is expected over the next five-year period. In contrast to the export market, domestic coal remained steady. Extended periods of warmer-than-usual temperatures in the Southeast resulted in increased business for a number of utility customers. NS was able to provide coal service to some whose customary carriers were adversely affected by flooding in the Midwest and the UMWA strike. NS continued to do well in domestic steel markets, especially in the Midwest. While total volumes in the domestic steel market remained relatively flat, compared with 1992, NS was able to increase its market share. The outlook for domestic NS coal traffic remains promising. New movements of western coal to an eastern utility began late in 1993 and are expected to reach 3 million tons in 1994 and to grow to nearly 7 million tons annually in the next few years. Changes in emissions regulations for sulfur dioxide included in the Clean Air Act Amendments of 1990 may increase NS utility traffic. Coal volume in 1992 decreased 2%, compared with 1991, and revenues were down 3% from 1991. Traffic volume in 1991 represented NS' second best year since the 1982 consolidation. As shown in the table above, NS had mixed results in 1992 in the four basic coal market segments it serves. The largest decline in coal tonnage was in export coal, down 8%, compared with 1991. Beginning in 1992, the European economies slumped badly, reducing demand for U.S. coal in both steel and electricity production. Domestic utility tonnages showed the second greatest decline, 2% below 1991, reflecting weakness in the overall economy and unusually mild weather in NS' service region. On the positive side, coal traffic to domestic steel companies in 1992 showed improvement. Compared with 1991, tonnage increased 15%, and NS increased its market share. NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations MERCHANDISE TRAFFIC volume in 1993 increased 6%, and revenues (excluding, for comparative purposes, the effect of the TCSC partnership with Conrail) increased by $104.6 million, or 5%, compared with 1992. Merchandise carloads handled in 1993 were 2.8 million, compared with 2.7 million in 1992. Despite the slow economic recovery, all six market groups comprising merchandise traffic showed revenue improvement over 1992. The largest gains were in intermodal, up $34.1 million, or 10% (excluding the TCSC effect); automotive, up $28.0 million, or 7%; and metals/construction, up $19.8 million, or 7%. PAPER/FOREST traffic was about even with 1992, and revenues increased 1%. Weak domestic and overseas demand for paper depressed NS' shipments for much of the year. Lumber, however, posted a solid 4% revenue gain due to a strong recovery in housing construction. Moderate growth, somewhat higher than industry production, is expected over the next few years due to growth in market share. CHEMICALS traffic rose 4% over 1992; however, revenues increased less than 1% due to a change in the mix of traffic. There were solid gains in general chemicals and plastics, but this was offset by weakness in movements of export fertilizer due to sluggish conditions overseas. Stronger growth is expected in 1994 and beyond, paced by additional rail- truck distribution facilities for bulk chemicals. While environmental concerns could adversely affect production of pesticides and chlorine, increased environmental awareness is likely to have a positive impact on movements of recyclables, hazardous wastes and alternative fuels such as ethanol. AUTOMOTIVE traffic rose 8%, and revenues increased 7%, compared with 1992. The gain was due to strong demand for vehicles produced at plants served by NS. NS' largest customer, Ford Motor Company, produced the top- selling automobile and truck in 1993. In addition, NS benefited from a full year of production at the Ford/Nissan plant located near Avon Lake, Oh. Successful marketing efforts, such as an innovative program with GM for just-in-time movement of auto parts, also contributed to the higher traffic levels. Further growth in automotive traffic is expected in 1994 and beyond, as U.S. automotive production is anticipated to increase for the next few years. From 1994 to 1997, operations will begin at three new or expanded automotive assembly plants located on NS' lines: the second Toyota plant at Georgetown, Ky., in 1994; BMW at Greer, S.C., in 1995; and Mercedes-Benz at Tuscaloosa, Al., in 1997. The retooling of GM's Wentzville, Mo., and Doraville, Ga., plants for van production should also increase traffic. AGRICULTURE traffic rose 4%, and revenues increased 6%, compared with 1992. In the early part of the year, NS benefited from a record harvest that continued well into 1993. During the summer, the flood in the Midwest diverted traffic to rail that formerly moved by barge. In the fall, good crop conditions in NS' sourcing areas and poor conditions elsewhere produced strong NS traffic gains. Although the special conditions present during 1993 are not likely to recur in 1994, a small increase in agriculture revenues is expected, driven by growth in poultry production in the Southeast, a prime NS feed grain market. METALS/CONSTRUCTION traffic rose 9%, and revenues increased 7%, compared with 1992. Most of the revenue gain was in shipments of iron and steel; strong industry production and new plants located on NS' lines boosted revenue $10 million. Shipments of construction commodities were also strong due to a recovery in housing. Further gains are expected over the next few years, as NS has initiatives under way intended to win back truck business in aluminum, and several new movements of municipal solid waste are expected. NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations INTERMODAL traffic rose 9%, and revenues (adjusted for the effect of the TCSC partnership) increased 10%, compared with 1992. Intermodal revenue growth in 1993 was led by a 21% increase in Triple Crown(RT) activity due to strong automotive shipments and expansion of service to the Northeast. Container revenues were up 6%, a smaller increase than previous years, reflecting reduced international traffic caused by continuing recessions in Europe and Japan. Trailer revenues were up 11%, boosted by gains from haulage arrangements with truckload carriers. Strong growth in intermodal traffic is expected in 1994 and for the next several years. TCSC should continue to grow as it expands to serve additional markets. Container traffic is expected to improve as recoveries overseas produce steady growth in international shipments. Trailer business also is expected to grow, as leading truckload carriers, such as Schneider National and J.B. Hunt, use rail for the long-haul portion of their shipments. During 1992, all six merchandise market groups showed improvement over 1991. Traffic volume increased 6% and revenues increased $159.4 million, or 7%. The largest revenue increases were in the automotive group, up $75.6 million, or 23%, over a weak 1991. The intermodal group was up $28.3 million, or 7%, over 1991, and the paper/forest and chemicals groups each reported 5% revenue gains. The growth in the automotive group was the result of a national rise in automobile production, especially increased production of popular models at plants which NS serves. All segments of intermodal traffic showed growth during 1992. Triple Crown(RT) (now TCSC), the fastest growing segment, which accounted for 24% of intermodal traffic, began a new domestic container service in the eastern part of the NS system, in addition to its RoadRailer(RT) business. Paper/forest revenues improved as the result of increased housing starts and greater paper production. Chemical revenues were higher because of a general recovery in chemical production over the recessionary levels of 1991. Transportation Operating Expenses - --------------------------------- Transportation operating expenses decreased 3% in 1993, compared with 1992, and decreased 14% in 1992, compared with 1991. Included in 1993's expenses was a $50.3 million charge for restructuring NAVL's operations (see motor carrier discussion on page 55). Included in 1991's expenses was a $680.0 million special charge discussed below. Excluding the 1993 restructuring charge and the 1991 special charge, transportation operating expenses decreased 5% in 1993, compared with 1992, and increased 2% in 1992, compared with 1991. SPECIAL CHARGE IN 1991 (see Note 15 on page 85): By the end of 1991, after several years of negotiations and a brief nationwide strike, new rail labor agreements were in place that allowed NS to begin operating trains with reduced crew sizes. The agreements also provide for future crew size reductions. To achieve the reductions in employment and other labor savings permitted by the new agreement, NS recorded a special charge that included $450 million to cover the cost of future separation payments, protective payments and amounts to buy out productivity funds. The special charge, which totalled $680 million, also included $187 million to write down the goodwill portion of NS' investment in NAVL and a $43 million write-down of certain properties to be sold or abandoned. NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations The following table compares, on a year-to-year basis, railway operating expenses summarized by major classifications. The special charge also is summarized, as well as comparative railway operating expenses, excluding the special charge. The narrative expense analysis presented in the following paragraphs focuses on the major factors contributing to changes in railway operating expenses, excluding the effects of the 1991 special charge discussed above and in Note 15 on page 85. COMPENSATION AND BENEFITS, which includes salaries, wages and fringe benefits, represents about half of total railway operating expenses and increased 1% in 1993, compared with 1992, and declined 2% in 1992, compared with 1991. The higher expenses in 1993 were mainly due to accruals for postretirement and postemployment benefits which were previously accounted for on a pay-as-you-go basis (see "Required Accounting Changes" in Note 1 on page 68) and higher costs for stock- based compensation plans. A voluntary early retirement program was completed in 1993, which resulted in a $42.4 million charge in compensation and benefits expense (see Note 11 on page 80). Also in 1993, a $46 million credit was recorded in compensation and benefits, reflecting a partial reversal of the 1991 special charge (see Note 15 on page 85). Labor expenses were favorably affected by a lower average train crew size, which was 2.6 in 1993, a moderate decline compared with 1992. The lower expenses in 1992, compared with 1991, were mainly due to savings associated with reduced train crew sizes. The average train crew size in 1992 was 2.7 compared with 3.5 in 1991. MATERIALS, SERVICES AND RENTS consists of items used for maintenance of road (rail line and related structures) and equipment (locomotives and freight cars); equipment rents representing the cost to NS of using freight equipment owned by other railroads or private owners, less the rent paid to NS for the use of its equipment; and the cost of services purchased from outside contractors, including the net costs of operating joint (or leased) facilities with other railroads. This category had the largest decrease in 1993, compared with 1992, down 6%, but was up 10% in 1992, compared with 1991. The decrease in 1993 was largely due to the absence of certain expenses which, NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations subsequent to March 31, 1993, were incurred by TCSC (see discussion on page 48). The increase in 1992 largely was a result of that year's greatly expanded equipment maintenance program. Also contributing to the 1992 increase were higher roadway maintenance activity, increased gross ton miles, and accruals related to a lease with Canadian National Railway. DEPRECIATION expense (see Note 1 "Properties" on page 68 for NS' depreciation policy) was up 7% in 1993, compared with 1992, and up 5% in 1992, compared with 1991. The increases in both periods were due to property additions, reflecting substantial levels of capital spending during the three-year period ended December 31, 1993. DIESEL FUEL costs declined 2% in 1993, compared with 1992, and declined 5% in 1992, compared with 1991. NS consumes substantial quantities of diesel fuel; therefore, changes in price per gallon or consumption have a significant impact on the cost of providing transportation services. The lower costs in 1993 were due to a lower price per gallon, offset in part by a 2% increase in consumption related to the 3% increase in gross ton miles. Expenses declined in 1992, compared with 1991, mainly due to a lower price per gallon offset partially by increased consumption. CASUALTIES AND OTHER CLAIMS (which includes insurance costs, estimates of costs related to personal injury, property damage and environmental- related costs) declined 2% in 1993, compared with 1992, and decreased 22% in 1992, compared with 1991. By far the largest component, personal injury expenses, which relate primarily to the cost of on-the-job employee injuries, has shown favorable trends since 1990, reflecting both success in reducing accidental employee injuries and effective claims handling. Unfortunately, the favorable trend in accidental injury claims has been more than offset by increased costs of nonaccidental "occupational" claims. The rail industry remains uniquely susceptible to both accidental injury and occupational claims because of an outmoded law, the Federal Employers' Liability Act (FELA), originally passed in 1908 and applicable only to railroads. This law provides the sole basis for compensating railroad employees who sustain job-related injuries. Under the FELA, claimants unable to reach an agreement with the railroad concerning compensation may file a civil suit to recover damages. In most cases, a jury must then determine whether the claimant is entitled to any damages and, if so, the amount. The system produces results that are unpredictable, inconsistent and frequently unfair, at a cost to the rail industry that is two or three times greater than the no-fault workers' compensation systems to which nonrail competitors are universally subject. The railroads have been unsuccessful so far in efforts to persuade Congress to replace the FELA with a no-fault workers' compensation act. OTHER expenses decreased 3% in 1993, compared with 1992, and 7% in 1992, compared with 1991. These decreases were largely the result of favorable settlements of issues related to property and other state taxes. The NS railway operating ratio (the percentage of railway operating revenues consumed by railway operating expenses) continues to be the best among the major railroads in the United States. NS will continue to pursue cost-containment efforts to assure that its rail subsidiaries are operated efficiently. The operating ratios for past six years were as follows: NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations Other Income-Net - ---------------- Nonoperating income increased $39.0 million, or 40%, in 1993, compared with 1992, but decreased $33.5 million, or 26%, in 1992, compared with 1991 (see Note 4 on page 74). The 1993 increase principally arose from gains on stock and property sales. The 1992 decline was a result of an absence of stock sales in 1992, coupled with a decline in interest income due to lower cash and short-term investments balances and lower rates. Interest Expense on Debt - ------------------------ Interest expense on debt decreased 10%, compared with 1992, due principally to lower levels of equipment debt and lower interest rates on NS' commercial paper. Interest expense increased 9% from 1991 to 1992 mainly as a result of an additional $250 million of notes issued under NS' shelf registration statement and new equipment debt (see Note 8 on page 76). MOTOR CARRIER RESULTS Motor Carrier operations resulted in a loss of $54.9 million in 1993, compared with a loss of $39.7 million in 1992 and income of $0.2 million in 1991. Despite significant turnaround efforts, NAVL's persistently poor performance in its general commodities operations led to a decision to restructure its operations in 1993, which resulted in the disposition of two of its businesses. The Commercial Transport Division (CT), a truckload carrier, was liquidated, and Tran-Star (TS), a refrigerated carrier, was sold. A restructuring charge of $50.3 million was recorded in 1993, reflecting costs to discontinue these businesses, including projected operating losses during the phase-out period, as well as labor, equipment and facility-related costs. The large operating loss reported in 1993 was almost entirely attributable to the restructuring charge. However, results of the two remaining divisions produced an operating profit of $14.4 million in 1993. Contributing principally to the loss in 1992 were actuarially determined increases in reserves for casualty claims and workers' compensation, which added $27 million to operating expenses, and accruals for litigation. The following table presents a three-year comparison of revenues by principal operations. Prior year amounts have been reclassified to reflect the transfer of a subsidiary from the RS Division to the HVP Division. NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations RS' revenues depend on four primary segments of household goods' transportation: corporate national accounts, interstate C.O.D. movements, military and international relocations. RS' 1993 revenues were even with 1992, and increased 1% in 1992, compared with 1991. Revenues in 1993 were adversely affected by a decline in domestic military volume and fewer Canadian shipments. These decreases were offset largely by a modest rate increase and gains in the international household relocation segment. The increase in 1992 revenues was due to modest rate increases and some improvement in domestic household goods shipments. The continued downsizing of U.S. corporations and changes in policy relative to military staffing levels are likely to result in ongoing pressure on this division's operating revenues. HVP's main line of business is transporting office products and other sensitive equipment, as well as exhibits and displays. The division also is capitalizing on its specialized handling expertise to generate new revenues in the Customized Logistics Services (CLS) segment. HVP's revenues increased 8% in 1993, compared with 1992, and in 1992, compared with 1991. The increase in 1993 was due to the award of a significant logistics contract by IBM, and also to the expansion of air freight services into several new markets. The increase in 1992 was the result of additional interstate transportation activity reflecting some improvement in the demand for office products and an increase in revenues from European subsidiary operations. HVP may benefit from a continued increase in demand for office products; however, a trend toward smaller shipment sizes will subject this operation to increasing competition from LTL (less than truckload) carriers. Significant future revenue growth in the CLS segment is possible as more shippers look to carriers like NAVL to provide logistics expertise to reduce their overall shipping and handling costs. CT's and TS' revenues for 1993 are reflected only through June 30, 1993. A decision to discontinue these businesses was made, and accordingly, results subsequent to June were charged to the reserve established for the restructuring. Motor carrier operating expenses as a percentage of revenues were 108%, 105% and 100%, respectively, in 1993, 1992 and 1991. Overall, the negative operating ratio was caused by the losses sustained in the truckload operations, which more than offset the positive results of RS and HVP. The high operating ratio in 1993 was primarily due to the restructuring charge and in 1992 to increased reserves for casualty claims, litigation and workers' compensation. NAVL's continuing operations (excluding CT and TS) achieved a 97% operating ratio in 1993, as compared to 102% in 1992 and 96% in 1991. Excluding insurance reserve adjustments, the 1992 operating ratio would have been 99%. Due to deregulation and overcapacity in the industry, motor carriers will continue to face vigorous competition that will keep profits at a modest level. For RS, contract carriage and volume discount programs dominate the corporate relocation segment, and guaranteed price options are common in the individual consumer segment. Contract carriage agreements also are utilized by HVP to meet customers' service and price requirements. However, given the elimination of unprofitable businesses, NAVL is now positioned to compete in these markets, as well as to expand where opportunities such as providing customized logistics solutions present themselves. Income Taxes - ------------ Income tax expense in 1993 was $349.9 million for an effective rate of 38.9%, compared with an effective rate of 36.3% in 1992 and 36.0% in 1991, excluding the special charge. Income tax expense in 1993 was accrued under SFAS 109, rather than under the prior accounting rules (see Note 1 on page 68). Absent the federal income tax rate increase imposed by the Revenue Reconciliation Act of 1993, income tax expense in 1993 would have been $295.8 million for an effective rate of 32.9%. This low effective rate was partly due to tax benefits related to the motor carrier restructuring (see Note 3 on page 74). Current income tax expense increased from $253.5 million in 1992 to $293.7 million in 1993, primarily due to tax payments made in anticipation of Revenue Agent Reports for the 1988-1989 federal income tax audit. Deferred tax expense for 1993, compared to 1992, decreased primarily for the same reason. NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations Current and deferred tax expenses for 1991 were affected significantly by the special charge. Much of the tax benefit resulting from this charge was not deductible in 1991 and therefore was recorded as a deferred tax benefit. Excluding the payment discussed above and the federal tax rate increase, the portion of the special charge that reversed in 1993 and 1992, combined with property-related adjustments, including depreciation, were the principal causes for the increase in deferred tax expense over the 1991 level. As a result of changes in tax law that limit or defer the timing of deductions and recent tax rate increases, NS expects current taxes to remain high in relation to pretax earnings (see Note 2 on page 70 for the components of income tax expense). Required Accounting Changes - --------------------------- Effective January 1, 1993, NS adopted required accounting for postretirement benefits other than pensions, postemployment benefits and income taxes (see Note 1 on page 68 for a discussion of these accounting changes). The net cumulative effect of these noncash adjustments increased 1993's net income by $223.3 million, or $1.60 per share. The balance sheet effects of these accrual adjustments are reflected primarily in "Other liabilities" for the postretirement and postemployment benefits and in "Deferred income taxes" for the income tax accounting change. FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES FINANCIAL CONDITION refers to the assets, liabilities and stockholders' equity of an organization, including the value of those individual elements in relation to each other. Generally, financial condition is evaluated at a point in time using an organization's balance sheet (see page 64). LIQUIDITY refers to the ability of an organization to generate adequate amounts of cash, principally from operating results or through borrowing power (based on net income or financial condition), to meet its short-term and long-term cash requirements. CAPITAL RESOURCES refers to the ability of an organization to attract investors through the sale of either debt or equity (stock) securities. CASH PROVIDED BY OPERATING ACTIVITIES, which is NS' principal source of liquidity, declined 9% in 1993, compared with 1992, but was up 26% in 1992, compared with 1991. These fluctuations were primarily due to the timing of income tax payments. In 1993, tax payments were $139.9 million higher than in 1992, due to payments related to the 1988-1989 federal income tax audit, higher 1993 earnings and the fact that 1992's tax payments were low. In 1992, tax payments were $74.1 million less than 1991, primarily due to the higher tax payments in 1991 related to the federal income tax audit for 1986 and 1987, and to estimated tax payments in 1991 utilized in 1992. NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations Implementation of the labor portion of the 1991 special charge also contributed to the fluctuations in cash provided by operations. In 1993, only $36.1 million was used for labor costs related to the special charge, compared with $134.7 million in 1992 and $108.0 million in 1991. The decline in 1993 was partly due to the failure to reach agreement on terms for certain further labor savings. This situation also led to a partial reversal of the 1991 special charge (see discussion in Note 15 on page 85). Looking ahead, the labor portion of the special charge is expected to continue to require the use of cash to achieve productivity gains permitted by the agreements, although at a level somewhat lower than previously anticipated. NS regards this cash outflow as an investment because, in view of the high cost of labor and fringe benefits, these payments are expected to produce significant future labor savings. It is estimated that NS' labor-related payments will be reduced by about $150 million per year upon full implementation of the new labor agreements. Since the NS consolidation in 1982, cash provided by operating activities has been sufficient to fund dividend requirements, debt repayments and a significant portion of capital spending (see Consolidated Statements of Cash Flows on page 65). CASH USED FOR INVESTING ACTIVITIES declined 30% in 1993, compared with 1992, but was up 24% in 1992, compared with 1991. A combination of higher proceeds from property and investment sales and reduced capital spending yielded the improvement in 1993. Increased capital spending and the absence of investment sales caused the 1992 over 1991 increase. Although the high level of property and stock sales that occurred in 1993 is not expected to continue, efforts to hold down capital spending will be ongoing as NS seeks to maximize utilization of all its assets. In this connection, NS continues to review its route network to identify areas where efficiency can be enhanced by coordinated agreements with other railroads, or through sale or abandonment. The following table summarizes capital spending over the last five years, as well as track maintenance statistics and the average ages of railway equipment. The average age of locomotives retired during 1993 was 24.7 years. In recent years, NS has rebodied over 14,000 coal cars and plans to continue that program at the rate of about 3,000 cars per year for the next several years. This process, performed at NS' Roanoke Car Shop, converts hopper cars into high-capacity steel gondolas or hoppers. As a result, the remaining serviceability of the freight car fleet is greater than indicated by the increasing average age of the freight car fleet. Construction of two surge silos at the coal transloading facility in Norfolk was completed in 1993. The silos, which have a total capacity of 8,150 tons, allow for continuous dumping which reduces operating costs and loading time. NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations For 1994, NS is planning $634 million of capital spending, of which $627 million will be for railway projects and $7 million for motor carrier property. NS anticipates new equipment financing of approximately $72 million in 1994. NS also plans to spend approximately $70 million for coal reserves located in the Lincoln, Mingo and Logan counties of West Virginia and in the Floyd, Johnson and Martin counties of Kentucky. This acquisition should add approximately 210 million tons of high-volatile, low-sulfur steam coal to NS' holdings. Looking further ahead, the restructuring of NAVL, which was completed in 1993, is expected to reduce the level of capital spending for motor carrier property. Rail capital spending is likely to increase moderately over the next few years. The proposed construction of a $100 million coal ground storage facility in Isle of Wight County, Va., may affect capital spending in future years. However, because of delays in the permitting process and reduced demand for export coal, any significant spending on this project is not expected until after 1994. In addition to adding capacity, this new facility should further increase the efficiency of coal transportation service and reduce the need for new coal hopper cars. A substantial portion of future capital spending is expected to be funded through internally generated cash, although debt financing will continue as the primary funding source for equipment acquisitions. Investments (see Note 5 on page 75) decreased $122.6 million in 1993, compared with 1992. This decline reflects a $220 million reclassification to "Other current assets" for the cash surrender value of certain corporate owned life insurance (COLI), which is expected to be borrowed in April 1994, and accounts for the increase in working capital. Absent this reclassification, "Investments" would have increased almost $100 million, principally reflecting premium payments on COLI, which increase the cash surrender value of the underlying insurance policies. CASH USED FOR FINANCING ACTIVITIES increased 32% in 1993, compared with 1992, but had declined 27% in 1992, compared with 1991. The 1993 increase was principally a result of lower borrowing, making it the first year in the past 5 years to produce a net reduction in debt. Debt activity over the past five years was as follows: Debt requirements for 1994 are expected to remain moderate partly because another source of cash, borrowing on the cash surrender value of COLI, will satisfy some of 1994's cash requirements (see Note 5 on page 75 regarding COLI). The decline in cash used for financing activities in 1992, compared with 1991, principally was due to purchases of fewer shares of NS stock. Cash spent in recent years to purchase and retire stock amounted to $2.2 billion, of which $138.1 million, $177.2 million and $635.3 million was spent in 1993, 1992 and 1991, respectively (see Note 14 on page 85 for details of the stock purchase programs). Before 1991 and during 1993, a significant portion of this total spending was from cash reserves, whereas 1991 and 1992 purchases were funded largely through issuance of debt. NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations ENVIRONMENTAL MATTERS NS is subject to various jurisdictions' environmental laws and regulations. Certain NS rail subsidiaries have received notices from the Environmental Protection Agency that they are potentially responsible parties under the Comprehensive Environmental Response, Compensation and Liability Act (CERCLA), which generally imposes joint and several liability for cleanup costs. State agencies also have notified certain NS rail subsidiaries that they may be potentially responsible for environmental damages, and in several instances they have agreed voluntarily to initiate cleanup. For CERCLA sites and all other known environmental incidents where loss or liability is probable, NS has recorded an estimated liability. The amount of that liability, which includes estimated costs of remediation (and any associated restoration) on a site-by-site basis, is expected to be paid over several years. Claims, if any, against third parties for recovery of remediation costs incurred by NS are reflected as receivables in the balance sheet and are not netted against the associated NS liability. Environmental engineers perform ongoing analyses of all identified sites, and--after consulting with counsel--any necessary adjustments to initial liability estimates are recorded. NS also has established an Environmental Policy Council, composed of senior managers, to prescribe and direct its environmental initiatives. Estimates of a company's potential financial exposure even for known environmental claims or incidents are necessarily imprecise because of the widely varying costs of available remediation techniques, the difficulty of determining in advance the nature and extent of contamination and each potential participant's share of an estimated loss and evolving statutory and regulatory standards governing liability. The risk of incurring environmental liability--for acts and omissions, both past and current--is inherent in railroad operations. Moreover, some of the commodities, particularly those classified as hazardous materials, in NS' traffic mix can pose special risks that NS and its subsidiaries work diligently to minimize. In addition, several NS subsidiaries have land holdings that may be leased (and operated by others) or held for sale. Because certain conditions may exist on these properties for which NS ultimately may bear some financial responsibility, there can be no assurance that NS will not incur liabilities or costs, the amount and materiality of which, to a single accounting period or in the aggregate, cannot be estimated reliably now, related to environmental problems that are latent or undiscovered. However, based on its assessments of the facts and circumstances now known and after consulting with its legal counsel, Management believes that it has recorded appropriate estimates of liability for those environmental matters of which the Corporation is aware. INFLATION Generally accepted accounting principles require the use of historical costs in preparing financial statements. This approach disregards the effects of inflation on the replacement cost of property and equipment. NS, a capital-intensive company, has approximately $12.8 billion invested in such assets. The replacement costs of these assets, as well as the related depreciation expense, would be substantially greater than the amounts reported on the basis of historical costs. NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations RAIL INDUSTRY TRENDS NS and other railroads are continuing to seek opportunities to share traffic routes and facilities, furthering the goals of providing seamless service to customers, making railroads more competitive with trucks and maximizing efficiency of the respective railroads. NS is responding to concerns regarding the emission of coal dust from in- transit coal trains. Testing is under way of various methods of controlling such emissions. However, at this time final results of the testing and estimated costs that may be incurred to implement the conclusions resulting therefrom are not available. NS and the rail industry are continuing their efforts to replace the FELA with a no-fault workers' compensation system, which we strongly believe to be fairer both to the rail industry and to its employees. (Continued) (Continued) NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements The following notes are an integral part of the consolidated financial statements. 1. Summary of Significant Accounting Policies Principles of Consolidation - --------------------------- The consolidated financial statements include Norfolk Southern Corporation (Norfolk Southern) and its majority-owned and controlled subsidiaries (collectively NS). The major subsidiaries are Norfolk Southern Railway Company and North American Van Lines, Inc. (NAVL). All significant intercompany balances and transactions have been eliminated in consolidation. Cash Equivalents - ---------------- Cash equivalents are highly liquid investments purchased three months or less from maturity. The carrying value approximates fair value because of the short maturity of these investments. Materials and Supplies - ---------------------- Materials and supplies, which consist mainly of fuel oil and items for maintenance of property and equipment, are stated at average cost. The cost of materials and supplies expected to be used in capital additions or improvements is included in properties. Properties - ---------- Properties are stated principally at cost and are depreciated using group depreciation. Rail is primarily depreciated on the basis of use measured by gross ton miles. The effect of this method is to write off these assets over 42 years on average. Other properties are depreciated generally using the straight-line method over estimated service lives at annual rates that range from 1% to 25%. The overall depreciation rate averaged 2.7% for roadway and 4.6% for equipment. NS capitalizes interest on major capital projects during the period of their construction. Maintenance expense is recognized when repairs are performed. When properties other than land are sold or retired in the ordinary course of business, the cost of the assets less the sale proceeds or salvage is charged to accumulated depreciation rather than recognized through income. Gains and losses on disposal of land, which is a nondepreciable asset, are included in other income. Revenue Recognition - ------------------- Revenue is recognized proportionally as a shipment moves from origin to destination. Earnings Per Share - ------------------ Earnings per share are computed by dividing net income by the weighted average number of common shares outstanding during the respective periods. Recent decreases in the number of shares outstanding are the result of the stock purchase program described in Note 14. NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements 1. Summary of Significant Accounting Policies (continued) Balance Sheet Classification - ---------------------------- Beginning with 1991, the balance sheet classification of certain revenue-related balances appears on an actual (net) basis rather than an estimated (gross) basis due to the earlier availability of certain settlement data with other railroads. This modification, which had no income statement effect, resulted in large offsetting declines in accounts receivable and accounts payable as illustrated in the Statement of Cash Flows for 1991. Required Accounting Changes - --------------------------- Effective January 1, 1993, NS adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" (SFAS 106), and Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" (SFAS 112). SFAS 106 requires NS to accrue the cost of specified health care and death benefits over an employee's active service period rather than, as was the previously prevailing practice, accounting for such expenses on a pay-as-you-go basis. SFAS 112 requires corporations to recognize the cost of benefits payable to former or inactive employees after employment but before retirement on an accrual basis. For NS, such postemployment benefits consist principally of benefit obligations related to participants in the long-term disability plan. NS recognized the effects of these changes in accounting on the immediate recognition basis. The cumulative effects on years prior to 1993 of adopting SFAS 106 and SFAS 112 increased pretax expenses $360.2 million ($223.8 million after-tax), and $31.8 million ($19.7 million after-tax), respectively (see Note 12). The impact on 1993 expenses is not material. The pro forma effects of applying SFAS 106 and SFAS 112 on individual prior years is not presented, as the effect on each separate year also is not material. Also effective January 1, 1993, NS adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS 109). SFAS 109 requires a change from the deferred method of accounting for income taxes to the asset and liability method of accounting for income taxes. Under the asset and liability method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax laws and tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Under SFAS 109, the effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Under the deferred method, which applied for 1992 and prior years, deferred income taxes were recognized for income and expense items that were reported in different years for financial reporting purposes and income tax purposes using the tax rate applicable for the year of the calculation, and deferred taxes were not adjusted for subsequent changes in tax rates. The cumulative effect on years prior to 1993 of adopting SFAS 109 increased net income by $466.8 million (see also Note 2). The effect on net income and earnings per share as a result of implementing the accounting changes was to increase net income and earnings per share by $223.3 million and $1.60 per share, respectively. NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements 2. Income Taxes Federal Income Tax Rate Increase - -------------------------------- In August 1993, Congress enacted the Revenue Reconciliation Act of 1993, which increased the federal corporate income tax rate from 34% to 35%, retroactive to January 1, 1993. The tax rate increase had two components which, as required by SFAS 109, were recognized in 1993's earnings. The first component relates to the increased income tax rate's effect on 1993's earnings, which increased the provision for income taxes and reduced net income by $7.9 million, or $0.06 per share. The second component increased the provision for the net deferred tax liability in the Consolidated Balance Sheet, which reduced net income by $46.2 million, or $0.33 per share. Excluding the one-time noncash charge of $0.33 per share, 1993's earnings per share before accounting changes would have been $4.27. NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements 2. Income Taxes (continued) Deferred Income Tax Expense - --------------------------- Some income and expense items are reported differently for financial reporting and income tax purposes. Provisions for deferred income taxes were made in recognition of these differences in accordance with APB Opinion No. 11 for years prior to 1993, and SFAS 109 for 1993 (see Note 1 for an explanation of this required accounting change). NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements 2. Income Taxes (continued) NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements 2. Income Taxes (continued) Except for amounts for which a valuation allowance is provided, Management believes the other deferred tax assets will be realized. The valuation allowance for deferred tax assets as of January 1, 1993, was $9.8 million. The net change in the total valuation allowance for the year ended December 31, 1993, was an increase of $1.1 million. Internal Revenue Service (IRS) Reviews - -------------------------------------- Consolidated federal income tax returns have been examined and Revenue Agent Reports have been received for all years up to and including 1989. The consolidated federal income tax returns for 1990 through 1992 are being audited by the IRS. Management believes that adequate provision has been made for any additional taxes and interest thereon that might arise as a result of these examinations. NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements 3. Motor Carrier Restructuring On June 25, 1993, NS announced a plan to restructure its motor carrier subsidiary by seeking buyers for the truckload freight portion of North American Van Lines, Inc. (NAVL) which consisted of the Commercial Transport Division (CT), a nationwide truckload carrier, and Tran-Star (TS), a refrigerated carrier. In recent years, these businesses contributed about one third of NAVL's revenues but, primarily due to CT, produced operating losses. As a result of the restructuring, NS recorded a $50.3 million pretax ($32.3 million after-tax) charge and recognized an additional tax benefit of $36.8 million. The estimated costs of this restructuring included projected operating losses during the phase-out period, as well as labor, equipment and facility related costs. Accordingly, results of operations for these businesses are excluded from the Statement of Income after June 30, 1993. On December 31, 1993, NS completed a sale of TS' operations. The proceeds from this sale are reflected in "Investment sales and other" in the Consolidated Statement of Cash Flows. Most of the assets and liabilities of the CT Division were liquidated or transferred to other NAVL divisions. CT's assets remaining at December 31, 1993, are expected to be disposed of within the first six months of 1994 and, accordingly, have been classified in the Consolidated Balance Sheet in "Other current assets." NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements Corporate Owned Life Insurance - ------------------------------ The cash surrender value of certain corporate owned life insurance amounting to approximately $220 million, which is expected to be borrowed in April 1994, has been reclassified in the Consolidated Balance Sheet from "Investments" to "Other current assets." Fair Values - ----------- At December 31, 1993, the fair value of investments approximated $217 million. The fair values of marketable securities were based on quoted market prices. At December 31, 1993 and 1992, the market value of marketable equity securities was $14.5 million and $45.5 million, respectively. The fair values of stock in nonmarketable securities were estimated based on the underlying net assets. For the remaining investments, consisting principally of corporate owned life insurance, the carrying value approximates fair value. Investment Write-Downs in 1991 - ------------------------------ In 1991, NS recorded a $20 million pretax ($13.2 million after-tax) loss to write off its remaining investment in a bank that declared bankruptcy. This write-down, as well as investment sales transactions, are reflected in "Other income-net" in the Consolidated Statements of Income (see Note 4). Investment write-downs (which are noncash transactions) are not included in the Consolidated Statements of Cash Flows. NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements 6. Properties (continued) Noncash Property Transactions Excluded from the Consolidated Statements - ----------------------------------------------------------------------- of Cash Flows - ------------- Additions to "Other property" in 1991 included $66.6 million for assets acquired from a real estate partnership in which an NS subsidiary owns an equity interest. Of this transaction, $54 million was noncash and relates to amounts invested in or advanced to that partnership which previously had been classified in "Investments." Capitalized Interest - -------------------- Total interest cost incurred on debt for 1993, 1992 and 1991 was $120.2 million, $126.9 million and $117.3 million, respectively, of which $21.6 million, $17.9 million and $17.6 million was capitalized. 8. Debt Commercial Paper Program - ------------------------ In 1990, a commercial paper program was initiated principally to finance the purchase and retirement of common stock (see Note 14). As of December 31, 1993 and 1992, NS had $521.8 million and $520.5 million, respectively, of notes outstanding under this program. NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements 8. Debt (continued) Commercial paper debt is due within one year, but a portion has been classified as long-term because NS has the ability and intends to refinance its commercial paper on a long-term basis, either by issuing additional commercial paper (supported by a revolving credit agreement) or by replacing the commercial paper notes with long-term debt. The credit agreement, which is effective through June 9, 1995, has a $400 million credit limit. A portion of the commercial paper outstanding, to the extent of the revolving credit limit, is classified as long-term debt. The credit agreement provides for interest at prevailing short-term rates and contains customary financial covenants, including principally a minimum tangible net worth requirement of $3 billion. Debt Registration - ----------------- In February 1992, NS issued and sold $250 million principal amount of its 7-7/8% notes due February 15, 2004. In March 1991, NS issued and sold $250 million principal amount of its 9% notes due March 1, 2021. These notes were issued under a shelf registration statement on Form S-3 filed in 1991 with the Securities and Exchange Commission covering the issuance of unsecured debt securities in an aggregate principal amount of up to $750 million. Proceeds from the sale of these notes were used to purchase and retire shares of NS common stock (see Note 14), to retire short-term commercial paper debt issued to fund previous share purchases and for general corporate purposes. These notes are not redeemable prior to maturity and are not entitled to any sinking fund. NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements 8. Debt (continued) A substantial portion of NS' properties and certain investments in affiliated companies are pledged as collateral for much of the secured debt. Fair Values - ----------- The carrying value of short-term debt approximates fair value. The fair value of long-term debt, including current maturities, approximated $1.74 billion at December 31, 1993. The fair values of debt were estimated based on quoted market prices or discounted cash flows using current interest rates for debt with similar terms, company rating and remaining maturity. NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements 9. Lease Commitments Among NS' leased properties are approximately 300 miles of road in North Carolina. The leases expire in 1994, and NS is discussing renewals with the lessor (see also page 6). NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements 11. Pension Plans Norfolk Southern and certain subsidiaries have defined benefit pension plans which principally cover salaried employees. Pension benefits are based primarily on years of creditable service with NS and compensation rates near retirement. Contributions to the plans are made on the basis of not less than the minimum funding standards set forth in the Employee Retirement Income Security Act of 1974, as amended. Assets in the plans consist mainly of common stocks. NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements 11. Pension Plans (continued) Early Retirement Program - ------------------------ During 1993, NS completed a voluntary early retirement program for salaried employees that resulted in a $42.4 million charge in compensation and benefits expense. The principal benefit for those who participated in the program was enhanced pension benefits which are reflected in the accumulated benefit obligation at December 31, 1993. Transfer of Pension Plan Assets - ------------------------------- During 1991, the NS Retirement Plan was amended to establish a Section 401(h) account for the purpose of transferring a portion of pension plan assets in excess of the projected actuarial liability to fund current- year medical payments for retirees. In December 1993, 1992 and 1991, $13 million, $15 million and $14.5 million, respectively, were transferred from this account to reimburse NS for such payments. NS contributed equal amounts to a Voluntary Employee Beneficiary Association account in those years to fund future medical costs for retirees (see Note 12). 401(k) Plan - ----------- Norfolk Southern and certain subsidiaries provide a 401(k) savings plan for salaried employees. Under the plan, NS matches a portion of the employee contributions, subject to applicable limitations. NS' expenses under this plan were $5.2 million, $4.9 million and $4.5 million in 1993, 1992 and 1991, respectively. NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements 12. Postretirement Benefits Other Than Pensions Norfolk Southern and certain subsidiaries provide specified health care and death benefits to eligible retired employees, principally salaried employees. Under the present plans, which may be amended or terminated at NS' option, a defined percentage of health care expenses is covered, reduced by any deductibles, co-payments, Medicare payments and, in some cases, coverage provided by other group insurance policies. The cost of such health care coverage to a retiree may be determined, in part, by the retiree's years of creditable service with NS prior to retirement. Death benefits are determined based on various factors, including, in some cases, salary at time of retirement. NS continues to fund benefit costs principally on a pay-as-you-go basis. However, in 1991, NS established a Voluntary Employee Beneficiary Association (VEBA) account to fund a portion of the cost of future health care benefits for retirees. NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements 12. Postretirement Benefits Other Than Pensions (continued) For measurement purposes, a 12% annual rate of increase in the per capita cost of covered health care benefits was assumed for 1993; the rate was assumed to decrease gradually to an ultimate rate of 6% for 2005 and remain at that level thereafter. The health care cost trend rate has a significant effect on the amounts reported in the financial statements. To illustrate, increasing the assumed health care cost trend rates by one percentage point in each year would increase the accumulated postretirement benefit obligation as of December 31, 1993, by about $55.8 million and the aggregate of the service and interest cost components of net periodic postretirement benefit cost for the year 1993 by about $5.1 million. The weighted-average discount rate used in determining the accumulated postretirement benefit obligation was 7.25%. A 6% salary increase assumption was used for death benefits based on salary at the time of retirement. The VEBA trust holding the plan assets is not expected to be subject to federal income taxes as the assets are invested entirely in trust- owned life insurance. The long-term rate of return on plan assets, as determined by the growth in cash surrender value of the life insurance policies, is expected to be 9%. Under collective bargaining agreements, NS and certain subsidiaries participate in a multi-employer benefit plan, which provides certain postretirement health care and life insurance benefits to eligible union employees. Premiums under this plan are expensed as incurred and amounted to $6.4 million, $6.2 million and $6.2 million in 1993, 1992 and 1991, respectively. 13. Long-Term Incentive Plan Under the stockholder-approved Long-Term Incentive Plan, a disinterested committee of the Board of Directors may grant stock options, stock appreciation rights (SARs), and performance share units (PSUs), up to a maximum 11,675,000 shares of Norfolk Southern common stock. Grants of SARs and PSUs result in charges to earnings while grants of stock options currently have no effect on earnings. Options may be granted for a term not to exceed 10 years but may not be exercised prior to the first anniversary date of grant. Options are exercisable at the fair market value of Norfolk Southern stock on the date of grant. SARs were granted on a one-for-one basis in tandem with certain of the stock option shares. Upon the exercise of an SAR, the optionee receives in common stock or cash or both (as determined by the committee administering the plan) the amount by which the fair market value of common stock on the exercise date exceeds the option price. Exercise of an SAR or option cancels any related option/SAR. During 1991, the Securities and Exchange Commission issued new regulations under Section 16(b) of the Securities Exchange Act of 1934. In view of these new regulations, plan participants surrendered, without cash or other consideration, all outstanding SARs granted after 1988. Consistent with the new regulations and the surrender of post-1988 SARs, future grants of SARs are not anticipated at this time. SARs outstanding as of each year end were as follows: 95,852 in 1993; 133,659 in 1992; and 203,728 in 1991. NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements 13. Long-Term Incentive Plan (continued) Performance Share Units - ----------------------- Performance share units, which were added to this plan by a 1989 amendment, entitle participants to earn shares of common stock at the end of a three-year performance cycle based upon achievement of certain predetermined corporate performance goals. PSU grants totaled 186,000 in 1991; 196,000 in 1992; and 160,500 in 1993. Shares earned and issued may be subject to share retention agreements and held by NS for up to 5 years. The plan also permits the payment, in cash or in stock, of dividend equivalents on shares of common stock covered by options and PSUs granted after January 1, 1989, commensurate with dividends paid on common stock. Tax absorption payments, in an amount estimated to equal the federal and state income taxes applicable to shares of common stock issued subject to a share retention agreement, also are authorized. Dividend equivalents and tax absorption payments, if made, result in charges to earnings. NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements 14. Stock Purchase Programs Since 1987, the Board of Directors has authorized the purchase and retirement of up to 65 million shares of common stock. Purchases under the programs initially were made with internally generated cash. Beginning in May 1990, some purchases were financed with proceeds from the sale of commercial paper notes. In March 1991, $250 million of long- term notes were issued in part to repay a portion of the commercial paper notes, as well as to provide funds for additional purchases. An additional $250 million of long-term notes were issued in February 1992 (see Note 8 for debt details). On January 29, 1992, NS announced that, for reasons primarily related to issues surrounding the 1991 special charge (see Note 15), the purchase program would continue, but at a slower pace and over a longer authorized period, with actual purchases dependent on market conditions, the economy, cash needs and alternative investment opportunities. The recent decreases in the average number of outstanding common shares, as disclosed in the Ten-Year Financial Review on page 36, are the results of these purchase programs. Since the first purchases in December 1987 and through December 31, 1993, NS has purchased and retired 53,615,800 shares of its common stock under these programs at a cost of $2.2 billion. 15. Special Charge in 1991 and Subsequent Partial Reversal in 1993 Included in 1991 results was a $680 million special charge for labor force reductions and asset write-downs. The special charge reduced net income by $498 million, or $3.37 per share. The principal components of the special charge were as follows: Labor - ----- Significant new labor agreements were reached late in 1991 following a Presidential Emergency Board's recommendations that railroads be permitted to modify long-standing unproductive work rules. The principal feature of the new agreements concerned a change in crew consist (the required number of crew members on a train) from four to two members to be implemented over a five-year period across most of NS' system. Surplus employees whose positions were eliminated as a result of the restructured crew size are entitled to protective pay and may be offered voluntary separation incentives. Related to crew-consist changes, separate agreements were reached concerning the buyout of certain productivity funds (payments to train service employees whenever a train operates with a reduced crew). The labor portion of the special charge amounted to $450 million and represented the estimated costs of achieving the productivity gains provided by these new agreements. Goodwill - -------- In 1985, NS acquired all the common stock of NAVL for $369 million. The transaction was accounted for as a purchase and included $211 million representing cost in excess of net assets acquired (goodwill). The price NS paid for NAVL was based on an evaluation of its earning power. Generally, earnings since acquisition were much lower than anticipated. In 1991, NS evaluated the carrying value of its investment in NAVL and concluded that the goodwill portion of its investment was not recoverable primarily because of reduced profit margins resulting from intense competition in the motor carrier industry. As a result of this determination, NS recorded a $187 million noncash charge against 1991 earnings (with no related tax benefit) representing the unamortized balance of its investment in NAVL's goodwill. See also Note 3 regarding NAVL's restructuring in 1993. NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements 15. Special Charge in 1991 and Subsequent Partial Reversal in 1993 (continued) Property - -------- The property portion of the special charge, which amounted to $43 million, was for marginally productive railroad property and motor carrier equipment assets that were scheduled for sale or abandonment. Special Charge Reversal - ----------------------- Based on NS' success in eliminating reserve board positions in 1992 and 1993, and on events occurring in the third quarter of 1993, the accrual included in the 1991 special charge related to labor was reduced by $46 million and was reflected as a credit in compensation and benefits expense. The principal factor contributing to the reversal was that, in 1993, agreement on terms for certain further labor savings could not be reached. Accordingly, it became apparent that a surplus existed in the labor portion of the provision established in the 1991 special charge. 16. Contingencies Lawsuits - -------- Norfolk Southern and certain subsidiaries are defendants in numerous lawsuits relating principally to railroad operations. While the final outcome of these lawsuits cannot be predicted with certainty, it is the opinion of Management, after consulting with its legal counsel, that ultimate liability will not materially affect the consolidated financial position of NS. Debt Guarantees - --------------- As of December 31, 1993, certain Norfolk Southern subsidiaries are contingently liable as guarantors with respect to $37 million of indebtedness of related entities. Environmental Matters - --------------------- NS is subject to various jurisdictions' environmental laws and regulations. Certain NS rail subsidiaries have received notices from the Environmental Protection Agency that they are potentially responsible parties under the Comprehensive Environmental Response, Compensation and Liability Act (CERCLA), which generally imposes joint and several liability for cleanup costs. State agencies also have notified certain NS rail subsidiaries that they may be potentially responsible for environmental damages, and in several instances they have agreed voluntarily to initiate cleanup. For CERCLA sites and all other known environmental incidents where loss or liability is probable, NS has recorded an estimated liability. The amount of that liability, which includes estimated costs of remediation (and any associated restoration) on a site-by-site basis, is expected to be paid over several years. Claims, if any, against third parties for recovery of remediation costs incurred by NS are reflected as receivables in the balance sheet and are not netted against the associated NS liability. Environmental engineers perform ongoing analyses of all identified sites, and--after consulting with counsel--any necessary adjustments to initial liability estimates are recorded. NS also has established an Environmental Policy Council, composed of senior managers, to prescribe and direct its environmental initiatives. NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES Notes to Consolidated Financial Statements 16. Contingencies (continued) Estimates of a company's potential financial exposure even for known environmental claims or incidents are necessarily imprecise because of the widely varying costs of available remediation techniques, the difficulty of determining in advance the nature and extent of contamination and each potential participant's share of an estimated loss, and evolving statutory and regulatory standards governing liability. The risk of incurring environmental liability--for acts and omissions, both past and current--is inherent in railroad operations. Moreover, some of the commodities, particularly those classified as hazardous materials, in NS' traffic mix can pose special risks that NS and its subsidiaries work diligently to minimize. In addition, several NS subsidiaries have land holdings that may be leased (and operated by others) or held for sale. Because certain conditions may exist on these properties for which NS ultimately may bear some financial responsibility, there can be no assurance that NS will not incur liabilities or costs, the amount and materiality of which, to a single accounting period or in the aggregate, cannot be estimated reliably now, related to environmental problems that are latent or undiscovered. However, based on its assessments of the facts and circumstances now known and after consulting with its legal counsel, Management believes that it has recorded appropriate estimates of liability for those environmental matters of which the Corporation is aware. INDEPENDENT AUDITORS' REPORT The Stockholders and Board of Directors Norfolk Southern Corporation: We have audited the consolidated financial statements of Norfolk Southern Corporation and subsidiaries as listed in Item 8. In connection with our audits of the consolidated financial statements, we also have audited the consolidated financial statement schedules as listed in Item 14(a)1. These consolidated financial statements and consolidated financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and consolidated financial statement schedules 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 Norfolk Southern Corporation and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1993, in conformity with generally accepted accounting principles. Also in our opinion, the related consolidated financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. As discussed in Note 1, the Company changed its methods of accounting in 1993 by adopting the provisions of the Financial Accounting Standards Board's Statement 109, Accounting for Income Taxes; Statement 106, Employers' Accounting for Postretirement Benefits Other Than Pensions; and Statement 112, Employers' Accounting for Postemployment Benefits. /s/ KPMG Peat Marwick Norfolk, Virginia January 25, 1994 (continued) EXHIBIT INDEX ------------- Electronic Submission Exhibit Number Description Page Number - ---------- ----------------------------------------- ----------- 10.g Norfolk Southern Corporation Officers' Deferred Compensation Plan as amended effective January 1, 1994. 97-106 10.h Directors' Deferred Fee Plan of Norfolk Southern Corporation as amended effective January 1, 1994. 107-112 11 Computation of Earnings Per Share. 113-116 12 Computation of Ratio of Earnings to Fixed Charges. 117 21 Subsidiaries of Norfolk Southern. 118-120 23 Consent of Independent Auditors. 121

1993 ITEM 1. BUSINESS (a) General Development of Business. The Charles Schwab Corporation (CSC) is a holding company engaged, through its subsidiaries, in brokerage and related investment services. CSC's principal operating subsidiary, Charles Schwab & Co., Inc. (Schwab), serves an estimated 44% of the discount brokerage market as measured by commission revenue. Another subsidiary, Mayer & Schweitzer, Inc. (M&S), a market maker in Nasdaq securities, provides trade execution services to institutional clients and broker-dealers. During 1993, customer orders handled by M&S totaled over 4 billion shares, or over 6% of the total shares traded on Nasdaq. As used herein, the "Company" refers to CSC and subsidiaries. Schwab was incorporated in California in 1971 and adopted the name Charles Schwab & Co., Inc. after Mr. Charles R. Schwab became its owner and President. In 1974, Schwab participated in the Securities and Exchange Commission's (SEC) pilot program to permit discounts on securities commissions. In 1975, when fixed commission rates were abolished, Schwab focused its strategy on providing financial services to investors who wish to conduct their own research and make their own investment decisions and who do not wish to pay, through brokerage commissions, for research or portfolio management. Schwab grew significantly through January 1983 when, to ensure the availability of sufficient capital for continued expansion, Schwab merged with an affiliate of BankAmerica Corporation (BAC). CSC was incorporated in November 1986 for the purpose of acquiring Schwab from BAC. In March 1987, Schwab was acquired from BAC in a management-led leveraged buyout. In September 1987, the Company raised $123 million in its initial public offering, using the offering proceeds to expand its business and repay debt issued in the leveraged buyout. Since becoming a publicly-owned entity, the Company has continued to experience significant growth in revenues, customer assets and number of accounts. This growth has been accomplished through investment in technology, product and service development, marketing programs and customer service delivery systems. In addition, the Company has broadened its service capability through the acquisition and development of additional businesses. In October 1989, Charles Schwab Investment Management, Inc. (CSIM) was formed as a subsidiary of CSC. In January 1990, CSIM became the general investment adviser (employing a sub-adviser to perform portfolio management for certain funds), as well as the administrator for three money market mutual funds organized as portfolios of the then newly organized The Charles Schwab Family of Funds. Substantially all of the balances previously invested by Schwab customers in other money market mutual funds having similar investment objectives were transferred to these money market mutual funds in January 1990. Schwab subsequently introduced additional mutual funds, some as portfolios of two separate Massachusetts business trusts, Schwab Investments and Schwab Capital Trust. The Company refers to all funds for which CSIM is the investment adviser as the SchwabFunds (registered trademark). During July 1992, Schwab introduced nationally its no-transaction-fee mutual fund service, known as the Mutual Fund OneSource (trademark) service, which by December 31, 1993, enabled customers to trade over 200 mutual funds in 25 well-known fund families without incurring brokerage transaction fees. Customer assets held by Schwab that have been purchased through the Mutual Fund OneSource service, excluding SchwabFunds, totaled $8.3 billion at December 31, 1993. In response to the continued growth of customer trading activity in Nasdaq securities and a desire to secure a capability to execute customer trades in these and other securities, CSC acquired M&S in July 1991. Since the acquisition, M&S has executed essentially all the Nasdaq security trades originated by the customers of Schwab, which in 1993 accounted for approximately 20% of Schwab's total trading volume. Principal transaction revenues generated by M&S have contributed significantly to the Company's operating results. In March 1992, the Company opened The Charles Schwab Trust Company (CSTC), which provides custody services for investment portfolios and serves as trustee for employee benefit plans (primarily 401(k) plans). CSTC, based in San Francisco, is regulated as a limited-purpose bank by the California State Banking Department. CSTC's primary focus is to provide services to independent, fee-based financial advisers and 401(k) plan record keepers and administrators. In November 1992, the Company capitalized Charles Schwab Limited, its first European subsidiary. The wholly owned subsidiary is registered as an arranger with the United Kingdom Securities and Futures Authority, and engages in business development activities on behalf of Schwab. The subsidiary's first office, located in London, was opened in February 1993. DEVELOPMENTS DURING 1993 AND EARLY 1994 During 1993, the Company experienced record revenues, net income, and growth in customer assets and accounts. Net income for 1993 was $118 million, or $1.98 per share, up from $81 million, or $1.39 per share, in 1992 and $49 million, or $.84 per share, in 1991. Reflected in - 1 - THE CHARLES SCHWAB CORPORATION 1993's operating results is an extraordinary charge of $.11 per share relating to CSC's prepayment of its Junior and Senior Subordinated Debentures. Schwab opened 706,000 new accounts during 1993, which contributed significantly to the $30.2 billion, or 46%, increase in assets held in Schwab customer accounts. The Company made significant capital expenditures during 1993, investing $77 million in a new primary data center, a fourth regional customer telephone service center, which opened in January 1994, and enhancements to its data processing and telecommunications systems. The Company also opened 23 branch offices and made improvements to certain existing office facilities. A new Massachusetts business trust, Schwab Capital Trust, was formed in July 1993. During 1993, Schwab added to the SchwabFunds (registered trademark) by introducing two new funds under the Schwab Capital Trust, an international index fund and an index fund that attempts to track the performance of common stocks of the second 1,000 largest United States corporations. During 1993, Schwab also introduced a long-term government bond fund and two short/intermediate tax-free bond funds. Customer assets invested in the SchwabFunds at December 31, 1993 totaled $15.8 billion, a 39% increase over the prior year. Several financing transactions were completed during 1993. The Company prepaid its 10% Senior and 9% Junior Subordinated Debentures totaling $116 million, and paid a related prepayment premium of approximately $11 million. The Company prepaid the debentures using proceeds received from the issuance of medium-term notes with an average interest rate of 5.91%. In March 1993, the Company's Board of Directors approved a three-for-two stock split of the Company's common stock, which was effected in the form of a 50% stock dividend. The stock dividend was paid on June 1, 1993 to stockholders of record May 3, 1993. In January 1994, the Board increased the Company's quarterly cash dividend 40% to $.070 per share payable February 15, 1994 to stockholders of record February 1, 1994. (b) Financial Information About Industry Segments. The Company operates in a single industry segment: securities brokerage and related investment services. No material part of the Company's consolidated revenues is received from a single customer or group of customers, or from foreign operations. As of December 31, 1993, approximately 29% of Schwab's total customer accounts were located in California. The next highest geographic concentrations of total customer accounts were approximately 7% in each of New York and Florida. (c) Narrative Description of Business. Schwab provides brokerage and related investment services to more than 2.5 million active investor accounts. These accounts held $95.8 billion in assets at December 31, 1993. M&S operates four offices in four states offering trade execution services for Nasdaq securities to institutional clients and broker-dealers, including Schwab. Schwab's primary focus is serving retail clients who seek a wide selection of quality investment services at fees that, in most cases, are substantially lower than those of full-commission firms. The table on the following page sets forth on a comparative basis the Company's revenues for the three years ended December 31, 1993. These revenue figures reflect developments in, and the composition of, the Company's business. Schwab provides its customers, most of whom are retail investors, with convenient and prompt execution of their orders to purchase and sell securities, and with rapid access to market-related information. A key to both the quality and speed of Schwab's service and to its ability to provide commission discounts is its sophisticated communications and information processing systems. Schwab primarily serves investors who wish to conduct their own research and make their own investment decisions and do not wish to pay, through brokerage commissions, for research or portfolio management. To attract and accommodate investors who want research and portfolio management services, however, Schwab offers a variety of fee-based (primarily third-party) research and portfolio management products. This customer segment has become increasingly significant to Schwab's growth in customer assets and accounts. During 1993, Schwab client assets held in customer accounts managed by financial advisors increased $9.6 billion (73%) to a total of $22.9 billion. Schwab does not generally maintain inventories of securities for sale to its customers or engage in principal transactions with its customers. Exceptions to this general rule include: (1) having temporary positions resulting from execution errors, unavailability of the various exchanges' automated trade execution facilities, or nonpayment by customers, (2) positioning of listed securities to accommodate institutional customers, and (3) engaging in certain riskless principal and other similar transactions where, in response to a customer order, Schwab will purchase securities (generally municipal and government securities) from another source and resell them to customers at a markup. Schwab concentrates on the execution of unsolicited transactions on an agency basis. Schwab's customer service delivery system reduces dependency on the need for personal relationships between Schwab's customers and employees to generate orders. Schwab does not generally assign customers to individual employees. Each customer-contact employee has immediate access to the customer account and market-related information necessary to respond to any customer's inquiries, and for most customer orders, can enter the order and confirm the transaction. Customer orders involving certain - 2 - THE CHARLES SCHWAB CORPORATION SOURCES OF REVENUES (DOLLAR AMOUNTS IN THOUSANDS) Certain prior years' revenues and expenses have been reclassified to conform to the 1993 presentation. This table should be read in connection with the Company's consolidated financial statements and notes in the Company's 1993 Annual Report to Stockholders, which are incorporated herein by reference to Exhibit No. 13.1 of this report. - ------------------------------------------------------------------------------- types of transactions, such as those in fixed income securities and mutual funds, are handled by separate groups of registered representatives that specialize in such transactions. As a result of this approach, the departure of a registered representative generally does not result in a loss of customers for the firm. As a market maker in Nasdaq securities, M&S executes customer trades generally as principal. M&S' business practices call for competitively priced customer executions. As a member of the National Association of Securities Dealers, Inc. (NASD), M&S provides its customers with the highest bid price on a customer's sell order and the lowest offer price on a customer's buy order available through the network of NASD member firms that are market makers. Customer trades exceeding certain sizes are executed on a negotiated basis. M&S maintains inventories in Nasdaq securities on both a "long" and "short" basis. While long inventory positions represent M&S' ownership of securities, short inventory positions represent obligations of M&S to deliver specified securities at a contracted price, which may differ from market prices prevailing at the time of completion of the transaction. Accordingly, long or short inventory positions may result in gains or losses to M&S as market values of these securities fluctuate. The securities brokerage industry is directly affected by - 3 - THE CHARLES SCHWAB CORPORATION fluctuations in volumes and price levels of securities transactions generally, which are affected by many national and international economic and political factors that cannot be predicted, including broad trends in business and finance, legislation and regulation affecting the United States and international business and financial communities, currency values, and the level and volatility of interest rates. Sustained low volumes of retail investment activity or of securities transactions generally, particularly if accompanied by low securities prices, could substantially reduce the Company's transaction-based revenues and could lead to reduced margin account balances, thus reducing interest revenue as well. Shifts in customer investment vehicle preferences from individual equity securities to products that have lower commissions per transaction, such as mutual funds, could also reduce transaction-based revenues. In connection with its information processing systems, its branch network, and other aspects of its business, the Company incurs substantial expenses that do not vary directly, at least in the short term, with fluctuations in securities transaction volumes and revenues. In the event of a material reduction in revenues, the Company may not reduce such expenses quickly and, as a result, the Company could experience reduced profitability or losses. Conversely, sudden surges in transaction volume can result in increased profits and profit margins. To ensure that it has the capacity to process projected increases in transaction volumes, the Company has historically made substantial capital and operating expenditures in advance of such projected increases, including during periods of low transaction volumes. In the event that such growth in transaction volumes does not occur, the expenses related to such investments could, as they have in the past, cause reduced profitability or losses. COMPETITION The Company encounters rigorous competition from full-commission and discount brokerage firms, as well as from financial institutions, mutual fund sponsors, market makers in Nasdaq securities and other organizations. The recent general financial success of the securities industry has strengthened existing competitors, and management believes that such success will continue to attract additional competitors such as banks and insurance companies. Some of these competitors are larger, more diversified, and have greater capital resources than the Company. In many instances the Company is competing with such organizations for the same customers. Management believes that the main competitive factors are quality, convenience, price of services and products offered, and breadth of product line. Most discount brokerage firms charge commissions lower than Schwab. Full- commission brokerage firms also offer discounted commissions to selected retail customers. Many brokerage firms employ substantial funds in advertising and direct solicitation of customers to increase their market share of commission dollars and other securities-related income. If the well-capitalized brokerage firms pursue these competitive strategies successfully, Schwab's new account growth, commission revenues and profit margins could be adversely affected. Many of the large full-commission brokerage firms, as well as other financial institutions, including commercial banks and insurance companies, offer a wider range of services and financial products than does the Company. Particularly as financial services and products proliferate, to the extent such competitors are able to attract and retain customers on the basis of the convenience of one-stop shopping, the Company's business or its ability to grow could be adversely affected. Schwab's philosophy of generally refraining from directly recommending particular securities and its methods of marketing may cause it not to offer some of the financial products and services offered by others. MARKETING AND PROMOTION Advertising plays a crucial role in obtaining new customers, which have constituted an important source of revenue and revenue growth for the Company. The Company's advertising and market development expense for the years ended December 31, 1993, 1992 and 1991 was $41 million, $34 million and $25 million, respectively. For the same years, the numbers of new accounts opened were approximately 706,000, 562,000 and 384,000, respectively. New account openings represent a significant portion of the growth in customer assets, which the Company believes is critical to growth in revenues. The Company estimates that accounts opened during 1993 generated 16% of total commission revenues during that year and that accounts opened during 1992 and 1991 generated 18% and 19% of total commission revenues during each of those years, respectively. The branch office network also plays a key role in building Schwab's business. Many customers prefer to open accounts in person in Schwab branch offices. With the customer service support of the regional customer telephone service centers and TeleBroker (trademark), branch personnel are able to focus a significant portion of their time on business development. Branch training programs and compensation plans emphasize identifying customer needs that can be satisfied with Schwab products and services, and increasing customer assets held in Schwab accounts. Schwab advertises regularly in financially-oriented newspapers and periodicals and occasionally in general circulation publications. Schwab advertisements appear regularly on national and local cable television and - 4 - THE CHARLES SCHWAB CORPORATION periodically on radio and independent television stations. Schwab's national network television advertising campaign, launched during the fourth quarter of 1991, has resulted in significant increases in Schwab brand awareness among investors. Schwab employs volume-buying and other strategies to minimize the expense of broadcast advertising. Through these broadcast-buying strategies and by using Schwab employees to produce and buy print advertising, management believes Schwab realizes savings on its promotional expenses. Schwab also engages extensively in targeted direct mail advertising through monthly statement "inserts" and special mailings. In its advertising, as well as in promotional events such as press appearances, Schwab has aggressively promoted the name and likeness of its Chairman, Mr. Schwab. The Company believes there is a substantial benefit related to Mr. Schwab's association with the Company and that Schwab's marketing programs and overall business is dependent on the ability to continue to use Mr. Schwab's name and likeness. The Company has entered into an agreement with Mr. Schwab by which he, subject to certain limitations, has assigned to the Company and Schwab all service mark, trademark, and trade name rights in his name (and variations thereon) and likeness. PRODUCTS AND SERVICES Securities and Other Investments Available. Schwab's customers may purchase and sell both listed and unlisted corporate securities, and listed put, call and index options. Through its Mutual Fund Marketplace (registered trademark) program, Schwab purchases and redeems for its customers shares of over 700 mutual funds in approximately 100 fund families sponsored by third parties. This program provides Schwab's customers with the convenience of purchasing and redeeming mutual fund shares with a single telephone call and of using margin credit to purchase most mutual fund shares. Schwab charges a transaction fee on trades placed in the funds included in its Mutual Fund Marketplace (except as described below), or in some cases, receives compensation directly from the funds and/or fund sponsors. Commissions from customer transactions in mutual fund shares comprised approximately 9% of Schwab's total commission revenues in 1993, compared to approximately 8% in 1992 and approximately 7% in 1991. During July 1992, Schwab introduced nationally its no-transaction-fee mutual fund service, known as the Mutual Fund OneSource (trademark) service, which by December 31, 1993, enabled customers to trade over 200 mutual funds in 25 well-known fund families without incurring brokerage transaction fees. The service is particularly attractive to investors who previously chose to execute mutual fund trades directly with multiple mutual fund companies to avoid brokerage transaction fees and achieve investment diversity among fund families. Mutual fund trades placed through the Mutual Fund OneSource service grew from an average of 1,000 per day in July 1992, including 500 per day in SchwabFunds (registered trademark), to an average of 9,800 per day in December 1993, including 1,200 per day in SchwabFunds. While Schwab does not receive transaction fees (commissions) on customer trades in the Mutual Fund OneSource participating mutual funds, it is compensated directly by the participating funds or their sponsors via fees received for providing record keeping and shareholder services. Such compensation is ongoing, based on daily balances of customer assets invested in the participating funds and held at Schwab. These revenues are recorded as mutual fund service fees. Fixed income investments available through Schwab include U.S. Treasuries, zero-coupon bonds, listed and OTC corporate bonds, municipal bonds, GNMAs, unit investment trusts and bond mutual funds. Schwab also makes available to its customers certificates of deposit (CDs) with specific financial institutions located in a variety of states. Schwab does not perform a credit evaluation of such institutions. Such institutions pay Schwab fees for its services in making such CDs available and in transmitting funds and performing certain accounting functions. Schwab's customers do not pay any commission or fee when they purchase CDs. Accounts and Features. Each Schwab customer has a brokerage account through which securities may be purchased or sold. If approved for margin transactions, a customer may borrow a portion of the price of certain securities purchased through Schwab, or may sell securities short. Customers must have specific approval to trade options; as of December 31, 1993, approximately 131,000 accounts were so approved. To write uncovered options, customers must go through an additional approval process and must maintain a significantly higher level of equity in their brokerage accounts. Because Schwab does not pay interest on cash balances in basic brokerage accounts, it provides customers with an option to have cash balances in their accounts automatically swept into money market mutual fund portfolios available through the SchwabFunds. For basic brokerage accounts opened after January 1, 1991, cash balances (that exceed specified minimum amounts) are automatically swept into the Schwab Money Market Fund unless customers elect otherwise. A customer may receive additional services by qualifying for and opening a Schwab One (registered trademark) Brokerage Account. A customer may remove available funds from his or her Schwab One account either with a personal check or a VISA debit card. If a Schwab One customer is approved for margin trading, which most are, the checks and debit card also provide access to margin cash available. For cash - 5 - THE CHARLES SCHWAB CORPORATION balances awaiting investment, Schwab pays interest to Schwab One (registered trademark) customers at a discretionary rate of interest. Alternatively, Schwab One customers seeking tax-exempt interest income may elect to have cash balances swept into one of three tax-exempt money market mutual funds, including two that are available through the SchwabFunds (registered trademark). During 1993, the number of active Schwab One accounts increased 19% and the customer assets in all Schwab One accounts increased 42%. The Company considers all customer accounts with cash balances, positions or trading activity within the preceding twelve months to be active. Schwab acts as custodian, as well as broker, for Individual Retirement Accounts (IRAs). In Schwab IRAs, cash balances are swept daily into one of three SchwabFunds money market mutual funds. During 1993, active IRAs increased 31% and customer assets in all IRAs increased 53%. Schwab also acts as custodian and broker for Keogh accounts. During 1992, Schwab introduced an IRA that does not carry an annual fee for accounts with balances of $10,000 or more, which was offered to existing and prospective IRA customers. The Company had previously charged an annual account fee of $22 on virtually all IRAs. At December 31, 1993, over two-thirds of the Company's 760,000 active IRAs were included in the no-annual-fee program. In order for the Company to maintain a competitive pricing structure, this lifetime no-annual-fee offer will continue through 1994. Customer Financing. Customers' securities transactions are effected on either a cash or margin basis. Generally, a customer buying securities in a cash-only brokerage account is required to make payment by settlement date, usually five business days after the trade is executed. However, for purchases of certain types of securities, such as mutual fund shares, a customer must have a cash balance in his or her account sufficient to pay for the trade prior to execution. When selling securities, a customer is required to deliver the securities, and is entitled to receive the proceeds, on the settlement date. In an account authorized for margin trading, Schwab may lend its customer a portion of the market value of certain securities up to the limit imposed by the Federal Reserve Board, which for most equity securities is initially 50%. Such loans are collateralized by the securities in the customer's account. "Short" sales of securities represent sales of borrowed securities and create an obligation to purchase the securities at a later date. Customers may sell securities "short" in a margin account subject to minimum equity and applicable margin requirements and the availability of such securities to be borrowed and delivered. Interest on margin loans to customers provides an important source of revenue to Schwab. During the year ended December 31, 1993, Schwab's outstanding margin loans to its customers averaged approximately $2.2 billion, up from 1992's average of $1.6 billion. In permitting a customer to engage in transactions, Schwab takes the risk of such customer's failure to meet his or her obligations in the event of adverse changes in the market value of the securities positions in his or her account. Under applicable rules and regulations for margin transactions, Schwab, in the event of such an adverse change, requires the customer to deposit additional securities or cash, so that the amount of the customer's obligation is not greater than specified percentages of the cash and market values of the securities in the account. As a matter of policy, Schwab generally requires its customers to maintain higher percentages of collateral values than the minimum percentages required under these regulations. Schwab may use cash balances in customer accounts to extend margin credit to other customers. Under the SEC's Rule 15c3-3, the portion of such cash balances not used to extend margin credit (increased or decreased by certain other customer-related balances) must be held in segregated investment accounts. The balances in these segregated investment accounts may be invested in qualified interest-bearing securities. To the extent customer cash balances are available for use by Schwab at interest costs lower than Schwab's costs of borrowing from alternative sources (e.g., balances in Schwab One brokerage accounts) or at no interest cost (e.g., balances in other accounts and outstanding checks that have not yet cleared Schwab's bank), Schwab's cost of funds is reduced and its net income is enhanced. Such interest savings contribute substantially to Schwab's profitability and, if a significant reduction of customer cash balances were to occur, Schwab's borrowings from other sources would have to increase and such profitability would decline. To the extent Schwab's customers elect to have cash balances in their brokerage accounts swept into certain SchwabFunds money market mutual funds, the cash balances available to Schwab for investments or for financing margin loans are reduced. However, Schwab receives mutual fund service fees from such funds based on the average daily invested balances. See also "Regulation" on page 9 and "Management's Discussion and Analysis of Results of Operations and Financial Condition" in the Company's 1993 Annual Report to Stockholders, which is incorporated herein by reference to Exhibit No. 13.1 of this report. Mutual Funds. CSIM provides investment advisory and administrative services to the SchwabFunds, which consisted of six money market funds, a broad-based equity index fund, an international index fund, an index fund that attempts to track the performance of common stocks of the second 1,000 largest United States corporations and six bond funds at December 31, 1993. Customer assets invested in the SchwabFunds totaled approximately $15.8 billion at December 31, 1993. - 6 - THE CHARLES SCHWAB CORPORATION The Company intends to offer additional mutual funds to its customers in the future. Market Making In Nasdaq Securities. M&S provides trade execution services in Nasdaq securities to institutional and broker-dealer clients. These services feature highly automated, competitively priced executions of both Nasdaq and non-Nasdaq stocks and warrants. In most instances, customer orders are routed directly to M&S' trading system and are executed automatically. Other Activities. To attract the business of accounts managed by independent fee-based financial advisors, Schwab has a dedicated group through which, among other things, it assigns specific, experienced registered representatives to individual financial advisors and occasionally provides certain research materials for the benefit of the advised accounts. Financial advisors participating in this program may access the information in their clients' accounts directly from Schwab's computer data bases. During 1993, Schwab added approximately 1,000 advisors to this program, which at December 31, 1993 included more than 4,200 financial advisors. Schwab has taken other steps to provide services tailored to meet the specialized needs of other professional investors, including corporations and institutions such as pension funds and investment companies. For example, Schwab's institutional brokerage department provides its customers with technical information and analysis of general conditions and trends in the securities market. Schwab also acts as agent for corporations in repurchasing their securities and in implementing dividend reinvestment plans. Schwab's brokerage business generated by financial advisors and other professional investors represented approximately 11% of Schwab's total commission revenues in 1993, 10% in 1992 and 9% in 1991. DELIVERY SYSTEMS Branch Office Network. Schwab believes that the existence of branch offices is important to increasing new account openings and maintaining high levels of customer satisfaction. At December 31, 1993, the Company maintained a network of 198 branches throughout the United States, including a branch office in the United Kingdom. Schwab plans to continue its branch expansion program in 1994 by opening approximately 28 new branches. Customers can use branch offices to obtain market information, place orders, open accounts, deliver and receive checks and securities and obtain related customer services in person, yet most branch activities are conducted by telephone and mail. Branch offices remain open during normal market hours to service customers in person and by telephone. Many branch offices offer extended office hours. Customer calls received during nonbranch hours are routed to customer telephone service centers. Customer Telephone Service Centers. Schwab's four customer telephone service centers, located in Indianapolis, Denver, Phoenix and Orlando (which opened in January 1994), handle calls to many of Schwab's toll-free numbers, customer calls that otherwise would have to wait for available registered representatives at branches during business hours, and calls routed from branches after hours and on weekends. Through the service centers, customers may place orders twenty-four hours a day, seven days a week, except for certain holidays. Customer orders placed during nonmarket hours are routed to appropriate markets the following business day. The capacity of the service centers allows new branches to be opened and maintained at lower staffing levels. The service centers, the first of which was opened in 1990, have developed into a significant component of Schwab's overall service delivery system and handled 28% of customer calls and 31% of customer trades during 1993. Electronic Delivery Services. Schwab provides automated brokerage services through which investors may place orders, receive account information and obtain securities market information. These services are designed to provide added convenience for customers and minimize Schwab's costs of responding to and processing routine customer transactions. Schwab's TeleBroker Service (registered trademark), which enables customers to place orders for stocks, options and certain mutual funds, as well as obtain real-time securities quotes and account information electronically from any touchtone telephone, was introduced in 1989 and was made available to customers nationally during 1991. TeleBroker (trademark), which provides customers with an additional 10% discount on commissions, has become increasingly important in providing customers access to Schwab, particularly during periods of heavy customer activity. During 1992, Schwab more than doubled the processing capacity of TeleBroker to accommodate increased customer usage and continued to increase capacity in 1993. In November 1993, TeleBroker was enhanced to accommodate Mutual Fund OneSource (trademark) transactions. On-line access to brokerage and investment information services is also available through Schwab's on-line trading software, StreetSmart (trademark) for Windows (trademark), introduced in October 1993. During 1993, TeleBroker and other on-line brokerage services handled over 53% of Schwab's customer calls and 22% of customer trades. Information Systems. Schwab's system for processing a securities transaction is highly automated. Registered - 7 - THE CHARLES SCHWAB CORPORATION representatives equipped with on-line computer terminals can access customer account information, obtain securities prices and related information and enter orders on-line. Most equity market orders are automatically executed and the representative is able to confirm execution to the customer while on the telephone. A written confirmation is generated automatically and is generally sent to the customer on the next business day. Under normal circumstances, most customer orders are executed without any Schwab employee filling out a single piece of paper. To support its service delivery system, as well as other applications such as clearing functions, account administration, record keeping and direct customer access to investment information, Schwab maintains a sophisticated computer network connecting all of the branch offices. Schwab's computers are also linked to the major registered United States securities exchanges, M&S, the National Securities Clearing Corporation and The Depository Trust Company. In 1979, Schwab obtained from Beta Systems, Inc. a non-exclusive license to use its basic software for executing brokerage functions. Since that time, Schwab has made substantial additions and modifications to that program. Schwab's computer systems also support on-line employee training, management information systems, software development activities and telecommunication network control functions. During periods of exceptionally high trading volume, the Company takes steps to provide customer service functions with maximum processing capacity. These steps include rescheduling processing jobs unrelated to customer trading functions and restricting on-line access to the Company's mainframe computer functions. The Company's computer capacity is continuously monitored and efforts are made to achieve an optimal balance between the costs of additional processing capacity and the customer service benefits it provides during high-volume periods. Schwab's operations rely heavily on its information processing and communications systems. External events, such as an earthquake or power failure, loss of external information feeds, such as security price information, as well as internal malfunctions, could render part of or all such systems inoperative. To enhance the reliability of the system and integrity of data, Schwab maintains carefully monitored backup and recovery functions. These include logging of all critical files intraday, duplication and storage of all critical data outside of its central computer site every 24 hours, and maintenance of facilities for backup and communications in San Francisco. They also include the maintenance and periodic testing of a disaster recovery plan that management believes would permit Schwab to recommence essential operations within 72 hours if its central computer site were to become inaccessible. In March 1994, Schwab installed a new recovery system which permits essential operations to recommence within 24 hours. Failure of Schwab's information processing or communications systems for a significant period of time could limit Schwab's ability to process its large volume of transactions accurately and rapidly, could cause it to be unable to satisfy its obligations to customers and other securities firms, and could result in regulatory violations. The Company constructed a computer data center in Phoenix and relocated its primary data center to this site in 1993. This move strengthens the Company's backup recovery capability and provides additional support in the event of extended interruptions in existing processing capability. CLEARING AND ACCOUNT MAINTENANCE Schwab performs clearing services for all securities transactions in customer accounts. These services involve the confirmation, receipt, execution, settlement and delivery functions involved in securities transactions. Among other things, performing its own clearing services allows Schwab to provide margin loans and use customer cash balances to finance them. During the year ended December 31, 1993, Schwab processed over nine million separate securities, options and mutual fund trades. Schwab clears the vast majority of customer transactions through the facilities of the National Securities Clearing Corporation or the Options Clearing Corporation. Certain other transactions, such as mutual fund transactions and transactions in securities not eligible for settlement through a clearing corporation, are settled directly with the mutual funds or other financial institutions. Schwab is obligated to settle transactions with clearing corporations, mutual funds and other financial institutions even if Schwab's customer fails to meet his or her obligations to Schwab. In addition, for transactions that do not settle through a clearing corporation, Schwab takes the risk of the other party's failure to settle the trade. See "Commitments, Contingent Liabilities and Other Information" in the Notes to Consolidated Financial Statements in the Company's 1993 Annual Report to Stockholders, which are incorporated herein by reference to Exhibit No. 13.1 of this report. Customer securities are typically held by Schwab in nominee name, on deposit at one or more of the recognized securities industry depository trust companies, or in the case of government and certain other fixed-income securities and other instruments (e.g., certain limited partnership interests), at a custodial bank. Schwab collects dividends and interest on securities held in nominee name, making the appropriate credits to customer accounts. Schwab also facilitates exercise of subscription rights on securities held for customers. Schwab arranges for the transmittal of proxy and tender offer materials and company reports to customers. - 8 - THE CHARLES SCHWAB CORPORATION EMPLOYEES As of December 31, 1993, the Company had approximately 6,500 employees, including full-time, part-time and temporary employees, as well as persons employed on a contract basis. None of the employees are represented by a union, and the Company believes its relations with its employees are good. REGULATION The securities industry in the United States is subject to extensive regulation under both Federal and state laws. The SEC is the Federal agency charged with administration of the Federal securities laws. Schwab and M&S are registered as broker-dealers with the SEC. Schwab and CSIM are registered as investment advisers with the SEC. Much of the regulation of broker-dealers has been delegated to self-regulatory organizations, principally the NASD and the national securities exchanges such as the New York Stock Exchange, Inc. (NYSE), which has been designated by the SEC as Schwab's primary regulator with respect to its securities activities. The NASD has been designated as M&S' primary regulator by the SEC with respect to its securities activities. During 1993, the NASD was Schwab's designated primary regulator with respect to options trading activities. Currently, the American Stock Exchange is Schwab's designated primary regulator with respect to options trading activities. These self-regulatory organizations adopt rules (subject to approval by the SEC) governing the industry and conduct periodic examinations of broker-dealers. Securities firms are also subject to regulation by state securities commissions in the states in which they do business. Schwab is registered as a broker-dealer in 50 states, the District of Columbia and Puerto Rico. M&S is registered as a broker-dealer in 17 states as of December 1993. The regulations to which broker-dealers and investment advisers are subject cover all aspects of the securities business, including sales methods, trading practices among broker-dealers, uses and safekeeping of customers' funds and securities, capital structure of securities firms, record keeping, fee arrangements, disclosure to clients, and the conduct of directors, officers and employees. Additional legislation, changes in rules promulgated by the SEC and by self-regulatory organizations, or changes in the interpretation or enforcement of existing laws and rules may directly affect the method of operation and profitability of broker-dealers and investment advisers. The SEC, self-regulatory organizations, and state securities commissions may conduct administrative proceedings which can result in censure, fine, cease and desist orders, or suspension or expulsion of a broker-dealer or an investment adviser, its officers, or employees. In the past, Schwab occasionally has been the subject of such administrative proceedings. The principal purpose of regulations and discipline of broker-dealers and investment advisers is the protection of customers and the securities markets, rather than protection of creditors and stockholders of broker-dealers and investment advisers. As registered broker-dealers and NASD member organizations, Schwab and M&S are required by Federal law to belong to the Securities Investor Protection Corporation (SIPC), which provides, in the event of the liquidation of a broker-dealer, protection for securities held in customer accounts held by the firm of up to $500,000 per customer, subject to a limitation of $100,000 on claims for cash balances. SIPC is funded through assessments on registered broker-dealers. SIPC assessments currently are .054% of net operating revenues (as defined) per year. In addition, Schwab has purchased from private insurers additional account protection of up to $24.5 million per customer, as defined, in 1993 for customer securities positions only. This account protection is up from protection in 1992 of $2 million. Mutual funds, including money market funds, are considered securities for the purposes of SIPC coverage and the supplemental coverage. Schwab is also authorized by the Municipal Securities Rulemaking Board to effect transactions in municipal securities on behalf of its customers and has obtained certain additional registrations with the SEC and state regulatory agencies necessary to permit it to engage in certain other activities incidental to its brokerage business. For example, Schwab is registered with the SEC as a transfer agent in connection with certain services it provides to the SchwabFunds (registered trademark). Margin lending by Schwab and M&S is subject to the margin rules of the Board of Governors of the Federal Reserve System and the NYSE. Under such rules, broker-dealers are limited in the amount they may lend in connection with certain purchases and short sales of securities and are also required to impose certain maintenance requirements on the amount of securities and cash held in margin accounts. In addition, those rules and rules of the Chicago Board Options Exchange govern the amount of margin customers must provide and maintain in writing uncovered options. As a California state-chartered trust company, CSTC is authorized to conduct business in California, and is primarily regulated by the California State Banking Department. Since it provides custody services to employee benefit plan trusts, CSTC is also required to comply with the Employee Retirement Income Security Act of 1974 (ERISA) and, consequently, is subject to oversight by both the Internal Revenue Service and Department of Labor. CSTC is required under state law to maintain a fidelity bond for the protection of account holders. - 9 - THE CHARLES SCHWAB CORPORATION NET CAPITAL REQUIREMENTS As registered broker-dealers, Schwab and M&S are subject to the Uniform Net Capital Rule (Rule 15c3-1) promulgated by the SEC (the Net Capital Rule), which has also been adopted through incorporation by reference in NYSE Rule 325. Schwab is a member firm of the NYSE and the NASD, and M&S is a member firm of the NASD. The Net Capital Rule specifies minimum net capital requirements for all registered broker-dealers and is designed to measure financial integrity and liquidity. Failure to maintain the required net capital may subject a firm to suspension or expulsion by the NYSE and the NASD, certain punitive actions by the SEC and other regulatory bodies, and ultimately may require a firm's liquidation. Because CSC itself is not a registered broker-dealer, it is not subject to the Net Capital Rule. However, Schwab's failure to maintain specified levels of net capital would constitute a default by CSC under certain debt covenants. "Net capital" is essentially defined as net worth (assets minus liabilities), plus qualifying subordinated borrowings, less certain deductions that result from excluding assets that are not readily convertible into cash and from conservatively valuing certain other assets. These deductions include charges that discount the value of firm security positions to reflect the possibility of adverse changes in market value prior to disposition. During 1991, the SEC adopted Net Capital Rule amendments which limit withdrawals of equity capital from broker-dealers. The amendments require notice of withdrawals be provided to the SEC prior to and subsequent to withdrawals exceeding certain sizes. The amendments prohibit withdrawals that would reduce a broker-dealer's net capital to an amount less than 25% of its deductions required by the Net Capital Rule as to its security positions. The amendments also allow the SEC, under limited circumstances, to restrict a broker-dealer from withdrawing net capital for up to 20 business days. Schwab has elected the alternative method of calculation under paragraph (a)(1)(ii) of the Net Capital Rule, which requires a broker-dealer to maintain minimum net capital equal to 2% of its "aggregate debit items", computed in accordance with the Formula for Determination of Reserve Requirements for Brokers and Dealers (SEC Rule 15c3-3). "Aggregate debit items" are assets that have as their source transactions with customers, primarily margin loans. Under the alternative method of the Net Capital Rule, a broker-dealer may not (a) pay, or permit the payment or withdrawal of, any subordinated borrowings or (b) pay cash dividends or permit equity capital to be removed if, after giving effect to such payment, withdrawal, or removal, its net capital would be less than 5% of its aggregate debit items. Under NYSE Rule 326, Schwab is required to reduce its business if its net capital is less than 4% of aggregate debit items for 15 consecutive days; NYSE Rule 326 also prohibits the expansion of business if net capital is less than 5% of aggregate debit items for 15 consecutive days. The provisions of NYSE Rule 326 also become operative if capital withdrawals (including scheduled maturities of subordinated borrowings during the following six months) would result in a reduction of a firm's net capital to the levels indicated. Since its acquisition by the Company and through February 27, 1992, M&S computed net capital under the aggregate indebtedness method of the Net Capital Rule. Effective February 28, 1992, M&S elected to compute net capital under the alternative method of the Net Capital Rule. If compliance with applicable net capital rules were to limit Schwab's or M&S' operations and Schwab's ability to repay its subordinated debt to the Company, this in turn could limit the Company's ability to repay debt, pay cash dividends, and purchase shares of its outstanding stock. See "Management's Discussion and Analysis of Results of Operations and Financial Condition" in the Company's 1993 Annual Report to Stockholders, which is incorporated herein by reference to Exhibit No. 13.1 of this report. At December 31, 1993, Schwab was required to maintain minimum net capital under the Net Capital Rule of $53 million and had total regulatory net capital of $260 million. At December 31, 1993, the amounts in excess of 2%, 4% and 5% of aggregate debit items were $207 million, $155 million and $128 million, respectively. At December 31, 1993, M&S was required to maintain minimum net capital under the Net Capital Rule of $1 million and had total regulatory net capital of $13 million. At December 31, 1993, the amounts in excess of 2%, 4% and 5% of aggregate debit items all exceeded $12 million. During 1993, CSIM was deemed no longer to be subject to the regulations for investment advisers promulgated by the State of California Department of Corporations and, therefore, has no net capital requirements. CSTC's capital requirement is established by the California Superintendent of Banks under the California Financial Code. The Code requires that CSTC's ratio of contributed capital, as defined, to accumulated deficit shall exceed 2.5 to 1. At December 31, 1993 the ratio of contributed capital to accumulated deficit was 2.8 to 1. If CSTC's capital declines, or if the Superintendent of Banks determines that additional capital is required for other reasons, CSC could be required to contribute additional capital to CSTC. - 10 - THE CHARLES SCHWAB CORPORATION ITEM 2. ITEM 2. PROPERTIES The Company's corporate headquarters are located in a 28-story building at 101 Montgomery Street in San Francisco. The building contains approximately 295,000 square feet and is leased by Schwab under a term expiring in the year 2000. The current rental is approximately $8.6 million per year, subject to certain increases and obligations to pay certain operating expenses such as utilities, insurance and taxes. Schwab has three successive five-year options to renew the lease at the then market rental value. Schwab also leases space in other buildings for its San Francisco operations aggregating approximately 380,000 square feet at year-end 1993. M&S' headquarters are located in leased office space in Jersey City, New Jersey. In 1992, the Company purchased land in the Phoenix area and in 1993 completed construction of a data center that is Schwab's centralized computer processing facility. The data center has approximately 105,000 square feet of floor space. All of Schwab's branch offices and customer telephone service centers and M&S' branch offices are located in leased premises, generally with lease expiration dates five to ten years from inception. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The information required to be furnished pursuant to this item is set forth under the caption "Commitments, Contingent Liabilities and Other Information" in the Notes to the Consolidated Financial Statements in the Company's 1993 Annual Report to Stockholders, which are incorporated herein by reference to Exhibit No. 13.1 of this report. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of the Company's security holders during the fourth quarter of 1993. ITEM 4A. EXECUTIVE OFFICERS OF THE REGISTRANT See Item 10 in Part III of this report. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The information required to be furnished pursuant to this item is set forth under the captions "Common Stock Data" and "Quarterly Financial Information (Unaudited)" in the Company's 1993 Annual Report to Stockholders, which are incorporated herein by reference to Exhibit No. 13.1 of this report. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The information required to be furnished pursuant to this item is set forth under the captions "Operating Results (for the year)," "Other (at year end)" and "Other (for the year)" in the Company's 1993 Annual Report to Stockholders, which are incorporated herein by reference to Exhibit No. 13.1 of this report. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information required to be furnished pursuant to this item is set forth under the caption "Management's Discussion and Analysis of Results of Operations and Financial Condition" in the Company's 1993 Annual Report to Stockholders, which is incorporated herein by reference to Exhibit No. 13.1 of this report. Additional statistics for the fourth quarters of 1993 and 1992 are presented as follows. - 11 - THE CHARLES SCHWAB CORPORATION Average balances and interest rates for the fourth quarters of 1993 and 1992 are summarized as follows (dollars in millions): Average balances of investments increased 3% and margin loans to customers increased 38% from the fourth quarter of 1992 to the fourth quarter of 1993. The average yield on investments and margin loans to customers increased one basis point from the fourth quarter of 1992 to the fourth quarter of 1993. Over this same period, interest-bearing customer cash balances increased 11%, and the average interest rate paid on these balances declined 30 basis points. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information required to be furnished pursuant to this item is set forth in the Consolidated Financial Statements and under the caption "Quarterly Financial Information (Unaudited)" in the Company's 1993 Annual Report to Stockholders, which are incorporated herein by reference to Exhibit No. 13.1 of this report. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information relating to directors of the Company required to be furnished pursuant to this item is incorporated by reference from portions of the Company's definitive proxy statement for its annual meeting of stockholders to be filed with the Securities and Exchange Commission pursuant to Regulation 14A within 120 days after December 31, 1993 (the Proxy Statement) under the captions "Election of Directors" (excluding all information under the subcaption "Information about the Board of Directors and Committees of the Board") and "Principal Stockholders." Executive Officers of the Registrant The following table provides certain information about each of the Company's current executive officers. Executive officers are elected by and serve at the discretion of the Company's Board of Directors. - 12 - THE CHARLES SCHWAB CORPORATION EXECUTIVE OFFICERS OF THE REGISTRANT MR. SCHWAB has been Chairman and Chief Executive Officer and a director of the Company since its incorporation in November 1986. Mr. Schwab was a founder of Schwab in 1971 and has been its Chairman since 1978. He also served as Chief Executive Officer of Schwab from 1978 to July 1988. Mr. Schwab is currently a director of The Gap, Inc., Transamerica Corporation and Chairman of Schwab Investments and The Charles Schwab Family of Funds and was formerly a director of BankAmerica Corporation. Mr. Schwab currently serves as Governor-at-Large of the National Association of Securities Dealers, Inc. MR. STUPSKI has been Vice Chairman of the Company since July 1992 and a director of the Company since its incorporation in November 1986. Mr. Stupski was Chief Operating Officer of the Company from November 1986 to March 1994, the Company's President from November 1986 to July 1992, and its Chief Financial Officer from April 1987 to March 1988. Mr. Stupski has been a director of Schwab since 1981. He also served as President of Schwab from 1981 to July 1988, and as Chief Executive Officer of Schwab from that date to July 1992. He served as Chief Operating Officer of Schwab from 1981 to July 1992. During 1990 and 1991, Mr. Stupski was a member of the board of directors of the Chicago Board Options Exchange. From 1982 to 1985, Mr. Stupski was a Governor of The Pacific Stock Exchange Incorporated. MR. POTTRUCK was named Chief Operating Officer and a director of the Company in March 1994 and has been President of the Company since July 1992. Mr. Pottruck was Executive Vice President from March 1987 until July 1992. Mr. Pottruck joined Schwab in 1984 and served as Executive Vice President - Marketing and Branch Management until his appointment as President and a director of Schwab in July 1988. He was promoted to Chief Executive Officer of Schwab in July 1992. Mr. Pottruck was Senior Vice President of Consumer Marketing and Advertising for Shearson/American Express from 1981 until joining Schwab, with responsibility for execution of all retail marketing, advertising, direct response and consumer communications. MR. READMOND has been Senior Executive Vice President of the Company and Schwab, as well as Chief Operating Officer of Schwab, since July 1992. From August 1989 until July 1992, he was Executive Vice President - Operations, Trading and Credit of the Company and Schwab. Prior to joining Schwab, Mr. Readmond held various positions with Alex Brown & Sons, Inc., including Operations Principal in 1985, Managing Director in 1986 and Division Manager of Information Systems and Operations from 1987 until he joined Schwab. - 13 - THE CHARLES SCHWAB CORPORATION MR. SEIP was named Senior Executive Vice President - Retail Brokerage of the Company and Schwab in March 1994. He has been President of Charles Schwab Investment Management, Inc. (CSIM) since July 1992 and Chief Operating Officer of CSIM since June 1991. From July 1992 until March 1994, he was Executive Vice President - Mutual Funds and Fixed Income Products. Mr. Seip has been with the Company since January 1983. Prior to becoming Senior Vice President of the Company and assuming his mutual fund responsibilities in June 1991, Mr. Seip was the divisional executive in charge of Schwab's retail branches east of the Mississippi. From 1985 to 1988, Mr. Seip founded and was responsible for Schwab's Financial Advisors Service. Before joining Schwab, he was a Vice President and Partner at Korn Ferry International. MR. CHOATE has been Executive Vice President - Retail Service Delivery of the Company and Schwab since March 1991. Mr. Choate was Executive Vice President of Branch Systems with Security Pacific Bank from 1988 until joining Schwab, responsible for the statewide branch banking system. He held a full range of branch administration positions with Security Pacific Bank from 1969 to 1988, including Division Administrator, Regional Vice President and Branch Manager. MR. COGHLAN has been Executive Vice President and General Manager of Schwab Institutional of the Company and Schwab since July 1992. Mr. Coghlan joined Schwab in 1986, became a Vice President in 1988 and became Senior Vice President in 1990. From 1988 to 1990, he was also an Adjunct Professor of Marketing at the McLaren School of Business at the University of San Francisco and from 1985 to 1987 he was a Lecturer in the Department of Marketing and Management in the School of Business at San Francisco State University. MR. GAMBS has been Executive Vice President and Chief Financial Officer of the Company and Schwab since March 1988. Mr. Gambs was Deputy Treasurer of Merrill Lynch & Co., Inc. from 1987 until he joined Schwab, and from 1984 to 1987 was Vice President/Corporate Staff, with responsibilities for financing, cash management and credit relationships. MS. LEPORE has been Executive Vice President and Chief Information Officer of the Company and Schwab since October 1993. Ms. Lepore joined Schwab in 1983, became a Vice President in 1987 and became Senior Vice President in 1989. Prior to joining Schwab, Ms. Lepore was a consultant with Informatics, an information consulting firm in San Francisco. MS. OJHA has been Executive Vice President - Core Services of the Company and Schwab since March 1993. Before joining the Company, Ms. Ojha served as a Director and then a Partner in the National Advanced Technology Group, of Coopers & Lybrand, an international professional service firm, since 1987. From 1975 to 1987, Ms. Ojha was a consultant in the Operations Research Practice and then a manager in the Center for Applied Artificial Intelligence of Arthur D. Little, Inc. MS. SAWI was named Executive Vice President - Mutual Funds in March 1994 and she was Executive Vice President - Marketing and Advertising from January 1992 until March 1994. Ms. Sawi joined Schwab in 1982, became a Vice President in 1984 and became Senior Vice President in 1985. Before joining Schwab in 1982, Ms. Sawi was a Marketing Manager for the travel and entertainment card division of American Express. MR. TOGNINO joined the Company in October 1993 as the Executive Vice President of Capital Markets and Trading. Prior to joining Schwab, Mr. Tognino was a Managing Director at Merrill Lynch in New York since 1991, and was based in London as Managing Director of the equity product from 1990 to 1991. He served as Managing Director of Unlisted Trading from 1987 to 1988, and previously served as Managing Director of the OTC department, which included agency orders, institutional sales trading and market making. Mr. Tognino serves on the Nasdaq Board of Governors as Chairman of the Securities Traders Association and as President of the Securities Traders Association of New York. MR. VALENCIA joined the Company and was named Executive Vice President - Human Resources of the Company and Schwab in March 1994. Before joining the Company, Mr. Valencia served as a Managing Director of Commercial Credit Corp., a subsidiary of the Travelers engaged in consumer finance for the Travelers, from January 1993 to February 1994. From 1975 to 1993, he held various positions with Citicorp, including Regional Business Manager in the New York Banking Division from 1981 to 1984, President and Chief Executive Officer of Citicorp Savings from 1984 to 1990, and President and Chief Executive Officer of Transaction Technology, a subsidiary of Citicorp, from 1990 to 1993. Prior to Citicorp, Mr. Valencia held Human Resource positions with Pfizer, Inc. - 14 - THE CHARLES SCHWAB CORPORATION ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information required to be furnished pursuant to this item is incorporated by reference from portions of the Proxy Statement under the captions "Executive Compensation" (excluding all information under the subcaption "Board Compensation Committee Report on Executive Compensation" and "Performance Graph") and "Certain Transactions." ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required to be furnished pursuant to this item is incorporated by reference from portions of the Proxy Statement under the caption "Principal Stockholders." ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND TRANSACTIONS The information required to be furnished pursuant to this item is incorporated by reference from a portion of the Proxy Statement under the caption "Certain Transactions." PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) Documents filed as part of this Report 1. Financial Statements The financial statements and independent auditors' report are set forth in the Company's 1993 Annual Report to Stockholders, which are incorporated herein by reference to Exhibit No. 13.1 of this report and are listed below: Consolidated Statement of Income Consolidated Balance Sheet Consolidated Statement of Cash Flows Consolidated Statement of Stockholders' Equity Notes to Consolidated Financial Statements Independent Auditors' Report 2. Financial Statement Schedules The financial statement schedules required to be furnished pursuant to this item are listed in the accompanying index appearing on page. (b) Reports on Form 8-K None filed during the last quarter of 1993. - 15 - THE CHARLES SCHWAB CORPORATION (c) Exhibits The exhibits listed below are filed as part of this annual report on Form 10-K. - 16 - THE CHARLES SCHWAB CORPORATION - 17 - THE CHARLES SCHWAB CORPORATION - 18 - THE CHARLES SCHWAB CORPORATION - 19 - THE CHARLES SCHWAB CORPORATION * Incorporated by reference to the identically-numbered exhibit to Registrant's Registration Statement No. 33-16192 on Form S-1, as amended and declared effective on September 22, 1987. - 20 - THE CHARLES SCHWAB CORPORATION 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, on March 30, 1994. THE CHARLES SCHWAB CORPORATION (Registrant) By: CHARLES R. SCHWAB /s/ ----------------------------- Charles R. Schwab Chairman 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 indicated, on March 30, 1994. - 21 - THE CHARLES SCHWAB CORPORATION INDEX TO FINANCIAL STATEMENT SCHEDULES Schedules not listed are omitted because of the absence of the conditions under which they are required or because the information is included in the Company's consolidated financial statements and notes in the Company's 1993 Annual Report to Stockholders, which are incorporated herein by reference to Exhibit No. 13.1 of this report. INDEPENDENT AUDITORS' REPORT To the Stockholders and Board of Directors of The Charles Schwab Corporation: We have audited the consolidated financial statements of The Charles Schwab Corporation (the Company) and subsidiaries as of December 31, 1993 and 1992, and for each of the three years in the period ended December 31, 1993, and have issued our report thereon dated February 17, 1994 (February 25, 1994 as to Subsequent Event note); such consolidated financial statements and report are included in your 1993 Annual Report to Stockholders and are incorporated herein by reference. Our audits also included the financial statement schedules of the Company and subsidiaries appearing on pages through. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. DELOITTE & TOUCHE San Francisco, California February 17, 1994 (February 25, 1994 as to Subsequent Event note) SCHEDULE III THE CHARLES SCHWAB CORPORATION (PARENT COMPANY ONLY) CONDENSED FINANCIAL INFORMATION OF REGISTRANT CONDENSED BALANCE SHEET (In thousands, except share data) * Reflects the 1993 three-for-two common stock split. See Notes to Consolidated Financial Statements in the Company's 1993 Annual Report to Stockholders, which are incorporated herein by reference to Exhibit No. 13.1 of this report, for a discussion of long-term and subordinated borrowings and contingent liabilities. SCHEDULE III THE CHARLES SCHWAB CORPORATION (PARENT COMPANY ONLY) CONDENSED FINANCIAL INFORMATION OF REGISTRANT CONDENSED STATEMENT OF INCOME AND RETAINED EARNINGS (In thousands) SCHEDULE III THE CHARLES SCHWAB CORPORATION (PARENT COMPANY ONLY) CONDENSED FINANCIAL INFORMATION OF REGISTRANT CONDENSED STATEMENT OF CASH FLOWS (In thousands) Prior years' financial statements have been reclassified to conform to the 1993 presentation. See Notes to the Consolidated Financial Statements in the Company's 1993 Annual Report to Stockholders, which are incorporated herein by reference to Exhibit No. 13.1 of this report, for a discussion of additional cash flow information. SCHEDULE VIII THE CHARLES SCHWAB CORPORATION VALUATION AND QUALIFYING ACCOUNTS (In thousands) (1) Primarily represents collections of previously written off accounts. Amounts for 1993, 1992 and 1991 include a $57, a $123 and a $65 reduction, respectively, to the allowance recorded in connection with CSC's 1989 acquisition of Rose & Company Investment Brokers, Inc. SCHEDULE IX THE CHARLES SCHWAB CORPORATION SHORT-TERM BORROWINGS (In thousands) (1) Bank loans are under lines of credit, are payable on demand, and may be collateralized by customer securities. (2) Represents the weighted average daily balances outstanding for days on which there were borrowings - 25 days in 1993, 42 days in 1992 and 41 days in 1991. (3) Weighted average interest rate computed by dividing the daily interest expense by the daily amounts outstanding. SCHEDULE X THE CHARLES SCHWAB CORPORATION SUPPLEMENTAL INCOME STATEMENT INFORMATION (In thousands) Items not shown have been omitted because they do not exceed 1% of total revenues.

1993 ITEM 3. LEGAL PROCEEDINGS Williston Basin has been named as a defendant in a legal action primarily related to its transportation services. Such suit was filed by KN as described under "Pending Litigation". Williston Basin's assessment of this proceeding is included in the description of the litigation. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the fourth quarter of 1993. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS MDU Resources Group, Inc. common stock is listed on the New York Stock Exchange and uses the symbol "MDU". The price range of the Company's common stock as reported by the Wall Street Journal composite tape during 1993 and 1992 and dividends declared thereon were as follows: Common Common Common Stock Stock Price Stock Price Dividends (High) (Low) Per Share First Quarter . . . . . . . . $29 1/4 $25 7/8 $ .37 Second Quarter. . . . . . . . 32 1/2 29 .37 Third Quarter . . . . . . . . 32 29 3/4 .39 Fourth Quarter. . . . . . . . 33 1/8 30 1/2 .39 $1.52 First Quarter . . . . . . . . $25 3/4 $23 1/4 $ .36 Second Quarter. . . . . . . . 26 7/8 21 7/8 .36 Third Quarter . . . . . . . . 25 1/2 23 7/8 .37 Fourth Quarter. . . . . . . . 26 3/4 25 .37 $1.46 As of December 31, 1993, the Company's common stock was held by approximately 15,100 stockholders. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Reference is made to selected Financial Data on pages 52 and 53 of the Company's Annual Report which is incorporated herein by reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Overview The following table (in millions of dollars) summarizes the contribution to consolidated earnings by each of the Company's businesses. Years ended December 31, Business 1993 1992 1991 Utility -- Electric . . . . . . . . . . . . $12.6 $13.3 $15.3 Natural gas. . . . . . . . . . . 1.2 1.4 3.6 13.8 14.7 18.9 Natural gas transmission . . . . . 4.7 3.5 0.5 Mining and construction materials. . . . . . . . . . . . 12.4 10.7 9.8 Oil and natural gas production . . 7.1 5.7 8.0 Earnings on common stock . . . . . $38.0 $34.6 $37.2 Earnings per common share. . . . . $2.00 $1.82 $1.96 Return on average common equity. . 12.3% 11.6% 12.7% Earnings information presented in this table and in the following discussion is before the $8.9 million ($5.5 million after-tax) cumulative effect of an accounting change. See Note 2 of Notes to Consolidated Financial Statements for a further discussion of this accounting change. 1993 compared to 1992 Consolidated earnings for 1993 are up $3.4 million when compared to 1992. The improvement is attributable to increased earnings from the natural gas transmission, mining and construction materials, and oil and natural gas production businesses, partially offset by a slight decrease in utility earnings. The reasons for such changes are described in the "1993 compared to 1992" discussions which follow. 1992 compared to 1991 Consolidated earnings for 1992 are down $2.6 million from the $37.2 million earned in 1991. The decline was the result of decreased earnings in the utility and oil and natural gas production businesses, partially offset by increased natural gas transmission and mining and construction materials earnings. The reasons for such changes are described in the "1992 compared to 1991" discussions which follow. ________________________________ Reference should be made to Items 1 and 2 -- "Business and Properties - - Interstate Natural Gas Transmission Operations and Property" and Notes 3, 4 and 5 of Notes to Consolidated Financial Statements for information pertinent to pending litigation, regulatory matters and revenues subject to refund and a natural gas repurchase commitment. Financial and operating data The following tables (in millions, where applicable) are key financial and operating statistics for each of the Company's business units. Certain reclassifications have been made in the following statistics for 1992 and 1991 to conform to the 1993 presentation. Such reclassifications had no effect on net income or common stockholders' investment as previously reported. Montana-Dakota -- Electric Operations Years ended December 31, 1993* 1992 1991 Operating revenues . . . . . . . . $131.1 $123.9 $128.7 Fuel and purchased power . . . . . 41.3 37.9 38.4 Operation and maintenance expenses . . . . . . . . . . . . 37.4 34.2 33.7 Operating income . . . . . . . . . 30.5 30.2 34.6 Retail sales (kWh) . . . . . . . . 1,893.7 1,829.9 1,877.6 Power deliveries to MAPP (kWh) . . 511.0 352.6 331.3 Cost of fuel and purchased power per kWh. . . . . . . . . . $ .016 $ .016 $ .016 Montana-Dakota -- Natural Gas Distribution Operations Years ended December 31, 1993* 1992 1991 Operating revenues: Sales. . . . . . . . . . . . . . $151.7 $123.8 $134.4 Transportation & other . . . . . 4.3 4.4 4.2 Purchased natural gas sold . . . . 114.0 89.5 98.3 Operation and maintenance expenses . . . . . . . . . . . . 28.6 26.0 23.8 Operating income . . . . . . . . . 4.7 4.5 8.5 Volumes (dk): Sales. . . . . . . . . . . . . . 31.2 26.7 30.1 Transportation . . . . . . . . . 12.7 13.7 12.2 Total throughput . . . . . . . . . 43.9 40.4 42.3 Degree days (% of normal). . . . . 105.5% 87.1% 97.9% Cost of natural gas per dk . . . . $ 3.66 $ 3.35 $ 3.27 *See Note 2 of Notes to Consolidated Financial Statements for a discussion of an accounting change to reflect unbilled revenues. Williston Basin Years ended December 31, 1993 1992 1991 Operating revenues: Sales for resale. . . . . . . . . $51.3* $63.5* $78.8* Transportation & other. . . . . . 40.0* 35.5* 37.2* Purchased natural gas sold . . . . 20.6 33.6 45.3 Operation and maintenance expenses . . . . . . . . . . . . 39.0** 33.0** 39.6** Operating income . . . . . . . . . 20.1 21.3 19.9 Volumes (dk): Sales for resale: Montana-Dakota. . . . . . . . . 13.0 16.5 19.3 Other . . . . . . . . . . . . . .2 .3 .3 Transportation: Montana-Dakota. . . . . . . . . 27.3 24.9 22.1 Other . . . . . . . . . . . . . 32.1 39.6 31.8 Total throughput . . . . . . . . . 72.6 81.3 73.5 Cost of natural gas per dk . . . . $1.78 $1.91 $2.07 _________________________________ * Includes recovery of deferred natural gas contract buy-out/buy-down costs. . . . . $13.0 $ 5.8 $ 6.5 ** Includes amortization of deferred natural gas contract buy-out/buy-down costs. . . . . $11.8 $ 6.2 $ 6.6 Knife River Years ended December 31, 1993 1992 1991 Operating revenues: Coal. . . . . . . . . . . . . . . $44.2 $43.8 $41.2 Construction materials. . . . . . 46.2 1.2 --- Operation and maintenance expenses . . . . . . . . . . . . 59.6 21.2 20.2 Reclamation expense. . . . . . . . 3.1 3.0 2.8 Severance taxes. . . . . . . . . . 4.4 4.3 4.2 Operating income . . . . . . . . . 17.0 11.5 9.7 Sales (000's): Coal (tons) . . . . . . . . . . . 5,066 4,913 4,731 Aggregates (tons) . . . . . . . . 2,391 263 --- Ready-mixed concrete (cubic yards) . . . . . . . . . 157 --- --- Asphalt (tons). . . . . . . . . . 141 --- --- Fidelity Oil Years ended December 31, 1993 1992 1991 Operating revenues . . . . . . . . $39.1 $33.8 $33.9 Operation and maintenance expenses. . . . . . . . . . . . . 11.6 12.0 11.8 Depreciation, depletion and amortization. . . . . . . . . . . 12.0 8.8 6.0 Operating income . . . . . . . . . 11.8 9.5 12.6 Production (000's): Oil (barrels) . . . . . . . . . 1,497 1,531 1,491 Natural gas (Mcf). . . . . . . . 8,817 5,024 2,565 Average sales price: Oil (per barrel) . . . . . . . . $14.84 $16.74 $19.90 Natural gas (per Mcf). . . . . . 1.86 1.53 1.48 1993 compared to 1992 Montana-Dakota--Electric Operations Operating income for the electric business increased due to an improvement in retail sales to residential and commercial markets, primarily the result of colder weather in the first quarter of 1993 and the addition of nearly 540 customers. Also, improving operating income was an increase in deliveries into the MAPP, the result of water conservation efforts by hydroelectric generators and the temporary shutdown of a nuclear generating station in Iowa. Increased fuel and purchased power costs, largely higher demand charges associated with the purchase of an additional five megawatts of firm capacity through a participation power contract partially offset the improvement in operating income. Higher operation and maintenance expenses also negatively affected operating income. Employee benefit-related costs increased operation expense while higher costs associated with repairs made at the Heskett, Big Stone and Coyote stations accounted for the increase in maintenance expense. Earnings from this business unit declined as a result of a decrease in Other Income--Net, reflecting the on-going effects of adopting SFAS No. 106, and increased federal income taxes. A decrease in interest expense due to lower interest rates stemming from long-term debt refinancing in 1992 and lower average short-term borrowings and interest rates, and the aforementioned operating income improvement, somewhat offset the earnings decline. Montana-Dakota--Natural Gas Distribution Operations Sales increases of 4.5 MMdk or $3.6 million, due to significantly colder weather than 1992 and the addition of over 3,500 residential and commercial customers, improved operating income for the natural gas distribution business. However, partially offsetting this improvement were the 1992 refinement of the estimated amount of delivered but unbilled natural gas volumes and increased operation and depreciation expenses. Employee benefit-related costs and distribution and sales expenses related to the system expansion into north-central South Dakota accounted for the majority of the operation expense increase. A Wyoming rate decrease effective in the second quarter of 1992 also reduced the operating income improvement. Gas distribution earnings decreased due to higher financing costs related to increased capital expenditures and carrying charges being accrued on natural gas costs refundable through rate adjustments, offset in part by interest savings resulting from 1992 long-term debt refinancing. The aforementioned operating income change and increased Other Income--Net, primarily due to the return being earned on deferred storage costs and increased interest income earned on natural gas costs recoverable through rate adjustments in Montana, reduced the earnings decline. Williston Basin Operating income declined at the natural gas transmission business as a result of decreased transportation volumes reflecting the effects of bypasses by two major transportation customers. Partially offsetting the effects of these bypasses were the increased movement of 3.4 MMdk of natural gas held under the repurchase commitment, due to favorable natural gas prices, and higher volumes transported on the November 1992 interconnection with NSP (1.8 MMdk), although at lower average rates than those replaced. Operating income was also negatively affected by the delay in the implementation of Order 636 until November 1, 1993. See Items 1 and 2 for Williston Basin for further discussions on the implementation of Order 636. Operation expenses increased slightly due to additional reserves related to the Koch settlement, increased transmission expenses and higher employee benefit-related costs. Largely offsetting the increased operation expenses are lower contract restructuring amortizations, an out-of-period adjustment to take-or-pay surcharge amortizations and a 1992 accrual for retroactive company production royalties. An adjustment to regulatory reserves reflected in operating revenues offset the effects of the additional reserves provided for the Koch settlement. Maintenance expenses increased as a result of compressor overhauls at several compressor station facilities. A weather-related sales improvement of 3.3 MMdk, or $2.8 million, combined with increased general rates implemented in November 1992, partially offset the operating income decline. Income from company production improved due to increased production, but at lower average prices. Earnings for this business unit increased due to reduced interest expense on long-term debt, the result of debt refinancing in mid-1993, and lower carrying costs associated with the natural gas repurchase commitment, primarily the result of both lower borrowings and decreased average rates, offset in part by the decline in operating income discussed above. Knife River Operating income increased due to sales from the newly acquired Alaskan and Oregon construction materials businesses and an improvement in coal tons sold at all mines, mainly the result of increased demand by electric generation customers. Lower selling prices at the Gascoyne Mine, effective June 1, 1992, following an amendment to the current coal supply agreement, partially offset the operating income increase. An increase in operating expenses resulting from the newly acquired construction materials businesses and a volume-related increase in coal operating expenses, combined with the accrual of SFAS No. 106 costs and increased stripping expense at the Beulah mine, due to higher overburden removal costs, also reduced operating income. Earnings increased due to the above-described operating income improvement, offset in part by reduced investment income (included in Other Income--Net), primarily resulting from lower investable funds due to the 1993 acquisitions and lower earned returns, and increased federal income taxes. Fidelity Oil Operating income for the oil and natural gas production business increased as a result of higher natural gas production and prices. In addition, decreased operation and maintenance expenses per equivalent barrel were somewhat offset by volume-related increases in such costs. Partially offsetting the operating income improvement was a decline in oil production and prices and increased depreciation, depletion and amortization, reflecting both increased production and higher rates. The aforementioned increase in operating income was further improved by the realization of certain investment gains resulting in the earnings improvement for this business. Increased interest expense, stemming from both higher average borrowings and rates, and increased federal income taxes, somewhat reduced earnings. 1992 compared to 1991 Montana-Dakota -- Electric Operations The decline in operating income was due to reduced residential and commercial sales resulting primarily from warmer winter weather combined with a cooler summer than that experienced a year ago. An increase in deliveries into the MAPP, primarily in the fourth quarter, was more than offset by the decline in the average price. The fourth quarter increase in deliveries into the MAPP reflects water conservation efforts by hydroelectric generators. The discounting of sales prices necessitated by a weak wholesale market contributed to the price decline experienced for sales to the MAPP. Higher demand charges associated with the purchase of firm capacity through a participation power contract and an increase in operation expense, primarily payroll and benefit-related, also reduced operating income. The demand charge increase results from the additional purchase of 5 megawatts of firm capacity which began in May 1992 and the passthrough of costs associated with a periodic maintenance outage. Partially mitigating the operating income decline was an increase in large industrial sales, lower depreciation expense and a reduction in maintenance expense reflecting the impact of 1991 maintenance outages at the Heskett and Coyote stations. Earnings from this business unit decreased for the reasons discussed above, partially offset by reduced interest expense, the result of certain bond refinancings in the second and fourth quarter of 1991 and the second quarter of 1992 offset in part by increased average borrowings under lines of credit. Montana-Dakota -- Gas Distribution Operations A sales decline of 2.4 MMdk or $2.0 million, related to significantly warmer first quarter weather than in 1991, the refinement of the estimated amount of delivered but unbilled natural gas volumes and an increase in operation expenses, largely payroll and benefit-related costs, were the primary contributors to the operating income decline. The addition of over 2,400 residential and commercial customers mitigated in part the sales decline. Transportation volumes increased largely due to the addition of a large industrial customer in the second quarter of 1992, although at discounted rates, and the conversion of a principal customer from firm commercial sales to transportation. A North Dakota rate increase, which was placed into effect in the third quarter of 1991, partially mitigated the operating income decline. Gas distribution earnings decreased for the reasons discussed above offset in part by decreased interest expense related to carrying charges being accrued on natural gas costs refundable through rate adjustments and the effects of the bond refinancings discussed in Electric Operations above. Williston Basin Operating income improved as a result of increased transportation volumes reflecting the movement of 4.4 MMdk of natural gas held under the repurchase commitment, due to favorable natural gas prices. Reduced operation expenses resulting from December 1991 additions to reserves maintained for regulatory and market uncertainties and reduced litigation expenses and contract restructuring amortizations, offset in part by increased payroll and benefit-related costs and the accrual for retroactive company production royalties, also contributed to the increase in operating income. Partially offsetting the operating income increase were decreased weather-related sales of approximately 571 Mdk or $516,000, lower average realized rates on transportation services, due to a higher level of discounted transportation services being used, and decreased company production revenues, the result of both reduced volumes and lower prices. Earnings for this business unit increased as a result of the changes in operating income discussed above, decreased carrying costs associated with the natural gas repurchase commitment, largely due to lower interest rates, and reduced interest expense on revenues being reserved stemming from lower interest rates and lower carrying charges being accrued on natural gas costs refundable through rate adjustments. Decreased interest income related to recoverable natural gas contract litigation settlement costs and higher company-owned production refund accruals somewhat mitigated the earnings improvement. Knife River Increased coal sales at the Beulah mine, primarily due to outages experienced in 1991 by a major electric generation customer, were the primary factor improving operating income. Aggregate sales at the newly acquired construction materials business also added to operating revenues. Decreased coal sales at the Gascoyne and Savage mines due to reduced weather-related demand from electric generating station customers and increased operation and maintenance expenses partially offset the operating income improvement. The increase in operation and maintenance expenses resulted from a volume-related increase in coal operation expenses and first year expenses at the construction materials business offset in part by equipment efficiencies and lower stripping costs due to recovery of third seam coal at the Beulah mine. Mining and construction materials earnings increased for reasons discussed above offset in part by reduced investment income, largely due to lower returns resulting from declining interest rates, and increased corporate development-related costs (both included in Other Income--Net). Fidelity Oil An increase in oil and natural gas production was more than offset by lower average sales prices for oil producing the decline in operating income. A volume-related increase in operating costs related to working interests and increased depreciation, depletion and amortization also reduced operating income. Decreased operating costs associated with the net proceeds interests resulting from cost controls implemented by the operator, somewhat mitigated the operating income decline. Earnings for the oil and natural gas production business decreased as a result of the above changes in operating income and increased interest expense stemming from increased average borrowings. Prospective Information The operating results of the Company's utility and pipeline businesses are significantly influenced by the weather, the general economy of their respective service territories, and the ability to recover costs through the regulatory process. Montana-Dakota is generally allowed to recover through general rates the costs of providing utility services which include fuel and purchased power costs and the cost of natural gas purchased. The electric business utilizes either fuel adjustment clauses or expedited rate filings to recover changes in fuel and purchased power costs in the interim periods. The natural gas business has similar mechanisms in place to pass through the changes in natural gas commodity, transportation and storage costs. Both recovery mechanisms reduce the effect the changes in these costs have on Montana-Dakota's results. See Items 1 and 2 for a further discussion of these items as they apply to Montana-Dakota's operations. In July 1992, Montana-Dakota requested the NDPSC to implement a gas weather normalization adjustment mechanism in November 1992. In October 1992, the NDPSC disallowed the adjustment mechanism. Montana-Dakota requested reconsideration of this matter, which was granted by the NDPSC in December 1992. A continuance was granted until such time as a general natural gas rate case should be filed. Based on a settlement reached with the NDPSC in connection with a general natural gas rate case filed in July 1993, the implementation of the weather normalization adjustment mechanism was omitted from the settlement. See Items 1 and 2 under Montana- Dakota for a further discussion of the weather normalization adjustment mechanism as well as general rate increase applications filed and settlements reached with the NDPSC, SDPUC and WPSC, respectively. Montana-Dakota is extending natural gas service to 11 north central South Dakota communities at an estimated cost of $9.0 million. This extension has the potential of adding approximately 1.6 MMdk to annual natural gas sales. Service to seven communities began in late 1993 with plans to provide service to the remaining four communities, as well as surveys to determine feasibility in neighboring communities, scheduled for 1994. See Items 1 and 2 for both Montana-Dakota and Williston Basin for additional information related to the FERC's Order 636, which requires fundamental changes in the way natural gas pipelines do business. Williston Basin, based on a September 1993, FERC order, implemented Order 636 on November 1, 1993. Although no assurances can be provided, the Company believes that Order 636 will not have a significant effect on its financial position or results of operations. See Items 1 and 2 for Williston Basin for a further discussion on Williston Basin's construction of a 49-mile pipeline in eastern North Dakota and Williston Basin's interconnection in northwestern North Dakota with a Canadian pipeline. Williston Basin continues to evaluate certain opportunities which may exist to increase transportation and storage services through system expansion or interconnections. In late 1992 and early 1993 two major transportation customers, Koch and Amerada, bypassed Williston Basin's transportation system. As a result of these bypasses, Williston Basin received 11.3 MMdk less natural gas for transportation in 1993 than in 1992. See Items 1 and 2 under Williston Basin for a further discussion of these system bypasses. On October 1, 1992, as a result of increases in natural gas prices, Williston Basin began to sell and transport a portion of the natural gas held under the repurchase commitment. Williston Basin will continue to aggressively market this natural gas as long as market conditions remain favorable. In addition, it will continue to seek long-term sales contracts. See Items 1 and 2 under Williston Basin for additional information on the natural gas held under this repurchase agreement. Montana-Dakota and Williston Basin filed suit against Rockwell International Corporation to recover any costs which may be associated with the presence of polychlorinated biphenyls in portions of their natural gas distribution and transmission systems. See Items 1 and 2 under Montana-Dakota and Williston Basin for a discussion of this and other environmental matters. In early 1993, Knife River, together with the Lignite Energy Council, supported the introduction of legislation in North Dakota which would provide severance tax relief for its Gascoyne Mine. Under the legislation, the state will forego its 50 percent share of severance taxes for coal shipped out of state after July 1, 1995, and local political subdivisions are given the option to forego their 35 percent of the tax. The legislation passed both House and Senate with strong support and was signed by the governor. This tax relief will help keep the price of Gascoyne coal competitive. Knife River continues to seek out additional growth opportunities. These include not only identifying possibilities for alternate uses of lignite coal but also investigating the acquisition of other surface mining properties, particularly those relating to sand and gravel aggregates and related products such as ready-mixed concrete, asphalt and various finished aggregate products. In 1993, Knife River acquired two construction materials operations, one in Anchorage, Alaska, and the other with locations in Medford, Oregon and Stockton, California. See Items 1 and 2 under Knife River for a further discussion of these acquisitions. Future cash flows and operating income from oil and natural gas production and reserves are influenced by fluctuations in sales prices as well as the cost of acquiring, finding and producing those reserves. Although Fidelity Oil continues to acquire, develop and explore for oil and natural gas reserves, no assurances can be made as to the future net cash flows from those operations. On January 1, 1993, Montana-Dakota changed its revenue recognition method to include the accrual of estimated unbilled revenues. This change will provide for a better matching of revenues and expenses and is consistent with predominant industry practice. See Note 2 of Notes to Consolidated Financial Statements for a further discussion of this accounting change. The FASB issued SFAS No. 109, "Accounting for Income Taxes" (SFAS No. 109) in February 1992, which changes the accounting method used to measure and recognize income tax effects in financial statements. SFAS No. 109, among other things, requires that existing deferred tax balances be revised to reflect any change in statutory rates. The Company adopted this new standard on January 1, 1993. Based on the provisions of SFAS No. 109, the effect on the Company's financial position or results of operations was not material. Any excess deferred income tax balances associated with rate-regulated activities at the time of implementation have been recorded as a regulatory liability and are expected to be reflected as a reduction in future rates charged customers in accordance with applicable regulatory procedures. See Notes 2 and 13 for a further discussion on the adoption of this standard. In December 1990, the FASB issued SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions" (SFAS No. 106). SFAS No. 106 establishes accounting standards for postretirement benefits whereby an employer must recognize in its financial statements on an ongoing basis the actuarially calculated obligation (accumulated postretirement benefit obligation) and related annual costs associated with providing such benefits to employees upon retirement. These benefits are recognized ratably over the employee's term of employment to such employee's eligible retirement date, as earned, rather than the previously used pay-as- you-go practice which recognized such costs when they were paid. The Company adopted this new standard on January 1, 1993. Based on the health care and life insurance benefits which are available to all eligible employees and their dependents upon the employees' retirement, the Company's annual cost based on the provisions of SFAS No. 106 for 1993 is approximately $7.5 million, including amortization of the initial accumulated postretirement benefit obligation of $49 million over 20 years. See Notes 2 and 15 of Notes to Consolidated Financial Statements for a further discussion on the adoption of this standard and the Company's efforts regarding regulatory recovery, including the NDPSC's January 19, 1994, order which requires the expensing, commencing January 1, 1994, of the ongoing SFAS No. 106 incremental expense estimated at $1.0 million annually. The FASB issued SFAS No. 112, "Employers' Accounting for Postemployment Benefits" (SFAS No. 112) in November 1992. SFAS No. 112 establishes accounting standards for postemployment benefits whereby an employer must recognize the benefits provided to former or inactive employees, their beneficiaries, and covered dependents after employment, but before retirement. SFAS No. 112 is effective for fiscal years beginning after December 15, 1993, and therefore, the Company will be required to adopt this new standard in 1994. The Company believes, based on an evaluation of the benefits it provides which are covered by the provisions of SFAS No. 112, that such amounts are not material to its financial position or results of operations. Liquidity and Capital Commitments The Company's construction costs and additional investments in non-regulated mining and construction materials, and oil and natural gas activities (in millions of dollars) for 1991 through 1993 and as anticipated for 1994 through 1996 are summarized in the following table, which also includes the Company's capital needs for the retirement of maturing long-term securities. Estimated 1991 1992 1993 Company/Description 1994 1995 1996 Montana-Dakota: $ 11.7 $ 13.2 $ 16.2 Electric $16.9 $19.8 $ 19.4 5.8 6.5 15.0 Natural Gas Distribution 12.4 10.4 11.3 17.5 19.7 31.2 29.3 30.2 30.7 4.1 9.4 5.4 Williston Basin 19.5 14.6 24.3 .9 16.3 46.5 Knife River 4.5 5.6 7.6 22.3 25.8 24.9 Fidelity 30.0 30.0 30.0 --- --- 1.0 Prairielands .2 .2 --- 44.8 71.2 109.0 83.5 80.6 92.6 Retirement/Repurchase 94.1 140.3 18.4 of Securities 15.3 10.8 10.8 $138.9 $211.5 $127.4 Total $98.8 $91.4 $103.4 In 1993, both Montana-Dakota's and Williston Basin's internal sources provided all of the funds needed for construction purposes. The Company's capital needs to retire maturing long-term corporate securities were $300,000. It is anticipated that Montana-Dakota will continue to provide all of the funds required for its construction requirements for the years 1994 through 1996 from internal sources, through the use of its $30 million revolving credit and term loan agreement, all of which is outstanding at December 31, 1993, and through the issuance of long-term debt, the amount and timing of which will depend upon the Company's needs, internal cash generation and market conditions. Williston Basin expects to meet its construction requirements and financing needs with a combination of internally generated funds, a $35 million line of credit currently available, none of which is outstanding at December 31, 1993, and through the issuance of long-term debt, the amount and timing of which will depend upon the Company's needs, internal cash generation and market conditions. As further described in Items 1 and 2 under Williston Basin, on August 11, 1993, Koch and Williston Basin reached a settlement that terminated the litigation with respect to all parties. The settlement provided that Williston Basin make an immediate cash payment to Koch of $40 million and to transfer to Koch certain natural gas gathering facilities owned by Williston Basin having a cost, net of accumulated depreciation, of approximately $10.4 million. The company believes that it is entitled to recover from ratepayers most of the costs that were incurred as a result of this settlement. Although the amount of the costs which can ultimately be recovered is subject to regulatory and market uncertainties, Williston Basin believes that financing arrangements currently in place are adequate to finance these costs. See Items 1 and 2 under Williston Basin for a further discussion of this settlement and Williston Basin's efforts regarding regulatory recovery. In March and May 1993, Williston Basin was directed by the MMS to pay approximately $3.5 million, plus interest, in claimed royalty underpayments for the period December 1, 1978, through February 29, 1988. In December 1993, Williston Basin also received an assessment from the MDR claiming additional production taxes due of $3.7 million, plus interest, for 1988 through 1991 production. See Items 1 and 2 under Williston Basin for a further discussion of Williston Basin's appeal efforts in these matters. Knife River's 1993 capital needs were met through funds on hand and funds generated from internal sources. It is anticipated that funds on hand and funds generated from internal sources will continue to meet the needs of this business unit for 1994 through 1996, excluding funds which may be required for future acquisitions. Fidelity Oil's 1993 capital needs related to its oil and natural gas acquisition, development and exploration program were met through funds generated from internal sources and a $20 million secured line of credit. It is anticipated that Fidelity's 1994 through 1996 capital needs will be met from internal sources and its secured line of credit. There was $1.5 million outstanding at December 31, 1993, under the secured line of credit. See Note 13 of Notes to the Consolidated Financial Statements for a discussion of deficiency notices received from the IRS proposing substantial additional income taxes. The level of funds which could be required as a result of the proposed deficiencies could be significant if the IRS position were upheld. Prairielands' 1993 capital needs were met through funds generated internally. It is anticipated that Prairielands' 1994 and 1995 capital needs will be met through funds generated from internal sources and a $5 million line of credit, $2.0 million of which is outstanding at December 31, 1993. The Company utilizes its $40 million lines of credit and its $30 million revolving credit and term loan agreement to meet its short-term financing needs and to take advantage of market conditions when timing the placement of long-term or permanent financing. There was $7.5 million outstanding at December 31, 1993, under the lines of credit. The Company's issuance of first mortgage debt is subject to certain restrictions imposed under the terms and conditions of its Indenture of Mortgage. Generally, those restrictions require the Company to pledge $1.43 of unfunded property to the Trustee for each dollar of indebtedness incurred under the Indenture and that annual earnings (pretax and before interest charges) as defined in the Indenture, equal at least two times its annualized first mortgage bond interest costs. Under the more restrictive of the two tests, as of December 31, 1993, the Company could have issued approximately $153 million of additional first mortgage bonds. The Company's coverage of fixed charges including preferred dividends was 3.0 and 2.4 times for 1993 and 1992, respectively. Additionally, the Company's first mortgage bond interest coverage was 3.4 times in 1993 compared to 3.3 times in 1992. Stockholders' equity as a percent of total capitalization was 56% and 53% at December 31, 1993 and 1992, respectively. Effects of Inflation The Company's consolidated financial statements reflect historical costs, thus combining the impact of dollars spent at various times. Such dollars have been affected by inflation, which generally erodes the purchasing power of monetary assets and increases operating costs. During times of chronic inflation, the loss of purchasing power and increased operating costs could potentially result in inadequate returns to stockholders primarily because of the lag in rate relief granted by regulatory agencies. Further, because the ratemaking process restricts the amount of depreciation expense to historical costs, cash flows from the recovery of such depreciation are inadequate to replace utility plant. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Reference is made to Pages 27 through 51 of the Annual Report. ITEM 9. ITEM 9. CHANGE IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Reference is made to Pages 3 through 6 and 13 and 14 of the Company's Proxy Statement dated March 7, 1994 (Proxy Statement) which is incorporated herein by reference. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Reference is made to Pages 7 through 13 of the Proxy Statement. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Reference is made to Page 14 of the Proxy Statement. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS None. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) Financial Statements, Financial Statement Schedules and Exhibits. Index to Financial Statements and Financial Statement Schedules. 1. Financial Statements: Report of Independent Public Accountants. . . . . * Consolidated Statements of Income for each of the three years in the period ended December 31, 1993 . . . . . . . . . . . . . . . * Consolidated Balance Sheets at December 31, 1993, 1992 and 1991 . . . . . . . . . . . . . . * Consolidated Statements of Capitalization at December 31, 1993, 1992 and 1991. . . . . . . . * Consolidated Statements of Cash Flows for each of the three years in the period ended December 31, 1993 . . . . . . . . . . . . . . . * Notes to Consolidated Financial Statements. . . . * 2. Financial Statement Schedules: Report of Independent Public Accountants on Schedules . . . . . . . . . . . . . . . . . ** Schedule V -- Property, Plant and Equipment for the three years ended December 31, 1993 Schedule VI -- Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment for the three years ended December 31, 1993 . . . . . . . . . . . . ** Schedule IX -- Short-Term Borrowings for each of the three years in the period ended December 31, 1993 . . . . . . . . . . . . . . . ** Schedule X -- Supplementary Income Statement Information for each of the three years in the period ended December 31, 1993 . . . . . ** Schedules other than those listed above are omitted because of the absence of the conditions under which they are required, or because the information required is included in the Company's Consolidated Financial Statements and Notes thereto. ____________________ * The Consolidated Financial Statements listed in the above index which are included in the Company's Annual Report to Stockholders for 1993 are hereby incorporated by reference. With the exception of the pages referred to in Items 6 and 8, the Company's Annual Report to Stockholders for 1993 is not to be deemed filed as part of this report. **Filed herewith. 3. Exhibits: 3(a) Composite Certificate of Incorporation of MDU Resources Group, Inc., as amended to date, filed as Exhibit 4(a) in Registration No. 33-13092 . . . . . . . . . * 3(b) By-laws of MDU Resources Group, Inc., as amended to date. . . . . . . . . . . . . ** 4(a) Indenture of Mortgage, dated as of May 1, 1939, as restated in the Forty-Fifth Supplemental Indenture, dated as of April 21, 1992, and the Forty-Sixth through Forty-Eighth Supplements thereto between the Company and the New York Trust Company (The Bank of New York, successor Corporate Trustee) and A. C. Downing (W. T. Cunningham, successor Co-Trustee), filed as Exhibit 4(a) in Registration No. 33-66682; and Exhibits 4(e), 4(f) and 4(g) in Registration No. 33-53896 . . . * + 10(a) Management Incentive Compensation Plan, filed as Exhibit 10(a) in Registration No. 33-66682. . . . . . . . . . . . . . . . * + 10(b) 1992 Key Employee Stock Option Plan, filed as Exhibit 10(f) in Registration No. 33-66682. . . . . . . . . . . . . . . . * + 10(c) Restricted Stock Bonus Plan, filed as Exhibit 10(b) in Registration No. 33-66682. . . . . . . . . . . . . . . . * + 10(d) Supplemental Income Security Plan, filed as Exhibit 10(c) in Registration No. 33-66682. . . . . . . . . . . . . . . . * + 10(e) Directors' Compensation Policy, filed as Exhibit 10(d) in Registration No. 33-66682. . . . . . . . . . . . . . . . * + 10(f) Deferred Compensation Plan for Directors, filed as Exhibit 10(e) in Registration No. 33-66682. . . . . . . . . . . . . . . . * 13 Financial statements and supplementary data as contained in the Annual Report to Stockholders for 1993 . . . . . . . . . . . ** 21 Subsidiaries of MDU Resources Group, Inc. . ** 23(a) Consent of Independent Public Accountants . ** 23(b) Consent of Engineer . . . . . . . . . . . . ** 23(c) Consent of Engineer . . . . . . . . . . . . ** (b) Reports on Form 8-K. None. ____________________ * Incorporated herein by reference as indicated. ** Filed herewith. + Management contract, compensatory plan or arrangement required to be filed as an exhibit to this form pursuant to Item 14(c) of this report. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON SCHEDULES To MDU Resources Group, Inc: We have audited, in accordance with generally accepted auditing standards, the consolidated financial statements included in the MDU Resources Group, Inc. Annual Report to Stockholders incorporated by reference in this Form 10-K, and have issued our report thereon dated January 25, 1994. Our audits of the consolidated financial statements were made for the purpose of forming an opinion on those statements taken as a whole. The schedules are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state 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 & CO. ARTHUR ANDERSEN & CO. Minneapolis, Minnesota, January 25, 1994 ____________________ *Reclassification between plant accounts. Plant is depreciated on a straight-line basis as follows: Electric . . . . . . . . . . . . . . . . . . . .3.2% Natural Gas Distribution. . . . . . . . . . . . .4.3% Natural Gas Transmission. . . . . . . . . . . . .3.5% Mining and Construction Materials . . . . . . . .3.3 to 33.3% Depletion of natural gas, coal and oil production properties is provided on a unit-of-production method based on estimated proved recoverable reserves. ____________________ *Reclassification between plant accounts. Plant is depreciated on a straight-line basis as follows: Electric . . . . . . . . . . . . . . . . . . . .3.2% Natural Gas Distribution. . . . . . . . . . . . .4.3% Natural Gas Transmission. . . . . . . . . . . . .3.1% Mining and Construction Materials . . . . . . . .3.3 to 33.3% Depletion of natural gas, coal and oil production properties is provided on a unit-of-production method based on estimated proved recoverable reserves. ____________________ *Reclassification between plant accounts. Plant is depreciated on a straight-line basis as follows: Electric . . . . . . . . . . . . . . . . . . . .3.3% Natural Gas Distribution. . . . . . . . . . . . .4.3% Natural Gas Transmission. . . . . . . . . . . . .3.0% Mining and Construction Materials . . . . . . . .3.3 to 33.3% Depletion of natural gas, coal and oil production properties is provided on a unit-of-production method based on estimated proved recoverable reserves. ____________________ (a) Includes depreciation on transportation and other equipment that is charged to construction, operations, maintenance and merchandising accounts. ____________________ (a) Includes depreciation on transportation and other equipment that is charged to construction, operations, maintenance and merchandising accounts. ____________________ (a) Includes depreciation on transportation and other equipment that is charged to construction, operations, maintenance and merchandising accounts. The Company and its subsidiaries had unsecured lines of credit from several banks totalling $86 million at December 31, 1993, $80 million at December 31, 1992, and $73 million at December 31, 1991. These line of credit agreements provide for bank borrowings against the lines and/or support for commercial paper issues. The agreements provide for commitment fees at varying rates. The unused portions of the lines of credit are subject to withdrawal based on the occurrence of certain events. The weighted average interest rate is calculated by dividing interest expense for the year by the amount of average daily borrowings outstanding. Note: Depreciation and amortization of intangible assets, preoperating costs and similar deferrals, royalties and advertising costs are omitted as they are each less than 1% of operating revenues.

1993 ITEM 1. BUSINESS Russ Berrie and Company, Inc. was incorporated in New Jersey in 1966. Its principal executive offices are located at 111 Bauer Drive, Oakland, New Jersey 07436; its telephone number is (201) 337-9000. The term "Company" refers to Russ Berrie and Company, Inc. and its consolidated subsidiaries, unless the context requires otherwise. The Company designs, manufactures through third parties and markets to retail stores throughout the United States and most countries throughout the world, a wide variety of impulse gift and toy items. The impulse gift products are designed to appeal to the emotions of consumers, who purchase the products impulsively to reflect their feelings of friendship, fun, love and affection. The suggested retail prices of the Company's products range from $.30 to over $300. Approximately 83% of the Company's dollar sales are accounted for by products with a suggested retail price of $14 or less which, coupled with the products' appeal to consumers' emotions, encourages spontaneous purchases by consumers. The Company's extensive line of over 10,000 products encompasses both seasonal and everyday gift items, including stuffed animals, Trolls, picture frames, ceramic mugs, porcelain gifts, collectible figurines, gift bags, greeting cards, keyrings, kitchen magnets, stationery products, toys, and National Football League and Major League Baseball merchandise. The products are produced by independent manufacturers, generally in the Far East, under close supervision by Company personnel and are marketed primarily by the Company's own direct sales force of approximately 700 full-time employees. In some foreign countries, the Company utilizes distributors and the Company's toy product line is marketed through independent representative organizations. The Company believes that its present position as one of the leaders in the impulse gift industry is due primarily to its imaginative product design, broad and effective marketing of its products, efficient distribution, high product quality and commitment to customer service. PRODUCTS The Company markets its impulse gift product line under the trade name "RUSS" through two divisions: "Plush N' Stuff" and "Gift/Expression". The Company also markets some of its products through its wholly-owned subsidiary Papel/Freelance, Inc. The Company markets its product line of toys through Cap Toys, Inc., a business acquired in October, 1993. Also, the Company's Bright of America, Inc. subsidiary markets gift products to schools and other organizations for fundraising purposes and directly to mass market customers. In addition, the Company operates a chain of retail stores, Fluf N' Stuf, Inc., which sells the Company's products and products of unaffiliated companies. (3) Plush N' Stuff products include stuffed animals, soft body Trolls, soft message products, puppets and soft holiday items, generally having suggested retail prices between $1 and $30. Gift/Expression products include hard body Trolls, gift bags, ceramic figurines, ceramic mugs, magnets, hair ornaments, childrens' jewelry and picture frames. Most Gift/Expression products have suggested retail prices between $1 and $30. For example, the suggested retail prices for mugs generally range from $5 to $8 and for greeting cards are generally less than $1.75. Papel/Freelance, Inc.'s products include ceramic mugs, related ceramic giftware, back to school items and fashion accessories. Cap Toys, Inc.'s products generally have suggested retail prices between $3 and $25. The percentages of dollar sales accounted for by the various divisions during the periods indicated are as follows: * Includes primarily sales by Effanbee Doll Company, the assets of which were sold in January, 1992, Fluf N' Stuf, Inc., Bright of America, Inc. and Cap Toys, Inc. (since its acquisition in October 1993). In addition to its everyday product lines, the Company produces specially designed products for individual seasons during the year, including Christmas, Valentine's Day, St. Patrick's Day, Easter, Mother's Day, Graduation, Father's Day, Halloween and Thanksgiving. During 1993, items specially designed for individual seasons accounted for approximately 46% of the Company's dollar sales; no individual season accounted for more than 12% of the Company's dollar sales. See "Business-Seasonality". The Company has experienced success with its product line of Trolls which are marketed through both the Plush N' Stuff and Gift/Expression divisions. Net sales of the various products associated with Trolls accounted for approximately 31% during 1993 and 56% during 1992 of consolidated net sales. However, in the second quarter of 1993 the Company experienced a decline in the net sales of its Troll product line. The Company's product line currently consists of more than 10,000 items (including distinctive variations on basic product designs). Other than the products associated with Trolls, no single basic product design accounted for more than 1.8% of dollar sales during 1993. The Company has entered into a number of license agreements under which it markets certain items, including products marketed under the National Football League and Major League Baseball trademarks. Licensed products represented approximately 10% of the Company's dollar sales in 1993 and 5% in 1992. During 1993, no single license accounted for more than 1.8 % of dollar sales. (4) DESIGN AND PRODUCTION The Company has a continuing program of new product development. The Company designs its own products and then generally evaluates consumer response through test marketing in selected unaffiliated retail stores and those operated by Fluf N' Stuf, Inc. Items are added to the product line only if they can be obtained and marketed on a basis that meets the Company's profitability standards. Substantially all of the Company's products are produced by independent manufacturers on a purchase order basis. The Company believes that the breadth of its product line and the continuous development of new products are key elements of its success and that it is capable of designing and producing large numbers of new products quickly. The Company has approximately 200 employees responsible for product development and design in the United States and in the Far East. Generally, a new design is brought to market in less than nine months after a decision is made to produce a new product. Sales of the Company's impulse gift products are, in large part, dependent on the Company's ability to identify and react quickly to changing consumer preferences and to utilize its sales and distribution systems to bring new products to market. Generally, marketing direction and concept planning are determined by the marketing committee, which is composed of key executives and marketing and market research personnel. The design committee, consisting of certain members of the product development department, is responsible for the development of new products which are compatible with the marketing and product concepts approved by the marketing committee. The design committee meets frequently to discuss the development of new products and the adaptation, refinement or supplementing of existing products to reflect new trends and preferences. Members of the committees are also in frequent contact with the Company's customers and sales personnel to obtain their ideas relating to expansion of the Company's product line. The design committee seeks new products which, though not necessarily similar to the products now marketed by the Company, can be marketed through its existing marketing and distribution systems to current and potential customers. Members of the design and marketing committees regularly attend trade shows to maintain contact with customers and to observe market trends. The Company engages in market research and test marketing to evaluate consumer reactions to its products. Research into consumer buying trends often suggest new products. The Company assembles information from retail stores, including those operated by Fluf N' Stuf, Inc., the Company's sales force and the Company's own market research department. The Company continually analyzes its products to determine whether they should be adapted into new or different products using elements of the initial design or whether they should be removed from the product line. (5) Substantially all of the Company's products are produced by independent manufacturers. During 1993, products accounting for approximately 94% of its dollar purchases were produced in the Far East and 6% in the United States. The Company utilizes approximately 225 manufacturers in the Far East, primarily in the People's Republic of China, Hong Kong, Taiwan, Korea, Thailand and Indonesia. During 1993, approximately 57% of the Company's dollar amount of purchases were attributable to manufacturing in the People's Republic of China. Legislation has been proposed from time to time that would revoke the most-favored nation status (which is a designation determined annually by the President of the United States, subject to possible override by Congress) of the People's Republic of China. Such a revocation would cause import duties to increase or become applicable to products imported by the Company from the People's Republic of China. A majority of the Company's staff of approximately 280 employees in Hong Kong, Taiwan, Korea, Thailand and Indonesia monitors the production process with responsibility for ensuring the quality, safety and prompt delivery of Company products. Members of the Company's Far East staff make frequent visits to the manufacturers for which they are responsible. Most of the Company's manufacturers are small operations, some selling exclusively to the Company. The Company believes that there are many alternate manufacturers for the Company's products and the loss of any manufacturer will not significantly adversely affect the operations of the Company. In 1993, the supplier accounting for the greatest dollar volume of the Company's purchases accounted for approximately 12% of such purchases and the five largest suppliers accounted for approximately 36% in the aggregate. MARKETING The Company sells its impulse gift products primarily through its own direct sales force. Products are sold directly to retail stores in the United States and in foreign countries, including gift stores, pharmacies, card shops, book stores, stationery stores, hospitals, college and airport gift shops, resort and hotel shops, florists, chain stores and military post exchanges. During 1993, the Company sold products to approximately 85,000 customers. No single customer accounted for more than 1.3% of dollar sales. The Company believes that the use of its direct sales force has been a significant factor in its success. Although sales managers have primary responsibility for the management of salespeople that report to them, they also have the responsibility for sales of the Company's products directly to certain accounts generally located in a defined geographic area. The Company's sales personnel visit each of their customers every six to eight weeks. The Company motivates its salespeople through its compensation package, which consists of salary, commissions and bonuses based on sales. All sales managers are compensated for their own sales and the sales generated by the salespeople that report to them. The Company also establishes performance levels for individual sales personnel. The Company maintains a training program for its salesforce and offers sales personnel the opportunity for advancement to sales management positions. Each of the Company's current sales managers started as a salesperson in the Company. (6) The Company's salespeople sell impulse gift products from either the Plush 'N Stuff division, the Gift/Expression division or from Papel/Freelance, Inc. further enabling the Company to successfully market the full range of its impulse gift products. The Company reinforces the marketing efforts of its salesforce through an active promotional program, including showrooms, participation in trade shows, trade advertising and seasonal catalogs. In addition, beginning in 1992 the Company engaged in advertising through consumer publications and national television. These advertising programs are designed to increase consumer awareness of, and esteem toward, RUSS products. The Company maintains a sales and distribution network to serve customers in Great Britain, Holland, Belgium, Ireland and Canada. The remainder of the Company's foreign sales, primarily in Germany, Latin America, Spain, Japan, Italy, Philippines, and France, are made to distributors for resale to their customers. Foreign sales, including export sales from the United States, aggregated $68,295,000, $101,471,000 and $57,867,000 in the years ended December 31, 1993, 1992 and 1991, respectively. For more information regarding operations by geographic area, see Note 12 of the Notes to the Consolidated Financial Statements. The Company believes that effective packaging and merchandising of its products are very important to its marketing success. Many products are shipped in colorful corrugated cartons which can be used as free-standing displays and can be discarded when all the products have been sold. The Company also prepares semi-permanent free-standing lucite, metal and wood products, thereby providing an efficient promotional vehicle for selling the Company's products. The displays are designed to stimulate consumers' impulse purchase decisions. The Company believes that customer service is an important component of its marketing strategy and therefore has established a Customer Service Department at each distribution facility that responds to customer requests, investigates and resolves problems and generally assists customers. The Company's general terms of sale are believed to be competitive in the impulse gift industry. The Company provides limited extended payment terms to customers on sales of seasonal merchandise, e.g., Christmas, Halloween and Easter and other seasons. The Company has a general policy of not accepting returns or selling on consignment. The Company's Cap Toys, Inc. subsidiary develops products in conjunction with independent toy product inventors. The products selected are produced by independent manufacturers and are sold primarily to mass merchandisers. Certain products are supported by an advertising program consisting primarily of television advertising. (7) DISTRIBUTION The Company has customers located throughout the United States and in order to serve them quickly and effectively, the Company has a distribution center in South Brunswick, New Jersey, which receives products from suppliers and then distributes them directly to the Company's customers as well as supplying the distribution center in Columbus, Ohio. The distribution center in Petaluma, California receives products directly from suppliers and serves the Company's customers in the western part of the United States. The Company generally uses common carriers to distribute to its customers. The Company maintains two distribution centers in Southampton, England to serve its customers in Europe and two facilities in the Toronto, Canada area for its Canadian customers. The Company's Cap Toy product line is distributed from a facility in Bedford Heights, Ohio. SEASONALITY The pattern of the Company's sales is influenced by the shipment of seasonal merchandise. The Company generally ships the majority of orders each year for Christmas in the quarter ended September 30, for Valentine's Day in the quarter ended December 31 and for Easter in the quarter ended March 31. The following table sets forth the Company's quarterly sales during 1993, 1992 and 1991. The Company has historically had higher profit margins in the quarter ended September 30 as a result of the economies of scale which accompany the higher sales volume. Commencing late in the second quarter of 1991, net sales of the Company were favorably impacted by the success of products associated with the Troll product line which continued into the first quarter of 1993. However, the Company has experienced a decline in the net sales of its Troll products beginning in the second quarter of 1993. (8) BACKLOG It is characteristic of the Company's business and of the industry in general that orders for seasonal merchandise are taken in advance of shipment. The Company's backlog at December 31, 1993 was $32,546,000 and at December 31, 1992 was $37,197,000. The Company ships substantially all of its backlog within 50 days. COMPETITION The impulse gift industry is highly competitive and fragmented. The Company believes that the principal competitive factors are marketing ability, reliable delivery, product design, quality, customer service and price. The Company's principal competitors in the Plush N' Stuff line are Gund, Inc., Ganz Bros., Ty, Inc., Applause, Inc. and Dakin. Competitors for the Company's other divisions include American Greetings, Hallmark, Recycled Paper Products, Enesco and numerous small suppliers and toy competitors. Certain of the Company's existing or potential competitors may have financial resources that are substantially greater than those of the Company. COPYRIGHTS, TRADEMARKS, PATENTS AND LICENSES The Company prints notices of claim of copyright on substantially all of its products and has registered hundreds of its designs with the United States Copyright Office. It also has registered, in the United States and certain foreign countries, the trademark "RUSS" with a distinctive design, which it utilizes on most of its products. The Company believes its copyrights, trademarks and patents are valid, and has pursued a policy of aggressively protecting them from infringement. However, it does not consider its business materially dependent on copyright, trademark or patent protection. The Company also enters into various license agreements to market products compatible with its product line. Examples of licensed products include designs of National Football League and Major League Baseball. EMPLOYEES As of January 31, 1994, The Company employed approximately 1,900 persons on a full-time basis. The Company considers its employee relations to be good; substantially all of the Company's employees are not covered by a collective bargaining agreement. The Company's policy is to require that its management, sales and product development and design personnel enter into contracts in which they agree not to disclose confidential information concerning the Company and, in the case of management and sales personnel, not to compete with the Company (subject to certain territorial limitations in the case of salespersons) for a period of six months after termination of their employment. (9) GOVERNMENT REGULATION Certain of the Company's products are subject to the provisions of, among other laws, the Federal Hazardous Substances Act and the Federal Consumer Product Safety Act. Those laws empower the Consumer Product Safety Commission to protect children from certain hazardous articles by excluding them from the market and requiring a manufacturer to repurchase articles which become banned. The Commission's determination is subject to judicial review. Similar laws exist in some states and cities in the United States and in Canada and Europe. The Company maintains a quality control program to ensure compliance with applicable laws. ITEM 2. ITEM 2. PROPERTIES The Company's principal facilities consist of its corporate offices in Oakland, New Jersey, and the distribution centers in South Brunswick, New Jersey; Petaluma, California; and Reynoldsburg, Ohio. Additionally, office and distribution facilities are located in Southampton, England and in the Toronto, Canada area. The Company owns the facility used by Bright of America, Inc. in Summersville, West Virginia, one of its facilities in Southampton, England and most of the office space it uses in Hong Kong. The Company leases its other facilities. The facilities of the Company are maintained in good operating condition, are generally adequate for the Company's purposes and, except for the Dayton, New Jersey; Lakeland, Florida; and Marietta, Georgia facilities, which were closed as part of restructuring of the Company's distribution system, are generally fully utilized. THE COMPANY'S CURRENT PRINCIPAL FACILITIES ARE AS FOLLOWS: (10) - ----------------- (1) Not including renewal options. (2) Properties owned directly or indirectly by Russell Berrie or members of his immediate family. See ITEM 13 - "CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS". (3) Regional distribution center. (4) Corporate headquarters. (5) Property leased from a partnership of which a director of the Company is a general partner. See ITEM 13 - "CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS". (6) Subsidiary (or division) headquarters. (7) Subsidiary (or division) distribution center. (8) Facility closed in connection with a restructuring undertaken by the Company. The Company has subleased the Lakeland facility, and continues its efforts to sublease or otherwise terminate the lease with regard to the Dayton facility and has entered into an agreement for sale for the Marietta facility. In addition, the Company leases an aggregate of approximately 19,700 square feet of showroom facilities in New York City; Los Angeles and San Francisco, California; Atlanta, Georgia; Dallas, Texas; Toronto, Montreal and Vancouver, Canada; Brussels, Belgium; and Utrecht, Holland. The remaining lease terms at these facilities range between one and eight years. Fluf N' Stuf, Inc., leases retail store space in shopping and outlet malls located primarily on the East Coast. The aggregate square footage of these 26 stores is approximately 47,500 square feet. The remaining lease terms at these facilities range between one and eight years. ITEM 3. ITEM 3. LEGAL PROCEEDINGS In the ordinary course of its business, the Company is party to various copyright, patent and trademark infringement, unfair competition, breach of contract, customs, employment and other legal actions, as plaintiff or defendant. As previously reported, on September 27, 1993, the United States Court for the Southern District of New York issued a decision in a previously reported action brought by EFS Marketing, Inc. ("EFS") against the Company and Russell Berrie, its Chairman and Chief Executive Officer, with respect to EFS's and the Company's product lines of troll dolls. The Court dismissed EFS' claims for monetary damages and for certain injunctive relief. The Court also invalidated the copyrights claimed by EFS and the Company in certain of the troll dolls sold by them; however, the Company does not consider its business materially dependent on copyright, trademark, or patent protection. (11) EFS is seeking reconsideration by the Court of the invalidity of their troll copyrights. The Company anticipates vigorously pursuing an appeal of this decision. The Company believes that the outcome of the proceedings to which it is currently a party will not have a material adverse effect on its business or financial condition. (See Note 13 of the Notes to Consolidated Financial Statements). ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. ITEM 4A. EXECUTIVE OFFICERS OF THE REGISTRANT The following table provides information with respect to the executive officers of the Company. All officers are elected by the Board of Directors and may be removed with or without cause by the Board. (12) Russell Berrie, the founder of the Company, has been Chairman of the Board and Chief Executive Officer of the Company since its incorporation in 1966. Mr. Berrie was also President and Chief Operating Officer of the Company from its incorporation until October 1988. Arnold S. Bloom has been employed by the Company as Vice President and General Counsel since January 1988 and as Secretary since March 1990. Paul Cargotch has been employed by the Company as Chief Financial Officer since March 1990 and Vice President - Finance for more than the past five years. A. Curts Cooke has been employed as President and Chief Operating Officer of the Company since March 17, 1990; Executive Vice President of the Company, from December 1984 and Chief Financial Officer and Secretary of the Company from 1984 until March 17, 1990. Mr. Cooke has served as a director of the Company since 1982. Jimmy Hsu has been employed by the Company as Senior Vice President - Product Development and Far East Operations since August 1991; he was also Vice President - Far East Operations from 1977 to August 1991. He has served as a director of the Company since 1988. Y.B. Lee has been employed by the Company as either Managing Director or President - Korean Operations from 1977 to February 1990, when he was elected Vice President - Far East Plush Division. Guy M. Lombardo has been employed by the Company as Vice President- Administration and Information Systems since January 1994; and prior to that, was Vice President-Management Information Systems for more than the past five years. Bernard Tenenbaum has been employed by the Company as Vice President-Corporate Development since January 14, 1993; he also serves as President and Chief Executive Officer of a division of the Company which focuses on the development of sales to mass merchandisers. From September 1988 until joining the Company as an officer, Mr. Tenenbaum was a founding Director of the George Rothman Institute of Entrepreneurial Studies, Fairleigh Dickenson University, and was previously Associate Director of the Snider Entrepreneurial Center of the Wharton School. Barker T. Torrey, Jr., has been Senior Vice President - Operations for more than the past five years. (13) PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's Common Stock has been traded on the New York Stock Exchange under the symbol "RUS" since its initial public offering on March 29, 1984. Prior to that time, there was no public market for the Common Stock. At December 31, 1993 the Company's Common Stock was held by approximately 941 shareholders of record. The following table sets forth the high and low sale prices on the New York Stock Exchange Composite Tape for the calendar periods indicated, as furnished by the National Quotation Bureau Inc.: The Board of Directors declared its first dividend to holders of the Company's Common Stock in November, 1986. Since then, a cash dividend has been paid quarterly. The current quarterly rate is $.15 per share. This rate has been in effect since February 1993. From February 1992 to February 1993 the quarterly rate was $.117 per share (restated to reflect the 3-for-2 stock split effective April 1, 1993). The quarterly rate from December 1990 to February 1992 was $.10 (restated). The Board of Directors will review its dividend policy from time to time and declaration of dividends will remain within its discretion. (14) ITEM 6. ITEM 6. SELECTED FINANCIAL DATA (FOR YEARS ENDED DECEMBER 31,) (Dollars in Thousands, Except Per Share Data) * Includes a restructuring charge of $5.0 million in 1993 and $9.5 million in 1989. (15) ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION RESULTS OF OPERATIONS - YEARS ENDED DECEMBER 31, 1993 AND 1992 For the year ended December 31, 1993 the Company's net sales of $279,111,000 represents a decrease of $165,271,000 or 37.2% compared to the year ended December 31, 1992. This decrease can be attributed to the significant reduction of net sales of the Company's Troll product line. During 1993 net sales of the products associated with the Troll product line were approximately $86,700,000 or 31.1% of consolidated net sales compared to approximately $250,000,000 or 56.3% of consolidated net sales during 1992. In addition, the Company believes that its customers have experienced a general softness in their business as a result of the growth of mass merchandisers, factory outlet malls, and warehouse clubs. Included in the results for the year ended December 31, 1993 are the net sales of $12,653,000 achieved by Cap Toys, Inc. since its acquisition in October 1993. Cost of sales was 45.1% of net sales in 1993 compared to 39.7% of net sales in 1992. This increase can be attributed to the higher gross profit margins on sales of Troll products during 1992. In addition, certain components of cost of sales are fixed costs, primarily costs associated with the sourcing of product in the Far East and provisions for slow moving inventory, which were absorbed by the higher sales volume in 1992. Also contributing to the increase are the effects of the reduction of the selling price of certain of the Company's products in August 1993. Selling, general and administrative expense was $133,188,000 for the year ended December 31, 1993 compared to $170,948,000 in 1992, a decrease of $37,760,000 or 22.1%. This decrease can be primarily attributed to a decrease in the expenses required to support lower sales levels principally salesforce commissions (approximately $30,750,000) and to lower expenses related to the Company's consumer advertising program (approximately $6,200,000). Included in the results of operations in 1993 is a restructuring charge of $5,000,000 representing the write-down of certain assets, employee severance costs and other costs related to the closing and consolidating of distribution centers and administrative functions. Also included are additional provisions for future lease obligations relating to a previously closed facility. The restructuring charge resulted in an after tax effect on net income of $3,150,000 or $.15 per share. This restructuring, in addition to a reduction in the salesforce, is expected to result in an annualized savings in selling, general and administrative expense of approximately $10,000,000. (16) The provision for income taxes as a percentage of income before taxes decreased to 25.0% in 1993 compared to 35.1% in 1992. The lower effective rate can be attributed to an increased relative benefit associated with investment income resulting from tax- advantaged investments within the Company's short-term investment portfolio, an increased proportion of income before income taxes related to certain foreign subsidiaries with lower tax provisions and to an increased relative benefit for deductions permitted on contribution to charitable organizations. Net income of $13,182,000 for 1993 decreased by $47,166,000 when compared to 1992. The decrease in net income can be attributed to the decrease in net sales, partially offset by the decrease in selling, general and administrative expense. RESULTS OF OPERATIONS - YEARS ENDED DECEMBER 31, 1992 AND 1991 For the year ended December 31, 1992 the Company's net sales of $444,382,000 represents an increase of 65.9% from the year ended December 31, 1991. This increase can be attributed to the success of the Company's Troll product line. During 1992 net sales of the various products associated with the Troll product line were approximately $250,000,000 or 56.3% of consolidated net sales. This compares to sales of these products of approximately $44,400,000 or 16.6% of consolidated net sales during 1991. The Company continues to introduce new products associated with the Troll product line, however the Company is unable to forecast the future sales levels of this product line. Cost of sales was 39.7% of net sales in 1992 compared to 41.0% of net sales in 1991. This decrease can be primarily attributed to higher gross profit margins on sales of Troll products as compared to the average gross profit margin generated by the Company's other product lines. In addition, some components of the cost of sales are fixed costs, which were absorbed by the higher sales volume during 1992. Selling, general and administrative expense was $170,948,000 for the year ended December 31, 1992 compared to $130,216,000 in 1991, an increase of $40,732,000 or 31.3%. However, as a result of the increase in net sales, selling, general and administrative expense as a percentage of net sales decreased to 38.5% for the year ended December 31, 1992 compared to 48.6% in 1991. The increase of $40,732,000 can be primarily attributed to increased expenses (approximately $26,900,000) necessary to support the higher level of sales, consisting primarily of increased salesforce compensation (principally commissions based on sales), expenses related to the consumer advertising program implemented in 1992 (approximately $11,000,000) and to an additional provision required for future lease payments related to facilities previously closed pursuant to a restructuring implemented in 1989 (approximately $2,800,000). (17) The year ended December 31, 1992 includes a charge of $6,300,000 which represents a provision for damages awarded to a former employee by a jury, in February 1993, based on allegations that she was slandered and other pending claims by the plaintiff. The Company believes that the verdict is not supported by the evidence and the claims are without merit. The Company will vigorously pursue its position before the trial court and appeals process. Investment and other income-net was $2,130,000 for the year ended December 31, 1992 compared to $3,960,000 in the prior year. The year ended December 31, 1991 includes a gain of approximately $2,000,000 related to the sale of an office facility in Hong Kong. The provision for income taxes, as a percentage of income before taxes, increased to 35.1% in 1992 compared to 30.6% in 1991. The higher effective rate in 1992 can be attributed in part to provisions for U.S. Federal income tax on unremitted earnings of foreign subsidiaries, which are not considered to be permanently reinvested. Additionally, the effective rate in 1991 was affected by the gain on the sale of an office facility in Hong Kong which was not subject to taxation. (See Note 1 of the Notes to Consolidated Financial Statements for Accounting for Income Taxes). Net income for 1992 increased by $38,306,000 to $60,348,000 when compared to 1991. The increase in net income can be attributed to the increase in net sales offset by the increase in selling, general and administrative expense. LIQUIDITY AND CAPITAL RESOURCES At December 31, 1993 the Company had cash and cash equivalents and short-term investments of $82,899,000 compared to $92,727,000 at December 31, 1992. The Company generated net cash flows from operating activities of $50,477,000 resulting from net income of $13,182,000, a decrease in accounts receivable of $34,509,000, and a decrease in inventories of $17,207,000. This was offset by a decrease in accrued expenses of $10,495,000 and a decrease in accrued income tax of $10,886,000. The decrease in accounts receivable is attributable to the lower level of sales in the fourth quarter of 1993 compared to the fourth quarter of 1992. The decrease in inventories can be primarily attributed to the Company's efforts to control inventory levels given the lower level of sales. During the year ended December 31, 1993 funds of $24,175,000 were used for the acquisition of Cap Toys, Inc. Funds were also used for the purchase of treasury stock (under a stock repurchase program) of $22,214,000 and the payment of dividends of $12,797,000. (18) The Company has available $87,811,000 in bank lines of credit that provide for direct borrowings and letters of credit used for the purchase of inventory. At December 31, 1993 letters of credit of $17,511,000 were outstanding. There were no direct borrowings under the bank lines of credit. Working capital requirements during 1993 were met entirely through internally generated funds. The Company remains in a highly liquid position and believes that the resources available from operations and bank lines of credit are sufficient to meet the foreseeable requirements of its business. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors Russ Berrie and Company, Inc.: We have audited the accompanying consolidated balance sheet of Russ Berrie and Company, Inc. as of December 31, 1993 and 1992, and the related consolidated statements of income, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 1993. 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 financial statements referred to above present fairly, in all material respects, the consolidated financial position of Russ Berrie and Company, Inc. as of December 31, 1993 and 1992, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. As discussed in Note 1 to the consolidated financial statements, effective January 1, 1992, the Company changed its method of accounting for income taxes. COOPERS & LYBRAND Parsippany, New Jersey February 7, 1994 (19) CONSOLIDATED STATEMENT OF INCOME FOR THE YEARS ENDED DECEMBER 31 (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) The accompanying notes are an integral part of the consolidated financial statements. (20) CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY (DOLLARS IN THOUSANDS) The accompanying notes are an integral part of the consolidated financial statements. (21) CONSOLIDATED BALANCE SHEET AT DECEMBER 31 (Dollars in Thousands) The accompanying notes are an integral part of the consolidated financial statements. (22) CONSOLIDATED STATEMENT OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31 (Dollars in Thousands) The accompanying notes are an integral part of the consolidated financial statements. (23) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING PRACTICES: PRINCIPALS OF CONSOLIDATION The consolidated financial statements include the accounts of Russ Berrie and Company, Inc. and its wholly-owned subsidiaries (collectively, the "Company") after elimination of intercompany accounts and transactions. ADVERTISING COSTS Production costs for advertising are charged to operations in the year the related advertising campaign begins. All other advertising costs are charged to results of operations during the year in which they are incurred. CASH EQUIVALENTS Cash equivalents consist of investments in interest bearing accounts and highly liquid securities having a maturity of three months or less. SHORT-TERM INVESTMENTS Short-term investments consist of highly liquid obligations with a maturity of more than three months when purchased. The Company uses these short-term investments as part of its cash management program. Short-term investments are stated at cost plus accrued interest, which approximates market. INVENTORIES Inventories, which mainly consist of finished goods, are stated at the lower of cost (first-in, first-out) or market value. PROPERTY Property, plant and equipment are stated at cost and are depreciated using the straight-line method over their estimated useful lives which range from three to eighteen years. Leasehold improvements are amortized using the straight-line method over the term of the respective lease or asset life, whichever is shorter. Expenditures for maintenance and repairs are charged to operations as incurred. Gain or loss on retirement or disposal of individual assets is recorded as income or expense. (24) GOODWILL AND OTHER INTANGIBLE ASSETS Goodwill, which represents the excess of purchase price of acquired assets over the fair market value of net assets acquired, is being amortized using the straight-line method, over fifteen years or less. Other intangible assets acquired are being amortized over the period for which benefit is derived which ranges from two to six years. Accumulated amortization was $3,876,000 and $2,683,000 at December 31, 1993 and 1992, respectively. FOREIGN CURRENCY TRANSLATION Aggregate foreign exchange gains or losses resulting from the translation of those foreign currency financial statements which are denominated in the local currency of each foreign subsidiary are recorded as a separate component of shareholders' equity. Gains and losses from foreign currency transactions are included in investment and other income-net. ACCOUNTING FOR INCOME TAXES For the year ended December 31, 1992 the Company adopted the provisions of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes". NET INCOME PER SHARE Net income per share is based on the weighted average number of shares outstanding during the year. The number of shares used in the computation at December 31, 1993, 1992 and 1991 were 21,470,672, 22,391,739 and 22,452,033, respectively. LEASES Capital leases are recorded at amounts equal to the lesser of the present value of the minimum lease payments or the fair value of the leased properties at the beginning of the respective lease terms. Such assets are being amortized on the straight-line basis over the related lease terms or life of asset, whichever is shorter. Interest expense relating to the lease liabilities is recorded to reflect constant rates of interest over the terms of the leases. Operating lease rentals are charged to operating expense as incurred. POST-EMPLOYMENT BENEFITS In November 1992, Statement of Financial Accounting Standards No. 112 was issued which establishes the method of accounting for post-employment benefits which must be implemented by the year ended December 31, 1994. The impact of such adoption on the consolidated financial statements is not expected to be material. (25) FOREIGN CURRENCY CONTRACTS The Company enters into forward exchange contracts and currency options, principally to hedge the purchase of inventory by its foreign subsidiaries. Gains and losses are reported as a component of the related transactions. The Company does not speculate in foreign currencies. At December 31, 1993 the aggregate amount of foreign exchange contracts was $1,000,000. ACQUISITION In October 1993, the Company completed the acquisition of substantially all of the assets, including inventory and accounts receivable of Cap Toys, Inc., a toy company based in Cleveland, Ohio. The acquisition, accounted for as a purchase, was funded entirely by the Company's cash and $13,606,000 of goodwill was recorded. Additional payments may be required based upon the attainment of certain future operating profit levels of Cap Toys, Inc. Amounts related to additional payments will be accrued and charged to goodwill when they become earned. RECLASSIFICATION Certain 1992 and 1991 amounts have been reclassified to conform with the 1993 presentation. NOTE 2 - PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment consist of the following: NOTE 3 - LINES OF CREDIT Under its existing domestic bank lines of credit, the Company has available $75,000,000 of direct borrowings and letters of credit at any one time. The maximum amount available to the Company's foreign operations at December 31, 1993 under local lines of credit is $12,811,000. These lines, which are guaranteed by the Company, provide for direct borrowings, letters of credit, and overdraft facilities. (26) In connection with the purchase of imported merchandise, the Company, at December 31, 1993, had letters of credit outstanding of $17,511,000. NOTE 4 - ACCRUED EXPENSES Accrued expenses at December 31, 1993 and 1992 include accrued sales commissions of $2,110,000 and $9,243,000, respectively. Accrued expenses at December 31, 1993 and 1992 also include accrued litigation of $6,300,000 (see Note 13). NOTE 5 - RESTRUCTURING COSTS A restructuring charge of $5,000,000 was recorded in the year ended December 31, 1993. This charge includes the write-down of certain assets, employee severance costs and other incremental costs related to the closing, moving and consolidating of distribution and administrative functions. Also, additional provisions for future lease obligations related to a previously closed facility leased from a partnership in which a director of the Company is a general partner (see Note 8), are included in such restructuring charge. NOTE 6 - INVESTMENT AND OTHER INCOME - NET The significant components of investment and other income - net for the years ended December 31, 1993, 1992, and 1991 are shown as follows: (27) NOTE 7 - INCOME TAXES The Company and its domestic subsidiaries file a consolidated Federal income tax return. Income before income taxes was: The provision for income taxes consists of the following: A reconciliation between the U.S. statutory rate and the effective rate is shown below: (28) The components of the net deferred tax asset, net of a valuation allowance of $750,000, resulting from differences between accounting for financial reporting purposes and accounting for tax purposes were as follows: Provisions are made for estimated United States and foreign income taxes, less available tax credits and deductions, which may be incurred on the remittance of foreign subsidiaries' undistributed earnings less those earnings deemed to be permanently reinvested. NOTE 8 - RELATED PARTY TRANSACTIONS Certain buildings, referred to in Note 9, are leased from Russell Berrie, the Company's majority shareholder, or entities owned or controlled by him. Rentals under these leases for the years ended December 31, 1993, 1992 and 1991 were $4,406,000, $4,133,000 and $4,065,000, respectively. The Company is also a guarantor under two mortgages for property so leased with a principal amount aggregating approximately $8,455,000 as of December 31, 1993, $2,000,000 of which is collateralized by assets of the Company. The Company also leases a facility from a partnership in which a director of the Company is a general partner. Annual rentals under this lease agreement for the years ended December 31, 1993, 1992, and 1991 were $996,000, $831,000 and $797,000, respectively. This facility is included in the estimate for future lease obligations with respect to the accrued restructuring costs (see Note 5). (29) NOTE 9 - LEASES At December 31, 1993, the Company and its subsidiaries are obligated under operating lease agreements (principally for buildings and other leased facilities) for remaining lease terms ranging from one to twenty-one years. Rent expense for the years ended December 31, 1993, 1992 and 1991, amounted to $8,456,000, $8,167,000 and $8,318,000, respectively. The approximate aggregate future rental payments as of December 31, 1993 under operating leases are as follows: NOTE 10 - STOCK OPTION AND EMPLOYEE STOCK PURCHASE PLANS The Company has three stock option plans and an employee stock purchase plan. At December 31, 1993, the existing plans terminated and, on January 1, 1994, the 1994 Stock Option Plans and the 1994 Employee Stock Purchase Plan become effective. As of December 31, 1992, there were 2,126,276 shares of common stock reserved for issuance of options under all plans. There are 3,800,000 shares of common stock reserved for issuance of options under all the 1994 stock plans. There are outstanding options under prior plans; however, these plans have been terminated and no additional options can be granted. The option price for all stock option plans is equal to the closing price of the stock as of the date the option is granted and no options may be exercised within one year from the date of grant. (30) Options are exercisable at prices ranging from $9.34 to $21.17 per share under the various plans. The exercise price of options exercised during 1993 ranged from $11.09 to $16.17. Summarized stock option data follows: * These plans allowed for the granting of Stock Appreciation Rights (SARs). The SARs, which relate to specific options under the plans, permit the participant to exercise the SAR and be entitled to an amount equal to the excess of the closing market price of Russ Berrie and Company, Inc. Common Stock on the date of exercise over the exercise price of the related option. Under the Employee Stock Purchase Plan, the option price is 90% of the closing market price of the stock on the first business day of the plan year. During 1993, 1,292 shares were acquired under this plan. The 1994 Employee Stock Purchase Plan has 150,000 shares reserved for future issuance. NOTE 11 - RETIREMENT PLAN The Company has a non-contributory retirement plan for substantially all employees which provides for contributions by the Company, on a calendar year basis, in such amounts (subject to certain maximum limitations) as the Board of Directors may determine. (31) The provisions for contributions charged to operations for the years ended December 31, 1993, 1992 and 1991 were $1,991,000, $2,384,000 and $1,868,000, respectively. NOTE 12 - GEOGRAPHIC AREAS The Company is in one line of business and generates revenue from operating entities worldwide. Financial data by geographic area are presented below: NOTE 13 - LITIGATION The Company is subject to legal proceedings and claims which arise in the ordinary course of its business. In the opinion of management, the amount of ultimate liability with respect to these actions will not materially affect the results of operations or the financial position of the Company. For the year ended December 31, 1992, the Company reserved $6,300,000 relating to an award by a jury in February 1993 for slander and other pending claims made by the plaintiff. It is the opinion of the Company that the verdict is not supported by the evidence and the claims are without merit. The Company will vigorously defend its position before the trial court and, if necessary, on appeal. (32) NOTE 14 - QUARTERLY FINANCIAL INFORMATION (UNAUDITED) The following selected financial data for the eight quarters ended December 31, 1993 are derived from unaudited financial statements and include, in the opinion of management, all adjustments necessary for fair presentation of the results for the interim periods presented and are of a normal recurring nature. However, the quarter ended December 31, 1993 includes a restructuring charge of $5,000,000 ($3,150,000 or $.15 per share after taxes) and a provision for slow moving inventory of $4,380,000 ($2,760,000 or $.13 per share after taxes): NOTE 15 - STOCK SPLIT: On February 11, 1993 the Company's Board of Directors approved a three-for-two common stock split effective April 1, 1993 for shareholders of record as of March 15, 1993. All numbers of common shares and per share data, except shares authorized, throughout the consolidated financial statements, have been restated to reflect the stock split. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. (33) PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information relating to this item appears under the caption "ELECTION OF DIRECTORS" on pages 1 and 2 of the 1994 Proxy Statement, which is incorporated herein by reference and under the caption "EXECUTIVE OFFICERS OF THE REGISTRANT" on pages 11 and 12 of this Annual Report on Form 10-K. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Information relating to this item appears under the caption "THE BOARD OF DIRECTORS AND COMMITTEES OF THE BOARD" on pages 3 through 5, "EXECUTIVE COMPENSATION" on pages 9 through 11 and "COMPENSATION COMMITTEE REPORT" on pages 5 and 6 in the 1994 Proxy Statement, which are incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information relating to this item appears under the captions "SECURITY OWNERSHIP OF MANAGEMENT" and "SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS" on page 8 and 9 of the 1994 Proxy Statement, which are incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information relating to this item appears under the captions "EXECUTIVE COMPENSATION" on pages 9 through 11, "CERTAIN TRANSACTIONS" on pages 11 through 13 and "COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION" on page 6 of the 1994 Proxy Statement, which are incorporated herein by reference. (34) PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULE AND REPORTS ON FORM 8-K (A) DOCUMENTS FILED AS PART OF THIS REPORT. 1. FINANCIAL STATEMENTS: - -------------------- Other schedules are omitted because they are either not applicable or not required or the information is presented in the Consolidated Financial Statements or Notes thereto. (35) 3. EXHIBITS: Exhibit No. - ----------- 3.1(a) Restated Certificate of Incorporation of the Registrant and amendment thereto. (9) (b) Certificate of Amendment to Restated Certificate of Incorporation of the Company filed April 30, 1987. (23) 3.2(a) By-Laws of the Registrant. (9) (b) Amendment to Revised By-Laws of the Company adopted April 30, 1987. (23) (c) Amendment to Revised By-Laws of the Company adopted February 18, 1988. (23) 4.1 Form of Common Stock Certificate. (1) 10.1(a) Russ Berrie and Company, Inc. Stock Option and Restricted Stock Plan. (2) (b) Amendment to the Russ Berrie and Company, Inc. Stock Option and Restricted Stock Plan. (11) 10.2(a) Russ Berrie and Company, Inc. Stock Option Plan for Outside Directors. (3) (b) Amendment to the Russ Berrie and Company, Inc. Stock Option Plan for Outside Directors. (11) 10.3 Russ Berrie and Company, Inc. Profit Sharing Plan. (3) 10.4 Agreement dated January 26, 1982 between the Registrant and A. Curts Cooke and amendment thereto dated March 10, 1984. (3) - ------------------- (1) Incorporated by reference to Amendment No. 2 to Registration Statement No. 2-88797 on Form S-1, as filed on March 29, 1984. (2) Incorporated by reference to Annual Report on Form 10-K for the year ended December 31, 1984. (3) Incorporated by reference to Amendment No. 1 to Registration Statement No. 2-88797 on Form S-1, as filed on March 13, 1984. (9) Incorporated by reference to Amendment No. 1 to Registration Statement No. 33-10077 on Form S-1, as filed on December 16, 1986. (11) Incorporated by reference to Annual Report on Form 10-K for the year ended December 31, 1987. (23) Incorporated by reference to Registration No. 33-51823 on Form S-8, as filed on January 6, 1994. (36) Exhibit No. - ----------- 10.26 Lease Agreement, dated April 1, 1981, between Tri-State Realty and Investment Company and Russ Berrie and Company, Inc. (4) 10.27 Guaranty, dated March 20, 1981, from Russ Berrie and Company, Inc. and Russell Berrie to the New Jersey Economic Development Authority and Midlantic National Bank as Trustee. (4) 10.28 Mortgage, dated April 6, 1981, between Tri-State Realty and Investment Company and the New Jersey Economic Development Authority. (4) 10.29 Credit and Security Agreement, dated as of March 1, 1981, between the New Jersey Economic Development Authority and Tri-State Realty and Investment Company. (4) 10.30 Assignment of Leases, Rents & Profits, dated April 6, 1981, by Tri-State Realty and Investment Company to the New Jersey Economic Development Authority. (4) 10.31 Note, dated April 6, 1981, made by Tri-State Realty and Investment Company to the order of the New Jersey Economic Development Authority in the principal amount of $2,000,000. (4) 10.32 Specimen of State of New Jersey Economic Development Authority $2,000,000 Economic Development Bond (Tri-State Realty and Investment Company -- 1980 Project), dated April 6, 1981. (4) 10.33 Lease, dated December 28, 1983, between Russell Berrie and Russ Berrie and Company, Inc. (4) - ----------------- (4) Incorporated by reference to Registration Statement No. 2-88797 on Form S-1 as filed on February 2, 1984. (37) Exhibit No. - ----------- 10.35 Guarantee dated as of December 1, 1983, from Russ Berrie and Company, Inc. to the New Jersey Economic Development Authority, Bankers Trust Company as Trustee and each Holder of a Bond. (4) 10.36 Letter of Credit and Reimbursement Agreement, dated as of December 1, 1983, between Russ Berrie and Company, Inc. and Citibank, N.A. (4) 10.37 Loan Agreement, dated as of December 1, 1983, between the New Jersey Economic Development Authority and Russell Berrie. (4) 10.38 Mortgage, dated December 28, 1983, between Russell Berrie and Citibank, N.A. (4) 10.39 Form of New Jersey Economic Development Authority Variable/Fixed Rate Economic Development Bond (Russell Berrie -- 1983 Project). (4) 10.51 Grant Deed, dated June 28, 1982, from Russ Berrie and Company, Inc. to Russell Berrie. (1) 10.52 Russ Berrie and Company, Inc. 1989 Employee Stock Purchase Plan. (13) - ---------------- (1) Incorporated by reference to Amendment No. 2 to Registration Statement No. 2-88797 on Form S-1, as filed on March 29, 1984. (4) Incorporated by reference to Registration Statement No. 2-88797 on Form S-1, as filed on February 2, 1984. (13) Incorporated by reference to Form S-8 Registration Statement No. 33-26161, as filed on December 16, 1988. (38) Exhibit No. - ----------- 10.53(a) Russ Berrie and Company, Inc. Stock Option Plan. (6) (b) Amendments to the Russ Berrie and Company, Inc. Stock Option Plan. (11) 10.55 Executive Employment Agreement, dated May 21, 1982, between Russ Berrie and Company, Inc. and James Madonna and Amendment thereto, dated September 23, 1986. (9) 10.68(a) Lease Agreement, dated as of May 1, 1977, between Fred T. Reisman and Associates Limited, Amram's Distributing, LTD, and Alfa Romeo (Canada) Limited (8) (b) Lease Agreement, dated April 8, 1986, between Pensionfund Realty Limited and Amram's Distributing LTD. (9) 10.70 Amendment, dated October 29, 1985 to the restated Russ Berrie and Company, Inc. Profit Sharing Plan. (8) - ---------------- (6) Incorporated by reference to Post-Effective Amendment No. 1 to Registration Statement No. 2-96238 on Form S-8, as filed on November 6, 1985. (8) Incorporated by reference to Annual Report on Form 10-K for the year ended December 31, 1985. (9) Incorporated by reference to Amendment No. 1 to Registration Statement No. 33-10077 of Form S-1, as filed on December 16, 1986. (11) Incorporated by reference to Annual Report on Form 10-K for the year ended December 31, 1987. (39) Exhibit No. - ----------- 10.73 Russ Berrie and Company, Inc. Deferred Compensation Plan. (9) 10.74 License Agreement, dated April 23, 1986, between Lever Brothers Company and Russ Berrie and Company, Inc. (9) 10.76(a) Lease agreement, dated September 17, 1987, between Forsgate Industrial Complex and Russ Berrie and Company, Inc. (11) (b) Amendment, dated March 18, 1988, between Forsgate Industrial Complex and Russ Berrie and Company, Inc. (11) 10.77 Lease agreement, dated July 1, 1987, between Hunter Street, Inc. and Russ Berrie and Co. (West), Inc. (11) 10.78 Lease agreement, dated October 1, 1987, between David Benjamin and Nicole Berrie Lakeland Trust and Russ Berrie and Company, Inc. (11) - --------- (9) Incorporated by reference to Amendment No. 1 to Registration Statement No. 33-10077 of Form S-1, as filed on December 16, 1986. (11) Incorporated by reference to Annual Report on Form 10-K for the year ended December 31, 1987. (40) 10.80 Russ Berrie and Company, Inc. 1989 Stock Option Plan. (14) 10.81 Russ Berrie and Company, Inc. 1989 Stock Option Plan for Outside Directors. (15) 10.82 Russ Berrie and Company, Inc. 1989 Stock Option and Restricted Stock Plan. (16) 10.83 Lease Agreement dated November 7, 1988 between A. Mantella & Sons Limited and Amram's Distributing, Ltd. (17) 10.84 Lease Agreement dated November 7, 1988 between Russell Berrie and Russ Berrie and Company, Inc. (17) 10.86 Lease Agreement dated June 8, 1989 between Americana Development, Inc. and Russ Berrie and Company, Inc. (18) 10.87 Lease dated December 25, 1989 between Kestrel Properties, Ltd. and Russ Berrie (U.K.) Ltd. (18) 10.89 Amendment dated January 9, 1989 to Letter of Credit and Reimbursement Agreement dated as of December 1, 1983 between Russ Berrie and Company, Inc. and Citibank, N.A. (18) 10.91(a) Assignment of Underlease of Unit 10 Nursling Industrial Estate, Marks and Spencer plc to Russ Berrie (U.K.) Limited. (19) (b) Underlease of Unit 10 Nursling Estate County of Hants. (19) 10.92 Agreement for sale and purchase of parts or shares of Sea View Estate between Sino Rank Company Limited and Tri Russ International (Hong Kong) Limited dated March 10, 1990. (19) -------- (14) Incorporated by reference to Form S-8 Registration Statement No. 33-27406, as filed on March 16, 1989. (15) Incorporated by reference to Form S-8 Registration Statement No. 33-27897, as filed on April 5, 1989. (16) Incorporated by reference to Form S-8 Registration Statement No. 33-27898, as filed on April 5, 1989. (17) Incorporated by reference to Annual Report on Form 10-K for the year ended December 31, 1988. (18) Incorporated by reference to Annual Report on Form 10-K for the year ended December 31, 1989. (19) Incorporated by reference to Annual Report on Form 10-K for the year ended December 31, 1990. (41) 10.95(a) Asset Purchase Agreement dated September 18, 1990 by and among Bright, Inc., Bright of America, Inc., Bright Crest, LTD. and William T. Bright. (19) (b) Non-Compete Agreement dated September 18, 1990 by and between William T. Bright and Bright, Inc. (19) (c) Deed of Trust dated September 18, 1990 by and among Bright, Inc. F.T. Graff Jr. and Louis S. Southworth, III Trustees, and Bright of America, Inc. (19) (d) Guaranty Agreement dated September 18, 1990 executed by Russ Berrie and Company, Inc. delivered to Bright of America, Inc. and Bright Crest, LTD. (19) (e) Guaranty Agreement dated September 18, 1990 executed by Russ Berrie and Company, Inc. delivered to William T. Bright. (19) 10.97 Russ Berrie and Company, Inc. Retirement Plan Amended and Restated Effective January 1, 1989. (19) ---------- (19) Incorporated by reference to Annual Report on Form 10-K for the year ended December 31, 1990. (42) 10.100 Letter dated February 4, 1991 to call Development Authority of Cobb County Industrial Development Revenue Bond (Russ Berrie and Company, Inc. Project), Series 1980, dated August 8, 1980. (20) 10.101(a) Sale and Purchase Agreement dated October 16, 1991 by and among Weaver Corp. and Papel/Freelance, Inc. (20) (b) Non-competition Agreement made October 16, 1991 by and among Weaver Corp., an Indiana corporation, Steven Weaver and Papel/Freelance, Inc. a Pennsylvania corporation. (20) 10.102 Transfer of Freehold land between British Telecommunications plc and BT Property Limited and Russ Berrie (UK) Ltd. (21) 10.103 Executive Employment Agreement dated December, 1992 between Russ Berrie and Company, Inc. and Bernard Tenenbaum. (21) 10.104 Russ Berrie and Company, Inc. 1994 Stock Option Plan. (21) 10.105 Russ Berrie and Company, Inc. 1994 Stock Option Plan for Outside Directors. (21) 10.106 Russ Berrie and Company, Inc. 1994 Stock Option and Restricted Stock Plan. (21) 10.107 Russ Berrie and Company, Inc. 1994 Employee Stock Purchase Plan. (21) 10.108 Asset Purchase Agreement dated October 1, 1993 by and between RBTACQ, Inc. and Cap Toys, Inc. (22) 21.1 List of Subsidiaries 23.1 Report of Independent Accountants 23.2 Consent of Independent Accountants - --------------------- (20) Incorporated by reference to Annual Report on Form 10-K for the year ended December 31, 1991. (21) Incorporated by reference to Annual Report on Form 10-K for the year ended December 31, 1992. (22) Incorporated by reference to Quarterly Report on Form 10-Q for the quarter ended September 30, 1993. (B) REPORTS ON FORM 8-K No reports on From 8-K were filed by the Company during the quarter ended December 31, 1993. (43) Undertaking In order to comply with amendments to the rules governing the use of Form S-8 under the Securities Act of 1933, as amended, as set forth in Securities Act Release No. 33-6867, the undersigned Registrant hereby undertakes as follows, which undertaking shall be incorporated by reference into Registrant's Registration Statements on Forms S-8 (File Nos. 2-96238, 2-96239, 2-96240, 33-10779, 33-26161, 33-27406, 33-27897 and 33-27898): Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers and controlling persons of the registrant pursuant to the foregoing provisions, or otherwise, the registrant has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Act and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the registrant of expenses incurred or paid by a director, officer or controlling person of the registrant in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, the registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Act and will be governed by the final adjudication of such issue. (44) 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. Russ Berrie and Company, Inc. (Registrant) By s/Paul Cargotch ------------------------------- Paul Cargotch Vice President - Finance and Chief Financial Officer March 23, 1994 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 dates indicated. Signatures Date ---------- ---- s/Russell Berrie March 28, 1994 - -------------------------------------------- Russell Berrie, Chairman of the Board, Chief Executive Officer, and Director (Principal Executive Officer) s/A. Curts Cooke March 23, 1994 - -------------------------------------------- A. Curts Cooke, President, Chief Operating Officer and Director (Principal Operating Officer) s/Paul Cargotch March 23, 1994 - -------------------------------------------- Paul Cargotch, Vice President - Finance and Chief Financial Officer (Principal Financial and Accounting Officer) (45) s/Raphael Benaroya March 24, 1994 - ------------------------------------------ Raphael Benaroya, Director s/Arthur D. Charpentier March 24, 1994 - ------------------------------------------ Arthur D. Charpentier, Director s/Jimmy Hsu March 23, 1994 - ------------------------------------------- Jimmy Hsu, Director s/Charles Klatskin March 24, 1994 - ------------------------------------------ Charles Klatskin, Director March , 1994 - ------------------------------------------ Joseph Kling, Director s/Sidney Slauson March 26, 1994 - ------------------------------------------ Sidney Slauson, Director s/Bernard Tenenbaum March 23, 1994 - ------------------------------------------ Bernard Tenenbaum, Director S-1 RUSS BERRIE AND COMPANY, INC. AND SUBSIDIARIES SCHEDULE I - MARKETABLE SECURITIES - OTHER INVESTMENTS DECEMBER 31, 1993 S-2 RUSS BERRIE AND COMPANY, INC. AND SUBSIDIARIES SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS *Principally account write-offs and disposal of merchandise, respectively. Exhibit Index Exhibit Numbers - --------------- 21.1 List of Subsidiaries 23.1 Report of Independent Accountants 23.2 Consent of Independent Accountants

1993 ITEM 1. BUSINESS Development and Description of Business --------------------------------------- Information concerning the business of American Insured Mortgage Investors L.P.-Series 86 (the Partnership) is contained in Part II, Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations and in Notes 1, 4 and 5 of the notes to the financial statements of the Partnership contained in Part IV (filed in response to Item 8 hereof), which is incorporated herein by reference. Also see Schedule XII- Mortgage Loans on Real Estate, contained in Item 14, for the table of the Insured Mortgages (as defined below), including Assets Held for Sale Under Coinsurance Program (as defined below), invested in by the Partnership as of December 31, 1993. Employees --------- The business of the Partnership is managed by CRIIMI, Inc. (the General Partner), while its portfolio of mortgages is managed by AIM Acquisition Partners, L. P. (the Advisor) and CRI/AIM Management, Inc. (the Sub-advisor). CRIIMI, Inc. is a wholly-owned subsidiary of CRIIMI MAE Inc. (CRIIMI MAE), formerly CRI Insured Mortgage Association, Inc., which is managed by an adviser whose general partner is C.R.I., Inc. (CRI). CRI is also an affiliate of the Sub-advisor. The Partnership has no employees. Competition ----------- In acquiring Insured Mortgages, the Partnership competes with private investors, mortgage banking companies, mortgage brokers, state and local government agencies, lending institutions, trust funds, pension funds, and other entities, some with similar objectives to those of the Partnership and some of which are or may be affiliates of the Partnership, its General Partner, the Advisor or their respective affiliates. Some of these entities may have substantially greater capital resources and experience than the Partnership in acquiring mortgages which are fully insured or guaranteed by the Federal National Mortgage Association, the Government National Mortgage Association (GNMA), the Federal Housing Administration (FHA) or the Federal Home Loan Mortgage Corporation. Pursuant to the Sub-advisory Agreements, the Advisor retained the Sub-advisor to perform the services required of the Advisor under the Advisory Agreements. The Sub-advisor performs advisory services for American Insured Mortgage Investors (AIM 84), American Insured Mortgage Investors - Series 85, L.P. (AIM 85) and American Insured Mortgage Investors L.P.-Series 88 (AIM 88), as well as the Partnership (collectively, the AIM Partnerships). CRI also serves as a general partner of the advisers to CRIIMI MAE and CRI Liquidating REIT, Inc., which have investment objectives similar to those of the AIM Partnerships. CRI and its affiliates are also general partners of a number of other real estate limited partnerships. CRI and its affiliates also may serve as general partners, sponsors or managers of real estate limited partnerships, real estate investment trusts (REITs) or other entities in the future. With respect to mortgage acquisitions, CRI may from time to time be faced with a conflict in determining whether to place a particular mortgage with the Partnership, one of the other AIM Partnerships, or other entities which CRI and its affiliates may sponsor or manage. CRIIMI, Inc., as General Partner, may also face a similar conflict. Both CRI and CRIIMI, Inc., however, are subject to their fiduciary duties in evaluating the appropriate action to be taken when faced with such conflicts. ITEM 2. ITEM 2. PROPERTIES Although the Partnership does not own the underlying real estate, the Insured Mortgages in which the Partnership has invested are first liens on the respective multifamily residential developments or retirement homes. PART I ITEM 3. ITEM 3. LEGAL PROCEEDINGS There are no material legal proceedings to which the Partnership is a party. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to the security holders to be voted on during the fourth quarter of 1993. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S SECURITIES AND RELATED SECURITY HOLDER MATTERS Principal Market and Market Price for Units ------------------------------------------- The United States Congress recently repealed portions of the Federal tax code which have had an adverse impact on tax-exempt investors in "publicly traded partnerships." This tax code change, effective January 1, 1994, cleared away the major impediment standing in the way of listing the Partnership's Depository Units of Limited Partnership Interest ("Units") for trading on a national stock exchange. As a result, the General Partner listed the Partnership's Units for trading on the American Stock Exchange (AMEX) on January 18, 1994 in order to provide investment liquidity as contemplated in the Partnership's original prospectus. The Units are traded under the symbol "AIJ." Prior to listing of the Partnership's Units for trading on the AMEX, the Units were only tradable through an informal market called the "secondary market". Distribution Information ------------------------ Distributions per Unit, payable out of the cash flow of the Partnership during 1993 and 1992 were as follows: Distributions for the Amount of Distribution Quarter Ended Per Unit --------------------- ---------------------- March 31, 1993 $ .23 June 30, 1993 .21 September 30, 1993 .29(1) December 31, 1993 .28(2) -------- $ 1.01 ======== March 31, 1992 $ .30 June 30, 1992 .22 September 30, 1992 .30 December 31, 1992 .32 -------- $ 1.14 ======== (1) In September 1993, the Partnership received $591,872 (approximately $.06 per Unit) from the mortgage on Victoria Pointe Apartments-Phase II, representing mortgage interest from October 1991 through June 1992, and a partial payment for July 1992. The Partnership distributed approximately $.03 per Unit of this previously undistributed interest and reserved approximately $.03 per Unit for the continued funding of coinsurance expenses. The Partnership distributed the remaining interest of approximately $.03 per Unit to Unitholders as part of the fourth quarter distribution, as discussed below. PART II ITEM 5. MARKET FOR REGISTRANT'S SECURITIES AND RELATED SECURITY HOLDER MATTERS - Continued (2) Includes a special distribution of approximately $.10 per Unit comprised of (i) $.03 per Unit of previously undistributed accrued interest from the mortgage on Victoria Pointe Apartments-Phase II which was reserved as part of the third quarter distribution, described above, and (ii) $.07 per Unit representing previously undistributed accrued interest received in December 1993 resulting from the disposition of the mortgage on Victoria Pointe Apartments-Phase II. Approximate Number of Unitholders Title of Class as of December 31, 1993 --------------------------- ------------------------------- Depository Units of Limited 15,000 Partnership Interest PART II ITEM 6. ITEM 6. SELECTED FINANCIAL DATA (Dollars in thousands, except per Unit amounts) PART II ITEM 6. SELECTED FINANCIAL DATA - Continued The selected statements of operations data presented above for the years ended December 31, 1993, 1992 and 1991, and the balance sheet data as of December 31, 1993 and 1992, are derived from and are qualified by reference to the Partnership's financial statements which have been included elsewhere in this Form 10-K. The statements of operations data for the years ended December 31, 1990 and 1989 and the balance sheet data as of December 31, 1991, 1990 and 1989 are derived from audited financial statements not included in this Form 10-K. This data should be read in conjunction with the financial statements and the notes thereto. PART II ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS General ------- American Insured Mortgage Investors L.P. - Series 86 (the Partnership) was formed under the Uniform Limited Partnership Act of the State of Delaware on October 31, 1985. During the period from May 2, 1986 (the initial closing date of the Partnership's public offering) through June 6, 1987 (the termination date of the offering), the Partnership, pursuant to its public offering of Units, raised a total of $191,523,300 in gross proceeds. In addition, the initial limited partner contributed $2,500 to the capital of the Partnership and received 125 units of limited partnership interest in exchange therefor. From inception through September 6, 1991, AIM Capital Management Corp. served as managing general partner (with a partnership interest of 4.8%), IRI Properties Capital Corp. served as corporate general partner (with a partnership interest of 0.1%) and Second Group Partners, an affiliate of the former general partners, served as the associate general partner (with a partnership interest of 0.1%). All of the foregoing general partners are sometimes collectively referred to as former general partners. At a special meeting of the limited partners and Unitholders of the Partnership held on September 4, 1991, a majority of these interests approved, among other items, the assignment of the general partner interests and the shares of the company which acts as the assignor limited partner in the Partnership. Effective September 6, 1991, CRIIMI, Inc. (the General Partner) succeeded the former general partners to become the sole general partner of the Partnership. CRIIMI, Inc. purchased the interests of the former managing general partner and the former corporate general partner pursuant to the terms of the Partnership Agreement. CRIIMI, Inc. is a wholly-owned subsidiary of CRIIMI MAE Inc. (CRIIMI MAE), formerly CRI Insured Mortgage Association, Inc., which is managed by an adviser whose general partner is C.R.I., Inc. (CRI). In addition, the General Partner acquired the shares of the company which acts as the assignor limited partner in the Partnership. The interest of the former associate general partner (0.1%) was purchased by the Partnership on September 6, 1991, pursuant to the terms of the Partnership Agreement. Also, on September 6, 1991, AIM Acquisition Partners, L.P. (the Advisor) succeeded Integrated Funding, Inc. (IFI) as the adviser of the Partnership. AIM Acquisition Corporation (AIM Acquisition) is the general partner of the Advisor and the limited partners include, but are not limited to, AIM Acquisition, The Goldman Sachs Group, L.P., Broad Inc. and a limited partnership formed by CRI and CRIIMI MAE. Pursuant to the terms of certain amendments to the Partnership Agreement, as discussed below, the General Partner is required to receive the consent of the Advisor prior to taking certain significant actions which affect the management and policies of the Partnership. The limited partners and Unitholders of the Partnership approved the execution of a Sub-advisory Agreement with CRI/AIM Management, Inc., an affiliate of CRI, pursuant to which CRI/AIM Management, Inc. manages the Partnership's portfolio and directs the acquisition and disposition of the Partnership's mortgages. Until the change in the Partnership's investment policy, as discussed below, the Partnership was in the business of originating mortgage loans (Originated Insured Mortgages) and acquiring mortgage loans (Acquired Insured Mortgages, and together with Originated Insured Mortgages, referred to herein as Insured Mortgages). As of December 31, 1993, the Partnership had invested in either Originated Insured Mortgages which are insured or guaranteed, in whole or in part, by the FHA or Acquired PART II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued Insured Mortgages which are fully insured (as more fully described below). The Partnership's reinvestment period expires on December 31, 1994 and the Partnership Agreement states that the Partnership will terminate on December 31, 2020, unless previously terminated under the provisions of the Partnership Agreement. The Partnership's principal investment objectives are to invest in Insured Mortgages which (i) preserve and protect the Partnership's invested capital; (ii) provide quarterly distributions of adjusted cash from operations which may be increased over time as a result of Participations (as defined below), when obtainable, on Originated Insured Mortgages; and (iii) provide appreciation by selecting Acquired Insured Mortgages which present the possibility of early prepayment. Effective September 19, 1991, the General Partner changed, at the Advisor's recommendation, the investment policies of the Partnership to invest only in Acquired Insured Mortgages which are fully insured or guaranteed by the Federal National Mortgage Association, the Government National Mortgage Association (GNMA), FHA or the Federal Home Loan Mortgage Corporation. The Partnership had invested in 18 Insured Mortgages, including Mortgages Held for Disposition and Assets Held for Sale under Coinsurance Program (AHFS), with an aggregate carrying value of $167,145,316 and a face value of $165,972,392 as of December 31, 1993, as discussed below. As of December 31, 1993, the Partnership had available approximately $7.5 million for reinvestment in Acquired Insured Mortgages. Results of Operations --------------------- 1993 versus 1992 ---------------- Net earnings for 1993 increased as compared to 1992 primarily due to an increase in mortgage investment income, as discussed below. Mortgage investment income increased during 1993 as compared to 1992 primarily as a result of the Partnership beginning, effective January 1, 1993, to recognize mortgage investment income for the mortgages classified as AHFS in the amount coinsured by the United States Department of Housing and Urban Development (HUD). Given the improved financial performance of the borrowers and the General Partner's assessment of the collateral underlying the mortgages, the General Partner determined that it was appropriate to begin recognizing interest income at least to the level of insurance provided by HUD. To the extent the borrower remits interest in excess of the HUD insured amount, this excess amount is recognized as income on the cash basis. Interest and other income decreased during 1993 as compared to 1992 primarily due to a reduction in funds available for short-term investment and a reduction in short-term interest rates. In 1992, the Partnership had proceeds from a December 1991 mortgage disposition approximating $3 million which were invested in short-term investments pending the acquisition of two Acquired Insured Mortgages during the first quarter of 1992. General and administrative expenses decreased for 1993 as compared to 1992 due primarily to reductions in payroll reimbursements and nonrecurring professional fees incurred in 1992, in connection with the mortgages with performance problems, as discussed below. Also contributing to the decrease in general and administrative expenses was a reduction in quarterly and annual reporting expense resulting from reduced mailing costs. PART II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued The following is a discussion of the types of Insured Mortgages, along with the risks related to each type of investment: Fully Insured Originated Insured Mortgages and Acquired Insured Mortgages ------------------------------------------------------- The former managing general partner, on behalf of the Partnership, had invested in eight fully insured Originated Insured Mortgages with an aggregate carrying value of $69,539,851 and $69,888,943 as of December 31, 1993 and 1992, respectively, and an aggregate face value of $66,934,689 and $67,240,257 as of December 31, 1993 and 1992, respectively. As of December 31, 1993 and 1992, the Partnership had invested in two fully insured Acquired Insured Mortgages with an aggregate carrying value of $3,012,158 and $3,026,972, respectively, and an aggregate face value of $3,034,084 and $3,049,283, respectively. As of December 31, 1993, all of the fully insured Originated Insured Mortgages and Acquired Insured Mortgages are current with respect to the payment of principal and interest. In connection with Originated Insured Mortgages, the Partnership has sought, in addition to base interest pay- ments, additional interest (commonly termed Participations) based on a percentage of the net cash flow from the develop- ment and of the net proceeds from the refinancing, sale or other disposition of the underlying development. All eight of the Originated Insured Mortgages made by the Partnership contain such Participations. During the years ended December 31, 1993, 1992 and 1991, the Partnership received additional interest of $113,822, $104,350 and $52,816, respectively, from the Participations. These amounts are included in mortgage investment income in the accompanying statements of operations. In the case of fully insured Originated Insured Mortgages and Acquired Insured Mortgages, the Partnership's maximum exposure for purposes of determining loan losses would generally be approximately 1% of the unpaid principal balance of the Originated Insured Mortgage or Acquired Insured Mortgage (an assignment fee charged by FHA) at the date of a default, plus the unamortized balance of acquisi- tion fees and closing costs paid in connection with the acquisition of the Insured Mortgages and the loss of approximately 30-days accrued interest. PART II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued Coinsured Mortgages ------------------- Under the HUD coinsurance program, both HUD and the coinsurance lender are responsible for paying a portion of the insurance benefits if a mortgagor defaults and the sale of the development collateralizing the mortgage produces insufficient net proceeds to repay the mortgage obligation. In such case, the coinsurance lender will be liable to the Partnership for the first part of such loss in an amount up to 5% of the outstanding principal balance of the mortgage as of the date foreclosure proceedings are instituted or the deed is acquired in lieu of foreclosure. For any loss greater than 5% of the outstanding principal balance, the responsibility for paying the insurance benefits will be borne on a pro-rata basis, 85% by HUD and 15% by the coinsurance lender. While the Partnership is due payment of all amounts owed under the mortgage, the coinsurance lender is responsible for the timely payment of principal and interest to the Partnership. The coinsurance lender is prohibited from entering into any workout arrangement with the borrower without the Partnership's consent and must file a claim for coinsurance benefits with HUD, upon default, if the Partnership so directs. As an ongoing HUD-approved coinsurance lender, and under the terms of the participation documents, the coinsurance lender is required to satisfy minimum net worth requirements as set forth by HUD. However, it is possible that the coinsurance lender's potential liability for loss on these developments, and others, could exceed its HUD-required minimum net worth. In such case, the Partnership would bear the risk of loss if the coinsurance lenders were unable to meet their coinsurance obligations. In addition, HUD's obligation for the payment of its share of the loss could be diminished under certain conditions, such as the lender not adequately pursuing regulatory violations of the borrower or the failure to comply with other terms of the mortgage. However, the General Partner is not aware of any conditions or actions that would result in HUD diminishing its insurance coverage. 1. Coinsured by third parties -------------------------- As of December 31, 1993 and 1992, the former managing general partner, on behalf of the Partnership, had invested in eight and nine coinsured mortgages respectively, five of which are coinsured by an unaffiliated third party coinsurance lender under the HUD coinsurance program. Two of the coinsured mortgages which are coinsured by an unaffiliated third party are classified as Mortgages Held for Disposition as of December 31, 1993 and are discussed below. The remaining three coinsured mortgages which are coinsured by unaffiliated third parties are current with respect to the payment of principal and interest and are classified as investment in mortgages as of December 31, 1993 and 1992. As of December 31, 1993 and 1992, these three coinsured mortgages had an aggregate carrying value of $22,680,052 and $22,792,326, respectively, and an aggregate face value of $21,945,884 and $22,047,027 respectively. The following is a discussion of actual and potential performance problems with respect to certain mortgage investments coinsured by an unaffiliated third party: The Originated Insured Mortgage on The Villas, a 405-unit apartment complex located in Lauderhill, Florida, is coinsured by the Patrician Mortgage Company PART II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued (Patrician) and had a carrying value equal to its face value of $15,856,842 and $15,878,027 as of December 31, 1993 and 1992, respectively. Since August 1, 1990, the mortgagor has not made the full monthly payments of principal and interest to Patrician. Patrician began collecting rents from the project and continued to make the monthly debt service payments to the Partnership through February 1992. The Partnership and Patrician entered into a modification agreement which provided for reduced payments through July 1992, regular scheduled payments from August 1992 to December 1992, and then increased payments for a period lasting approximately 10 years. The mortgagor of the mortgage on The Villas was unable to comply with the terms of the modification. As a result, Patrician filed a foreclosure action on October 14, 1993. On November 2, 1993, the mortgagor of The Villas filed for protection under Chapter 11 of the Federal Bankruptcy Code. If Patrician and the mortgagor are unable to negotiate a settlement, Patrician intends to litigate the case in bankruptcy court and to subsequently acquire and dispose of the property. As of March 4, 1994, Patrician had made payments of principal and interest due through November 1993. The mortgagor of The Villas mortgage is also the mortgagor of the Originated Insured Mortgage on St. Charles Place-Phase II, a 156-unit apartment complex located in Miramar, Florida, which is also coinsured by Patrician. The St. Charles Place-Phase II mortgage had a carrying value and a face value of $3,098,630 and $3,107,542 as of December 31, 1993 and December 31, 1992, respectively. These amounts represent the Partnership's approximately 45% ownership interest in the mortgage. The remaining 55% ownership interest is held by AIM 88, an affiliated entity. During 1993, the mortgagor of St. Charles Place-Phase II paid its monthly principal and interest payments to Patrician in arrears, and did not make the monthly payment of principal and interest due to Patrician for the period of October 1993 through December 1993. However, Patrician has remitted monthly payments of principal and interest due for these months to the Partnership. As the mortgagor was unable to bring the loan current, Patrician filed a foreclosure action on October 14, 1993. On November 2, 1993, the mortgagor of the mortgage on St. Charles Place-Phase II filed for protection under Chapter 11 of the Federal Bankruptcy Code. If Patrician and the mortgagor are unable to negotiate a settlement, Patrician intends to litigate the case in bankruptcy court and to subsequently acquire and dispose of the property. The General Partner is overseeing Patrician's efforts to complete the foreclosure action, including the subsequent acquisition and disposition of the above two properties. As the coinsurance lender, Patrician is liable to the Partnership for the outstanding principal balance of both mortgages plus all accrued but unpaid interest through the date of such payment. If the sale of the properties collateralizing the mortgages produces insufficient net proceeds to repay the mortgage obligations to the Partnership, Patrician will be liable to the Partnership for the coinsurance lender's share of the deficiency. Based on the General Partner's assessment of the collateral underlying the mortgages, including information related to the PART II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued financial condition of Patrician, the General Partner believes the carrying value of these assets is realizable. As a result of Patrician's coinsurance obligation these mortgages were classified as Mortgages Held for Disposition as of December 31, 1993. The Partnership intends to reinvest any net disposition proceeds from these mortgages in Acquired Insured Mortgages. The General Partner intends to continue to oversee the Partnership's interest in these mortgages to ensure that Patrician meets its coinsurance obligations. The General Partner's assessment of the realizability of The Villas and St. Charles Place-Phase II mortgages is based on current information, and to the extent current conditions change or additional information becomes available, then the General Partner's assessment may change. However, the General Partner does not believe that there would be a material adverse impact on the Partnership's financial condition or its results of operations should Patrician be unable to comply with its full coinsurance obligation. 2. Coinsured by affiliate ---------------------- a. The former managing general partner, on behalf of the Partnership, had invested in coinsured originated mortgages where the coinsurance lender is IFI. As of December 31, 1993 and 1992, the Partnership had investments remaining in three and four coinsured originated mortgages, respectively, where the coinsurance lender is IFI. As structured by the former managing general partner, with respect to these mortgages, the Partnership bears the risk of loss upon default for IFI's portion of the coinsurance loss. As of December 31, 1993 and 1992, one and two of these mortgages, respectively, were classified as AHFS and are discussed below. As of December 31, 1993, the remaining two IFI coinsured mortgages, as shown in the table below, are classified as investment in mortgages and are current with respect to the payment of principal and interest. The General Partner believes there is adequate collateral value underlying the mortgages. Therefore, no loan losses were recognized on these mortgages during the years ended December 31, 1993, 1992 and 1991. PART II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued PART II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued b. Assets Held for Sale Under Coinsurance Program As of December 31, 1993 and 1992, the former managing general partner, on behalf of the Partnership, had invested in one and two coinsured mortgages which are accounted for as AHFS, respectively. The coinsurer on these mortgages is IFI and the Partnership bears the risk of any coinsurance loss. Coinsured mortgage loans are deemed to be AHFS when a determination has been made that the borrower meets the following criteria: 1. The borrower has little or no equity in the collateral, considering the current fair value of the collateral; and 2. proceeds for repayment of the loan can be expected to come only from the operation or sale of the collateral; and 3. the borrower has either: a. formally or effectively abandoned control of the collateral to the creditor; or, b. retained control of the collateral, but because of the current financial condition of the borrower or the economic prospects for the borrower and/or the collateral in the foreseeable future, it is doubtful that the borrower will be able to rebuild equity in the collateral or otherwise repay the loan in the foreseeable future. AHFS represent the estimated cash flow to be received from any claims filed with HUD, including the estimated asset disposition proceeds. The disposition proceeds are based on the estimated fair value of the collateral underlying the mortgage which represents the amount that could reasonably be expected to be received in a current sale between a willing buyer and a willing seller. The General Partner initially determined the estimated fair values of the AHFS and the General Partner periodically assesses the estimated current fair value of the properties to determine whether additional loan losses are appropriate due to, among other factors, a change in market conditions affecting the properties. The loan losses related to these AHFS reduce the carrying value of the Originated Insured Mortgages. On the AHFS determination date for the applicable mortgages and through December 31, 1993, the Partnership discontinued accruing interest income in accordance with the original terms of the mortgage. For the years ended December 31, 1992 and 1991, the Partnership recognized $1,170,700 and $572,572, respectively, as interest income and received $2,794,186 and $1,461,309, respectively, representing the borrowers interest payments on the mortgages which were applied to reduce the outstanding basis in the mortgage investment. Beginning on January 1, 1993, the Partnership began to recognize mortgage investment income for the mortgages classified as AHFS in the amount coinsured by HUD. Given the improved financial performance of the borrowers and the General Partner's assessment of the collateral underlying the mortgages, the General Partner determined that it was appropriate to begin recognizing interest income at least to the level of insurance provided by HUD. To the extent the borrower remits interest in excess of the HUD insured amount, this excess amount is recognized as income on the cash basis. PART II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued During 1993, the Partnership recognized $2,898,882 in interest income. Cash totalling $639,756 was received from mortgages classified as AHFS. PART II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued The following table summarizes the coinsured mortgages accounted for as AHFS as of December 31, 1993 and 1992, respectively: PART II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued The following is a discussion of performance problems with respect to those mortgage investments accounted for as AHFS: 1. In December 1993, the General Partner entered into a Modification Agreement with the mortgagor of the mortgage on One East Delaware wherein the mortgagor had until April 30, 1994 to pay off the mortgage at a discount. The mortgagor prepaid the loan in January 1994. Total proceeds received were approximately $33.6 million, which resulted in a financial statement gain of approximately $1.2 million which was recognized in 1994. The Partnership intends to reinvest the net disposition proceeds from this mortgage in Acquired Insured Mortgages. 2. In December 1993, the Partnership settled, for approximately $9,050,000, the mortgage on Victoria Pointe Apartments-Phase II. As of December 31, 1993, the Partnership recognized a loan loss amounting to $63,488 which is reflected in the accompanying statement of operations for the year ended December 31, 1993. As of December 31, 1993, the Partnership had committed to reinvest the net disposition proceeds in Acquired Insured Mortgages. 1992 versus 1991 ---------------- Net earnings for 1992 increased compared to 1991 primarily due to the recognition of loan losses of approximately $4.9 million in 1991 as a result of the General Partner's evaluation of certain coinsured mortgages considered AHFS. This increase was partially offset by a decrease in mortgage investment income during 1992, as discussed below. Mortgage investment income decreased for 1992 as compared to 1991 primarily due to the discontinuance of the accrual of mortgage interest income for the two coinsured mortgages classified as AHFS, partially offset by income from accreting the discount on these two mortgages. Also contributing to the reduction in mortgage investment income was temporarily reduced interest payments from the mortgage on The Villas resulting from a modification agreement. The decrease in mortgage investment income was partially offset by the mortgage investment income recognized on the two Acquired Insured Mortgages which the Partnership purchased in January and March 1992. The Asset Management Fee decreased during 1992 compared to 1991 primarily as a result of a reduction in the Asset Management Fee percentage, effective October 1, 1991. At a special meeting held on September 4, 1991, the limited partners and Unitholders consented to, among other items, a reduction in the Asset Management Fee payable by the Partnership to the Advisor from the previous level of 1.25% to .95%, effective October 1, 1991 through December 31, 1991, and a reduction in the Asset Management Fee payable from January 1, 1992 through December 31, 1996 from the previous level of 1.00% to .95%. As provided for in the Partnership Agreement, the annual Asset Management Fee will be reduced from the previous level of .95% to .75% as of January 1, 1997 and will remain at that level thereafter. The limited partners and Unitholders also consented to the elimination of the subordinated fees. General and administrative expenses increased during 1992 as compared to 1991 primarily as a result of an increase in payroll expense and professional fees incurred in connection with the property issues, as previously discussed, partially offset by a reduction in investor services expenses. PART II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued Fair Value of Financial Instruments ----------------------------------- The following estimated fair values of the Partnership's financial instruments are presented in accordance with generally accepted accounting principles which define fair value as the amount at which a financial instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. These estimated fair values, however, do not represent the liquidation value or the market value of the Partnership. PART II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued PART II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued The following methods and assumptions were used to estimate the fair value of each class of financial instruments: Investment in mortgages and mortgages held for disposition ---------------------------------------------------------- The fair value of the fully insured mortgages is based on the average of the quoted market prices from three investment banking institutions which trade these investments as part of their day-to-day activities. In order to determine the fair value of the coinsured mortgage portfolio, the Partnership valued the coinsured mortgages as though they were fully insured (in the same manner fully insured mortgages were valued). From this amount, the Partnership deducted five percent of the face value of the loan and fifteen percent of the difference between the remaining face value and the value of these loans as though they were uninsured. These deductions are based on HUD's coinsurance limitations. The uninsured values were based on the average of the quoted market prices from two investment banking institutions which trade these types of investments as part of their day-to-day activities. Liquidity and Capital Resources ------------------------------- The Partnership's operating cash receipts, derived from payments of principal and interest on Insured Mortgages, plus cash receipts from interest on short-term investments, were sufficient during 1993 to meet operating requirements. The basis for paying distributions to Unitholders is cash flow from operations, which is comprised of regular interest income and principal from Insured Mortgages and gain, if any, from mortgage dispositions. Although Insured Mortgages yield a fixed monthly mortgage payment once purchased, the cash distributions paid to the Unitholders will vary during each quarter due to (1) the fluctuating yields in the short-term money market where the monthly mortgage payments received are temporarily invested prior to the payment of quarterly distributions, (2) the reduction in the asset base and monthly mortgage payments due to monthly mortgage payments received or mortgage dispositions, (3) variations in the cash flow attributable to the delinquency or default of Insured Mortgages and professional fees and foreclosure and acquisition costs incurred in connection with those Insured Mortgages and (4) variations in the Partnership's operating expenses. If necessary, the Partnership has the right to establish reserves either from the Net Proceeds of the Offering or from Cash Flow (as defined in the Partnership Agreement). It should be noted, however, that the Partnership also has the right to reinvest the Proceeds of Mortgage Prepayments, Sales and Insurance in Acquired Insured Mortgages through December 31, 1994 and generally intends to distribute substantially all of its Cash Flow from operations. If any reserves are deemed to be necessary by the Partnership, they will be invested in short-term, interest-bearing investments. The Partnership anticipates that reserves generally would only be necessary in the event the Partnership elected to foreclose on an Originated Insured Mortgage insured by FHA and take over the operations of the underlying development. In such case, there may be a need for additional capital. Since foreclosure proceedings can be expensive and time-consuming, the Partnership expects that it will generally assign the fully insured Originated Insured Mortgages to HUD for insurance proceeds rather than foreclose. In the case of an Originated Insured Mortgage insured under the HUD coinsurance program, the likelihood of foreclosure (and the potential need for reserves) exists since these coinsured mortgages generally cannot be PART II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued assigned to HUD and the coinsurance lender would be required to acquire title to the property and hold the property for 12 months or until an earlier sale in order to realize the benefit of HUD insurance. The determination of whether to assign the mortgage to HUD or institute foreclosure procedures or whether to set aside any reserves will be made on a case-by-case basis by the General Partner, the Advisor and the Sub-advisor. As of December 31, 1993 and 1992, the Partnership had not set aside any reserves. Cash flow - 1993 versus 1992 ---------------------------- Net cash provided by operating activities decreased during 1993 as compared to 1992 principally due to mortgage investment income accrued for mortgages classified as AHFS. Also contributing to the decrease was an increase in receivables and other assets in 1993 due to the balance of disposition proceeds, received in January 1994, from the disposition of the mortgage on Victoria Pointe Apartments-Phase II. Net cash provided by investing activities increased in 1993 as compared to 1992 principally due to disposition proceeds received in 1993 of approximately $9.0 million from the mortgage on Victoria Pointe Apartments-Phase II, partially offset by the acquisition in 1992 of two Acquired Insured Mortgages of approximately $3.0 million. Net cash used in financing activities decreased during 1993 compared to 1992 as a result of a decrease in 1993 distributions to Unitholders as compared to 1992 distributions. This decrease in distributions to Unitholders was due, in part, to the delinquencies and subsequent cessation of the receipt of principal and interest from the mortgage on One East Delaware and the delinquency of the monthly payments by the mortgagor of the mortgages on The Villas and St. Charles Place-Phase II. Cash flow - 1992 versus 1991 ---------------------------- Net cash provided by operating activities decreased in 1992 as compared to 1991 principally due to a decrease in mortgage investment income, partially offset by a net decrease in expenses, as previously discussed. This decrease was partially offset by payments received from the AHFS mortgages, principally One East Delaware, during 1992 and the payment of the Accrued Fees, as discussed below, in 1991. Net cash used in investing activities increased in 1992 as compared to 1991 principally due to the acquisition in 1992 of two Acquired Insured Mortgages. Net cash used in financing activities decreased during 1992 as compared to 1991 as a result of the decrease in distributions paid to investors. This decrease was primarily the result of the one to two month delay of monthly payments by the mortgagor of the mortgage on One East Delaware and the modification agreement entered into in May 1992 with the mortgagor on The Villas mortgage which provided for a temporary reduction in the monthly principal and interest payments during 1992. In addition, the distributions for 1992 decreased from 1991 as a result of the default by the mortgagor of the Victoria Pointe Apartments-Phase II mortgage in 1991. In May 1993, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 115 "Accounting for Certain Investments in Debt and Equity Securities" (SFAS 115), effective for fiscal years beginning after December 15, 1993. This statement requires that investments in debt and equity securities be classified into one of the following investment categories based upon the circumstances under which such securities might be sold: Held to Maturity, Available for PART II ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued Sale, and Trading. Generally, certain debt securities for which an enterprise has both the ability and intent to hold to maturity should be accounted for using the amortized cost method and all other securities must be recorded at their fair values. The General Partner believes that the majority of securities held by the Partnership will fall into either the Held to Maturity or Available for Sale categories. However, the General Partner has not yet determined the ultimate impact of the implementation of this statement in the Partnership's financial statements. Also in May 1993, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 114 "Accounting by Creditors for Impairment of a Loan" (SFAS 114), effective for fiscal years beginning after December 15, 1994. This statement requires that applicable loans which are impaired be measured based on the present value of expected future cash flows discounted at the loan's effective interest rate, or at the loan's market price, or the fair value of the collateral for impaired loans that are collateral dependent. The General Partner does not believe the ultimate impact of the implementation of this statement will materially affect the Partnership's financial statements. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information required by this item is contained in Part IV. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT (a),(b),(c),(e) The Partnership has no officers or directors. The affairs of the Partnership are generally managed by the General Partner, which is wholly-owned by CRIIMI MAE, a company whose shares are listed on the New York Stock Exchange. CRIIMI MAE is managed by an adviser whose general partner is CRI. Effective September 6, 1991, CRIIMI, Inc. (the General Partner) succeeded the former general partners to become the sole general partner of the Partnership. CRIIMI, Inc. purchased the interests of the former managing general partner and the former corporate general partner pursuant to the terms of the Partnership Agreement. CRIIMI, Inc. is a wholly-owned subsidiary of CRIIMI MAE Inc. (CRIIMI MAE), formerly CRI Insured Mortgage Association, Inc., which is managed by an adviser whose general partner is C.R.I., Inc. (CRI). In addition, the General Partner acquired the shares of the company which acts as the assignor limited partner in the Partnership. The interest of the former associate general partner (0.1%) was purchased by the Partnership on September 6, 1991, pursuant to the terms of the Partnership Agreement. Also, on September 6, 1991, AIM Acquisition Partners, L.P. (the Advisor) succeeded Integrated Funding, Inc. (IFI) as the adviser of the Partnership. AIM Acquisition Corporation (AIM Acquisition) is the general partner of the Advisor and the limited partners include, but are not limited to, AIM Acquisition, The Goldman Sachs Group, L.P., Broad Inc. and a limited partnership formed by CRI and CRIIMI MAE. Pursuant to the terms of certain amendments to the Partnership Agreement, as discussed below, the General Partner is required to receive the consent of the Advisor prior to taking certain significant actions which affect the management and policies of the Partnership. The limited partners and Unitholders of the Partnership approved the execution of a Sub-advisory Agreement with CRI/AIM Management, Inc., an affiliate of CRI, pursuant to which CRI/AIM Management, Inc. manages the Partnership's portfolio and directs the acquisition and disposition of the Partnership's mortgages. The General Partner is also the general partner of AIM 84, AIM 85 and AIM 88, limited partnerships with investment objectives similar to those of the Partnership. (d) There is no family relationship between any of the officers and directors of the General Partner. (f) Involvement in certain legal proceedings. None. (g) Promoters and control persons. Not applicable. (h) Based solely on its review of Forms 3 and 4 and amendments thereto furnished to the Partnership, and written representations from certain reporting persons that no Form 5s were required for those persons, the Partnership believes that all reporting persons have filed on a timely basis Forms 3, 4 and 5 as required in the fiscal year ended December 31, 1993. PART III ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information required by Item 11 is incorporated herein by reference to Note 7 of the notes to the financial statements of the Partnership contained in Part IV. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT As of December 31, 1993, no person was known by the Partner- ship to be the beneficial owner of more than five percent (5%) of the outstanding Units of the Partnership. As of December 31, 1993, neither the officers and directors, as a group, of the General Partner nor any individual director of the General Partner, are known to own more than 1% of the out- standing Units of the Partnership. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS (a) Transactions with management and others. Note 7 of the notes to the Partnership's financial statements contained in Part IV of this report which contains a discussion of the amounts, fees and other compensation paid or accrued by the Partnership to the directors and executive officers of the General Partner and their affiliates, is incorporated herein by reference. (b) Certain business relationships. Other than as set forth in Item 11 of this report which is incorporated herein by reference, the Partnership has no business relationship with entities of which the former general partners or the current General Partner of the Partnership are officers, directors or equity owners. (c) Indebtedness of management. None. (d) Transactions with promoters. Not applicable. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a)(1) Financial Statements: See Item 8. "Financial Statements and Supplementary Data." (a)(2) Financial Statement Schedules: XII - Mortgage Loans on Real Estate All other schedules have been omitted because they are inapplicable, not required, or the information is included in the Financial Statements or Notes thereto. (a)(3) Exhibits: 3. Amended and Restated Certificate of Limited Partnership is incorporated by reference to Exhibit 4(a) to Amendment No. 1 to the Partnership's Registration Statement on Form S-11 (No. 33-1735) dated March 6, 1986 (such Registration Statement, as amended, is referred to herein as the "Amended Registration Statement"). 4. Second Amended and Restated Agreement of Limited Partnership is incorporated by reference in Exhibit 3 to the Amended Registration Statement. 4.(a) Material Amendments to the Second Amended and Restated Agreement of Limited Partnership are incorporated by reference to Exhibit 4(a) to the Annual Report on Form 10-K for the year ended December 31, 1987. 4.(b) Amendment to the Second Amended and Restated Agreement of Limited Partnership of the Partnership dated February 12, 1990, incorporated by reference to Exhibit 4(b) to the Partnership's Annual Report on Form 10-K for the year ended December 31, 1989. 10.(a) Escrow Agreement is incorporated by reference to Exhibit 10(a) to the Amended Registration Statement. 10.(b) Origination and Acquisition Services Agreement is incorporated by reference to Exhibit 10(b) to the Amended Registration Statement. 10.(c) Management Services Agreement is incorporated by reference to Exhibit 10(c) to the Amended Registration Statement. 10.(d) Disposition Services Agreement is incorporated by reference to Exhibit 10(d) to the Amended Registration Statement. 10.(e) Agreement among the former managing general partner, the former associate general partner and Integrated Resources, Inc. is incorporated by reference to Exhibit 10(e) to the Amended Registration Statement. 10.(f) Reinvestment Plan is incorporated by reference to the Prospectus contained in the Amended Registration Statement. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K - Continued 10.(g) Mortgagor-Participant Agreement regarding the One East Delaware Originated Insured Mortgage is incorporated by reference to Exhibit 10(g) to the Annual Report on Form 10-K for the year ended December 31, 1987. 10.(h) Mortgage, Assignment of Rents and Security Agreements regarding One East Delaware Originated Insured Mortgage is incorporated by reference to Exhibit 10(h) to the Annual Report on Form 10-K for the year ended December 31, 1987. 28. Pages A-1 - A-5 of the Partnership Agreement of Registrant. 28.(a) Purchase Agreement among AIM Acquisition, the former managing general partner, the former corporate general partner, IFI and Integrated dated as of December 13, 1990, as amended January 9, 1991. 28.(b) Purchase Agreement among CRIIMI, Inc., AIM Acquisition, the former managing general partner, the former corporate general partner, IFI and Integrated dated as of December 13, 1990 and executed as of March 1, 1991. 28.(c) Amendment to Partnership Agreement dated September 4, 1991. Incorporated by reference to Exhibit 28.(a), above. 28.(d) Non-negotiable promissory note to American Insured Investors - Series 85, L.P. in the amount of $1,737,722 dated December 31, 1991. 28.(e) Sub-Management Agreement by and between AIM Acquisition and CRI/AIM Management, Inc., dated as of March 1, 1991. 28.(f) Expenses Reimbursement Agreement by Integrated Funding Inc. and the AIM Funds, effective December 31, 1992. (b) Reports on Form 8-K filed during the last quarter of the fiscal year: None. All other items are not applicable. SIGNATURES Pursuant to the requirements 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. AMERICAN INSURED MORTGAGE INVESTORS L.P. - SERIES 86 (Registrant) By: CRIIMI, Inc. General Partner March 16, 1994 /s/H. William Willoughby --------------------------- ------------------------- DATE H. William Willoughby President and Principal Financial Officer and Board Member March 16, 1994 /s/William B. Dockser --------------------------- ----------------------- DATE William B. Dockser Chairman of the Board and Principal Executive Officer March 15, 1994 /s/Garrett G. Carlson, Sr. --------------------------- ------------------------- DATE Garrett G. Carlson, Sr. Director March 10, 1994 /s/G. Richard Dunnells --------------------------- ------------------------- DATE G. Richard Dunnells Director March 10, 1994 /s/Robert F. Tardio --------------------------- ------------------------- DATE Robert F. Tardio Director AMERICAN INSURED MORTGAGE INVESTORS L.P. - SERIES 86 Financial Statements as of December 31, 1993 and 1992 and for the Years Ended December 31, 1993, 1992 and 1991 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Partners of American Insured Mortgage Investors L.P. - Series 86: We have audited the accompanying balance sheets of American Insured Mortgage Investors L.P. - Series 86 (the Partnership) as of December 31, 1993 and 1992, and the related statements of operations, changes in partners' equity and cash flows for the years ended December 31, 1993, 1992 and 1991. These financial statements and the schedule referred to below are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements and the schedule 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 financial statements referred to above present fairly, in all material respects, the financial position of the Partnership as of December 31, 1993 and 1992, and the results of its operations and its cash flows for the years ended December 31, 1993, 1992 and 1991, in conformity with generally accepted accounting principles. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. Schedule XII-Mortgage Loans on Real Estate as of December 31, 1993 is presented for purposes of complying with the Securities and Exchange Commission's rules and regulations and is not a required part of the basic financial statements. The information in this schedule has been subjected to the auditing procedures applied in our audits of the basic financial statements and, in our opinion, is fairly stated in all material respects in relation to the basic financial statements taken as a whole. Washington, D.C. Arthur Andersen & Co. March 4, 1994 AMERICAN INSURED MORTGAGE INVESTORS L.P. - SERIES 86 BALANCE SHEETS ASSETS As of December 31, 1993 1992 ------------ ------------ Investment in mortgages: Originated insured mortgages $108,995,765 $128,470,730 Acquired insured mortgages 3,034,084 3,049,283 ------------ ------------ 112,029,849 131,520,013 Plus: unamortized premium, net of unamortized discount 4,056,467 4,122,136 ------------ ------------ 116,086,316 135,642,149 Assets held for sale under coinsurance program 32,103,528 38,110,016 Mortgages held for disposition, at lower of cost or market 18,955,472 -- Cash and cash equivalents 9,095,255 2,557,009 Investment in affiliate 1,730,087 1,730,910 Receivables and other assets 2,805,604 1,105,832 ------------ ------------ Total assets $180,776,262 $179,145,916 ============ ============ LIABILITIES AND PARTNERS' EQUITY Distributions payable $ 2,819,518 $ 3,222,311 Note payable to affiliate 1,737,723 1,730,910 Accounts payable and accrued expenses 212,428 185,706 ------------ ------------ Total liabilities 4,769,669 5,138,927 ------------ ------------ Partners' equity: Limited partners' equity 176,783,204 174,881,580 General partner's deficit (776,611) (874,591) ------------ ------------ Total partners' equity 176,006,593 174,006,989 ------------ ------------ Total liabilities and partners' equity $180,776,262 $179,145,916 ============ ============ The accompanying notes are an integral part of these financial statements. AMERICAN INSURED MORTGAGE INVESTORS L.P. - SERIES 86 NOTES TO FINANCIAL STATEMENTS 1. ORGANIZATION American Insured Mortgage Investors L.P. - Series 86 (the Partnership) was formed under the Uniform Limited Partnership Act of the state of Delaware on October 31, 1985. From inception through September 6, 1991, AIM Capital Management Corp. served as the managing general partner (with a partnership interest of 4.8%), IRI Properties Capital Corp. served as corporate general partner (with a partnership interest of 0.1%) and Second Group Partners, an affiliate of the former general partners, served as the associate general partner (with a partnership interest of 0.1%). All of the foregoing general partners are sometimes collectively referred to as former general partners. At a special meeting of the limited partners and Unitholders of the Partnership held on September 4, 1991, a majority of these interests approved, among other items, assignment of the general partner interests and the shares of the company which acts as the assignor limited partner in the Partnership. Effective September 6, 1991, CRIIMI, Inc. (the General Partner) succeeded the former general partners to become the sole general partner of the Partnership. CRIIMI, Inc. purchased the interests of the former managing general partner and the former corporate general partner pursuant to the terms of the Partnership Agreement. CRIIMI, Inc. is a wholly-owned subsidiary of CRIIMI MAE Inc. (CRIIMI MAE), formerly CRI Insured Mortgage Association, Inc., which is managed by an adviser whose general partner is C.R.I., Inc. (CRI). In addition, the General Partner acquired the shares of the company which acts as the assignor limited partner in the Partnership. The interest of the former associate general partner (0.1%) was purchased by the Partnership on September 6, 1991, pursuant to the terms of the Partnership Agreement. Also, on September 6, 1991, AIM Acquisition Partners, L.P. (the Advisor) succeeded Integrated Funding, Inc. (IFI) as the adviser of the Partnership. AIM Acquisition Corporation (AIM Acquisition) is the general partner of the Advisor and the limited partners include, but are not limited to, AIM Acquisition, The Goldman Sachs Group, L.P., Broad Inc. and a limited partnership formed by CRI and CRIIMI MAE. Pursuant to the terms of certain amendments to the Partnership Agreement, as discussed below, the General Partner is required to receive the consent of the Advisor prior to taking certain significant actions which affect the management and policies of the Partnership. The limited partners and Unitholders of the Partnership approved the execution of a Sub-advisory Agreement with CRI/AIM Management, Inc., an affiliate of CRI, pursuant to which CRI/AIM Management, Inc. manages the Partnership's portfolio and directs the acquisition and disposition of the Partnership's mortgages. Until the change in the Partnership's investment policy, as discussed below, the Partnership was in the business of originating mortgage loans (Originated Insured Mortgages) and acquiring mortgage loans (Acquired Insured Mortgages, and together with Originated Insured Mortgages, referred to herein as Insured Mortgages). As of December 31, 1993, the Partnership had invested in either Originated Insured Mortgages which are insured or guaranteed, in whole or in part, by the Federal Housing Administration (FHA) or Acquired Insured Mortgages which are fully insured (as more fully described below). The Partnership's reinvestment period expires on December 31, 1994 and the Partnership Agreement states that the Partnership will terminate on December 31, 2020, unless previously terminated under the provisions of the Partnership Agreement. The Partnership's principal investment objectives are to invest in Insured Mortgages which (i) preserve and protect the Partnership's invested capital; (ii) provide quarterly distributions of adjusted cash from operations which may be increased over time as a result of Participations (as defined AMERICAN INSURED MORTGAGE INVESTORS L.P. - SERIES 86 NOTES TO FINANCIAL STATEMENTS 1. ORGANIZATION - Continued below), when obtainable, on Originated Insured Mortgages; and (iii) provide appreciation by selecting Acquired Insured Mortgages which present the possibility of early prepayment. Effective September 19, 1991, the General Partner changed, at the Advisor's recommendation, the investment policies of the Partnership to invest only in Acquired Insured Mortgages which are fully insured or guaranteed by the Federal National Mortgage Association, the Government National Mortgage Association (GNMA), FHA or the Federal Home Loan Mortgage Corporation. The United States Congress recently repealed portions of the Federal tax code which have had an adverse impact on tax-exempt investors in "publicly traded partnerships." This tax code change, effective January 1, 1994, cleared away the major impediment standing in the way of listing the Partnership's Units for trading on a national stock exchange. As a result, the General Partner listed the Partnership's Units for trading on the American Stock Exchange (AMEX) on January 18, 1994 in order to provide investment liquidity as contemplated in the Partnership's original prospectus. The Units are traded under the symbol "AIJ." 2. SIGNIFICANT ACCOUNTING POLICIES Method of Accounting -------------------- The financial statements are prepared on the accrual basis of accounting in accordance with generally accepted accounting principles. Investment in Mortgages ----------------------- As of December 31, 1993 and 1992, the Partnership accounted for its investment in mortgages at amortized cost. The difference between the cost and the unpaid principal balance at the time of purchase is carried as a discount or premium and amortized over the remaining contractual term of the mortgage using the effective interest method. The effective interest method provides a constant yield of income over the term of the mortgage. Mortgage investment income is comprised of amortization of the discount plus the stated mortgage interest received or accrued less the amortization of the premium. In May 1993, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 115 "Accounting for Certain Investments in Debt and Equity Securities" (SFAS 115), effective for fiscal years beginning after December 15, 1993. This statement requires that investments in debt and equity securities be classified into one of the following investment categories based upon the circumstances under which such securities might be sold: Held to Maturity, Available for Sale, and Trading. Generally, certain debt securities for which an enterprise has both the ability and intent to hold to maturity should be accounted for using the amortized cost method and all other securities must be recorded at their fair values. The General Partner believes that the majority of securities held by the Partnership will fall into either the Held to Maturity or Available for Sale categories. However, the General Partner has not yet determined the ultimate impact of the implementation of this statement in the Partnership's financial statements. Also in May 1993, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 114 "Accounting by Creditors for Impairment of a Loan" (SFAS 114), effective for fiscal years beginning after December 15, 1994. This statement requires that applicable loans which are impaired be measured based on the present value of expected future cash flows discounted at the loan's AMERICAN INSURED MORTGAGE INVESTORS L.P. - SERIES 86 NOTES TO FINANCIAL STATEMENTS 2. SIGNIFICANT ACCOUNTING POLICIES - Continued effective interest rate, or at the loan's market price, or the fair value of the collateral for impaired loans that are collateral dependent. The General Partner does not believe the ultimate impact of the implementation of this statement will materially affect the Partnership's financial statements. Mortgages Held for Disposition ------------------------------ At any point in time, the Partnership may be aware of certain mortgages which have been (i) assigned to the United States Department of Housing and Urban Development (HUD) or (ii) for which the servicer has received proceeds from a prepayment or (iii) in the case of mortgages coinsured by unaffiliated third parties, the borrower is displaying continuous operating difficulties and the realization of the mortgage is dependent on a third party coinsurer (see Notes 4 B.1). In these cases, the Partnership will classify these mortgages as Mortgages Held for Disposition. Gains from dispositions of mortgages are recognized upon the receipt of cash or HUD debentures. Losses on dispositions of mortgages are recognized when it becomes probable that a mortgage will be disposed of and that the disposition will result in a loss. In the case of Insured Mortgages fully insured by HUD, the Partnership's maximum exposure for purposes of determining the loan losses would generally be an assignment fee charged by HUD repre- senting approximately 1% of the unpaid principal balance of the Insured Mortgage at the date of default, plus the unamortized balance of acquisition fees and closing costs paid in connection with the acquisition of the Insured Mortgage and the loss of approximately 30-days accrued interest (see discussion below for losses on mortgages accounted for as AHFS, as defined below). Assets Held for Sale Under Coinsurance Program (AHFS) ----------------------------------------------------- As of December 31, 1993 and 1992, the former managing general partner, on behalf of the Partnership, had invested in one and two coinsured mortgages which are accounted for as AHFS, respectively. The coinsurer on these mortgages is IFI and the Partnership bears the risk of any coinsurance loss. Coinsured mortgage loans are deemed to be AHFS when a determination has been made that the borrower meets the following criteria: 1. The borrower has little or no equity in the collateral, considering the current fair value of the collateral; and 2. proceeds for repayment of the loan can be expected to come only from the operation or sale of the collateral; and 3. the borrower has either: a. formally or effectively abandoned control of the collateral to the creditor; or, b. retained control of the collateral, but because of the current financial condition of the borrower or the economic prospects for the borrower and/or the collateral in the foreseeable future, it is doubtful that the borrower will be able to rebuild equity in the collateral or otherwise repay the loan in the foreseeable future. AHFS represent the estimated cash flow to be received from any claims filed with HUD, including the estimated asset disposition proceeds. The disposition proceeds are based on the estimated fair value of the collateral underlying the mortgage which represents the amount that AMERICAN INSURED MORTGAGE INVESTORS L.P. - SERIES 86 NOTES TO FINANCIAL STATEMENTS 2. SIGNIFICANT ACCOUNTING POLICIES - Continued could reasonably be expected to be received in a current sale between a willing buyer and a willing seller. The General Partner initially determined the estimated fair values of the AHFS and the General Partner periodically assesses the estimated current fair value of the properties to determine whether additional loan losses are appropriate due to, among other factors, a change in market conditions affecting the properties. The loan losses related to these AHFS reduce the carrying value of the Originated Insured Mortgages. The Partnership accounts for the AHFS at the lower of cost or market since its intent is to dispose of the assets in the short term and file coinsurance claims with HUD. Cash and Cash Equivalents ------------------------- Cash and cash equivalents consist of time and demand deposits and commercial paper with original maturities of three months or less. Reclassification ---------------- Certain amounts in the statements of operations for the year ended December 31, 1992 have been reclassified to conform with the 1993 presentation. Income Taxes ------------ No provision has been made for Federal, state or local income taxes since they are the personal responsibility of the Unitholders. Net Earnings Per Limited Partnership Unit ----------------------------------------- Net earnings per Limited Partnership Unit are computed based upon the weighted average number of Units outstanding of 9,576,290 for each of the years ended December 31, 1993, 1992 and 1991. 3. FAIR VALUE OF FINANCIAL INSTRUMENTS The following estimated fair values of the Partnership's financial instruments are presented in accordance with generally accepted accounting principles which define fair value as the amount at which a financial instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. These estimated fair values, however, do not represent the liquidation value or the market value of the Partnership. AMERICAN INSURED MORTGAGE INVESTORS L.P. - SERIES 86 NOTES TO FINANCIAL STATEMENTS 3. FAIR VALUE OF FINANCIAL INSTRUMENTS - Continued AMERICAN INSURED MORTGAGE INVESTORS L.P. - SERIES 86 NOTES TO FINANCIAL STATEMENTS 3. FAIR VALUE OF FINANCIAL INSTRUMENTS - Continued The following methods and assumptions were used to estimate the fair value of each class of financial instruments: Investment in mortgages and mortgages held for disposition ---------------------------------------------------------- The fair value of the fully insured mortgages is based on the average of the quoted market prices from three investment banking institutions which trade these investments as part of their day-to-day activities. In order to determine the fair value of the coinsured mortgage portfolio, the Partnership valued the coinsured mortgages as though they were fully insured (in the same manner fully insured mortgages were valued). From this amount, the Partnership deducted five percent of the face value of the loan and fifteen percent of the difference between the remaining face value and the value of these loans as though they were uninsured. These deductions are based on HUD's coinsurance limitations. The uninsured values were based on the average of the quoted market prices from two investment banking institutions which trade these types of investments as part of their day-to-day activities. Cash and cash equivalents and accrued interest receivable --------------------------------------------------------- The carrying amount approximates fair value because of the short maturity of these instruments. 4. INVESTMENT IN MORTGAGES The following is a discussion of the types of Insured Mortgages, along with the risks related to each type of investment: A. Fully Insured Originated Insured Mortgages and Acquired Insured Mortgages ---------------------------------------------- The former managing general partner, on behalf of the Partnership, had invested in eight fully insured Originated Insured Mortgages with an aggregate carrying value of $69,539,851 and $69,888,943 as of December 31, 1993 and 1992, respectively, and an aggregate face value of $66,934,689 and $67,240,257 as of December 31, 1993 and 1992, respectively. As of December 31, 1993 and 1992, the Partnership had invested in two fully insured Acquired Insured Mortgages with an aggregate carrying value of $3,012,158 and $3,026,972, respectively, and an aggregate face value of $3,034,084 and $3,049,283, respectively. As of December 31, 1993, all of the fully insured Originated Insured Mortgages and Acquired Insured Mortgages are current with respect to the payment of principal and interest. In connection with Originated Insured Mortgages, the Partnership has sought, in addition to base interest pay- ments, additional interest (commonly termed Participations) based on a percentage of the net cash flow from the develop- ment and of the net proceeds from the refinancing, sale or other disposition of the underlying development. All eight of the Originated Insured Mortgages made by the Partnership contain such Participations. During the years ended December 31, 1993, 1992 and 1991, the Partnership received additional interest of $113,822, $104,350 and $52,816, respectively, from the Participations. These amounts are included in mortgage investment income in the accompanying statements of operations. In the case of fully insured Originated Insured Mortgages and Acquired Insured Mortgages, the Partnership's maximum exposure for purposes of determining loan losses would generally be approximately 1% of the unpaid principal balance of the Originated Insured Mortgage or Acquired Insured Mortgage (an assignment fee charged by FHA) at the AMERICAN INSURED MORTGAGE INVESTORS L.P. - SERIES 86 NOTES TO FINANCIAL STATEMENTS 4. INVESTMENT IN MORTGAGES - Continued date of a default, plus the unamortized balance of acquisi- tion fees and closing costs paid in connection with the acquisition of the Insured Mortgages and the loss of approximately 30-days accrued interest. B. Coinsured Mortgages ------------------- Under the HUD coinsurance program, both HUD and the coinsurance lender are responsible for paying a portion of the insurance benefits if a mortgagor defaults and the sale of the development collateralizing the mortgage produces insufficient net proceeds to repay the mortgage obligation. In such case, the coinsurance lender will be liable to the Partnership for the first part of such loss in an amount up to 5% of the outstanding principal balance of the mortgage as of the date foreclosure proceedings are instituted or the deed is acquired in lieu of foreclosure. For any loss greater than 5% of the outstanding principal balance, the responsibility for paying the insurance benefits will be borne on a pro-rata basis, 85% by HUD and 15% by the coinsurance lender. While the Partnership is due payment of all amounts owed under the mortgage, the coinsurance lender is responsible for the timely payment of principal and interest to the Partnership. The coinsurance lender is prohibited from entering into any workout arrangement with the borrower without the Partnership's consent and must file a claim for coinsurance benefits with HUD, upon default, if the Partnership so directs. As an ongoing HUD-approved coinsurance lender, and under the terms of the participation documents, the coinsurance lender is required to satisfy minimum net worth requirements as set forth by HUD. However, it is possible that the coinsurance lender's potential liability for loss on these developments, and others, could exceed its HUD-required minimum net worth. In such case, the Partnership would bear the risk of loss if the coinsurance lenders were unable to meet their coinsurance obligations. In addition, HUD's obligation for the payment of its share of the loss could be diminished under certain conditions, such as the lender not adequately pursuing regulatory violations of the borrower or the failure to comply with other terms of the mortgage. However, the General Partner is not aware of any conditions or actions that would result in HUD diminishing its insurance coverage. 1. Coinsured by third parties -------------------------- As of December 31, 1993 and 1992, the former managing general partner, on behalf of the Partnership, had invested in eight and nine coinsured mortgages, respectively, five of which are coinsured by an unaffiliated third party coinsurance lender under the HUD coinsurance program. Two of the coinsured mortgages which are coinsured by an unaffiliated third party are classified as Mortgages Held for Disposition as of December 31, 1993 and are discussed below. The remaining three coinsured mortgages which are coinsured by unaffiliated third parties are current with respect to the payment of principal and interest and are classified as investment in mortgages as of December 31, 1993 and 1992. As of December 31, 1993 and 1992, these three coinsured mortgages had an aggregate carrying value of $22,680,052 and $22,792,326, respectively, and an aggregate face value of $21,945,884 and $22,047,027, respectively. The following is a discussion of actual and potential performance problems with respect to certain mortgage investments coinsured by an unaffiliated third party: AMERICAN INSURED MORTGAGE INVESTORS L.P. - SERIES 86 NOTES TO FINANCIAL STATEMENTS 4. INVESTMENT IN MORTGAGES - Continued The Originated Insured Mortgage on The Villas, a 405-unit apartment complex located in Lauderhill, Florida, is coinsured by the Patrician Mortgage Company (Patrician) and had a carrying value equal to its face value of $15,856,842 and $15,878,027 as of December 31, 1993 and 1992, respectively. Since August 1, 1990, the mortgagor has not made the full monthly payments of principal and interest to Patrician. Patrician began collecting rents from the project and continued to make the monthly debt service payments to the Partnership through February 1992. The Partnership and Patrician entered into a modification agreement which provided for reduced payments through July 1992, regular scheduled payments from August 1992 to December 1992, and then increased payments for a period lasting approximately 10 years. The mortgagor of the mortgage on The Villas was unable to comply with the terms of the modification. As a result, Patrician filed a foreclosure action on October 14, 1993. On November 2, 1993, the mortgagor of The Villas filed for protection under Chapter 11 of the Federal Bankruptcy Code. If Patrician and the mortgagor are unable to negotiate a settlement, Patrician intends to litigate the case in bankruptcy court and to subsequently acquire and dispose of the property. As of March 4, 1994, Patrician had made payments of principal and interest due through November 1993. The mortgagor of The Villas mortgage is also the mortgagor of the Originated Insured Mortgage on St. Charles Place-Phase II, a 156-unit apartment complex located in Miramar, Florida, which is also coinsured by Patrician. The St. Charles Place-Phase II mortgage had a carrying value and a face value of $3,098,630 and $3,107,542 as of December 31, 1993 and December 31, 1992, respectively. These amounts represent the Partnership's approximately 45% ownership interest in the mortgage. The remaining 55% ownership interest is held by American Insured Mortgage Investors L.P. - Series 88 (AIM 88), an affiliated entity. During 1993, the mortgagor of St. Charles Place-Phase II paid its monthly principal and interest payments to Patrician in arrears, and did not make the monthly payment of principal and interest due to Patrician for the period of October 1993 through December 1993. However, Patrician has remitted monthly payments of principal and interest due for these months to the Partnership. As the mortgagor was unable to bring the loan current, Patrician filed a foreclosure action on October 14, 1993. On November 2, 1993, the mortgagor of the mortgage on St. Charles Place-Phase II filed for protection under Chapter 11 of the Federal Bankruptcy Code. If Patrician and the mortgagor are unable to negotiate a settlement, Patrician intends to litigate the case in bankruptcy court and to subsequently acquire and dispose of the property. The General Partner is overseeing Patrician's efforts to complete the foreclosure action, including the subsequent acquisition and disposition of the above two properties. As the coinsurance lender, Patrician is liable to the Partnership for the outstanding principal balance of both mortgages plus all accrued but unpaid interest through the date of such payment. If the sale of the properties collateralizing the mortgages produces insufficient net proceeds to repay the mortgage obligations to the Partnership, Patrician will be liable to the Partnership for the coinsurance lender's share of the deficiency. Based on the General AMERICAN INSURED MORTGAGE INVESTORS L.P. - SERIES 86 NOTES TO FINANCIAL STATEMENTS 4. INVESTMENT IN MORTGAGES - Continued Partner's assessment of the collateral underlying the mortgages, including information related to the financial condition of Patrician, the General Partner believes the carrying value of these assets is realizable. As a result of Patrician's coinsurance obligation these mortgages were classified as Mortgages Held for Disposition as of December 31, 1993. The Partnership intends to reinvest any net disposition proceeds from these mortgages in Acquired Insured Mortgages. The General Partner intends to continue to oversee the Partnership's interest in these mortgages to ensure that Patrician meets its coinsurance obligations. The General Partner's assessment of the realizability of The Villas and St. Charles Place-Phase II mortgages is based on current information, and to the extent current conditions change or additional information becomes available, then the General Partner's assessment may change. However, the General Partner does not believe that there would be a material adverse impact on the Partnership's financial condition or its results of operations should Patrician be unable to comply with its full coinsurance obligation. 2. Coinsured by affiliate ---------------------- a. The former managing general partner, on behalf of the Partnership, had invested in coinsured originated mortgages where the coinsurance lender is IFI. As of December 31, 1993 and 1992, the Partnership had investments remaining in three and four coinsured originated mortgages, respectively, where the coinsurance lender is IFI. As structured by the former managing general partner, with respect to these mortgages, the Partnership bears the risk of loss upon default for IFI's portion of the coinsurance loss. As of December 31, 1993 and 1992, one and two of these mortgages, respectively, were classified as AHFS and are discussed below. As of December 31, 1993, the remaining two IFI coinsured mortgages, as shown in the table below, are classified as investment in mortgages and are current with respect to the payment of principal and interest. The General Partner believes there is adequate collateral value underlying the mortgages. Therefore, no loan losses were recognized on these mortgages during the years ended December 31, 1993, 1992 and 1991. AMERICAN INSURED MORTGAGE INVESTORS L.P. - SERIES 86 NOTES TO FINANCIAL STATEMENTS 4. INVESTMENT IN MORTGAGES - Continued AMERICAN INSURED MORTGAGE INVESTORS L.P. - SERIES 86 NOTES TO FINANCIAL STATEMENTS 4. INVESTMENT IN MORTGAGES - Continued b. Assets Held for Sale Under Coinsurance Program On the AHFS determination date for the applicable mortgages and through December 31, 1993, the Partnership discontinued accruing interest income in accordance with the original terms of the mortgage. For the years ended December 31, 1992 and 1991, the Partnership recognized $1,170,700 and $572,572, respectively, as interest income and received $2,794,186 and $1,461,309, respectively, representing the borrowers interest payments on the mortgages which were applied to reduce the outstanding basis in the mortgage investment. Beginning on January 1, 1993, the Partnership began to recognize mortgage investment income for the mortgages classified as AHFS in the amount coinsured by HUD. Given the improved financial performance of the borrowers and the General Partner's assessment of the collateral underlying the mortgages, the General Partner determined that it was appropriate to begin recognizing interest income at least to the level of insurance provided by HUD. To the extent the borrower remits interest in excess of the HUD insured amount, this excess amount is recognized as income on the cash basis. During 1993, the Partnership recognized $2,898,882 in interest income. Cash totalling $639,756 was received from mortgages classified as AHFS. AMERICAN INSURED MORTGAGE INVESTORS L.P. - SERIES 86 NOTES TO FINANCIAL STATEMENTS 4. INVESTMENT IN MORTGAGES - Continued The following table summarizes the coinsured mortgages accounted for as AHFS as of December 31, 1993 and 1992, respectively: AMERICAN INSURED MORTGAGE INVESTORS L.P. - SERIES 86 NOTES TO FINANCIAL STATEMENTS 4. INVESTMENT IN MORTGAGES - Continued The following is a discussion of performance problems with respect to those mortgage investments accounted for as AHFS: 1. In December 1993, the General Partner entered into a Modification Agreement with the mortgagor of the mortgage on One East Delaware wherein the mortgagor had until April 30, 1994 to pay off the mortgage at a discount. The mortgagor prepaid the loan in January 1994. Total proceeds received were approximately $33.6 million, which resulted in a financial statement gain of approximately $1.2 million which was recognized in 1994. The Partnership intends to reinvest any net disposition proceeds from this mortgage in Acquired Insured Mortgages. 2. In December 1993, the Partnership settled, for approximately $9,050,000, the mortgage on Victoria Pointe Apartments-Phase II. As of December 31, 1993, the Partnership recognized a loan loss amounting to $63,488 which is reflected in the accompanying statement of operations for the year ended December 31, 1993. As of December 31, 1993 the Partnership had committed to reinvest the net disposition proceeds in Acquired Insured Mortgages. 5. DISTRIBUTIONS TO UNITHOLDERS The composition of distributions paid or accrued to Unitholders on a per Limited Partnership Unit basis for the years ended December 31, 1993, 1992 and 1991 are as follows: 1993 1992 1991 Quarter ended March 31, $ .230 $ .300 $ .325 Quarter ended June 30, .210 .220 .325 Quarter ended September 30, .290(1) .300 .285 Quarter ended December 31, .280(2) .320 .327 ------ ------ ------ $1.010 $1.140 $1.262 ====== ====== ====== (1) In September 1993, the Partnership received $591,872 (approximately $.06 per Unit) from the mortgage on Victoria Pointe Apartments-Phase II, representing mortgage interest from October 1991 through June 1992, and a partial payment for July 1992. The Partnership distributed approximately $.03 per Unit of this previously undistributed interest and reserved approximately $.03 per Unit for the continued funding of coinsurance expenses. The Partnership distributed the remaining interest of approximately $.03 per Unit to Unitholders as part of the fourth quarter distribution, as discussed below. (2) This includes a special distribution of approximately $.10 per Unit comprised of (i) $.03 per Unit of previously undistributed accrued interest from the mortgage on Victoria Pointe Apartments-Phase II which was reserved as part of the third quarter distribution, described above, and (ii) $.07 per Unit representing previously undistributed accrued interest received in December 1993 resulting from the disposition of the mortgage on Victoria Pointe Apartments-Phase II. AMERICAN INSURED MORTGAGE INVESTORS L.P. - SERIES 86 NOTES TO FINANCIAL STATEMENTS 5. DISTRIBUTIONS TO UNITHOLDERS - Continued The basis for paying distributions to Unitholders is cash flow from operations, which is comprised of regular interest income and principal from Insured Mortgages and gain, if any, from mortgage dispositions. Although Insured Mortgages yield a fixed monthly mortgage payment once purchased, the cash distributions paid to the Unitholders will vary during each quarter due to (1) the fluctuating yields in the short-term money market where the monthly mortgage payments received are temporarily invested prior to the payment of quarterly distributions, (2) the reduction in the asset base and monthly mortgage payments due to monthly mortgage payments received or mortgage dispositions, (3) variations in the cash flow attributable to the delinquency or default of Insured Mortgages and professional fees and foreclosure and acquisition costs incurred in connection with those Insured Mortgages and (4) variations in the Partnership's operating expenses. 6. INVESTMENT IN AFFILIATE AND NOTE PAYABLE TO AFFILIATE Effective December 31, 1991, American Insured Mortgage Investors-Series 85, L.P. (AIM 85) transferred a GNMA security in the amount of $4,696,548 to IFI in order to capitalize IFI with sufficient net worth under HUD regulations. The Partnership and AIM 88 each issued a demand note payable to AIM 85 and recorded an investment in IFI through an affiliate (AIM Mortgage, Inc.) at an amount proportionate to each entity's coinsured mortgages for which IFI was the mortgagee of record as of December 31, 1991. The Partnership accounts for its investment in IFI on the equity method of accounting. Interest expense on the note, based on an interest rate of 8% per annum, was $139,018 for each of the years ended December 31, 1993 and 1992. In 1992, IFI entered into an expense reimbursement agreement with the Partnership, AIM 85 and AIM 88 (the AIM Funds) whereby IFI reimburses the AIM Funds for general and administrative expenses incurred on behalf of IFI. The expense reimbursement is allocated to the AIM Funds based on an amount proportionate to each entity's coinsured mortgages. The expense reimbursement, along with the Partnership's equity interest in IFI's net income or loss, substantially equals the interest expense on the note payable. 7. TRANSACTIONS WITH RELATED PARTIES In addition to the related party transactions described above in Note 6, the General Partner, former general partners and certain affiliated entities, during the years ended December 31, 1993, 1992 and 1991, earned or received compensation or payments for services from the Partnership as follows: AMERICAN INSURED MORTGAGE INVESTORS L.P. - SERIES 86 NOTES TO FINANCIAL STATEMENTS 7. TRANSACTIONS WITH RELATED PARTIES - Continued AMERICAN INSURED MORTGAGE INVESTORS L.P. - SERIES 86 NOTES TO FINANCIAL STATEMENTS 7. TRANSACTIONS WITH RELATED PARTIES - Continued (1) The General Partner, pursuant to amendments to the Partnership Agreement, effective September 6, 1991, is entitled to receive 4.9% of the Partnership's income, loss, capital and distributions including, without limitation, the Partnership's Adjusted Cash from Operations and Proceeds of Mortgage Prepayments, Sales or Insurance (both as defined in the Partnership Agreement). The principal officers of the General Partner for the period September 7, 1991 through December 31, 1993 did not receive fees for serving as officers of the General Partner, nor are any fees expected to be paid to the officers in the future. (2) The Advisor, pursuant to the Purchase Agreement and amendments to the Partnership Agreement, is entitled to an Asset Management Fee equal to .95% of Total Invested Assets (as defined in the Partnership Agreement), effective October 1, 1991. The Asset Management Fee was based on 1.25% of Total Invested Assets from September 7, 1991 through September 30, 1991. Of the amounts paid to the Advisor, the Sub-advisor earned a fee equal to $499,332, $497,716 and $158,545, or .28% of Total Invested Assets, for the years ended December 31, 1993 and 1992 and for the period September 7, 1991 through December 31, 1991, respectively. (3) The former general partners were entitled to receive an aggregate 5% of the Partnership's income, loss, capital and distributions through September 6, 1991 (4.8% to the former managing general partner, 0.1% to the former corporate general partner and 0.1% to the former associate general partner). (4) Asset management fees for managing the Partnership's mortgage portfolio for the period January 1, 1991 through September 6, 1991 were based on 1.25% of Total Invested Assets. (5) These amounts are paid to CRI as reimbursement for expenses incurred on behalf of the General Partner and the Partnership. 8. PARTNERS' EQUITY Depository Units representing economic rights in limited partnership interests were issued at a stated value of $20. A total of 9,576,165 depository Units of limited partnership interest were issued for an aggregate capital contribution of $191,523,300. In addition, the initial limited partner contributed $2,500 to the capital of the Partnership and received 125 Units of limited partnership interests in exchange therefor and the former general partners contributed a total of $1,000 to the Partnership. AMERICAN INSURED MORTGAGE INVESTORS L.P. - SERIES 86 NOTES TO FINANCIAL STATEMENTS 9. SUMMARY OF QUARTERLY RESULTS OF OPERATIONS (UNAUDITED) (In Thousands, Except Per Unit Data) The following is a summary of unaudited quarterly results of operations for the years ended December 31, 1993 and 1992: AMERICAN INSURED MORTGAGE INVESTORS L.P. - SERIES 86 NOTES TO SCHEDULE XII - MORTGAGE LOANS ON REAL ESTATE DECEMBER 31, 1993 (1) Under the Section 221 program of the National Housing Act of 1937, as amended, a mortgagee has the right to assign a mortgage (put) to the Federal Housing Administration (FHA) at the expiration of 20 years from the date of final endorsement, if the mortgage is not in default at such time. Any mortgagee electing to assign an FHA insured mortgage to FHA will receive in exchange HUD debentures having a total face value equal to the then outstanding principal balance of the FHA insured mortgage plus accrued interest to the date of assignment. These HUD debentures will mature 10 years from the date of assignment and will bear interest at the "going Federal" rate at such date. This assignment procedure is applicable to a mortgage which had a firm or conditional FHA commitment for insurance on or before November 30, 1983 and, in the case of mortgages sold in a GNMA auction, was sold in an auction prior to February of 1984. Certain of the Partnership's mortgages may have the right of assignment under this program. Certain mortgages that do not qualify under this program possess a special assignment option, in certain mortgage documents, which allows the Partnership, anytime after this date, the option to require payment of the unpaid principal balance of the mortgages. At such time, the borrowers must make payment to the Partnership or the Partnership may cancel the FHA insurance and institute foreclosure proceedings. (2) Inclusive of closing costs and acquisition fees. (3) Prepayment of these mortgages would be based upon the unpaid principal balance at the time of prepayment. (4) This represents the base interest rate during the permanent phase of this mortgage loan. Additional interest (referred to as Participations) measured as a percentage of the net cash flow from the development and of the net proceeds from sale, refinancing or other disposition of the underlying development (as defined in the Participation Agreements), will also be due. During the years ended 1993, 1992 and 1991, the Partnership received additional interest of $113,822, $104,350 and $52,816, respectively, as a result of the Participations. (5) In addition, the servicer or the sub-servicer of the mortgage, primarily unaffiliated third parties, is entitled to receive compensation for certain services rendered. Effective January 1993, CRICO Mortgage Company, Inc., an affiliate of CRI, became the sub-servicer of 3 of the 8 coinsured mortgages. (6) These mortgages are insured under the HUD coinsurance program, as previously discussed. The HUD-approved coinsurance lenders for these mortgages are Patrician Mortgage Company (The Villas and St. Charles Place-Phase II) and M-West Mortgage Corporation (Woodland Apartments, Woodbine at Lakewood Apartments and Carmen Drive Estates). (7) These mortgages are insured under the HUD coinsurance program. IFI is the HUD-approved coinsurance lender, and the Partnership bears the risk of any principal loss, as previously discussed. (8) These amounts represent the Partnership's 45% interest in these mortgages. The remaining 55% interest was acquired by AIM 88. AMERICAN INSURED MORTGAGE INVESTORS L.P. - SERIES 86 NOTES TO SCHEDULE XII - MORTGAGE LOANS ON REAL ESTATE DECEMBER 31, 1993 (9) A reconciliation of the carrying value of the Insured Mortgages, including Mortgages Held for Disposition and Assets Held for Sale Under Coinsurance Program, for the years ended December 31, 1993 and 1992 is as follows: 1993 1992 ------------ ------------ Beginning balance $173,752,165 $173,017,756 Investment in Acquired Insured Mortgages -- 3,032,831 Principal receipts on mortgages (600,361) (573,537) Mortgage acquisition costs -- 5,471 Payments made (received) for AHFS/mortgage investment income accrued/accreted on AHFS 3,106,783 (1,623,486) Loan losses (63,488) (106,870) Disposition of AHFS (9,049,783) -- ------------ ------------ Ending balance $167,145,316 $173,752,165 ============ ============ (10) The Partnership's mortgages are non-recourse first liens on multifamily residential developments or retirement homes. (11) Principal and interest are payable at level amounts over the life of the mortgages. (12) Represents principal amount subject to delinquent principal or interest. See Note 4 to financial statements. (13) Annual payment reflects required principal and interest payments for 1993 as per the modification agreement. (14) As of December 31, 1993 and 1992, the tax basis of the Insured Mortgages, including Mortgages Held for Disposition and Assets Held for Sale Under Coinsurance Program, was approximately $168.0 million and $176.1 million, respectively.

1993 ITEM 1. BUSINESS A. GENERAL DEVELOPMENT OF BUSINESS Spiegel, Inc., a Delaware corporation, was incorporated in 1965. Spiegel, Inc. and its subsidiaries are sometimes referred to collectively in this Report on Form 10-K as the "Company." The Spiegel, Inc. catalog operations and related retail store operations are collectively referred to in this Report on Form 10-K as "Spiegel." The Company and its predecessors date from 1865. Since 1905, the Company has operated as a catalog merchandiser. In 1982, the Company was purchased by Otto Versand (GmbH & Co) ("Otto Versand"), a privately-held German partnership that is one of the largest catalog merchandisers in the world, selling its products in Europe and Japan. In 1984, all of the capital stock of the Company was transferred to the partners of Otto Versand or their designees. In this transaction, 65% of the capital stock of the Company was transferred to Spiegel Holdings, Ltd., an Illinois limited partnership, whose general partner was Dr. Werner Otto. Since 1984, additional shares of the Company's capital stock have been acquired by Spiegel Holdings, Ltd. and its successor. In 1986, Spiegel Holdings, Ltd. was converted to Spiegel Holdings, Inc., a Delaware corporation ("SHI"). Prior to the Company's 1987 initial public offering of Class A non-voting common stock, all of Spiegel's existing capital stock was converted into Class B voting common stock. SHI holds 97.5% of the Company's Class B voting common stock, affording SHI control of the Company. In 1988, the Company acquired Eddie Bauer, Inc. and certain related Canadian assets (collectively, "Eddie Bauer"). Eddie Bauer is a leading specialty retailer serving the casual lifestyle needs of men and women through the sale of high quality apparel, home furnishings and accessories through catalogs and specialty retail stores. In 1990, the Company acquired First Consumers National Bank ("FCNB"). FCNB is a special purpose bank limited to the issuance of credit cards, primarily FCNB Preferred Charge cards for use by Spiegel, Eddie Bauer and New Hampton customers. In August 1993, the Company acquired substantially all of the assets of New Hampton, Inc. ("New Hampton") through a bankruptcy proceeding. New Hampton is a specialty catalog company offering fashionable women's apparel at moderate price points. In September 1993, the Company entered into an arrangement with Otto-Sumisho, Inc. to sell Eddie Bauer products through Eddie Bauer retail stores and catalogs in Japan. In addition, the Company announced its intention to enter into a new channel of retail distribution, television home shopping, through a joint venture with Time Warner Entertainment Company, L.P. ("Time Warner") to develop catalog home shopping channels. B. NARRATIVE DESCRIPTION OF BUSINESS Principal products, services, and revenue sources. The Company has three principal merchandise categories: apparel, household furnishings and other merchandise. The components of net sales by merchandise category for the last three years were: The Company's household furnishings range from traditional to contemporary styles, including accent pieces, decorative accessories, bedding and bath, home electronics, window treatments and rugs. The other merchandise category includes items such as fitness and personal care equipment, toys, cameras and luggage. PRODUCT DEVELOPMENT AND SOURCING The Company's product development and sourcing teams have become an increasingly significant element of its private label merchandise strategy. The Company selects manufacturers based on their ability to produce high quality product on a cost-effective basis. The Company's product design teams select and source fabrics to be delivered to manufacturers along with product patterns, specifications and templates used for cutting fabric and other pre-production work. Prototype samples are submitted to the Company for final production approval to ensure manufacturer compliance with specifications. The Company does not have any manufacturing facilities; all production is done by third-party contractors. The product development and sourcing teams also closely monitor the timeliness of manufacturers' delivery to the Company's distribution facilities and provide them with packaging information. The Company believes this strategy permits maximum flexibility, enhanced inventory management and consistent quality control without the risks associated with operating its own manufacturing facilities. COMMON SYSTEMS STRATEGY By capitalizing on synergies between Spiegel and Eddie Bauer, the Company continues to make significant progress toward its long-term goal of operating common catalog systems for the two businesses. After implementing a common order-entry system for Spiegel and Eddie Bauer in 1990, the Company completed installation of a common customer-satisfaction system during the summer of 1992. These systems ensure rapid response to customer orders and inquiries and allow Spiegel and Eddie Bauer operators to handle each other's calls when back-up support is necessary. In addition, Eddie Bauer implemented a computerized marketing system patterned after Spiegel's system for managing its customer data base, which it believes will create marketing efficiencies and cost savings. Another phase of the Company's common systems strategy is the planned catalog distribution facility in Groveport, Ohio. The Company believes the new facility will be among the largest and most technologically advanced catalog fulfillment systems in the United States, providing improved productivity and customer service. This facility will replace certain current catalog distribution facilities for Spiegel and Eddie Bauer. Shipments of Eddie Bauer catalog merchandise from the new facility are scheduled to begin in July 1994, with Spiegel catalog shipments expected to follow in early 1995. The new facility is designed to meet the Company's catalog distribution capacity needs for the foreseeable future. The following is a discussion of the major operations of the Company: Spiegel, Eddie Bauer, New Hampton and Credit. SPIEGEL Spiegel offers apparel, household furnishings and other merchandise through its various catalogs and, to a lesser extent, Ultimate Outlet and For You retail stores. Spiegel is one of the largest catalog companies in the United States and in 1993 distributed over 225 million catalogs throughout the country. At December 31, 1993, Spiegel's customer base included 6.0 million active customers (customers who have purchased within the last 18 months). Spiegel's apparel merchandise, which represented 58% of its sales in 1993, is primarily private label, developed by its product design teams based on emerging fashion trends and customer research. In addition, Spiegel features apparel by well-known American designers such as Liz Claiborne, CK Calvin Klein and DKNY. Spiegel's household furnishings, which represented 38% of its sales in 1993, are a mixture of private label and branded merchandise ranging from traditional to contemporary styles, including accent pieces, decorative accessories, bedding and bath, home electronics, window treatments and rugs. Spiegel catalogs serve as a fashion resource for the busy working woman. These catalogs include Spiegel's trademark 600-page semi-annual catalog, specialty catalogs targeted to distinct market segments and other catalog mailings throughout the year. The Company has used proprietary and other data from within and outside its existing customer base and its fashion and marketing expertise to identify an assortment of niche markets. Spiegel addresses each of these markets with a targeted specialty merchandise concept, through specialty catalogs and through "shops" included in Spiegel's main semi-annual catalog. A shop is a focused merchandise assortment targeted to a specific group of customers. One such shop from the Spiegel catalog is Sarah Chapman, which features romantic, classic clothing for customers who prefer traditional styles. Shops are managed by entrepreneurial groups within the Spiegel catalog organization, each comprised of representatives from different areas such as fashion, merchandising, marketing, and advertising. Spiegel believes that this specialty or niche marketing approach enables it to address the widely varying needs of a diverse customer base. EDDIE BAUER Eddie Bauer is a leading specialty retailer serving the casual lifestyle needs of men and women through the sale of high quality apparel, home furnishings and accessories. Founded in 1920, Eddie Bauer operates 294 retail stores in addition to a large catalog operation. A key strategy for Eddie Bauer is to leverage synergies between its retail and catalog channels of distribution, maximizing opportunities for cross-promotion between catalog and retail. This strategy includes utilizing the catalog customer database to help identify potential store locations, using catalog space to advertise the retail concept, and utilizing retail store mailing lists to help build the catalog file. Eddie Bauer's principal retailing concept is its trademark Eddie Bauer sportswear stores and catalogs, which feature predominantly private label casual apparel and accessories. Eddie Bauer also has other specialty retail concepts that serve targeted niches. These specialty concepts include the Eddie Bauer Home, which offers home furnishings through retail stores and a separate catalog; All Week Long, which features women's sportswear, casual clothing and special occasion attire through retail stores and a separate catalog; and the Eddie Bauer Sport Shop, a store-within-a-store concept which provides premier apparel, equipment and accessories for field and stream sports. In September 1993, Eddie Bauer entered into an arrangement with Otto-Sumisho, Inc. to sell its full line of Eddie Bauer sportswear products through retail stores and catalogs in Japan. Three Eddie Bauer stores are expected to open in Japan in the Fall of 1994 along with the introduction of the Japanese Eddie Bauer catalog. In addition to its catalog and retail store businesses, Eddie Bauer has capitalized on selected licensing opportunities. Eddie Bauer's most significant current licensee is Ford Motor Company, which uses the Eddie Bauer name and logo on special series Ford vehicles. Eddie Bauer's private label merchandise is developed by its product design teams and manufactured by third party manufacturers according to its specifications. The Eddie Bauer product design teams work with the Company's product development and sourcing department in developing favorable sourcing alternatives. Beginning in 1991 and continuing throughout 1992, Eddie Bauer implemented several changes in its retail and catalog operations. One of the primary changes was to implement a new merchandise strategy which narrowed and focused the merchandise assortment into key items or "essential styles" that were supported by a stronger inventory position. Eddie Bauer also instituted an extensive store remodeling and refurbishment program to update the visual appearance of its stores and improve its merchandise presentation. In 1992 and 1993, Eddie Bauer remodelled 60 and 45 stores, respectively, and refixtured several others. Eddie Bauer plans to remodel approximately 50 more stores in 1994. These changes were instrumental in achieving strong sales growth, a reduction of promotional pricing and Eddie Bauer's improved performance in 1992 and 1993. In addition, Eddie Bauer believes that increased usage of its Preferred Charge card has resulted in larger average transaction sizes and greater frequency of purchases. EDDIE BAUER RETAIL DIVISION. Eddie Bauer operates 260 retail and 34 outlet stores in the United States and Canada. Of these stores, 13 are Eddie Bauer Home Collection and seven are All Week Long stores. A typical Eddie Bauer store is approximately 6,000 gross square feet and is located in an upscale regional mall or a high traffic downtown location, because the Company believes that convenience is a primary consideration for its target customers. Eddie Bauer's catalog customer database serves as a valuable tool in identifying potential store locations. Most of Eddie Bauer's current stores are located in large metropolitan markets. Eddie Bauer has also begun to explore opportunities in certain smaller markets where it believes a concentration of its target customers exists. Eddie Bauer believes that these markets have the potential to contribute store profit margins comparable to the existing store base. Eddie Bauer outlet stores, which offer overstock and end-of-season merchandise, are located predominantly in outlet malls and strip centers and generally in areas not served by its core specialty retail stores. Eddie Bauer opened 30 new stores in 1993. One store was closed in 1993. Growth in this division has been due principally to the growth in comparable store sales, which reached 17% in 1992 and 11% in 1993, and, to a lesser extent, to new store openings. The Company believes that its catalog and comparable store net sales increases during 1992 and 1993 were primarily the result of changes made to the Company's merchandising strategies initiated in 1991. The Company does not expect comparable store sales growth to continue at 1992 and 1993 rates. Also, the Company currently plans to increase the number of Eddie Bauer new store openings from the 30 stores in 1993 to approximately 60 in each of the next two years. The average cost of opening a typical new Eddie Bauer store in 1993, including inventory, furniture and fixtures, pre-opening expenses and net leasehold improvements, is approximately $800,000. Eddie Bauer's ability to open and operate new stores profitably is dependent on the availability of suitable store locations, the negotiation of acceptable lease terms, Eddie Bauer's financial resources and its ability to control the operational aspects and personnel requirements of its growth. EDDIE BAUER CATALOG DIVISION. In 1993, the Eddie Bauer catalog division distributed over 88 million catalogs and had approximately 2.7 million active customers who had purchased within the last 12 months. As a corollary to its retail operations, Eddie Bauer catalog concepts include its trademark Eddie Bauer catalog, Eddie Bauer Home Collection and All Week Long. Eddie Bauer recently introduced its largest catalog yet, The Complete Resource, combining all of its specialty retail store concepts in a single catalog. Eddie Bauer also actively pursues new customers within its target market through a variety of initiatives including national print advertising, list rentals and utilizing names of its retail store customers. NEW HAMPTON New Hampton, acquired by the Company in August 1993, is a specialty catalog company whose principal catalog, Newport News (formerly Avon Fashions) offers fashionable, moderately priced women's apparel. Merchandise categories currently include swimwear, dresses, casual wear, evening wear and career wear. In addition, New Hampton has another smaller catalog, James River Traders which markets value-oriented women's apparel. Newport News represented approximately 87% of New Hampton's sales in 1993 and the Company believes it will continue to represent a significant portion of New Hampton's revenues in the future. In 1993, Newport News and James River Traders mailed 161 million catalogs to active and prospective customers. During 1993, 4.0 million customers purchased from the Newport News and James River Traders catalogs. New Hampton's contribution to the Company's consolidated net sales in 1993 was approximately $63 million. CREDIT In an effort to build brand loyalty and to provide additional convenience for its customers, the Company offers a credit program for qualifying catalog and retail customers in the form of its Preferred Charge card, which is imprinted with a Spiegel, Eddie Bauer or E STYLE logo depending on the source of the original application for credit. This card allows a customer to purchase products from both Spiegel and Eddie Bauer, regardless of the imprint on the card. FCNB is the issuer of the Preferred Charge card, and its activities are limited to the issuance of credit cards. In February 1994, the Company introduced a proprietary credit card to customers of its recently acquired New Hampton subsidiary. Preliminary response to this offering has been very positive. Revenues generated by the credit operations represented 8% of the Company's total revenues in 1993. Approximately 47% of the Company's 1993 net sales were made on the Preferred Charge card. In 1993, approximately 75% of Spiegel catalog net sales and approximately 24% of Eddie Bauer's net sales were made using the Preferred Charge card. The lower percentage of Eddie Bauer sales made on the Preferred Charge card is attributable primarily to its relatively recent availability to Eddie Bauer customers and to the relatively higher percentage of retail store sales at Eddie Bauer. Catalog sales generally have a higher percentage of sales made on credit than retail store sales. FCNB solicits for new Preferred Charge card accounts with both preapproved and non-preapproved applications. The accounts are serviced through the Company's corporate data center located in Westmont, Illinois, with all credit application analysis, strategy and policy formulation performed at FCNB's Beaverton, Oregon headquarters. FCNB also issues MasterCard credit cards, which represent approximately 5% of its outstanding cards. MERCHANDISE. The Company sells domestically produced and imported merchandise, which it purchases in the open market from approximately 4,000 suppliers, none of which supplied as much as 5% of the merchandise purchased during 1993. A significant amount of the dollar value of merchandise purchased by the Company is imported directly from the Far East and Europe. Consequently, the Company is subject to the risks generally associated with conducting business abroad. The Company's business could be affected by economic events or political instability that might affect imports, including duties, quotas and work stoppages. To date these factors have not caused any material disruption of the Company's operations. As with other companies that denominate purchases in dollars, declines in the dollar relative to foreign currencies could over time increase the cost to the Company of merchandise purchased in foreign countries, which could adversely affect the Company's results of operations. The Company is unable to predict the effect, if any, of the above; however, the Company believes this risk exists for many other retailers. LICENSES AND TRADEMARKS. The Company utilizes its own trademarks and tradenames including "Spiegel" and "Eddie Bauer." The Company is also licensed to sell goods under the "Together!" label. With the exception of the names "Spiegel," "Eddie Bauer" and "Together!," the Company believes that loss or abandonment of any particular trademark would have no significant effect on its business. SEASONALITY OF BUSINESS. The Company, like other retailers, has experienced and expects to continue to experience seasonal fluctuations in its merchandise sales and net income. Historically, a disproportionate amount of the Company's net sales and a majority of its net earnings have been realized during the fourth quarter. If the Company's sales were materially different from seasonal norms during the fourth quarter, the Company's annual operating results could be materially affected. Accordingly, results for the individual quarters are not necessarily indicative of the results to be expected for the entire year. COMPETITION. The markets in which the Company participates are highly competitive and served by a significant number of catalog companies and retailers including traditional department stores, so-called "off-price" and discount retailers and specialty chains. The Company's success is highly dependent upon its ability to maintain its existing customer lists, solicit new customers, identify distinct fashion trends and continue to address the fashion tastes of its customers. EMPLOYEES. During 1993, the Company employed between approximately 7,600 and 16,700 full- time equivalent employees, depending on the time of year, reflecting the seasonality of the Company's business and the variations in its workforce during the year. At February 28, 1994, the Company employed 11,104 full-time equivalent employees. Spiegel is a party to three collective bargaining agreements. Approximately 2,000 full-time equivalent employees are covered by an agreement between Spiegel and the Warehouse, Mail Order, Office, Technical and Professional Employees Union, Local 743, affiliated with the International Brotherhood of Teamsters, Chauffeurs, Warehousemen, and Helpers of America ("Local 743"). This agreement, which is scheduled to expire on February 28, 1995, will be affected by the closure of Spiegel's Chicago catalog distribution facility. The Company intends to provide affected workers with all termination benefits called for by the agreement, as well as additional benefits such as early retirement enhancements, stay pay, job counseling and vocational training. Approximately 280 full-time equivalent employees of certain Spiegel outlet stores are covered by a separate agreement with Local 743. This agreement expires on May 31, 1994, and will be subject to negotiation in the ordinary course. Approximately 120 full-time equivalent employees are covered by an agreement with Teamsters Union 929 Philadelphia, affiliated with the International Brotherhood of Teamsters, Chauffeurs, Warehousemen, and Helpers of America. This agreement expires on January 31, 1996. The Company considers its relations with its employees to be good and has never experienced any material interruption of operations due to labor disagreements with its employees. ITEM 2. ITEM 2. PROPERTIES The Company's corporate headquarters is located in leased office space in Downers Grove, Illinois. In addition, all of the Company's retail store locations are leased, with the exception of a downtown San Francisco Eddie Bauer store, a downtown Chicago Eddie Bauer store and a Chicago Spiegel outlet store. A typical store lease is for a term of 10 years, with options for renewal. The principal properties and facilities used in Spiegel's catalog operations consist of approximately 20 warehouses and office buildings located in and around Chicago, Illinois. These facilities are primarily owned. Eddie Bauer's current retail and catalog distribution facilities are located in Columbus, Ohio, two of which are owned and four of which are leased. Eddie Bauer also occupies office space in 10 buildings located in and around Seattle, Washington, two of which are owned and eight of which are under lease. The Company's new Groveport, Ohio catalog distribution facility, which is being constructed on land owned by the Company, is expected to be completed in 1994 and is designed to consolidate the majority of catalog distribution functions of Spiegel and Eddie Bauer. The Company plans that Eddie Bauer will begin fulfilling catalog orders from the new facility in 1994, however fulfillment of Spiegel catalog orders is expected to begin in 1995. The Company has made provision for the closing of certain of its catalog distribution facilities, as described in note 4 to the Company's Consolidated Financial Statements. The Company leases customer order centers in Reno, Nevada, Bensalem, Pennsylvania and Norcross, Georgia, and customer service facilities in Rapid City, South Dakota and Oakbrook, Illinois. The Company owns its Westmont, Illinois corporate data center. New Hampton leases office space in New York, New York. Its order taking, customer service and administrative functions are performed in a leased facility, and its distribution function is performed in an owned facility, both of which are located in Hampton, Virginia. New Hampton also owns approximately 80 acres of vacant land in Hampton, Virginia adjacent to its distribution facility. At present, there are no plans to either expand upon or dispose of this vacant land. FCNB's headquarters is located in leased office space in Beaverton, Oregon (suburban Portland). The Company considers its present space and facilities under development adequate for anticipated future requirements. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company is routinely involved in a number of legal proceedings and claims that cover a wide range of matters. In the opinion of management, the outcome of these matters is not expected to have any material adverse effect on the consolidated financial position or results of operations of the Company. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS A. MARKET INFORMATION. The Class A Non-Voting Common Stock is traded on NASDAQ's National Market System. The ticker symbol is SPGLA. Daily trading information is listed in the stock tables carried by major newspapers as "SPIEGEL". See Item 8 "Selected Quarterly Financial Data" for information on the high and low sales prices of the Class A Non-Voting Common Stock. On March 18, 1994, the closing sales price of the Class A Non-Voting Common Stock, as quoted on the NASDAQ National Market System was $22 per share. B. HOLDERS There were approximately 4,200 Class A Non-Voting Common Stockholders as of March 18, 1994. The Company believes that certain of the outstanding shares of Class A Non-Voting Common Stock are held by nominees for an unknown number of beneficial stockholders. The Class B Voting Common Stock of the Company is privately held and is not publicly traded. As of the date hereof, there were seven Class B Voting Common Stockholders. C. DIVIDENDS The Company's policy since 1987 has been to pay regular cash dividends quarterly. Additionally, the Company has also paid a special cash dividend in the second quarter of each year. Cash dividends per share paid for the years ended December 31, 1993 and 1992 are as follows: Cash dividends per share for 1992 and the first three quarters of 1993 have been restated from amounts previously reported to reflect the two-for-one split in the Company's outstanding common stock effected by the 100% stock dividend declared and paid in 1993. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Five-Year Selected Financial Data Years ended December 31 ($000s omitted, except per share amounts) ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS ($000S OMITTED, EXCEPT PER SHARE AMOUNTS) In August 1993, the Company completed the purchase of substantially all of the assets of New Hampton, Inc. for approximately $40,000. New Hampton is a specialty catalog company selling predominantly women's apparel at moderate price points. In September 1993, the Company announced an arrangement with Otto-Sumisho, Inc. (a joint venture between Otto Versand and Sumitomo Corporation) to sell Eddie Bauer products through retail stores and catalogs in Japan. Three Eddie Bauer stores are expected to open in Japan in the Fall of 1994 along with the introduction of the Japanese Eddie Bauer catalog. Also in September 1993, the Company and Time Warner jointly announced their intention to create two new catalog home shopping channels for cable television. The channels are expected to debut in 1994. Beginning in 1991, the Company implemented several changes at Spiegel and Eddie Bauer, including merchandising strategies aimed at increasing market share and maximizing sales to existing customers. These strategies include more aggressive value pricing of Spiegel and Eddie Bauer products and changes in catalog presentation. In addition, Eddie Bauer changes include narrowing and refocusing the merchandise assortment to emphasize key items or "essential styles" which are supported by a stronger inventory position. The Company believes that these changes were instrumental in the improved performance in 1992 and 1993 in its merchandise businesses. In 1993, net sales grew 19% to $2,337,235, including 23% growth in Eddie Bauer net sales, with a comparable store sales increase of 11%. Net sales in 1992 grew 14% to $1,972,283, including 24% growth in Eddie Bauer net sales, with a comparable store sales increase of 17%. RESULTS OF OPERATIONS The following table sets forth certain items from the Company's consolidated financial statements as a percent of total revenue or net sales for the years ended December 31, 1993, 1992 and 1991. 1993 COMPARED WITH 1992 Net sales for the year ended December 31, 1993 increased 19% to $2,337,235 compared with $1,972,283 for the year ended December 31, 1992. This increase resulted from positive response to merchandise offerings at Spiegel and Eddie Bauer. Total Company catalog sales of $1,497,063 increased 18% for the year ended December 31, 1993 compared with the year ended December 31, 1992, due in part to aggressive catalog customer acquisition programs. Retail sales of $840,172 for the year ended December 31, 1993 increased $135,001, or 19%, compared with the year ended December 31, 1992, due primarily to Eddie Bauer's 11% increase in comparable store sales and, to a lesser extent, new store openings. The comparable store sales increase is primarily due to Eddie Bauer's change in its merchandise focus and retail store remodeling program initiated in 1991. Finance revenue for the year ended December 31, 1993 increased $20,959, or 12% over the year ended December 31, 1992 due to higher average customer accounts receivable in the current year. This increase in average customer accounts receivable was attributable to a higher level of Preferred Charge sales and a reduction in customer accounts receivable sold. Other revenue for the year ended December 31, 1993 decreased $8,496, or 12% from 1992, due to the effects of sales of customer accounts receivable in 1992, partially offset by the effects of the sale of a small portfolio of MasterCard receivables in 1993. Gross profit margin on net sales for the year ended December 31, 1993 was 34.3% compared with 31.8% for the year ended December 31, 1992. This improvement was due to lower levels of promotional activity throughout 1993 compared with 1992 and, to a lesser extent, lower costs associated with improved sourcing of merchandise. Selling, general and administrative expenses as a percent of total revenues for the year ended December 31, 1993 and 1992 were 33.2% and 32.2%, respectively. This expense ratio for the year ended December 31, 1992 was favorably impacted by revenue (with only nominal selling, general and administrative costs) related to the effects of sales of customer accounts receivable. The expense ratio for the year ended December 31, 1993 was not similarly impacted. Also reflected in this ratio was the relatively higher expense levels at newly acquired New Hampton, Inc. The Company plans to relocate certain of its distribution operations to a new facility in Groveport, Ohio, which will consolidate the majority of catalog distribution functions of Spiegel and Eddie Bauer. With this state-of-the-art facility, the Company expects to realize increased productivity and efficiency within its distribution functions and achieve reductions in overall relative costs. The transition from the existing facilities to the new distribution facilities is expected to begin in 1994 and to be completed by mid-1995. Included in operating results for 1993 was a $39,000 nonrecurring charge recorded in the third quarter to reflect the estimated impact of closing certain of the Company's existing catalog distribution facilities. These existing facilities consist principally of 20 warehouses and office buildings located in Chicago, Illinois. The $39,000 charge to earnings is comprised of termination benefits of $24,600 and other related costs of $14,400. The Company expects a portion of these costs will be paid in 1994 and the remainder in 1995, with the exception of the write-off of property and equipment of $6,500, which is a noncash item. Certain members of operations management will be relocated to the new distribution facility. The Company expects to reduce its number of distribution facility employees with this consolidation. Interest expense for the year ended December 31, 1993 was $3,830 lower than in 1992 due to a reduction in the Company's effective borrowing rate. Partially offsetting the effect of the lower borrowing rate was higher average debt maintained to finance higher average inventory levels, higher average levels of customer accounts receivable, continued expansion of the Eddie Bauer retail division, expenditures relating to the new distribution facility and the purchase of New Hampton. The effective tax rate for 1993 was 44.2% compared with 43.6% in 1992. This increase was primarily due to a change in the federal statutory corporate tax rate from 34% to 35% enacted in the third quarter of 1993 and retroactive to January 1, 1993. In accordance with Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," income tax expense for 1993 included a charge to cumulatively adjust taxes currently payable and deferred income taxes on the balance sheet to reflect the new tax rate. 1992 COMPARED WITH 1991 Net sales for the year ended December 31, 1992 increased $238,762, or 14%, to $1,972,283 from 1991's recession-related levels. Fourth quarter net sales of $814,153 (a 25% increase over 1991's fourth quarter net sales of $652,896) had a significant impact on the year's results. A 17% increase in comparable store sales at Eddie Bauer as well as the net addition of 28 Eddie Bauer stores contributed to the 26% increase in the Company's retail store sales of $705,171 in 1992. Catalog sales in 1992 increased $93,532, or 8%, compared with 1991. Finance revenue decreased $9,480, or 5%, in 1992, reflecting lower average outstanding customer accounts receivable due to the sales of customer accounts receivable. As a result of these sales of customer accounts receivable, other revenue increased in 1992 by $10,533. Gross profit margin on net sales for 1992 declined to 31.8% from 1991's 32.3%. This decrease was due to the effects of an aggressive pricing strategy aimed at gaining market share and providing value to the Company's customers, only partially offset by an improvement in fourth quarter gross profit margin, which improved to 36.5%, nearly two percentage points over the 1991 fourth quarter results. The fourth quarter increase reflected the strong sell-through of merchandise as well as lower markdowns taken in the Fall season of 1992 compared with 1991. Selling, general and administrative expenses as a percent of total revenues decreased to 32.2% in 1992 from 34.4% in 1991. Contributing to this positive trend were the effect of the sales of customer accounts receivable, improvement in credit performance and stringent cost controls throughout the Company. During 1991, the decision was made to close the retail division of Honeybee, Inc. and consolidate the Honeybee catalog operations with Spiegel. As part of this restructuring, a $10,800 charge was included in 1991's fourth quarter operating results. The Company continued to use the Honeybee name in its catalogs. In late 1992, it became apparent that Honeybee's merchandise performance did not support the trademarks and goodwill included in the balance sheet. Accordingly, a $14,467 nonrecurring charge reflecting the permanent impairment of these assets was included in the fourth quarter operating results for 1992. Interest expense decreased 4% from 1991 due to the Company's lower average borrowing rate in 1992. This rate decrease was realized primarily through variable rate financing, which is principally comprised of commercial paper. Partially offsetting the lower borrowing rate were overall higher average borrowings required during the year. The increased borrowings were the result of continued growth of the Eddie Bauer retail division as well as overall higher inventory levels maintained to service greater sales demand. The Company's effective tax rate decreased to 43.6% in 1992 from 45.0% in 1991 primarily due to the relative impact of the amortization of non-deductible goodwill as a percentage of earnings before taxes. In 1992, the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" and elected to immediately recognize the accumulated postretirement benefit obligation. Accordingly, net earnings included a charge of $3,304, or $.03 per share, for the cumulative effect of this accounting change. Also in 1992, the Company changed its method of determining inventory costs to a full absorption basis in order to more closely match revenues with expenses. Certain purchasing, warehousing and transportation costs which were previously expensed as incurred are now capitalized and expensed in the period in which the related inventory is sold. The cumulative effect of applying this change was a net earnings increase of $7,405, or $.07 per share. LIQUIDITY AND CAPITAL RESOURCES The Company has historically met its operating and cash requirements through funds generated from operations, the issuance of debt and the sale of customer accounts receivable. Customer accounts receivable sold were $330,000 and $380,000 at December 31, 1993 and December 31, 1992, respectively. In 1993, the Company issued 3,600,000 shares of Class A non-voting common stock. Proceeds from this transaction were $61,546. Capital expenditures for 1993 and 1992 were $104,489 and $58,779, respectively. The higher level of capital expenditures in 1993 compared with 1992 was related to the new catalog distribution facility as well as the continued expansion and remodeling of Eddie Bauer stores. Through December 31, 1993, total expenditures relating to the new distribution facility were $94,716. The total cost of the facility including related equipment expenditures is estimated to be approximately $135,000, with equipment financing provided through an operating lease. The remainder of costs associated with the construction of the facility are expected to be paid in 1994. As of December 31, 1993, total debt was $1,060,835, compared with $875,785 as of December 31, 1992. This higher level of debt was required primarily to finance higher average inventory levels, higher average customer accounts receivable owned, the purchase of New Hampton, the continued expansion of the Eddie Bauer retail division and expenditures related to the new catalog distribution facility. Average customer accounts receivable levels were greater than the comparable 1992 levels due to increased sales and a reduction in customer accounts receivable sold. The reduction in customer accounts receivable sold was due to the termination in 1992 of two customer accounts receivable financing programs. In 1993, FCNB sold $32,756 of customer accounts receivable which arose from a discontinued MasterCard affinity program. Although the proceeds of the sale are reflected as a component of the Company's cash equivalents, under banking regulations these proceeds are primarily available only to meet FCNB's operating and cash requirements. The Company believes that its cash on hand, together with cash flow anticipated to be generated from operations, borrowings under its existing credit facilities and other available sources of credit will be adequate to fund the Company's capital and operating requirements for the foreseeable future, including expenditures relating to the new catalog distribution facility and new store openings. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA CONSOLIDATED BALANCE SHEETS At December 31 ($000s omitted, except per share amounts) See accompanying notes to consolidated financial statements. CONSOLIDATED STATEMENTS OF EARNINGS Years ended December 31 ($000s omitted, except per share amounts) See accompanying notes to consolidated financial statements. CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY Years ended December 31 ($000s omitted, except per share amounts) See accompanying notes to consolidated financial statements. CONSOLIDATED STATEMENTS OF CASH FLOWS Years ended December 31 ($000s omitted, except per share amounts) See accompanying notes to consolidated financial statements. SUPPLEMENTAL DISCLOSURE OF NONCASH OPERATING ACTIVITY During 1993, the Company incurred an additional pension obligation liability of $4,365 with corresponding charges to equity of $1,599 (net of taxes of $1,269) and intangibles of $1,497 related to the closing of certain existing catalog distribution facilities. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ($000s omitted, except per share amounts) 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of Spiegel, Inc. and its wholly-owned subsidiaries (the Company). All significant transactions and balances among the companies included in the consolidated financial statements have been eliminated in consolidation. REVENUE RECOGNITION Sales made under installment accounts represent a substantial portion of net sales. Finance revenue on customer installment accounts receivable is recorded as income when earned, using the effective yield method. The Company provides for returns at the time of sale based upon projected merchandise returns. CASH EQUIVALENTS Cash equivalents consist principally of highly liquid government securities with maturities ranging from three to nine months. INVENTORIES Inventories, principally merchandise available for sale, are stated at the lower of cost or market. Cost is determined primarily by the average cost method or the weighted average cost method. Cost of certain other inventories is determined by the first-in, first-out method. CATALOG COSTS Prepaid catalog costs are amortized over the expected lives of the catalogs, which are less than one year. STORE PREOPENING COSTS Preopening and start-up costs for new stores are charged to operations as incurred. PROPERTY AND EQUIPMENT Property and equipment are stated at cost less accumulated depreciation and amortization. Depreciation of property and equipment is computed using the straight-line method over the estimated useful lives of the assets. Annual depreciation rates range from 2% to 20% for buildings and improvements and 10% to 50% for furniture and equipment. Leasehold improvements are amortized over the lesser of the term of the lease or asset life. INTANGIBLES Intangible assets represent principally trademarks and the excess of cost over the fair market value of net assets of businesses purchased. The Company amortizes these intangibles in relation to the anticipated benefits to be derived from the businesses acquired, not to exceed 40 years. Total accumulated amortization of these intangibles was $47,212 and $38,804 at December 31, 1993 and 1992, respectively. EMPLOYEE PENSION PLANS Company policy is to, at a minimum, fund the pension plans to meet the requirements of the Employee Retirement Income Security Act of 1974 (ERISA). In 1992 the Company made additional contributions in order to fully fund the accumulated benefit obligation. INCOME TAXES The Company uses the liability method in accounting for income taxes pursuant to Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes." Deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. The Company is included in the consolidated federal income tax return of Spiegel, Inc.'s parent, Spiegel Holdings, Inc. EARNINGS PER SHARE Earnings per share is based on the weighted average number of both classes of common shares outstanding during the year. RECLASSIFICATIONS Certain prior year amounts have been reclassified from amounts previously reported to conform with the 1993 presentation. 2. ACCOUNTING CHANGES In 1993 the Company adopted SFAS No. 109 and applied its provisions retroactively to January 1, 1988. Since this accounting change had no impact on the Company's earnings for any year from 1988 through 1992, there is no cumulative effect related to the accounting change to report. The restatement for the change relates to the classification of certain deferred tax assets and liabilities as to current versus long-term from those amounts reported under SFAS No. 96. In 1992, the Company refined its method of determining inventory costs to include capitalization of certain purchasing, warehousing, storage and transportation costs. Previously, these costs were charged to expense in the period incurred rather than in the period in which the related inventory was sold. The Company believes that this refinement provides a better measurement of operations by more closely matching revenues with expenses. The cumulative effect of applying this change in accounting on prior periods of $7,405 (net of income taxes of $5,725) is included in net earnings for 1992. For 1992, the effect of this change was to increase operating income by $3,334. Had the change been applied retroactively, the effect on 1991 operations would not have been material. In 1992, the Company adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." The Company elected to immediately recognize the cumulative effect of the change in accounting for post-retirement benefits of $3,304 (net of income tax benefit of $2,554) which represents the accumulated postretirement benefit obligation existing at January 1, 1992. The impact of this change on 1992 operations was not material. 3. ACQUISITION On August 27, 1993, the Company acquired substantially all of the assets of New Hampton, Inc. (New Hampton) through a bankruptcy proceeding for approximately $40,000 in cash. New Hampton is a specialty catalog company offering fashionable, moderately priced women's apparel. While the valuation of net assets acquired has not been completed, management believes the fair value of net assets acquired will exceed or approximate the purchase price. Accordingly, no goodwill has been recorded. The operating results of New Hampton subsequent to the acquisition date are included in the consolidated financial statements of the Company. 4. NONRECURRING CHARGES The Company plans to relocate certain of its catalog distribution operations to a new facility in Groveport, Ohio, which will consolidate the majority of catalog distribution functions of Spiegel and Eddie Bauer. Included in operating results for the third quarter of 1993 is a $39,000 nonrecurring charge to effect the estimated costs for closure of certain of the Company's existing catalog distribution facilities. The third quarter charge to earnings consists of estimates for termination benefits, disposal of certain fixed assets and other related costs. In 1991 the Company decided to restructure Honeybee's operations by consolidating its catalog operations with Spiegel's and by closing the Honeybee retail stores. Operating income was reduced by $10,800 in 1991 for this restructuring. The Company continued to use the Honeybee name in its catalogs; however, it became apparent late in 1992 that Honeybee's merchandise performance did not support the trademarks and goodwill included in the balance sheet. Accordingly, operating income was reduced in 1992 by $14,467 to reflect the permanent impairment of these assets. 5. RECEIVABLES Receivables consist principally of proprietary credit card receivables generated in connection with the sale of the Company's merchandise. The Company's customer base is diverse, in terms of both geographic and demographic coverage. Due to the revolving nature of the credit card portfolio, management believes that the current carrying value of credit card receivables approximates fair value. The collectibility of the credit card portfolio is stable and the average interest rate collected on the receivables approximates the current market rates on new accounts. Receivables at December 31, 1993 and 1992 consist of the following: In 1993, First Consumers National Bank (a wholly-owned subsidiary of the Company) sold $32,756 of customer accounts receivable which arose from a discontinued MasterCard affinity program. During 1992 and 1991, the Company transferred portions of its customer receivables to trusts which, in turn, sold certificates representing undivided interests in the trusts to investors. Certificates sold were $330,000 in 1992 and $75,000 in 1991. As a result of these transactions, other revenue increased by $10,533 in 1992. As of December 31, 1993, $330,000 of the certificates were outstanding. The bad debt reserve related to the net receivables sold has been reduced accordingly. In one of the transactions the Company acted as the cash collateral lender, providing $14,400 for the benefit of that trust. This amount is included in the Company's other assets. The Company owns the remaining undivided interest in the trusts not represented by the certificates and will continue to service all receivables for the trusts. Cash flows generated from the receivables in the trusts are dedicated to payment of fixed rate interest on the certificates, reimbursement of accounts charged off in the trusts, and payment of servicing fees to the Company. Excess cash flows revert to the Company and are used to establish reserve funds that are available if cash flows from the receivables become insufficient to make such payments. Restricted cash accounts have been maintained for these reserve funds, none of which has been utilized as of December 31, 1993. The restricted cash of $35,000 and $21,125 at December 31, 1993 and 1992, respectively, was included in other assets. 6. PROPERTY AND EQUIPMENT Property and equipment at December 31, 1993 and 1992 consist of the following: 7. LONG-TERM DEBT The following is a summary of the Company's long-term debt at December 31, 1993 and 1992: At December 31, 1993, outstanding commercial paper of $290,000 has been included in long-term debt, as the amount of the borrowings that will be outstanding throughout the period covered by the commitment is not expected to fall below this level or will be replaced with other long-term financing. This commercial paper program is supported by an irrevocable stand-by credit commitment of $450,000 with a group of 13 banks. The credit agreement expires in September 1996 and is subject to annual extension upon mutual agreement of the Company and banks. If the Company elects to borrow under certain provisions of the credit agreement, the loans would be payable on the expiration date of this agreement. Fees paid to the banks do not exceed 3/8 of 1% per year of outstanding borrowings and 1/4 of 1% of the total commitment. The effective annual interest rates were 4.2% in 1993 and 5.2% in 1992, including previously mentioned fees. The Company also borrows funds under a stand-by letter of credit and revolving credit facility of $125,000 with a group of eight banks. The credit agreement expires in February 1996. Certain provisions of the credit agreement limit availability of these funds through a specified time period. This time period generally coincides with peak cash flows generated by operations of the Company. Fees paid to the banks are 3/8 of 1% per year based on the unused portion of the commitment and 3/4 of 1% per year on the average daily face amount of the outstanding stand-by letters of credit. Borrowings under this commitment were an average of $21,422 and a maximum of $66,000 during 1993 and were insignificant in 1992. Included in notes payable is a $40,000 term loan with the same eight banks with amortizing payments through 1997. At December 31, 1993, $37,500 of this loan was outstanding. The agreement stipulates that interest is paid based on the London Interbank Offering Rate (LIBOR)plus a 1% margin. In January 1993, the Company entered into an interest rate swap agreement with a major financial institution that effectively fixes this rate at 6.92%. The notional amount of the swap agreement corresponds with that of the outstanding debt over the life of the term loan. The institution is expected to fully perform under the terms of the agreement, thereby mitigating the risk from this transaction. The Company has available uncommitted money market lines aggregating $30,000. Usage under these lines averaged $6,000 during 1993 at various floating rates of interest. The Company also has letter of credit facilities to support the purchase of inventories. The Company had letter of credit facilities of $155,000 and $90,000 at December 31, 1993 and 1992, respectively. Letter of credit commitments outstanding were $69,786 and $38,952 at December 31, 1993 and 1992, respectively. The fair value of the Company's long-term debt, based upon the discounting of future cash flows using the Company's borrowing rate for loans of comparable maturity, approximates the carrying value of such debt at December 31, 1993. Aggregate maturities of long-term debt for the five years subsequent to December 31, 1993 are as follows: 1994, $89,152; 1995, $136,570; 1996, $380,421; 1997, $91,792; and 1998 and thereafter, $362,900. 8. EMPLOYEE BENEFIT PLANS The Company has established the following employee benefit plans to recognize the contributions made to successful operations by the Company's employees. SAVINGS AND PROFIT SHARING PLANS Eligible salaried and hourly employees may participate in these plans. As specified in these plans the Company's annual contributions are determined by applying a formula to earnings before income taxes. Employees may elect to contribute a maximum of 10% of their base salary, subject to special limitations imposed by the Internal Revenue Service. Expense under these plans was $9,001, $6,983 and $4,374 in 1993, 1992 and 1991, respectively. THRIFT PLANS The Company has thrift plans for its eligible salaried employees in which employees may elect to contribute up to 6% of their base salary, with the Company matching the contribution dollar for dollar up to the first 3%, and 50 cents for each dollar contributed up to the next 3%. The Company also has separate thrift plans for certain eligible hourly employees. Employees may elect to contribute up to 6% of their base salary with the Company contributing 25 cents for each dollar of employee contributions. Expense under these plans was $4,092, $3,840 and $3,125 in 1993, 1992 and 1991, respectively. STOCK OPTION PLAN The Spiegel, Inc. Semi-Monthly Salaried Employees Incentive Stock Option Plan provides for the issuance of options to purchase up to 1,600,000 shares of Class A non-voting common stock to certain salaried employees. Under the plan, participants are granted options to purchase shares of the specified stock at the fair market value at the date of grant. The options are exercisable at the rate of 20% per year. A summary of the changes in the options outstanding is as follows: Total stock options authorized but unissued at December 31, 1993 were 159,900. PENSION PLANS The Company also has defined benefit pension plans covering substantially all employees other than those eligible to participate in the savings and profit sharing plans and those hourly employees eligible to participate in the thrift plans. The unit credit actuarial cost method is used in developing the costs of the pension plans. A flat benefit formula is used to measure the pension benefit obligation. Due to the relocation of certain of its catalog distribution operations, the Company recognized a curtailment of a related hourly pension plan. The impact on net periodic pension cost for 1993 was a charge to operating income of $12,100, which is included in the $39,000 nonrecurring charge in the consolidated statements of earnings. The net periodic pension cost for the years ended December 31, 1993, 1992 and 1991 is computed as follows: Weighted average assumptions used in accounting for obligations and assets were as follows: The following table sets forth the plans' funded status at December 31, 1993 and 1992: POSTRETIREMENT BENEFITS OTHER THAN PENSIONS In addition to the benefits described above, the Company provides certain medical benefits for eligible retired employees until age 65. The following table presents the accumulated postretirement benefit obligation at December 31, 1993 and 1992: The net periodic postretirement benefit cost for the years ended December 31, 1993 and 1992 is computed as follows: For measurement purposes, a 15% annual rate of increase in the per capita cost of covered benefits (i.e., health care cost trend rate) was assumed for 1992, the year of adoption of SFAS No. 106. This rate was assumed to decrease 1% per year to 7% in 2000 and remain at that level thereafter. The health care cost trend rate assumption has a significant effect on the amounts reported. For example, increasing the assumed health care cost trend rate by 1 percentage point in each year would increase the accumulated postretirement benefit obligation as of December 31, 1993 by $724 and the aggregate of the service and interest cost components of net periodic postretirement benefit cost for the year ended December 31, 1993 by $98. The weighted average discount rates used in determining the accumulated postretirement benefit obligation were 7.50% and 8.75% at December 31, 1993 and 1992, respectively. 9. INCOME TAXES The components of income tax expense (benefit) for the years ended December 31, 1993, 1992 and 1991 are as follows: The differences between the provision for income taxes at the statutory rate and the amounts shown in the consolidated statements of earnings for the years ended December 31, 1993, 1992 and 1991 are as follows: Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the Company's deferred tax assets and liabilities at December 31, 1993 and 1992 are as follows: 10. COMMITMENTS AND CONTINGENCIES LEASE COMMITMENTS The Company leases office facilities, distribution centers, retail store space and data processing equipment. Lease terms generally range from 10 to 25 years and many contain renewal options. Many of the retail store leases provide for minimum annual rentals plus additional rentals based upon percentage of sales, which range from 2.5% to 5%. Rental expense for all operating leases was $87,177 in 1993, $77,662 in 1992 and $62,363 in 1991. The following is a schedule by year of future minimum rental payments required under operating leases that have initial or remaining noncancelable lease terms in excess of one year as of December 31, 1993: LITIGATION The Company is routinely involved in a number of legal proceedings and claims that cover a wide range of matters. In the opinion of management, the outcome of these matters is not expected to have any material adverse effect on the consolidated financial position or results of operations of the Company. 11. STOCKHOLDERS' EQUITY On October 11, 1993, the holders of a majority of Class B voting common stock of the Company adopted an amendment to the Company's Restated Certificate of Incorporation to increase the number of authorized shares of Class A non-voting common stock of the Company from 8,000,000 to 16,000,000 shares and Class B voting common stock from 47,000,000 to 94,000,000 shares. On October 11, 1993, the Board of Directors declared a 100% stock dividend to stockholders of record on October 22, 1993, payable on November 2, 1993. The par value of these additional shares was capitalized by a transfer from retained earnings to common stock of $6,000 for Class A non-voting and $46,571 for Class B voting common stock. All current and prior year common share and per share disclosures have been restated to reflect the stock dividend. On October 22, 1993, the Board of Directors approved the retirement of the 1,027,776 shares of Class A non-voting common stock held in treasury with a carrying value of $4,553. Accordingly, common stock was reduced by $1,028 representing the par value of the shares and additional paid-in capital was reduced by $3,525 for the difference between the carrying value of the treasury shares and the par value. On December 20, 1993, the Company issued an additional 3,600,000 shares of Class A non-voting common stock through a public offering. Accordingly, common stock was increased by $3,600 for the par value of the shares and additional paid-in capital was increased by $57,946 for the difference between the proceeds from the issuance and the par value. 12. SUBSEQUENT EVENT On January 5, 1994 the Company issued 400,000 shares of Class A non-voting common stock. Accordingly, common stock will be increased by $400 representing the par value of the shares and additional paid-in capital will be increased by approximately $6,500 for the difference between the proceeds from the issuance and the par value. REPORT OF INDEPENDENT AUDITORS The Stockholders and Board of Directors of Spiegel, Inc.: We have audited the accompanying consolidated balance sheets of Spiegel, Inc. and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of earnings, stockholders' equity and cash flows for each of the years in the three-year period ended December 31, 1993. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated 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 Spiegel, Inc. and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1993 in conformity with generally accepted accounting principles. As discussed in note 2 to the consolidated financial statements, the Company adopted the provisions of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" in 1993 retroactively to 1988. As a result, the previously issued 1991 and 1992 consolidated financial statements have been restated. Also discussed in note 2, in 1992 the Company changed its method of accounting for inventory to include capitalization of certain purchasing, warehousing, storage and transportation costs, and adopted the provisions of Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." /s/ KPMG PEAT MARWICK Chicago, Illinois February 11, 1994 SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED) Quarters ended ($000s omitted, except per share amounts) ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT DIRECTORS The following persons are the directors of the Company. The terms of all the above-named directors expire on the date of the next annual meeting of the stockholders which is to be held in April, 1994. Dr. Michael Otto was a member of the Board of Directors and Director - Merchandise of Otto Versand for ten years prior to March 1, 1981. There is no family relationship between any of the directors. Executive Officers The following persons are the executive officers of the Company: The terms of all the above-named officers expire on the date of the next annual meeting of the Board of Directors which is to be held in April, 1994. There is no family relationship between any of the officers. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION SUMMARY COMPENSATION TABLE The following table sets forth all compensation paid or accrued by the Company for the years ended December 31, 1993, 1992 and 1991 to or on behalf of each of the five most highly compensated key policy-making executive officers of the Company. OPTION GRANTS TABLE The following table sets forth grants of stock options to the named executive officers during the year ended December 31, 1993 and the potential realizable value of the grants assuming that the market price of the underlying stock appreciates in value from the date of grant to the end of the option term at the stipulated annual rates of 5% and 10%: The stock options granted become exercisable at the rate of 20% per year from the date of the grant. AGGREGATED OPTION EXERCISES IN 1993 AND DECEMBER 31, 1993 OPTION VALUES The following table sets forth shares acquired on exercise and stock option values at December 31, 1993: COMPENSATION OF DIRECTORS The Company pays an annual fee of $10,000 to its independent directors and reimburses any reasonable out-of-pocket expenses incurred by all directors in attending meetings. EMPLOYMENT AGREEMENT The Company has an employment agreement with John J. Shea, President and Chief Executive Officer of the Company, the term of which extends through December 31, 1994. The annual base salary under this agreement is $550,000. The agreement entitles Mr. Shea to receive an annual bonus based on a sliding-scale percentage of the Company's consolidated net income before taxes. Mr. Shea is also eligible to receive certain other benefits. COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION The Board Committee, which determines executive officer compensation, consists of Dr. Michael Otto, Dr. Peter Muller and John J. Shea. Mr. Shea also serves as President and Chief Executive Officer of the Company. EMPLOYEE BENEFITS STOCK OPTION PLAN. The Spiegel, Inc. Semi-Monthly Salaried Employees Incentive Stock Option Plan is administered by a Stock Option Committee consisting of three members of the Company's Board of Directors who are not semi-monthly salaried employees of the Company or its participating subsidiaries and who are appointed to the Committee from time to time. Certain salaried employees of Spiegel and its subsidiaries are eligible to participate in the plan. Options are granted to those eligible employees as the Stock Option Committee shall select from time to time. The Stock Option Committee also has authority to determine the number of shares and terms consistent with the Plan with respect to each option. Options granted under the plan relate to the Class A Non-Voting Common Stock of the Company. The maximum number of shares which may be issued under options granted is 1,600,000 shares. The participants' options become exercisable at the rate of 20% per year. The options expire ten years after the date of grant of options. The option price upon exercise of the option is the fair market value of the shares on the date of grant of the option. Options granted under the plan are not transferable or assignable other than by will or by the laws of descent and distribution. The average per share price of stock options granted during the year was $22.25. Net cash realized with respect to the exercise of options during the year was approximately $786,000. SPIEGEL, INC., SAVINGS AND PROFIT SHARING PLAN. The Company maintains a savings and profit sharing plan covering its salaried and hourly executives and those of the participating subsidiaries. Participation commences on January 1 or July 1 after becoming an eligible employee. The Company and participating subsidiaries contribute annually to the plan 9% of the first $20 million of consolidated earnings before income taxes, plus 5.25% of consolidated earnings before income taxes in excess of $20 million plus any other amounts the Company's Board of Directors may determine. A minimum total annual contribution of $575,000 will be made, but in no event will the total contribution exceed the maximum amount deductible for Federal income tax purposes. Company contributions and forfeitures are allocated among eligible participants in proportion to considered compensation. A participant can make nondeductible voluntary contributions to the plan of up to 10% of his considered compensation while a participant, subject to special limitations imposed by the Internal Revenue Code thereon. All contributions are held in a trust for the benefit of plan participants. A participant receives the full amount in his account under the plan (including investment earnings) on termination of employment by reason of retirement (as defined by the plan document) or permanent disability. Upon death, the full value of the participant's account is distributable to his beneficiary. On any other termination of employment, a participant is always 100% vested in the portion of his account attributable to his voluntary contributions and is vested in the Company's contribution and earnings thereon at a rate based on years of service, with full vesting after a maximum of seven years. Participants who suffer financial hardship can withdraw their voluntary contributions from the plan. SPIEGEL, INC., EMPLOYEES THRIFT PLAN. The Company has a thrift plan covering its salaried and hourly executives and those of its adopting affiliates. Eligible employees may participate as of January 1 or July 1 following the completion of one year of service by electing to contribute between 1% and 6% of their base compensation to the plan. Employee contributions are made on a pretax basis under Section 401(k) of the Internal Revenue Code. The Company matches salaried employee contributions dollar for dollar up to the first 3% of base compensation and 50 cents for each dollar contributed up to the next 3%. The Company matches hourly employee contributions 25 cents for each dollar contributed up to 6% of base compensation. The Company's matching contributions, however, may not exceed the amount deductible under the Internal Revenue Code. All contributions and investments are held in a trust for the benefit of plan participants. Employees with three years of service prior to January 1, 1988, are 100% vested in the entire amounts held for them under the plan. All other employees who participate in the plan after one year of service are 100% vested in their pre-tax contributions and earnings thereon but become vested in the Company's matching contribution and earnings thereon at a rate based on years of service, with full vesting after a maximum of seven years. Participants who suffer a financial hardship may withdraw amounts from the plan while still employed. All participants receive the full value of their accounts under the plan upon retirement or permanent disability and the vested portion of their accounts on other termination of employment. The full value of a deceased participant's account is distributable to his beneficiaries. Distributions are usually made in a lump sum. SPIEGEL, INC., SUPPLEMENTAL RETIREMENT BENEFIT PLAN. The Company maintains a funded supplemental retirement plan for the benefit of its employees and those of its participating subsidiaries covered by the profit sharing and thrift plans described above (the "profit sharing and thrift plans") whose benefits under the profit sharing and thrift plans are reduced by application of Sections 415, 401(k) and 401(a)(17) of the Internal Revenue Code. If a participant's annual additions under the profit sharing and thrift plans are reduced by reason of special limitations of the Internal Revenue Code, the Company will make an annual contribution to the trust in the amount of the reduction. Supplemental benefits under the supplemental retirement plan are payable in cash at the same time and in the same manner as the participant's employer account under the profit sharing and thrift plans except no payments are made prior to death, retirement or other termination of employment. SPLIT DOLLAR LIFE INSURANCE PROGRAM. The Company maintains a split dollar life insurance program covering certain executives of the Company. A covered employee may apply for an individual life insurance policy on his life in a face amount up to three times his base salary. The employee pays a portion of the annual premium equal to the after tax cost of an equivalent amount of term life insurance. The balance of the premium due (if any) is paid by the Company. The Company owns a part of the cash value equal to its payments and is beneficiary for that amount. The employee names his own beneficiary and collaterally assigns the policy to the Company to the extent of the Company's payments. Cash value and dividends accumulate tax-free and all amounts in excess of the Company's payments belong to the employee. The Company premium payments will last only seven years. Future employee contributions will reduce the amounts advanced by the Company's premium payments. The Company may withdraw cash at the earlier of the employee's retirement, termination of employment or the time at which the policy dividends will pay the premium after the withdrawal. At termination of employment or retirement, the Company may withdraw its cash value and the employee may either surrender the policy for his portion of the cash value, receive an income from the insurance company in lieu of cash, or continue the policy in force. On the death of the employee, the Company receives any amounts due it with the balance of the proceeds payable as directed by the employee. EXECUTIVE BONUS AND INCENTIVE PLANS. The Company maintains various bonus plans for certain of its executives, designed to reward performance. The Company's annual payment of bonuses is based upon the attainment of pre-determined operating and financial objectives. For 1993, approximately $9,894,000 was paid under these bonus plans. Certain executives are also eligible for a long-term incentive bonus based on the Company's performance in 1995. In order for a bonus to be paid, Spiegel must achieve a pre-determined pre-tax profit in 1995. The formula for payout will be similar to those used for the normal yearly performance based bonuses. EDDIE BAUER SAVINGS AND PROFIT SHARING PLAN. Eddie Bauer maintains a savings and profit sharing plan covering its salaried and hourly executives. Participation commences on the January 1 or July 1 after becoming an eligible employee. Eddie Bauer contributes annually to the plan 5.5% of the consolidated earnings of Eddie Bauer before income taxes. A minimum total annual contribution of $1,100,000 will be made, but in no event will the total contribution exceed the maximum amount deductible for Federal income tax purposes. Company contributions and forfeitures are allocated among participants in proportion to considered compensation. A participant may make nondeductible voluntary contributions to the plan of up to 10% of their considered compensation while a participant, subject to special limitations imposed by the Internal Revenue Code thereon. Contributions are held in a trust for the benefit of plan participants. A participant receives the full amount in their account under the plan (including investment earnings) on termination of employment by reason of retirement (as defined in the Plan document) or permanent disability. Upon death, the full value of the participant's account is distributable to their beneficiary. On any other termination of employment, a participant is 100% vested at all times in the portion of their account attributable to voluntary contributions and in the balance of their account at a rate based on years of service, with full vesting after seven years. Participants who suffer financial hardship may withdraw their voluntary contributions from the plan. EDDIE BAUER EMPLOYEES' THRIFT PLAN. Eddie Bauer has a thrift plan covering its salaried and hourly employees. Eligible employees may participate as of the January 1 or July 1 following the completion of one year of service. Participating employees may elect to contribute from 1% to 6% of their base compensation to the plan. Employee contributions are made on a pre-tax basis under Section 401 (k) of the Internal Revenue Code. The company matches salaried employee contributions dollar for dollar up to the first 3% of base compensation and 50 cents for each dollar contributed up to the next 3%. The company matches hourly employee contributions 25 cents for each dollar contributed up to 6% of base compensation. The company's matching contributions, however, may not exceed the amount deductible under the Internal Revenue Code. Contributions are held in a trust for the benefit of plan participants. A participant receives the full amount in this account under the plan (including investment earnings) on termination of employment by reason of retirement (as defined in the Plan document) or disability. Upon death, the full value of the participant's account is distributable to their beneficiary. On any other termination of employment, a participant is 100% vested at all times in the portion of his account attributable to pre-tax contributions and any earnings thereon, and is vested in the company's matching contributions and earnings thereon at a rate based on years of service with full vesting after a maximum of seven years. Participants suffering certain financial hardships may request in- service withdrawal of any vested amounts. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT A. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS Spiegel Holdings, Inc. (SHI) holds 97.5% of the Company's Class B Voting Common Stock. The following table sets forth certain information with respect to the number of shares of Class B Voting Common Stock owned by SHI, which is the only stockholder beneficially owning more than 5% of the Class B Voting Common Stock. SHI is a holding company whose principal asset is stock of the Company. The total number of holders of the Company's Class B voting Common Stock as of March 18, 1994, was seven. B. SECURITY OWNERSHIP OF MANAGEMENT As of March 18, 1994, certain members of the Company's Board of Directors, and the directors and officers of the Company as a group, owned shares of the Company's Class A Non-Voting Common Stock as indicated in the following table: As shown in Column II, in the case of Company officers, portions of the shares indicated as beneficially owned are actually shares attributable to unexercised and unexpired options for Class A Common Stock granted by the Company to such officers, which are exercisable as of, or first become exercisable within 60 days after, March 18, 1994. ITEM 13. ITEM 13. CERTAIN TRANSACTIONS Since its acquisition of the Company in 1982, and following the transfer of its interest therein to its partners and designees in April 1984, Otto Versand and the Company have entered into certain agreements seeking to benefit both parties by providing for the sharing of expertise in the field of catalog marketing. The following is a summary of such agreements and certain other transactions. The Company utilizes the services of Otto Versand International (GmbH) as a buying agent for the Company in Hong Kong, Taiwan, Korea, India, Italy, Indonesia, Singapore, Thailand and Turkey. Otto Versand International (GmbH) is a wholly-owned subsidiary of Otto Versand. Buying agents locate suppliers, inspect goods to maintain quality control, arrange for appropriate documentation and, in general, expedite the process of procuring merchandise in these areas. Under the terms of its arrangements, the Company paid $4,126,000 in 1993, $3,012,000 in 1992 and $2,143,000 in 1991. The arrangements are indefinite in term but may generally be canceled by either party upon one year's written notice. The Company has an agreement with Together, Ltd., a United Kingdom company, which gives the Company the exclusive right to market "Together!" merchandise by catalog and in retail stores in the U.S.A. Otto Versand owns a 50% interest in Together, Ltd. Commission expenses incurred on this account were $7,417,000, $6,007,000 and $5,609,000 in 1993, 1992, and 1991, respectively. These expenses include certain production services, the cost of which would normally be borne by the Company, including design of the product, color separation, catalog copy and layout, identification of suggested manufacturing sources and test marketing information. In September 1993, the Company announced an agreement with Otto-Sumisho, Inc. (a joint venture company of Otto Versand and Sumitomo Corporation) to form a joint venture and enter into license agreements to sell Eddie Bauer products through retail stores and catalogs in Japan. The joint venture and license agreements were executed in 1994. The Company believes that the terms of the arrangement are no less favorable to Eddie Bauer than would be the case in an arrangement with an unrelated third party. In addition, during 1993 Eddie Bauer entered into a limited test marketing program with Sport Scheck GmbH (a subsidiary of Otto Versand) for the sale of Eddie Bauer products in Germany and Switzerland through Sport-Scheck catalogs. The Company believes that the terms of the arrangement are no less favorable to Eddie Bauer than would be the case in an arrangement with an unrelated third party. During 1993 Eddie Bauer received approximately $17,000 in royalty income from Sport-Scheck. In 1993 Eddie Bauer entered into an agreement with Eddie Bauer International, Ltd., (a subsidiary of Otto Versand) whereby the latter acts as buying agent in Asia and contacts suppliers, inspects goods and handles shipping documentation for Eddie Bauer. The Company believes that the terms of the arrangement are no less favorable to Eddie Bauer than would be the case in an arrangement with an unrelated third party. No purchases have been made under this agreement through December 31, 1993. In March 1994, New Hampton issued 113 shares of non-voting preferred stock to nine directors and 11 other executive officers of the Company and nine executive officers and directors of New Hampton and Otto Versand for $40,000 per share. The redemption price of the preferred stock prior to December 31, 1997 is the original purchase price of $40,000 per share. Each participant was eligible to purchase up to four shares. Subsequent to December 31, 1997, the redemption price is fair market value. All shares of New Hampton non-voting preferred stock must be redeemed by December 31, 1999. The Company is included in the consolidated federal income tax return of SHI. Pursuant to a tax reimbursement agreement with SHI, the Company records provisions for income tax expense as if it were a separate taxpayer. Jay A. Lipe, a director of the Company, is a partner in the firm of Rooks, Pitts and Poust, which has provided legal services to the Company since 1982. Rooks, Pitts and Poust is outside counsel to the Company. Rooks, Pitts and Poust also provides legal services to SHI. A brother-in-law of Mr. Lipe, Mr. Mark Glazier, is part owner of Circa Corporation of America which, through its sales agent in New York City, on a job order basis, sold approximately $848,000 of apparel to the Company in 1993. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K INDEPENDENT AUDITORS' REPORT ON SCHEDULES The Board of Directors and Stockholders Spiegel, Inc.: Under date of February 11, 1994, we reported on the consolidated balance sheets of Spiegel, Inc., and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of earnings, stockholders' equity, and cash flows for each of the years in the three-year period ended December 31, 1993, which are included elsewhere herein. In connection with our audits of the aforementioned consolidated financial statements, we also audited the related consolidated financial statement schedules as listed in Part IV, Item 14 (A) (2). These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statement schedules based on our audits. In our opinion, such schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. /S/ KPMG PEAT MARWICK Chicago, Illinois February 11, 1994 Schedule VIII SPIEGEL, INC. AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 ($000s omitted) Schedule X SPIEGEL, INC. AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 ($000s omitted) SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Spiegel, Inc., has duly caused this Annual Report on Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized, on March 29, 1994. SPIEGEL, INC. By: /S/ JOHN J. SHEA John J. Shea, President and Chief Executive Officer (Principal Operating Executive 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 Spiegel, Inc., and in the capacities indicated on March 29, 1994. SIGNATURE TITLE - -------------------------- -------------------------------------------- /S/ JOHN J. SHEA Vice Chairman, President, Chief Executive John J. Shea Officer and Director (Principal Operating Executive Officer) /S/ JAMES W. SIEVERS Chief Financial Officer and Vice James W. Sievers President-Finance (Principal Financial and Accounting Officer) /S/ KENNETH A. BOCHENSKI Director Kenneth A. Bochenski /S/ JAY A. LIPE Director Jay A. Lipe /S/ DAVID C. MOON Director David C. Moon /S/ THOMAS BOHLMANN Director Thomas Bohlmann /S/ HORST R. HANSEN Director Horst R. Hansen /S/ DR. PETER MULLER Director Dr. Peter Muller

1993 Item 3. Legal Proceedings. On September 3, 1993 Frenchmen's Reef Beach Resorts ("FRBA") filed for protection under chapter 11 of the Bankruptcy Code. FRBA is the owner of the Marriott Hotel, St. Thomas. U.S. Virgin Islands (the "Hotel"). The Company holds mortgages encumbering the Hotel which secure obligations of FRBA to the Company. In addition, the Company manages the Hotel for FRBA pursuant to a written agreement. FRBA has filed with the bankruptcy court a Disclosure Statement setting forth a Plan of Reorganization which, among other things, provides for the conveyance of the Hotel to the Company. The limited partners of FRBA have filed an objection to the Disclosure Statement. The Company has pending before the bankruptcy court a motion for permission to commence and pursue a foreclosure of its mortgages through the receipt of a judgement of foreclosure. In a proceeding captioned PMI Investment, Inc. vs. Allan V. Rose and Arthur Cohen et al. brought before the bankruptcy court the Company seeks to recover amounts owed by Rose and Cohen under a guaranty. In that same proceeding, the Company also seeks a determination that FSA has no claim to the proceeds of any recovery from Rose and Cohen. The Company has reached a settlement in that proceeding with Rose and Cohen. Under the settlement, the Company will receive $25.0 million in cash, which Rose has deposited in escrow, and the cash proceeds of the sale of approximately 1.1 million shares of the Company's stock owned by Rose under the Prime Motor Inns, Inc. Second Amended Plan of Reorganization. Disbursal of the settlement proceeds is subject to the bankruptcy court's approval of the settlement and the bankruptcy court's determination that FSA has no claim to the settlement proceeds. A trial was held in January, 1994 on both issues and the Company is awaiting the decision of the bankruptcy court. PMI has responded to informal requests for information by the United States Securities and Exchange Commission's Division of Enforcement relating to certain of PMI's significant transactions for the years 1985 through 1990. PMI has not submitted its Annual Report on Form 10-K for the fiscal year ended June 30, 1990 and Quarterly Reports on Form 10-Q during the pendency of its reorganization, except for its Quarterly Report on Form 10-Q for the quarter ended March 31, 1992. Contingent Claims As of March 1, 1994 unresolved bankruptcy claims of approximately $437,000,000 have been asserted against PMI. The Company has disputed substantially all of these unresolved bankruptcy claims and has filed objections to such claims. Management and its counsel believe that substantially all of these claims will be dismissed and disallowed. Any claims not disallowed will be satisfied by issuance of the Company's common stock. In accordance with SOP 90-7, the consolidated financial statements have given full effect to the issuance of the Company's common stock. The Company believes that the resolution of these claims will not have a material adverse effect on the Company's consolidated financial position or results of operations. In addition to the foregoing legal proceedings, the Company is involved in various other proceedings incidental to the normal course of its business. Management does not expect that any of such other proceedings will have a material adverse effect on the Company's financial position. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. No matters were submitted during the fiscal quarter ended December 31, 1993 to a vote of the security holders of the Company. PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. The Company's common stock, par value $.01 per share, commenced trading on the New York Stock Exchange (the "NYSE") on August 3, 1992 under the symbol "PDQ." As of March 10, 1994 there were 29,200,204 shares of common stock outstanding. The Company's Plan of Reorganization ("the Plan") provided for the issuance of 33,000,000 shares of common stock to holders of claims under the Plan. The number of shares ultimately distributed under the Plan could be less than 33,000,000 shares depending on the final outcome of disputed claims. In addition, the Company has issued warrants to purchase an aggregate of 2,106,000 shares of common stock. The warrants are not listed on any exchange. The following table sets forth the reported high and low closing sales prices of the common stock on the NYSE. As of March 10, 1994, the closing sales price of the common stock on the NYSE was $7 1/8. As of March 10, 1994, there were approximately 3,422 holders of record of common stock. Prime does not anticipate paying any dividends on the common stock in the foreseeable future. Covenants contained in certain of the Company's debt securities prohibit Prime from paying cash dividends. Item 6. Item 6. Selected Financial Data The Company is the successor in interest to PMI. The Company implemented "fresh start" reporting pursuant to the Statement of Position 90-7, "Financial Reporting by Entities in Reorganization under the Bankruptcy Code" of the American Institute of Certified Public Accountants, as of the Effective Date. Accordingly, the consolidated financial statements of the Company are not comparable in all material respects to any such financial statement as of any date or any period prior to the Effective Date. Subsequent to the Effective Date, the Company changed its fiscal year end from June 30 to December 31. The table below presents selected consolidated financial data derived from: (i) the Company's historical financial statements for the year ended December 31, 1993, (ii) the Company's historical financial statements as of and for the five month period ended December 31, 1992, (iii) the Company's "fresh start" balance sheet as of the Effective Date, and (iv) the historical consolidated financial statements of PMI for the one month ended July 31, 1992 and for each of the four years in the period ended June 30, 1992. This data should be read in conjunction with the Consolidated Financial Statements. - ---------------- (1) PMI filed for chapter 11 bankruptcy protection on September 18, 1990, at which time it owned or managed 141 hotels. During its approximately two-year reorganization, PMI restructured its assets, operations and capital structure. On the Effective Date, the Company emerged from chapter 11 reorganization with 75 owned or managed hotels (as compared to 141 owned or managed hotels prior to the chapter 11 reorganization) $135.6 million of stockholders' equity and $266.4 million of long-term debt. (2) PMI effectively discontinued the operations of its franchise segment on July 1, 1990, with the sales of the Howard Johnson, Ramada and Rodeway franchise businesses in July 1990. (3) Approximately $2.3 million, $28.0 million and $25.3 million of contractual interest expense during the one month ended July 31, 1992 and for the fiscal years ended June 30, 1992 and 1991, respectively, was not accrued and was not paid due to the chapter 11 proceeding. Item 6. (Continued) Selected Quarterly Financial Data (Unaudited) Quarterly financial data for the years ending December 31, 1993 and 1992 is presented as follows (in thousands, except per share amounts). (a) Gross profit is defined as net revenues less direct operating expenses, other operating and general expenses and depreciation and amortization expense. (b) Certain quarterly data has been reclassified to conform with the December 31, 1993 presentation. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations General The Company is the successor in interest to PMI, which emerged from chapter 11 reorganization on the Effective Date. During its approximately two-year reorganization, PMI restructured its assets, operations and capital structure. As a result, the Company (i) eliminated numerous unprofitable lease and management agreements, (ii) revalued its assets to reflect the then approximate current fair market value of such assets on its financial statements and (iii) reduced its liabilities by approximately $500 million. On the Effective Date, the Company emerged from chapter 11 reorganization with 75 owned or managed hotels (as compared to 141 hotels prior to the chapter 11 reorganization), $135.6 million of total equity and $266.4 million of long-term debt. Since the Effective Date, the Company has taken the following actions to further strengthen its operations and financial condition: - Reduced overhead costs, reconstituted its management team and recruited new senior management to the Company that is responsible to a new, independent board of directors; - Converted a portion of its notes, mortgages and other assets to cash or hotel operating assets that provided the Company with approximately $61.0 million in cash and six operating hotel properties obtained through settlements or lease expiration; - Repaid approximately $87.0 million of its long-term debt using the cash proceeds from conversions of other assets, tax refunds and income generated from Hotel operations; - Formulated and began implementing a hotel development and improvement plan pursuant to which the Company purchased one full- service hotel and built one new Wellesley Inn in 1993; and - Allocated more than 6.0% of its hotel revenues during this period to enhance the product quality and market position of its existing Hotels, including repositioning eight Hotels and changing the franchise affiliations of four of such Hotels. The following table sets forth certain operating data for the five year period ended December 31, 1993 with respect to the 41 Owned Hotels that were in the Company's portfolio on December 31, 1993 since the later of the year in which they were acquired or January 1, 1989. The data includes full year operating results for hotels that the Company previously managed and then acquired during the year. (1) Gross operating profit is defined as total hotel revenues less direct hotel operating expenses including room, food and beverage and selling and general expenses. - -------------- The Company's operating results for the five-year period from 1989 to 1993 were principally impacted by the overall trends in the U.S. lodging industry. In 1990 and 1991, occupancy and ADR declined due to the oversupply of hotel rooms and the weakness in demand due to the general slowdown in the U.S. economy. Beginning in 1992, the demand for hotel rooms increased primarily due to improved economic conditions in the United States. Coupled with the lack of new hotel supply, occupancy, ADR and REVPAR improved. In 1993, occupancy, ADR and REVPAR continued to rise due to improving industry fundamentals, the stabilization of the Company's Wellesley Inns and AmeriSuites and the positive effects of the capital investments made by the Company to improve product quality through repositionings of hotels. Over the five-year period ended December 31, 1993, gross operating profit was most affected by (i) the mix of the Company's limited- service hotels as compared to full-service hotels, (ii) labor and related costs and (iii) strategic marketing initiatives. The five Wellesley Inns added to the Company's portfolio generated high gross operating margins and allowed the Company to increase margins in 1990 despite a difficult economic environment. In 1991 and 1992, the positive impact on gross operating profits from the addition of the Wellesley Inns were offset by (i) above inflation rate increases in direct hotel labor and related expenses (including wages, health care benefits and workman's compensation), (ii) the Company's decision to increase advertising and promotions (including hiring additional sales staff, providing additional guest services such as enhanced continental breakfasts and increasing outdoor advertising and direct mail marketing campaigns) and (iii) the reallocation of previously centralized costs to specific hotels. In 1993, gross operating profit improved primarily due to the stabilization of labor and related costs and increased sales volumes. Given the current positive industry fundamentals and the Company's proposed new hotel development and acquisition refurbishment programs, the Company believes it will continue to benefit from operating leverage. Results of Operations for Year Ended December 31, 1993 Compared to Year Ended December 31, 1992 The Company implemented "fresh start" reporting in accordance with Statement of Position 90-7 of the American Institute of Certified Public Accountants upon its emergence from reorganization on the Effective Date. Under "fresh start" reporting, the purchase method of accounting was used and the assets and liabilities of the Company were restated to reflect their approximate fair value at the Effective Date. In addition, during the reorganization period (September 18, 1990 to the Effective Date), the Company's financial statements were prepared under accounting principles for entities in reorganization which includes reporting interest expense only to the extent paid and recording transactions and events directly associated with the reorganization proceedings. Accordingly, the consolidated financial statements of the Company are not comparable in all material respects to any such financial statement as of any date or for any period prior to the Effective Date. Subsequent to the Effective Date, the Company elected to change its fiscal year end from June 30 to December 31. For purposes of an analysis of the results of operations, comparisons of the Company's results of operations for the year ended December 31, 1993 to the prior year are made only when, in management's opinion, such comparisons are meaningful. Prior to the Effective Date, the Company did not employ "fresh start" reporting thereby making comparisons of certain financial statement data prior to such date less meaningful. The financial information set forth below presents the revenues and expenses which can be compared. The table excludes the items which were impacted by the changes in accounting such as interest expense, occupancy and other operating expense and depreciation expense for the years ended December 31, 1992 and 1993. The financial information should be read in conjunction with the consolidated financial statements of the Company included elsewhere in this report. Since the Company changed its fiscal year in 1992, management has compiled unaudited data for the calendar year ended December 31, 1992. The direct revenues and expenses of the Owned Hotels are classified into three categories: comparable hotels, new hotels and divested hotels. The following discussion focuses primarily on the 29 comparable hotel properties which were owned or leased by the Company during the entire two years presented. The 12 hotels classified as new hotels are composed of four new AmeriSuites hotels which were opened after December 31, 1991, a full-service Ramada Inn in Meriden, Connecticut which was purchased in July 1993, a newly constructed Wellesley Inn in Orlando, Florida which opened in November 1993 and six hotel properties which were added through settlements of mortgages and notes receivable and lease expirations. The hotels classified as divested hotels are composed of three hotel properties divested primarily as a result of property restructurings in 1992 and the Holiday Inn in Milford, Connecticut which was sold in September 1993. Room revenues increased by $7.1 million or 11.4% for the year ended December 31, 1993 over the prior year due to the impact of new hotels and improved occupancy and room rates at comparable hotels. The increase was partially offset by a decrease in room revenues as a result of the divestiture of hotels. Room revenues for comparable hotels increased by $3.5 million or 6.8% for the year ended December 31, 1993 compared to the prior year. The increase was primarily due to improved occupancy which increased 5.9% in 1993 reflecting improved economic conditions and the limited new construction of hotels. Average daily room rates were slightly higher in the year ended December 31, 1993 compared to the prior year, increasing by $1.30 or 2.4% over the prior year. The Company's comparable full-service hotels had an average occupancy of 69.3% for the year ended December 31, 1993 as compared to 65.2% in 1992. Average occupancy at the seven comparable Wellesley Inns in Florida remained relatively stable at approximately 90% while average occupancy at the three comparable Wellesley Inns in the Northeast increased to 73.4% for the year ended December 31, 1993 from 61.3% in 1992 primarily as a result of improved direct marketing efforts. Significant occupancy increases were also reported at the four comparable AmeriSuites hotels all of which were opened within the past four years. The average occupancy at the comparable AmeriSuites hotels increased to 67.7% for the year ended December 31, 1993 from 63.7% in 1992 reflecting stabilization of these hotels and their increased recognition in the market. Food and beverage revenues decreased by $792,000 or 6.1% for the year ended December 31, 1993 as compared to 1992 because all of the divested hotels contained food and beverage operations while many of the new hotels are limited-service hotels. Food and beverage revenues for comparable hotels increased by 5.3% for the year ended December 31, 1993 compared to the prior year primarily as a result of increased beverage revenues at the Company's sports lounges located in two Franchised Hotels. Management and other fees consist of base and incentive fees earned under management agreements, fees for additional services rendered to Managed Hotels and sales commissions earned by the Company's national sales group, MSI. The base and incentive fees comprise approximately 60% or $6.5 million of total management and other fees for the year ended December 31, 1993. Management and other fees decreased by $621,000 for the year ended December 31, 1993 as compared to the prior year primarily due to a decrease in charges for additional services. In addition, during the year ended December 31, 1993, the number of Managed Hotels declined by five due to property divestitures by independent owners, two of which were acquired by the Company. The decreases have been partially offset by increases in management fees attributable to increased hotel occupancies and higher incentive related performance fees. Interest income on mortgages and notes decreased by $5.3 million for the year ended December 31, 1993 as compared to the prior year primarily due to the Company's early collection of a note receivable with a face amount of $58.0 million in August 1992. Interest income for the year ended December 31, 1993 primarily related to mortgages secured by 12 Managed Hotels. Approximately $4.3 million or 28.8% of interest income is derived from the Company's $50 million note receivable secured by the Frenchman's Reef. For the year ended December 31, 1993, operating profits improved for the Frenchman's Reef over the prior year due to the stronger economy, the new affiliation with Marriott and product improvements and cost controls at the hotel. The Company's proposed mortgage restructuring is intended to provide the Company with ownership and control of the Frenchman's Reef. If consummated, the impact of this restructuring on operating income is expected to be minimal as direct revenues, expenses and depreciation would increase and interest income would decrease. In the year ended December 31, 1993, interest income also includes $976,000 recognized on subordinated mortgages which have been assigned no value on the Company's balance sheet due to substantial doubts as to their recoverability. These subordinated mortgages generated interest income primarily due to declines in interest rates on the variable rate mortgages senior to the Company's positions on these hotels. Direct room expenses increased by $1.6 million or 9.0% for the year ended December 31, 1993 over the prior year, as the increased occupancy of the comparable hotels combined with the new hotels more than offset the impact of the divested full-service hotels. Direct room expenses for comparable hotels increased by 6.0% for the year ended December 31, 1993 over the prior year primarily due to increased expenses associated with the higher occupancy levels including payroll costs, guest room supplies and reservation fees. In addition, the increase is also attributable to higher health benefits and worker's compensation expenses which have risen faster than the general inflation rate over the past three years. Direct room expenses as a percentage of room revenues decreased to 28.0% in 1993 as compared to 28.6% in 1992 primarily due to the impact of the divested hotels. Direct room expenses as a percentage of room revenues for comparable hotels were approximately 27% in 1993 and 1992 as the Company was able to increase room rates to offset the increases in costs. Direct food and beverage expenses decreased by $1.2 million or 10.3% primarily due to the impact of divested full-service hotels. Direct food and beverage expenses for comparable hotels increased by 2.4% for the year ended December 31, 1993 over the prior year. Direct food and beverage expenses as a percentage of food and beverage revenues for comparable hotels decreased to 84.3% for the year ended December 31, 1993 as compared to 86.7% for the year ended December 31, 1992. This improvement reflects the increase in beverage sales which have a lower cost of sales percentage versus food sales. Direct selling and general expenses consist primarily of hotel expenses which are not specifically allocated to rooms or food and beverage activities such as administration, selling and advertising, utilities and repairs and maintenance. Direct selling and general expenses decreased by $1.7 million or 7.6% as the divested hotels were all full-service operations which generally require increased overhead to support food and beverage operations. Direct selling and general expenses for comparable Hotels increased by only 1.2% for the year ended December 31, 1993 over the prior year primarily due to the restructuring of the Company's centralized operations which eliminated certain allocated central office charges. These cost savings were offset by higher utility charges as a result of the unusually warm summer in 1993. General and administrative expenses consist primarily of centralized management expenses such as operations management, sales and marketing, finance and hotel support services associated with operating both the Owned and Managed Hotels and general corporate expenses. For the year ended December 31, 1993, general and administrative expenses consisted of $11.7 million of centralized management expenses and $4.0 million in general corporate expenses. General and administrative expenses decreased by $1.5 million or 8.6% for the year ended December 31, 1993 as compared to the prior year primarily due to the restructuring of the Company's centralized management operations in February 1993 which eliminated approximately $2.5 million of annual costs. Other income consists primarily of a gain on the sale of a hotel of $1.0 million, settlement of closing adjustments of $625,000 related to the sale of a hotel in a prior year, interest of $1.2 million received as part of a federal tax refund and $500,000 received in settlement of prior year's fees on a Managed Hotel. The pre-tax extraordinary gains of $6.8 million in 1993 relate to the repurchase of debt. Pre-tax extraordinary gains of approximately $187,000 will be recognized in the first quarter of 1994 related to additional repurchases. See "Management's Discussion and Analysis of Financial Condition and Results of Operation- Liquidity and Capital Resources." Six Months Ended December 31, 1992 Compared to Six Months Ended December 31, The following discussion and analysis is based on the historical results of operations of the Company for the six-month periods ended December 31, 1992 and 1991. For purposes of the following discussion, comparisons of the Company's results of operations for the six-month period ended December 31, 1992 to the same period in the prior year are made only when, in management's opinion, such comparisons are meaningful. The financial information set forth below should be read in conjunction with the consolidated financial statements of the Company included elsewhere in this report. The following table presents the Company's condensed income statements for the six months ended December 31, 1992 and 1991 (in thousands): The Company's results of operations for the six months ended December 31, 1992 changed dramatically from the comparable period of the prior year. As a result of the Chapter 11, hotel properties were disposed of through lease rejection, lease expiration, contract termination or sale. The following table presents the direct revenues and expenses of the Company's owned and leased hotel properties for the six months ended December 31, 1992 and 1991. The hotel properties are classified into three categories: comparable hotels; new hotels; and divested hotels. The following discussion focuses on the 29 comparable hotel properties which were owned or leased by the Company during the two periods presented. At December 31, 1992, the Company owned or leased 34 hotel properties. Three new hotel properties which were opened after June 30, 1991 and two hotel properties which were added through note receivable settlements in 1992 are classified as "New Hotels". The hotel properties divested primarily as a result of the Chapter 11 are classified as "Divested Hotels". Owned and Leased Properties (In thousands, except for statistical information) Room revenues for comparable hotels increased by $1.1 million or 4.1% for the six months ended December 31, 1992 compared to the same period in the prior year. The increase was due to improved occupancy while average daily rate remained even with the prior year. The gain in occupancy was primarily attributable to the improved results at three AmeriSuites hotels, which were opened in the second half of 1990. In addition, occupancy increased at six Wellesley Inns located in Florida partially, as a result of Hurricane Andrew. The Company's inability to increase room rates was caused by the slowdown in the economy, particularly in the Northeast and increased competition. Food and beverage revenues for comparable hotels for the six months ended December 31, 1992 were relatively even with the same period in the prior year, as a result of the recession in the Northeast where the majority of the Company's food and beverage outlets are located. Room expenses as a percentage of room revenues for comparable hotels increased to 28.0% for the six months ended December 31, 1992 from 26.9% for the same period in the prior year. Food and beverage expenses as a percentage of food and beverage revenues for comparable hotels increased to 89.0% from 78.8% for the same period in the prior year. The increases in the percentage of expenses to revenues were primarily attributable to increased labor-related operating costs. In particular, health benefits and workers' compensation costs have increased at rates greater than inflation. Selling and general expenses for comparable hotels increased by 11.1% for the six months ended December 31, 1992 over the same period in the prior year primarily due to hiring of additional sales staff, sales training programs and increased advertising and sales promotion expenses. The following table presents the Company's other revenues and expenses for the six months ended December 31, 1992 and 1991 which are not considered direct operating revenues and expenses of the owned and leased hotels and which were not affected by accounting changes due to the reorganization and, therefore, can be compared. Other Revenues and Expenses (In thousands) The Company derived management fees from the hotel properties it managed based on a fixed percentage of gross revenues and charges for certain other services rendered. Under certain agreements, the Company was also eligible to receive performance-related incentive payments. The Company managed 28 of its 34 owned and leased hotel properties and managed 50 hotel properties for third party owners. Management fees increased by $0.4 million for the six months ended December 31, 1992 as compared to the same period of the prior year primarily due to incentive payments. The Company had a concentration of short-term management agreements with a limited number of related and third party owners. Fees derived from these agreements were approximately $3.3 million or 57% of the total management and other fees recognized during the six months ended December 31, 1992. Interest and dividend income decreased for the six months ended December 31, 1992 as compared to the same period of the prior year primarily due to a $58 million reduction in the principal amount of a note receivable arising from a note prepayment by New World Development Co., Ltd. in August 1992. General and administrative expenses decreased by 22.9% for the six months ended December 31, 1992 as compared to the same period of the prior year primarily due to staff reductions in administrative areas. Based on settlement negotiations and declines in cash flow generated by a hotel property, the Company recorded $13.0 million in valuation writedowns and reserves in July 1992 related to mortgages and notes receivable. Fiscal Year Ended June 30, 1992 Compared to Fiscal Year Ended June 30, 1991 PMI's results of operations for the years ended June 30, 1992 and 1991 changed dramatically from the prior years. On September 18, 1990 (the "Petition Date"), PMI and certain subsidiaries filed voluntary petitions in the Bankruptcy Court. Immediately after the Petition Date, the Company performed a detailed analysis of the operating performance of the 141 hotel properties that it operated either through ownership, lease or management. The 141 hotel properties were comprised of 81 owned or leased hotel properties and 60 hotel properties managed by PMI for third parties. As a result of the analysis 54 owned and leased hotel properties and 15 managed hotel properties were identified for disposal through lease rejection, lease expiration, contract termination or sale. The majority of the disposals occurred during the second and third quarters of fiscal 1991. In 1991, management segregated its hotel properties into Core Properties (those properties which PMI intended to retain) and Non-Core Properties (those properties intended for disposition). The following table presents the direct revenues and expenses of PMI's owned and leased Core and Non-Core Properties as shown in the accompanying consolidated statements of operations for the years ended June 30, 1992 and 1991. The discussion and analysis of direct revenues and expenses that follows the table focuses solely on the 30 owned and leased Core Properties that will continue to be owned or leased. Owned and Leased Properties (In thousands of dollars, except for statistical information) Room revenues for the 30 owned and leased Core Properties increased by $3.2 million in 1992 as compared to the prior year. Food and beverage revenues for such properties increased by $.4 million in 1992 as compared to the prior year. The increases were due to the opening of 3 new hotel properties in 1992 and the full year impact of 7 hotel properties opened in the first half of fiscal 1991. PMI experienced a decline in average daily rate which was offset by increased occupancy in 1992. The results were impacted by the slowdown in the economy, particularly in the Northeast, and increased competition resulting from the oversupply of hotels. Direct expenses as a percentage of revenues for rooms for the 30 owned and leased Core Properties increased to 26% in 1992 from 24% in 1991. Direct expenses as a percentage of revenues for food and beverage increased to 82% in 1992 from 80% in 1991. The increases were attributable to payroll and other fixed expenses which increased at inflation rates while revenues remained relatively stable. PMI derived management fees from the hotel properties it manages based on a fixed percentage of gross revenues and charges for services rendered. Under certain agreements, PMI was also eligible to receive performance-related incentive payments. PMI managed 24 of its 30 owned and leased Core Properties and managed 48 hotel properties for third parties as part of its core business. Management fees increased by $2.2 million in 1992, as compared to the prior year, primarily due to the increased level of services billed to third party owners. Interest income was derived primarily from PMI's portfolio of mortgage notes and other notes receivable. Certain of the notes held by PMI were received as part of the consideration for the sale of hotel properties, for services rendered or in connection with the development of hotel properties. PMI generally obtained contracts to manage the hotel properties securing the mortgages and notes and guaranteed that certain hotel properties would generate specific levels of cash flows which would enable the owners and investors to meet various obligations, including interest on the mortgage notes receivable. Other notes arose from loans to developers and operators of hotel properties and from transactions related to PMI's discontinued franchise operations. As a result of the oversupply of hotels and the slowdown of the economy, certain of the properties securing the notes experienced decreased operating cash flows and have been unable to pay some or all of the interest and principal due on the notes. Most of PMI's obligations to the owners and investors under financial guarantees were terminated as a result of PMI's bankruptcy filing. Accordingly, PMI suspended the accrual of interest on the related notes during September 1990 and began recognizing interest income only as cash was received. Interest and dividend income decreased by $7.0 million in 1992, versus the prior year, primarily as a result of the suspension of the accrual of interest in September 1990. Other operating and general expense decreased throughout 1992 primarily due to the elimination of expenses associated with properties disposed of as part of the Chapter 11. The most significant decrease is attributable to rent expense as properties operated under lease agreements with an annual rent expense of approximately $47 million were rejected as part of the Chapter 11 in 1991. Depreciation and amortization expense decreased in 1992 due to the impact of the disposition of hotel properties during 1991 and 1992. This was offset by the depreciation related to the new hotel properties. Interest expense declined in 1992, versus the prior year, as PMI discontinued accruing interest on certain debt obligations subject to compromise as of the Petition Date. Interest expense would have been higher by $28 million for the year ended June 30, 1992 had the Debtors' not filed for Chapter 11. If such interest expense had been recorded, the reported losses in 1992 would have increased. These debt obligations included $230 million aggregate principal amount of convertible subordinated debentures, the $110 million remaining balance under a bank credit agreement, and certain other notes to banks and others of approximately $58 million. Interest expense also decreased due to the reduction in interest rates throughout the year. Reorganization expenses consisted primarily of professional fees and other expenses of $19.3 million, estimated claims arising from bankruptcy of $6.0 million and losses on the disposal of assets of $2.3 million, offset by interest earned of $4.4 million on accumulated cash resulting from the Chapter 11. PMI also recorded $62.1 million in valuation writedowns and reserves in 1992 as part of the restructuring of its business. These items relate to mortgages and notes receivable of $49.5 million, land and buildings of $9.0 million, and other items of $3.6 million. The disproportionate tax rates in 1992 and 1991 resulted primarily from accounting losses for which deferred income tax credits cannot be recognized and state income taxes. Liquidity and Capital Resources The Company believes that it has sufficient financial resources to provide for its working capital needs, capital expenditures and debt service obligations in 1994. The Company anticipates meeting its future capital needs through a combination of existing cash balances, projected cash flow from operations, conversion of Other Assets to cash, and a portion of the proceeds from debt or equity offerings. Additionally, the Company may in the future incur mortgage financing on certain of its 15 unencumbered properties or enter into alliances with capital partners to provide additional funds for the development and acquisition of hotels to the extent such financing is available. At December 31, 1993, the Company had cash and cash equivalents of $41.6 million and restricted cash of $11.0 million, which was primarily collateral for various debt obligations. Cash flow from operations was approximately $19.7 million for the year ended December 31, 1993. Cash flow from operations exceeded income before extraordinary items of $8.2 million due to non-cash items such as depreciation and amortization of $7.1 million and the utilization of net operating loss carryforwards ("NOL's") of $4.5 million. At December 31, 1993, the Company has NOL's relating to its predecessor, PMI, of approximately $121.0 million which, subject to annual limitations, expire beginning in 2005 and continuing through 2008. The Company's other major sources of cash for the year ended December 31, 1993 were proceeds from asset settlements and scheduled collections of mortgages and notes receivable of $10.9 million and refunds of Federal income taxes of $17.7 million (of which approximately $1.2 million related to interest and was recorded as other income) related to PMI. The Company's major uses of cash for the year ended December 31, 1993 were debt repurchases and required principal payments of $30.9 million and capital expenditures of $14.3 million. During 1993, the Company repurchased $500,000 of its Senior Secured Notes, $16.5 million of its Junior Secured Notes and $8.8 million of its mortgage notes payable for an aggregate purchase price of $19.0 million. The repurchases were funded through internal sources of $17.5 million and additional borrowings of $1.5 million. As of March 15, 1994, the Company had repurchased during 1994 $7.2 million of its Senior Secured Notes and Junior Secured Notes for an aggregate purchase price of $7.0 million. During the first quarter of 1994, the Company also purchased through a third party agent approximately $5.2 million of its Senior Secured and Junior Secured Notes for aggregate consideration of $4.8 million. These notes are currently held by the third party agent and have not been retired due to certain restrictions under the note agreements. The purchases will be recorded as investments on the Company's balance sheet and no gain will be recorded on these transactions by the Company until the notes mature or are redeemed. The Company has a fully-secured demand credit agreement which permits borrowing of up to $5.0 million. This facility is supported by a certificate of deposit which is maintained by the lender. The Company currently has debt obligations of $19.3 million, $8.9 million and $42.8 million due in 1994, 1995, and 1996, respectively. Approximately $14.3 million, $5.0 million and $4.1 million of the debt due in 1994, 1995 and 1996, respectively, is owed by Suites of America. Of the approximately $14.3 million of Suites of America's debt due in 1994, approximately $9.2 is owed to ShoLodge and scheduled to mature in April 1994. The Company believes it will be able to refinance that debt with ShoLodge due to its relationship as a potential joint venture partner. Upon exercise of an option by either the Company or ShoLodge under a joint venture agreement, ShoLodge will hold a 50% equity interest in Suites of America and $9.1 million of its debt will be converted into equity of the joint venture. The remaining debt owed to ShoLodge will become debt of the joint venture with a five-year maturity. In addition, the Company has $34.0 million of debt obligations related to the Frenchman's Reef due in December 1996. The Company believes it will be required to seek an extension of the maturity of such debt or refinance it. The debt is secured by a first mortgage note receivable held by the Company with a book value of $50.0 million. See "Business--Lodging Operations--Franchised Hotels," "Business--Lodging Operations--AmeriSuites" and Note 9 to the Notes to the Consolidated Financial Statements. Capital Investments. The Company is implementing a hotel development and acquisition program, which focuses on its proprietary limited-service brands, Wellesley Inns and AmeriSuites, and on strategically positioned full-service hotels. In November 1993, the Company opened its newly constructed Wellesley Inn in Orlando, Florida. The Company is constructing a new Wellesley Inn in the Sawgrass section of Fort Lauderdale, Florida and has begun development of a Wellesley Inn site in Lakeland, Florida. The Company plans to acquire and convert two additional Wellesley Inns in 1994. The Company has also purchased a site in Tampa, Florida for planned construction of an AmeriSuites hotel. The Company plans to develop two additional AmeriSuites in 1994. The Company is also evaluating opportunities to acquire and rehabilitate existing full-service hotels either for its own portfolio or with investors. As part of the Company's full-service acquisition program, the Company acquired the Ramada Inn in Meriden, Connecticut in July 1993. The Company spent $7.8 million on its development and acquisition program in 1993. The Company anticipates capital spending for its hotel development and acquisition programs in 1994 will range between $35 and $40 million. No assurance can be given that the Company will locate suitable acquisitions and therefore will complete such capital expenditures in 1994. The Company is pursuing a program of refurbishing its Owned Hotels and repositioning them in order to meet the local market's demand characteristics. In some instances, this may involve a change in franchise affiliation. The refurbishment and repositioning program primarily involves Hotels which the Company has recently acquired through mortgage foreclosures or settlements, lease evictions/terminations or acquisitions. In 1993, the Company spent approximately $5.0 million on capital improvements at its Owned Hotels, of which $2.5 million related to refurbishments and repositionings on eight Owned Hotels. The Company intends to spend approximately $7.1 million on capital improvements related to its refurbishment and repositioning program at its Owned Hotels in 1994. Of this amount, $5.1 million relates to refurbishments and repositionings on eight Owned Hotels, which includes five hotels that were being refurbished in 1993 and will continue to be refurbished in 1994. Asset Realizations. The Company continues to negotiate settlements with mortgage and note obligors, from which it anticipates receiving cash or operating hotel assets. The Company intends to use the cash proceeds from asset conversions for debt repayments and general corporate purposes. In June 1993, the Company reached a settlement of an adversary proceeding regarding a note and promissory guarantee commenced by a subsidiary of PMI during PMI's bankruptcy case (the "Rose and Cohen Settlement") with Allan V. Rose ("Rose") and Arthur G. Cohen ("Cohen"). The settlement provided for Rose or his affiliate to pay the Company the sum of $25.0 million, all of which was paid into escrow on February 25, 1994, plus proceeds from approximately 1.1 million shares of the Company's common stock held by Rose which will be liquidated over a period of time. The Rose and Cohen Settlement is subject to a claim on the entire amount by Financial Security Assurance, Inc. ("FSA"). All proceeds from the Rose and Cohen Settlement must continue to be held in escrow until the Company receives an order of the U.S. Bankruptcy Court for the Southern District of Florida determining the Company's exclusive right to the settlement proceeds. A trial was held on such claim in such court in January 1994. The Company expects an order to be issued by that court in the near future, which order will be subject to appeal. Upon receipt of a favorable order, substantially all of the net proceeds will be used to repay the Senior Secured Notes and Junior Secured Notes. The Company has entered into a restructuring agreement relating to its mortgage notes receivable secured by the Frenchman's Reef with the general partner of Frenchman's Reef Beach Associates ("FRBA"), the owner of the hotel. In conjunction with the agreement, FRBA filed a pre-negotiated chapter 11 petition in September 1993. The plan of reorganization dated October 21, 1993 provides for the Company to receive ownership and control of the hotel through a 100% equity interest in the reorganized FRBA. The plan also provides for the existing equity holders and any other impaired claim holders to participate in excess cash flow above specified levels and all administrative and unsecured trade claims incurred in the ordinary course of business to be paid in full. There can be no assurance that the plan will become effective. A group purporting to represent a significant number of limited partners has filed an objection to the disclosure statement related to such plan and seeks to replace the Frenchman's Reef's general partner with a new general partner that may seek to redirect the bankruptcy proceedings in a way that may be materially adverse to the Company. In light of this uncertainty, the Company intends to pursue a foreclosure of its mortgages and has filed a motion with the bankruptcy court seeking to lift the stay of relief under the chapter 11 petition to permit a commencement of a foreclosure action. The motion is subject to approval by the Bankruptcy Court. Due to, among other factors, the contingent nature of bankruptcy proceedings, there can be no assurance of when and if any court approval will be obtained. Certain equity holders of the Frenchman's Reef have challenged the authority of the current general partner of the Frenchman's Reef and requested to replace it as general partner. If these equity holders were to become general partner, they have indicated through court filings that they would investigate the validity and priority of the Company's mortgages. In addition, the Company's management agreement with respect to the Frenchman's Reef could be rejected in connection with the bankruptcy case. The Company had, as of December 31, 1993, $39.6 million of debt secured by the Company's mortgage on the Frenchman's Reef. The Company does not intend to obtain ownership of the Frenchman's Reef unless the lender of such debt consents. The Company has entered into discussion with the lender regarding revising the terms of such debt. See "Management's Discussion and Analysis of Financial Conditions and Results of Operations," "Business--Lodging Operations--Franchised Hotels" and Note 3 to Notes to Consolidated Financial Statements. During 1993, the Company also collected a $5.0 million installment obligation related to the Baltimore Marriott hotel and received $4.0 million in settlement of a mortgage note secured by the East Brunswick, New Jersey Sheraton hotel. During 1993, the Company received the fee interest in a Ramada hotel in Danbury, Connecticut in settlement of its mortgage note receivable. The Company also acquired three hotels through lease expiration or foreclosure, one of which it is presently converting to a Shoney's Inn in Orlando, Florida. In September 1993, the Company sold the Holiday Inn in Milford, Connecticut for a net sales price of $2.4 million. After retiring the property's debt of $1.4 million, the Company received net cash proceeds of $1.0 million from the transaction. Item 8. Item 8. Financial Statements and Supplementary Data. See Index to Financial Statements and Financial Statement Schedules included in Item 14. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. None PART III Item 10. Item 10. Directors and Executive Officers of the Registrant. Set forth below are the names, ages and positions of the directors and executive officers of the Company: The following is a biographical summary of the experience of the directors and executive officers of the Company: David A. Simon has been President, Chief Executive Officer and a Director since 1992 and Chairman of the Board of the Company since 1993. Mr. Simon was a director of PMI from 1988 to 1992. Mr. Simon was the Chief Operating Officer of PMI from 1988 to 1989 and Chief Executive Officer of PMI from 1989 to 1992 and was an executive officer in September 1990 when PMI filed for protection under Chapter 11 of the United States Bankruptcy Code. John M. Elwood has been a Director and Executive Vice President of the Company since 1992, Chief Financial Officer since 1993 and the Director of Reorganization of the Company during 1992. Mr. Elwood was the Director of Reorganization of PMI from 1990 to 1992. Mr. Elwood was the director of Reorganization of Allegheny International, Inc. from 1988 to 1990 and a Vice President of Mellon Bank, N.A. during 1988. Herbert Lust, II has been a Director since 1992 and Chairman of the Compensation and Audit Committee of the Company since 1993 and Chairman of the Compensation Committee and a member of the Audit Committee of the Company from 1992 to 1993. Mr. Lust was a member of the Committee of Unsecured Creditors of PMI from 1990 to 1992. Mr. Lust is a director of BRT Realty Trust. Leon Moore has been a Director of the Company since 1992 and a member of the Audit and Compensation Committee since 1993. From 1992 to 1993, Mr. Moore was a member of the Compensation Committee. Mr. Moore has been the President, Chief Executive Officer and Chairman of the Board of Directors of ShoLodge, Inc. for more than the past five years. Mr. Moore is a director of the Bank of Nashville. Allen J. Ostroff has been a Director since 1992. Mr. Ostroff was Chairman of the Board of the Company and a member of the Audit Committee from 1992 to 1993. Mr. Ostroff has been a Senior Vice President of the Prudential Realty Group, a subsidiary of the Prudential Insurance Company of America, for more than the last five years. A. F. Petrocelli has been a Director since 1992 and a member of the Compensation and Audit Committee of the Company since 1993 and of the Compensation Committee of the Company from 1992 to 1993. Mr. Petrocelli has been the Chairman of the Board of Directors and Chief Executive Officer of United Capital Corp. for more than the past five years. Paul H. Hower has been an Executive Vice President of the Company since 1993. Mr. Hower was President of Integrity Hospitality Services from 1992 to 1993 and Vice President and Hotel Division Manager of B. F. Saul Co. from 1988 to 1991. Denis W. Driscoll has been a Senior Vice President of the Company since 1993. Mr. Driscoll was President of Driscoll Associates, a human resources consulting organization from 1988 to 1993. John H. Leavitt has been a Senior Vice President of the Company since 1992. Mr. Leavitt was a Senior Vice President of PMI from 1991 to 1992 and a Senior Vice President of Medallion Hotel Corporation from 1988 to 1991. John E. Stetz has been a Senior Vice President of Development of the Company since 1993. Mr. Stetz was a Vice President - Development of Choice Hotels International from 1988 to 1992. Joseph Bernadino has been Senior Vice President, Secretary and General Counsel of the Company since 1993. Mr. Bernadino was an Assistant Secretary and Assistant General Counsel of PMI from 1988 to 1992. Richard T. Szymanski has been a Vice President and Corporate Controller of the Company since 1992. Mr. Szymanski was Corporate Controller of PMI from 1989 to 1992, and Division Controller from 1988 to 1989. Douglas W. Vicari has been a Vice President and Treasurer of the Company since 1992 and was Vice President and Treasurer of PMI during 1992. Mr. Vicari was the Director of Budget and Financial Analysis of PMI from 1989 to 1992, and Budget Manager from 1988 to 1989. Item 11. Item 11. Executive Compensation The following summary compensation table sets forth information concerning compensation for services in all capacities awarded to, earned by or paid to the persons who were, at December 31, 1993, the Company's Chief Executive Officer and the five other most highly compensated executive officers of the Company. The information shown reflects compensation for services in all capacities awarded to, earned by or paid to these persons for the fiscal year ending December 31, 1993. Stock option grants during fiscal year ended December 31, 1993 The following table sets forth information concerning individual grants of stock options made during the fiscal year ending December 31, 1993 to each of the officers listed below. The Company did not grant any stock appreciation rights during such period. (1) These stock options were granted to David A. Simon as a director of the Company in connection with a grant of options to the directors. These stock options vest with respect to 15,000 shares on each of August 4, 1993, 1994 and 1995 and will continue to be exercisable through August 4, 1999, subject to the provisions of the Company's 1992 Stock Option Plan. (2) These stock options were granted to John M. Elwood as a director of the Company in connection with a grant of options to the directors. These stock options vest with respect to 15,000 shares on each of August 4, 1993, 1994, and 1995 and will continue to be exercisable through August 4, 1999, subject to the provisions of the Company's 1992 Stock Option Plan. (3) These stock options vest with respect to one third of the grant on each of June 18, 1994, 1995, and 1996 and will continue to be exercisable through June 18, 1999, subject to the provisions of the Company's 1992 Stock Option Plan. (4) Joseph Bernadino received separate stock option grants of 5,000 shares and 3,000 shares each. One third of the 5,000 share grant vests on each of June 18, 1994, 1995 and 1996 and will continue to be exercisable through June 18, 1999. One third of the 3,000 share grant vests on each of September 1, 1994, 1995 and 1996 and will continue to be exercisable through September 1, 1999. Both grants are subject to the Company's 1992 Stock Option Plan. Aggregated option in fiscal year ended December 31, 1993 and year-end option values Employment Agreement Under the Plan As provided in the Plan, Mr. David A. Simon and the Company executed an employment agreement which provides for an initial term of three years, with automatic successive one-year extensions unless a prior election is made by either party not to extend the agreement. The employment agreement provides for an annual base salary of $300,000 (which will increase annually based upon increases in the consumer price index), a discretionary annual bonus based on attainment of performance objectives set by the Board of Directors, a life insurance policy in an amount not less than $1,000,000, an automobile and other customary welfare benefits, including medical and disability insurance. The agreement also provides that, to the extent payments made by the Company for disability insurance, life insurance and the use of the automobile are subject to federal, state or local income taxes, the Company will pay Mr. Simon the amount of such additional taxes plus such additional amount as will be reasonable to hold him harmless from the obligation to pay such taxes. Pursuant to this employment agreement, Mr. Simon was granted stock options on July 31, 1992 to purchase 330,000 shares of Common Stock. Such stock options are exercisable with respect to 110,000 shares at the end of each of the first, second and third years of his employment, provided his employment has not been terminated by such date. This employment agreement may be terminated by the Company at any time, with or without cause. If the agreement is terminated by the Company prior to the expiration of the initial three-year term without cause, or if Mr. Simon resigns because of circumstances amounting to constructive termination of employment, severance would be paid in a single lump sum equal to one-year's base salary or, if greater, the base salary that would have been payable over the remainder of the initial term. All stock options would become fully vested and remain exercisable for 90 days after termination or, if longer, until the expiration of the initial three year term. Any bonus awarded for the year of termination would be prorated. If the Company does not terminate the agreement prior to the expiration thereof, but elects not to extend the agreement beyond the initial term, severance would be payable in a single lump sum equal to one-year's base salary. If the agreement is terminated by the Company for cause (as such term is defined in the employment agreement), or if Mr. Simon resigns voluntarily under circumstances not amounting to a constructive termination of employment, no benefits are payable other than accrued but unpaid salary. Employment Agreements Subsequent to the Plan As of December 31, 1992, Mr. Elwood and the Company executed an employment agreement which has a term of one year. This employment agreement provides for an annual base salary of $240,000, a discretionary annual bonus based on attainment of performance objectives set by the Board of Directors, a life insurance policy in an amount not less than $480,000 (of which the Company will not pay premiums which exceed $5,000), moving expenses, an automobile, and other customary welfare benefits, including medical and disability insurance. Pursuant to the agreement, Mr. Elwood was granted stock options to purchase 20,000 shares of Common Stock which are now fully vested. The agreement expired on December 31, 1993 by its terms, but was extended on a day to day basis pending negotiation of a new contract. As of May 18, 1993, Mr. Paul H. Hower and the Company executed an employment agreement which has a term commencing June 23, 1993 and ending June 30, 1994. This employment agreement provides for an annual base salary of $180,000, a cash bonus of $10,000. a discretionary annual bonus based on attainment of performance objectives set by the Board of Directors, a life insurance policy in an amount not less than $360,000, moving expenses, an automobile, and other customary welfare benefits, including medical and disability insurance. Pursuant to the agreement, Mr. Hower was granted stock options as of June 23, 1993 to purchase 20,000 shares of Common Stock. Such stock options vest on June 30, 1994 provided his employment has not been terminated by such date. The agreement may be terminated by the Company at any time, with or without cause. If the agreement is terminated by the Company prior to the expiration of the one year term without cause, or if Mr. Hower resigns because of circumstances amounting to constructive termination of employment, severance would be paid in a single lump sum equal to six month's base salary or, if greater, the base salary that would have been payable over the remainder of the term. All other benefits, any bonus (subject to adjustment) and any non-vested stock options (subject to adjustment) will terminate. If the agreement is terminated by the Company for cause (as such term is defined in the agreement), or if Mr. Hower resigns voluntarily under circumstances not amounting to a constructive termination of employment, no benefits are payable other than accrued but unpaid salary. As of March 1, 1993, Mr. John Stetz and the Company executed an employment agreement which has a term of one year. This employment agreement provides for an annual base salary of $115,000, an annual bonus equal to 10% of the first year base management fee for each management agreement obtained, and other customary welfare benefits, including medical and disability insurance. The Agreement expired on February 28, 1994. Stock Option Plans 1992 Stock Option Plan As provided in the Plan, the Company adopted the 1992 Stock Option Plan (the "SOP"), providing for the grant of non-qualified stock options to key employees, officers and directors. The SOP (but not outstanding options) will terminate on July 31, 2002 and is administered by the Audit and Compensation Committee of the Board of Directors (the "Committee"). The Company has reserved 1,320,000 shares of common stock for issuance upon the exercise of stock options under the SOP. During the fiscal year ended December 31, 1993 options covering 728,000 shares of common stock were granted. Recipients of options under the SOP are selected by the Committee. The Committee determines the terms of each option grant including the purchase price of shares subject to options, the dates on which options become exercisable and the expiration date of each option (which may not exceed six years from the date of grant). Of the 728,000 shares covered by option grants under the SOP, 45,000 were granted to Mr. David A. Simon and 45,000 were granted to Mr. John M. Elwood. Options to purchase 152,000 shares of common stock were granted to all current executive officers as a group. The terms of these option grants are described above under the heading "Stock option grants during fiscal year ended December 31, 1993". Recipients of option grants under the SOP will have no voting, dividend or other rights as stockholders with respect to shares of common stock covered by stock options prior to becoming the holders of record of such stock. All stock option grants will permit the exercise price to be paid in cash, by tendering stock or by cashless exercise. The number of shares covered by stock options will be appropriately adjusted in the event of any merger, recapitalization or similar corporate event. The Board of Directors may at any time terminate the SOP or from time to time make such modifications or amendments to the SOP as it may deem advisable; provided that the Board may not, without the approval of stockholders, increase the maximum number of shares of common stock for which options may be granted under the SOP. 1992 Performance Incentive Plan As provided in the Plan, the Company adopted the 1992 Performance Incentive Plan (the "PIP") under which stock options covering an additional 330,000 shares of common stock were reserved for grants to one or more other executives, including those newly hired, at the discretion of Mr. David A. Simon. No options have been granted under the PIP. Mr. Simon will determine the terms of each option grant under the PIP including the purchase price of shares subject to options, the dates on which options become exercisable and the expiration date of each option (which may not exceed six years from the date of grant). Recipients of stock option grants under the PIP will have no voting, dividend or other rights as stockholders with respect to shares of Common Stock covered by stock options prior to becoming the holders of record of such stock. All stock option grants under the PIP will permit the exercise price to be paid in cash, by tendering stock or by cashless exercise. The number of shares covered by stock options under the PIP will be appropriately adjusted in the event of any merger, recapitalization or similar corporate event. The Board of Directors may at any time terminate the PIP or from time to time make such modifications or amendments to the PIP as it may deem advisable; provided that the Board may not, without the approval of stockholders, increase the maximum number of shares of Common Stock for which options may be granted under the PIP or change the class of persons eligible to receive options under the PIP. Audit and Compensation Committee Report on Executive Compensation All members of the Audit and Compensation Committee are independent, non-employee Directors. As provided in the Plan, Mr. Simon and the Company are parties to an employment agreement which provides for an initial term of three years, with automatic successive one-year extensions unless a prior election is made by either party not to extend the agreement. The agreement provides for an annual base salary of $300,000 (which will increase annually based upon increases in the consumer price index) and a discretionary annual bonus based on attainment of performance objectives to be set by the Board of Directors. Pursuant to the Plan and his employment agreement, Mr. Simon was granted options to purchase 330,000 shares of Common Stock. Mr. Simon's employment agreement and option grants were approved by the former directors of the Company. During 1993, no bonus was paid to Mr. Simon pursuant to his employment agreement. The Company's compensation policy is designed to help the Company achieve its business objectives by: - setting levels of compensation designed to attract and retain qualified executive in a highly competitive business environment; - providing incentive compensation that varies directly with both the Company's financial performance and individual initiative and achievement contributing to such performance; and - linking compensation to elements which effect the Company's annual and long-term share performance. The Company intends to compensate executives and to grant stock options pursuant to the SOP in order to provide executives with a competitive total compensation package and reward them for their contribution to the Company's annual and long-term share performance. Compensation Committee Interlocks and Insider Participation Mr. Moore and Mr. Petrocelli have certain business relationships with the Company, which are described under the heading "Certain Relationships and Related Transactions." AUDIT AND COMPENSATION COMMITTEE Herbert Lust, II (Chairman) Leon Moore A. F. Petrocelli Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. The following table sets forth as of March 10, 1994, information with respect to the beneficial ownership of the Company's common stock by (i) each person known by the Company to own beneficially 5% or more of the Company's common stock, (ii) each director of the Company, (iii) the Company's Chief Executive Officer and each of the five remaining most highly compensated executive officers, and (iv) all executive officers and directors of the Company as a group. (a) Ingalls & Snyder filed a Schedule 13G, dated February 1, 1994, with the Securities and Exchange Commission (the "SEC") reporting ownership of 2,506,123 shares of common stock, with sole voting power with respect to 208,754 shares and sole dispositive power with respect to 2,506,123 shares. (b) Includes 101,726 shares owned by David A. Simon, 146 shares owned by his wife and 249 shares held by Mr. Simon as custodian for his children. Mr. Simon disclaims beneficial ownership of the shares owned by his wife and held as custodian for his children. Also includes warrants to purchase 6,774 shares with an exercise price of $2.71 a share, of which Mr. Simon disclaims beneficial ownership of 467 warrants owed by his wife and 697 warrants held as custodian for his children. (c) Includes warrants to purchase 12,122 shares with an exercise price of $2.71 a share. (d) Held by a trust under which Mr. Lust and his wife are co-trustees and beneficiaries. (e) These shares are owned by United Capital Corp. Mr. Petrocelli is Chairman of the Board of Directors and Chief Executive Officer of United Capital Corp. (f) Includes warrants to purchase 85 shares with an exercise price of $2.71. (g) The Directors and executive officers each own less than one percent of the outstanding common stock and own approximately one percent of the outstanding common stock as a group. Percentages were based on 29,200,204 shares outstanding as of March 10, 1994. Item 13. Item 13. Certain Relationships and Related Transactions. Leon Moore, a Director of the Company, is the President, Chief Executive Officer and Chairman of the Board of ShoLodge, Inc. ("ShoLodge"). Pursuant to an agreement with the Company and Suites of America, Inc. ("SOA"), a wholly owned subsidiary of the Company, ShoLodge was appointed the exclusive agent to develop certain AmeriSuites hotel properties. ShoLodge is entitled to receive fees for each hotel property developed. In addition, ShoLodge may receive, among other things, a profit sharing interest in certain sites. During the fiscal year ended December 31, 1993, ShoLodge earned development fees of $-0- and loan origination fees of $40,349. As of December 31, 1993, the Company and SOA have outstanding loans in the amount of $18,361,000 owed to ShoLodge and in the amount of $5,066,000 owed to the Bank of Nashville. Mr. Leon Moore is a director of The Bank of Nashville. The foregoing loans are secured by hotel properties owned by SOA. ShoLodge manages eight AmeriSuites hotel properties for the Company. During the fiscal year ended December 31, 1993, ShoLodge earned management fees and incentive fees totalling $468,000 from these AmeriSuites hotel properties. The Company and SOA are parties to agreements with ShoLodge which provide that, under certain circumstances, ShoLodge will contribute hotels to SOA, receive 50% ownership interest, and manage the AmeriSuites hotels owned by SOA pursuant to a new management agreement. In April 1993, the Company sold land located in Flagstaff, Arizona to an affiliate of Mr. Moore for the sum of $1.3 million. Upon its completion of the construction of an AmeriSuites hotel on the land in October 1993, Mr. Moore's affiliate sold the completed hotel to SOA for the sum of $5,875,000. ShoLodge financed a portion of the purchase price and received a mortgage on the hotel in the principal sum of $5,045,000. ShoLodge manages the hotel for SOA. In addition, in May 1993, the Company sold to an affiliate of Mr. Moore land located in Overland Park, Kansas on which the affiliate will build an AmeriSuites hotel for sum of $486,000. During 1993, the Company paid $2,376,000 in cash and cancelled its note receivable of $486,000 in full satisfaction of the profit participation of ShoLodge in four AmeriSuites hotel owned by SOA. An affiliate of Mr. Moore has entered into a contract to build a hotel for the Company in Tampa, Florida for $3,587,900. In April 1993, an affiliate of Mr. Moore completed construction of an AmeriSuites hotel located in Brentwood, Tennessee on land it leased from SOA and sold it to SOA for the sum of $4,035,000. ShoLodge financed the full purchase price and received a deed of trust on the hotel. The lease from SOA to the affiliate was terminated. ShoLodge manages the property for SOA. The Company uses the ShoLodge reservation system for its AmeriSuites and Wellesley Inn hotel properties. The total amount of reservation fees paid to ShoLodge for the fiscal year ended December 31, 1993 was approximately $222,000. A.F. Petrocelli, a Director of the Company, is the Chairman of the Board and Chief Executive Officer of United Capital Corp. In March 1994, the Company entered into management agreements with the corporate owners of two hotels who are affiliates of United Capital Corp. During 1993, the Company managed and held a nonrecourse junior note and mortgage on a hotel property owned partially by a partnership comprised of David A. Simon and certain former officers and directors of the Company. In connection with a settlement in lieu of foreclosure between the first mortgagee and the owners in which the hotel was conveyed to the first mortgagee, the Company discharged its junior mortgage. During 1989, a partnership in which Peter E. Simon, father of David A. Simon, is a partner acquired an interest in three hotels from PMI. In partial payment PMI received nonrecourse junior loans aggregating $21,590,000. As of December 31, 1993, the aggregate balance owed on these loans was $21,472,766. The Company is currently in the process of restructuring these loans. Due to the nonrecourse junior nature of these loans and the insufficient cash generated by the hotels, no debt payments were made on these loans during 1993. During 1989, this same partnership acquired PMI's interest in eight hotel properties. In partial payment PMI received a junior non- recourse mortgage note in the principal amount of $9,647,450. The Company restructured this transaction as of December 1, 1992 by (i) conveying to the partnership its interest in one hotel property, and (ii) amending the principal amount and interest rate of the note to $8,103,362 and 8.2% per annum, respectively. No debt payments were made on these loans during 1993. During February 1990, this same partnership purchased from PMI a note owing from a third party in the original principal amount of $3,255,380. This partnership paid PMI $488,318 in cash and granted PMI an 85% note participation. In partial settlement of its claim on the note, the Company acquired a hotel located in Miami, Florida in which the partnership has a 15% interest. In December 1993, the Company entered into a management agreement with the corporate owner of a hotel in which Peter E. Simon is a stockholder. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) 1. Financial Statements The Financial Statements listed in the accompanying index to financial statements are filed as part of this Annual Report. 2. Financial Statement Schedules The Financial Statement Schedules listed in the accompanying index to financial statements are filed as part of this Annual Report. 3. Exhibits (2) (a) Reference is made to the Disclosure Statement for Debtors' Second Amended Joint Plan of Reorganization dated January 16, 1992, which includes the Debtors' Second Amended Plan of Reorganization as an exhibit thereto filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (3) (a) Reference is made to the Restated Certificate of Incorporation of the Company dated June 5, 1992 filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (b) Reference is made to the Restated Bylaws of the Company filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (4) (a) Reference is made to the Form of 8.20% Fixed Rate Senior Secured Note of the Company filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (b) Reference is made to the Form of Adjustable Rate Senior Secured Note of the Company filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (c) Reference is made to the Form of 9.20% Junior Secured Note of the Company filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (d) Reference is made to the Form of 8.20% Tax Note of the Company filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (e) Reference is made to the Form of 10.20% Secured UND Restructured Note of the Company filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (f) Reference is made to the Form of 8% Secured UND Restructured Note of the Company filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (g) Reference is made to the Form of 9.20% OVR Restructured Note of the Company filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (h) Reference is made to the Collateral Agency Agreement among the Company, U.S. Trust and the Secured Parties, dated as of July 31, 1992 filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (i) Reference is made to the Security Agreement between the Company and U.S. Trust, dated as of July 31, 1992, filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (j) Reference is made to the Subsidiary Guaranty from FR Delaware, Inc. to United States Trust Company of New York, dated as of July 31, 1992, filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (k) Reference is made to the Security Agreement between FR Delaware, Inc. and United States Trust Company of New York, dated as of July 31, 1992, filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (l) Reference is made to the Subsidiary Guaranty from Prime Note Collections Company, Inc. to United States Trust Company of New York, dated as of July 31, 1992, filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (m) Reference is made to the Security Agreement between Prime Note Collections Company, Inc. and United States Trust Company of New York, dated as of July 31, 1992, filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (n) Reference is made to a Form 8-A of the Company as filed on June 5, 1992 with the Securities and Exchange Commission, as amended by Amendment No. 1 and Amendment No. 2, which is incorporated herein by reference. (10) (a) Reference is made to the Agreement of Purchase and Sale between Flamboyant Investment Company, Ltd. and VMS Realty, Inc. dated June 3, 1985, and its related agreements, each of which was included as Exhibits to the Form 8-K dated August 14, 1985 of PMI, which are incorporated herein by reference. (b) Reference is made to PMI's Flexible Benefit Plan, filed as an Exhibit to the Form 10-Q dated February 12, 1988 of PMI, which is incorporated herein by reference. (c) Reference is made to the Employment Agreement dated as of July 31, 1992, between David A. Simon and the Company filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (d) Reference is made to the 1992 Performance Incentive Stock Option Plan of the Company dated as of July 31, 1992, filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (e) Reference is made to the 1992 Stock Option Plan of the Company filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (f) Reference is made to the 1992 Non-Qualified Stock Option Agreement between the Company and David A. Simon filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (g) Reference is made to the 1992 Non-Qualified Stock Option Agreement between the Company and David L. Barsky filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (i) Reference is made to the Employment Agreement dated as of December 31, 1992 between John Elwood and the Company filed as an Exhibit to the Company's Form 10-K dated March 26, 1993, which is incorporated herein by reference. (j) Reference is made to the 1992 Non-Qualified Stock Option Agreement between the Company and John Elwood filed as an Exhibit to the Company's Form 10-K dated March 26, 1993, which is incorporated herein by reference. (k) Employment Agreement dated as of March 1, 1993 between John Stetz and the Company. (l) Employment Agreement dated as of May 18, 1993 between Paul Hower. (m) Consolidated and Amended Settlement Agreement dated as of October 12, between Allan V. Rose and the Company. (11) Computation of Earnings Per Common Share. (21) Subsidiaries of the Company. (23) (a) Consent of Arthur Andersen & Co. (b) Consent of J.H. Cohn & Co. (b) Reports on Form 8-K: None PRIME HOSPITALITY CORP. AND SUBSIDIARIES AND FINANCIAL STATEMENT SCHEDULES (ITEM 14 (A)) Other schedules are omitted because of the absence of conditions under which they are required or because the required information is given in the consolidated financial statements or notes thereto. Separate financial statements of 50% or less owned entities accounted for by the equity method have been omitted because such entities considered in the aggregate as a single subsidiary would not constitute a significant subsidiary. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Board of Directors and Stockholders of Prime Hospitality Corp.: We have audited the accompanying consolidated balance sheets of Prime Hospitality Corp. (a Delaware corporation) and subsidiaries ("the Company") as of December 31, 1993 and 1992 and the related consolidated statements of income, stockholders' equity and cash flows for the year ended December 31, 1993 and the five months ended December 31, 1992. 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 financial statements referred to above present fairly, in all material respects, the financial position of Prime Hospitality Corp. and subsidiaries as of December 31, 1993 and 1992 and the results of their operations and their cash flows for the year ended December 31, 1993 and the five months ended December 31, 1992 in conformity with generally accepted accounting principles. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed in the index to financial statements and financial statement schedules are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. The schedules have been subjected to the auditing procedures applied in our audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN & CO. Roseland, New Jersey March 17, 1994 PRIME HOSPITALITY CORP. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS DECEMBER 31, 1993 AND 1992 (IN THOUSANDS, EXCEPT SHARE DATA) See Accompanying Notes to Consolidated Financial Statements. PRIME HOSPITALITY CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) See Accompanying Notes to Consolidated Financial Statements. PRIME HOSPITALITY CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (IN THOUSANDS, EXCEPT SHARE DATA) See Accompanying Notes to Consolidated Financial Statements. PRIME HOSPITALITY CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) See Accompanying Notes to Consolidated Financial Statements. PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 AND 1992 NOTE 1 -- BUSINESS OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES Business Activities Prime Hospitality Corp. (the "Company") is a leading independent hotel operating company with ownership or management of full-service and limited-service hotels in the United States and one resort hotel in the U.S. Virgin Islands. The Company's hotels primarily provide moderately priced, quality accommodations in secondary or tertiary markets, and operate under franchise agreements with national hotel chains or under the Company's proprietary Wellesley Inns or AmeriSuites trade names. In addition to its hotel operations, the Company has a portfolio of financial assets including mortgages and notes receivable secured by hotel properties and owns real estate that is not part of its hotel operations. The Company emerged from the Chapter 11 reorganization case of its predecessor, Prime Motor Inns, Inc. and certain of its subsidiaries ("PMI"), which consummated its Plan of Reorganization ("the Plan") on July 31, 1992 (the "Effective Date"). PMI and certain of its subsidiaries had filed for protection under Chapter 11 of the United States Bankruptcy Code in September of 1990. During the reorganization, PMI renegotiated most of its leases, management agreements and debt commitments, resulting in the elimination of a substantial number of unprofitable contract relationships and excessive debt obligations. Basis of presentation Pursuant to the American Institute of Certified Public Accountant's Statement of Position 90-7, "Financial Reporting by Entities in Reorganization Under the Bankruptcy Code" ("SOP 90-7"), the Company adopted fresh start reporting as of July 31, 1992. Under fresh start reporting, the reorganization value of the entity was allocated to the reorganized Company's assets on the basis of the purchase method of accounting. The reorganization value (the approximate fair value) of the assets of the emerging entity was determined by consideration of many factors and various valuation methods, including discounted cash flows and price/earnings and other applicable ratios believed by management to be representative of the Company's business and industry. Liabilities were recorded at face values, which approximate the present values of amounts to be paid determined at appropriate interest rates. Under fresh start reporting, the consolidated balance sheet as of July 31, 1992 became the opening consolidated balance sheet of the emerging Company. In accordance with SOP 90-7, financial statements covering periods prior to July 31, 1992 are not presented because such statements have been prepared on a different basis of accounting and are thus not comparable. Principles of consolidation The consolidated financial statements include the accounts of the Company and all of its majority-owned subsidiaries. All material intercompany accounts and transactions have been eliminated in consolidation. Cash equivalents Cash equivalents are highly liquid unrestricted investments with a maturity of three months or less when acquired. Restricted cash Restricted cash consists primarily of highly liquid investments that serve as collateral for debt obligations due within one year. PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 AND 1992 (CONTINUED) Mortgages and other notes receivable Mortgages and other notes receivable are reflected at their fair value as of July 31, 1992, adjusted for payments and other advances since that date. The amount of interest income recognized on mortgages and other notes receivable is generally based on the stated interest rate and the carrying value of the notes. The Company has a number of subordinated or junior mortgages which remit payment based on hotel cash flow. Because there is substantial doubt that the Company will recover their face value, these mortgages have not been valued in the Company's consolidated financial statements. Interest on cash flow mortgages and delinquent loans is only recognized when cash is received. Property, equipment and leasehold improvements Property, equipment and leasehold improvements that the Company intends to continue to operate are stated at their fair market value as of July 31, 1992 plus the cost of acquisitions subsequent to that date less accumulated depreciation and amortization from August 1, 1992. Provision is made for depreciation and amortization using the straight-line method over the estimated useful lives of the assets. Properties identified for disposal are stated at their estimated net realizable value. Income taxes The Company and its subsidiaries file a consolidated Federal income tax return. For financial reporting purposes, the Company follows Financial Accounting Standards Board Statement of Financial Accounting Standards No. 109 ("FAS 109"). In accordance with FAS 109, as well as SOP 90-7, income taxes have been provided at statutory rates in effect during the period. Tax benefits associated with net operating loss carryforwards and other temporary differences that existed at the time fresh start reporting was adopted are reflected as a contribution to stockholders' equity in the period in which they are realized. Income per common share Net income per common share is computed based on the weighted average number of common shares and common share equivalents outstanding during each period. The weighted average number of common shares used in computing primary net income per share was 33,808,000 for the year ended December 31, 1993 and 33,000,000 for the five months ended December 31, 1992. The dilutive effect of stock warrants and options during the year ended December 31, 1993 and the five months ended December 31, 1992 was not material (see Note 10). Reclassifications Certain reclassifications have been made to the December 31, 1992 consolidated financial statements to conform them to the December 31, 1993 presentation. NOTE 2 -- CASH AND CASH EQUIVALENTS Cash and cash equivalents are comprised of the following (in thousands): PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 AND 1992 (CONTINUED) NOTE 3 -- MORTGAGES AND OTHER NOTES RECEIVABLE Mortgages and other notes receivable are comprised of the following (in thousands): - --------------- (a) These mortgage notes are secured by the Marriott Frenchman's Reef resort hotel, which is managed by the Company, and consist of first and second mortgages with face values of $53,383,000 and $25,613,000, respectively, with final scheduled principal payments of $51,976,000 and $25,613,000 due on July 31, 1995. The notes bear interest at a stated rate of 13%. Interest and principal payments on the first mortgage are payable in monthly installments. Interest and scheduled principal payments on the second mortgage note are payable only to the extent of available cash flow, as defined, with any unpaid interest due at maturity. In connection with the adoption of fresh start reporting, the Company valued the notes at $50,000,000. During the year ended December 31, 1993 and five months ended December 31, 1992, the Company recognized $4,250,000 and $1,770,000 of interest income on these notes, respectively (an effective rate of approximately 8.5%), based on the current level of cash flows generated from the hotel property available to service the notes. During 1993, the Company entered into a restructuring agreement related to these notes with the general partner of Frenchman's Reef Beach Associates ("FRBA"), the owner of the hotel. In conjunction with the agreement, FRBA filed a pre-negotiated Chapter 11 petition in September 1993. The disclosure statement setting forth the plan of reorganization dated October 21, 1993 provided for the Company to receive ownership and control of the hotel through a 100% equity interest in the reorganized FRBA. The plan also provided for the existing equity holders and any other impaired claim holders to participate in excess cash flow above specified levels and all administrative and unsecured trade claims incurred in the ordinary course of business to be paid in full. A group purporting to represent a significant number of limited partners has filed an objection to the disclosure statement and has challenged the authority of the general partner. These holders have also indicated that they intend to challenge the validity of the Company's lien. In light of this uncertainty, the Company intends to defend its position and pursue a foreclosure of its mortgages and has filed a motion to lift the stay of relief under the Chapter 11 petition to permit a commencement of a foreclosure action. The motion is subject to approval by the Bankruptcy Court. In the event that the Company is successful in its foreclosure proceedings and obtains title to the property, the assets and liabilities of the Frenchman's Reef resort hotel will be included in the consolidated financial statements of the Company at an initial net carrying value equal to the carrying value of the notes. (b) From 1988 through 1990, PMI loaned entities controlled by Allan Rose and Arthur Cohen (the "Rose and Cohen entities"), an aggregate of $100,890,000 which was initially fully secured by property and/or PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 AND 1992 (CONTINUED) personal guarantees. PMI was committed to make additional loans, also on a fully secured basis, to the Rose and Cohen entities of up to an aggregate of $130,000,000 if values of, and/or revenues generated by, certain hotel properties controlled by the Rose and Cohen entities attained specified levels. PMI was to receive a minimum annual return of 10% on all loans made to the Rose and Cohen entities and a maximum return of 20%. All loans and unpaid interest are payable on December 31, 1997. In 1992, certain of the Rose and Cohen entities owning a portion of the collateral that secures the loans filed for Chapter 11 protection in the United States Bankruptcy Court, Southern District of New York. Also during 1992, PMI commenced an adversary proceeding against Rose and Cohen to recover jointly and severally on the personal guarantees of $50,000,000 given by Rose and Cohen as part of the loan agreement. The accrual of interest on the Rose and Cohen note was discontinued in fiscal 1990 and the notes were reflected at their estimated net realizable value. In June 1993, the Company reached a settlement with Allan Rose and Arthur Cohen. The settlement provided for an affiliate of Rose to purchase the notes for the sum of $25,000,000 in cash, which was fully funded into escrow by Rose on February 25, 1994. The Company is also to receive the cash proceeds from approximately 1,100,000 shares of the Company's common stock owned by Rose which will be liquidated over a period of time. In addition, pursuant to the settlement, certain bankruptcy claims against PMI have been withdrawn (see Note 7). The settlement is subject to a claim on the entire amount of the proceeds by Financial Security Assurance, Inc. ("FSA"). A trial was held in the United States Bankruptcy Court for the Southern District of Florida in January 1994 to approve the settlement agreement and resolve FSA's claim on the settlement proceeds. The Company expects an order to be issued by that court in the near future, which may be subject to appeal. All proceeds received pursuant to the settlement must be held in escrow until such order is received. The Company believes that FSA is unlikely to prevail on its claim, and as a result, does not believe it will have a material impact on the financial statements. Upon receipt of a favorable order from the court, substantially all of the net proceeds will be used to retire debt (see Note 6). (c) The Company is the holder of mortgage notes receivable with a book value of $50,670,000 secured primarily by 11 hotel properties operated by the Company under management agreements and $14,653,000 in mortgages secured primarily by 4 properties operated under lease agreements. These notes currently bear interest at rates ranging from 8.5% to 14.0% and mature through 2003. The mortgages were primarily derived from the sales of hotel properties. Many of the 11 managed properties were unable to pay in full the annual debt service required under the terms of the original mortgages. The Company has restructured approximately $36,500,000 of these loans to pay based upon available cash and a participation in the future excess cash flow of such hotel properties. The restructurings generally include a "senior portion" featuring defined payment terms, and a "junior portion" payable annually based on cash flow. The junior portion represents the difference between the original mortgage and the new senior portion and provides the Company the opportunity to recover that difference if the hotel's performance improves. In addition to the junior portions of the restructured mortgages, the Company holds junior or other cash flow mortgages and subordinated interests in 19 other hotel properties operated by the Company under management agreements. The Company's consolidated balance sheets do not reflect any value related to the junior portion of the restructured notes or the junior mortgages and subordinated interests on the 19 other hotels as there is substantial doubt that the Company will recover any of their face value. During 1993, the Company recognized $976,000 of interest income related to these mortgages due to excess cash flow on certain properties attributable to decreased interest expense on variable rate borrowings senior to the Company's positions on these hotels. PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 AND 1992 (CONTINUED) (d) Other notes receivable currently bear interest at effective rates ranging from 4% to 11%, mature through 2011 and are secured primarily by hotel properties not currently managed by the Company. NOTE 4 -- PROPERTY, EQUIPMENT AND LEASEHOLD IMPROVEMENTS Property, equipment and leasehold improvements consist of the following (in thousands): At December 31, 1993, the Company was the lessor of land and certain restaurant facilities in Company-owned hotels with an approximate aggregate book value of $8,676,000 pursuant to noncancelable operating leases expiring on various dates through 2013. Minimum future rentals under such leases are $10,730,000, of which $3,939,000 is scheduled to be received in the aggregate during the five-year period ending December 31, 1998. Depreciation and amortization expense on property, equipment and leasehold improvements was $7,015,000 for the year ended December 31, 1993 and $2,784,000 for the five months ended December 31, 1992. NOTE 5 -- OTHER CURRENT LIABILITIES Other current liabilities consist of the following (in thousands): PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 AND 1992 (CONTINUED) NOTE 6 -- DEBT Debt consists of the following (in thousands): - --------------- (a) Pursuant to the Plan, the Company issued two classes of Secured Notes which are identified as "Senior Secured Notes" and "Junior Secured Notes". Senior Secured Notes were issued in two series of notes which are identified as the "8.20% Fixed Rate Senior Secured Notes" and the "Adjustable Rate Senior Secured Notes". Each series is identical except that the interest rate on the Adjustable Rate Senior Secured Notes will be periodically adjusted to one-half of one percent over the prime rate, with a maximum interest rate of 10.0% per annum. The aggregate principal amount of Senior Secured Notes issued under the Plan was $91,300,000, comprised of $30,100,000 of 8.20% Fixed Rate Senior Secured Notes and $61,200,000 of Adjustable Rate Senior Secured Notes. On August 11, 1992, the Company prepaid $17,900,000 of the 8.20% Fixed Rate Senior Secured Notes and $36,400,000 of the Adjustable Rate Senior Secured Notes from the proceeds of collections of portions of the collateral for the Senior Secured Notes. The other class of Secured Notes issued to satisfy claims was comprised of Junior Secured Notes that bear interest at a rate of 9.20% per annum and will mature on July 31, 2000. The aggregate principal amount of Junior Secured Notes issued under the Plan was approximately $70,000,000. The collateral for the Secured Notes consists primarily of mortgages and other notes receivable and real property, net of related liabilities, (the "Secured Note Collateral") with a book value of $104,790,000 as of December 31, 1993. Interest on the Secured Notes is payable semi-annually commencing January 31, 1993. The Secured Notes require that 85% of the cash proceeds from the Secured Note Collateral be applied first to interest, second to prepayment of the Senior Secured Notes and third to prepayment of the Junior Secured Notes. Any remaining principal balance of the Senior Secured Notes is due July 31, 1997. Aggregate principal payments on the Junior Secured Notes are required in order that one-third of the principal balance outstanding on December 31, 1996 is paid by July 31, 1998; two-thirds of the balance is paid by July 31, 1999; and all of the balance is paid by July 31, 2000. To the extent the cash proceeds from the Secured Note Collateral are insufficient to pay interest or required principal payments on the Secured Notes, the Company will be obligated to pay any deficiency out of its general corporate funds. The Secured Notes contain covenants which, among other things, require the Company to maintain a net worth of at least $100,000,000, limit expenditures related to the development of hotel properties through December 31, 1996 and preclude cash distributions to stockholders, including dividends and redemptions, until the Secured Notes have been paid in full. PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 AND 1992 (CONTINUED) During 1993, the Company repurchased $513,000 of its 8.2% Senior Secured Notes and $16,467,000 of its 9.2% Junior Secured Notes for an aggregate purchase price of $13,249,000. The Company recorded pre-tax extraordinary gains of $3,731,000 related to these repurchases. During the first quarter of 1994, the Company repurchased $6,527,000 of its Adjustable Rate Senior Secured Notes, $217,000 of its 8.20% Senior Secured Notes and $461,000 of its 9.20% Junior Secured Notes for an aggregate purchase price of $7,018,000. The repurchases resulted in pretax extraordinary gains of $187,000, which will be reflected in the Company's first quarter 1994 consolidated financial statements. These notes have been classified as long-term debt at December 31, 1993, in accordance with their terms, as repurchase was not contemplated at the balance sheet date. During the first quarter of 1994, the Company purchased through a third party agent approximately $5.2 million of its Senior Secured and Junior Secured Notes for aggregate consideration of $4.8 million. These notes are currently held by the third party agent and have not been retired due to certain restrictions under the note agreements. The purchases will be recorded as investments on the Company's balance sheet and no gain will be recorded on these transactions until the notes mature or are redeemed. (b) The Company has mortgage and other notes payable of approximately $66,039,000 that are secured by mortgage notes receivable and hotel properties with a book value of $104,324,000. Principal and interest on these mortgages and notes are generally paid monthly. At December 31, 1993 these notes bear interest at rates ranging from 4.68% to 10.5% and mature through 2008. At December 31, 1993, the Company has outstanding loans in the amount of $18,361,000 payable to ShoLodge, Inc. ("ShoLodge"), a company controlled by a director. The foregoing loans are secured by AmeriSuites hotel properties with an aggregate book value of $35,588,000. Interest is payable monthly at rates ranging from 8% (the prime rate plus 2%) to 9.5% (Note 9) and mature through April 1996. The Company has $11,665,000 of notes restructured under the Plan which bear interest at rates ranging from 8.00% to 9.50% per annum payable semi-annually. Prior to maturity, principal amounts outstanding will be paid semi-annually based on a thirty-year amortization schedule. Each note matures on July 31, 2002 and is secured by a lien on mortgage notes receivable and hotel properties with a book value of $11,074,000 at December 31, 1993. During 1993, the Company repurchased $8,828,000 of these notes for an aggregate purchase price of $5,799,000. The repurchase resulted in a pre-tax extraordinary gain of $3,030,000. The Company has other notes payable of $3,881,000, which bear interest at rates ranging from 8.0% to 8.2% and mature through 1999. (c) The Company has a fully-secured demand credit agreement which permits borrowing of up to $5,000,000 and bears interest at the prime rate plus 2%. This facility is supported by a certificate of deposit which is maintained by the bank. Maturities of long-term debt for the next five years ending December 31 are as follows (in thousands): PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 AND 1992 (CONTINUED) NOTE 7 -- LEASE COMMITMENTS AND CONTINGENCIES Leases The Company leases various hotels under lease agreements with initial terms expiring at various dates from 1994 through 2015. The Company has options to renew certain of the leases for periods ranging from 1 to 94 years. Rental payments are based on minimum rentals plus a percentage of the hotel properties' revenues in excess of stipulated amounts. The following is a schedule, by year, of future minimum lease payments required under the remaining operating leases that have terms in excess of one year as of December 31, 1993 (in thousands): Rental expense for all operating leases, including those with terms of less than one year, consist of the following for the year ended December 31, 1993 and the five months ended December 31, 1992 (in thousands): Employee Benefits The Company does not provide any material post employment benefits to its current or former employees. Contingent Claims As of March 1, 1994, unresolved bankruptcy claims of approximately $437,000,000 have been asserted against PMI. The Company has disputed substantially all of these unresolved claims and has filed objections to such claims. The Company believes that substantially all of these claims will be dismissed and disallowed. Any claims not disallowed will be satisfied through the distribution of the Company's common stock. In accordance with SOP 90-7, the consolidated financial statements have given full effect to the maximum distribution, pursuant to the Plan of the Company's common stock (see Note 10). The Company has responded to informal requests for information by the Staff of the United States Securities and Exchange Commission's Division of Enforcement relating to a number of the significant transactions of PMI, for the years 1985 through 1991. However, no formal allegations have been made by the Staff. In addition to the foregoing legal proceedings, the Company is involved in various other proceedings incidental to the normal course of its business. PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 AND 1992 (CONTINUED) The Company believes that the resolution of these contingencies will not have a material adverse effect on the Company's consolidated financial position or results of operations. Financial Instruments and Concentration of Credit Risk The Company's accounts receivable and mortgages and other notes receivable (see Note 3) are derived primarily from and are secured by hotel properties, which constitutes a concentration of credit risk. These notes are subject to many of the same risks as the Company's operating hotel assets. A significant portion of the collateral is located in the Northeastern and Southeastern United States. In addition to the hotel property related receivables referred to above, the Company's financial instruments include (i) assets; cash and cash equivalents and restricted cash investments and (ii) liabilities; trade and notes payable and long-term debt (see Note 6). As described in Note 1, in connection with the adoption of fresh start accounting as of July 31, 1992, the Company revalued its assets and liabilities at amounts approximating fair market value. Since there have been no substantive changes in market conditions since the date of the revaluation and on the basis of market quotes and experience on recent redemption offers for the Company's long-term debt, the Company believes that the carrying amount of these financial instruments approximated their fair market value as of December 31, 1993 and 1992. As a result of the reorganization proceedings and the rejection of certain leases, management contracts and other guarantees, the Company has no other material off-balance-sheet liabilities or credit risk as of December 31, 1993. NOTE 8 -- INCOME TAXES The provision for income taxes (including amounts applicable to extraordinary items) consisted of the following for the year ended December 31, 1993 and the five months ended December 31, 1992 (in thousands): Income taxes are provided at the applicable federal and state statutory rates. PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 AND 1992 (CONTINUED) The tax effects of the temporary differences in the areas listed below resulted in deferred income tax provisions for the year ended December 31, 1993 and the five months ended December 31, 1992 (in thousands): At December 31, 1993, the Company had available federal net operating loss carryforwards of approximately $121,000,000 which will expire beginning in 2005 and continuing through 2008. Of this amount, $114,000,000 is subject to an annual limitation of $8,735,000 under the Internal Revenue Code due to a change in ownership of the Company upon consummation of the Plan. The Company also has potential state income tax benefits relating to net operating loss carryforwards of approximately $9,900,000 which will expire during various periods from 1995 to 2006. Certain of these potential benefits are subject to annual limitations similar to federal requirements due to a change in ownership. The utilization is further dependent on such factors as the level of business conducted in each state and the amount of income subject to tax within each state's carryforward period. In accordance with FAS 109, the Company has not recognized the future tax benefits associated with the net operating loss carryforwards or with other temporary differences. Accordingly, the Company has provided a valuation allowance of approximately $42,000,000 against the deferred tax asset as of December 31, 1993. To the extent any available carryforwards or other tax benefits are utilized, the amount of tax benefit realized will be treated as contribution to stockholders' equity and will have no effect on the income tax provision for financial reporting purposes. For the year ended December 31, 1993 and the five months ended December 31, 1992, the Company recognized $4,525,000 and $789,000, respectively, of such tax benefits as a contribution to stockholders' equity. The Company's federal income tax returns for the years 1987 through 1991 were examined by the Internal Revenue Service. The Company received a $17,700,000 federal income tax refund, including interest relating to its predecessor, PMI. In accordance with SOP 90-7, the Company recorded the tax refund and the interest related to its predecessor as a contribution to additional paid in capital ($16,462,000). The remaining amount of $1,238,000, which represents interest since July 31, 1992, is included in other income in the accompanying financial statements. PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 AND 1992 (CONTINUED) NOTE 9 -- RELATED PARTY TRANSACTIONS The following summarizes significant financial information with respect to transactions with present and former officers, directors, their relatives and certain entities they control or in which they have a beneficial interest for the year ended December 31, 1993 and the five months ended December 31, 1992 (in thousands): - ------------ (a) The Company manages 12 hotels for partnerships in which a related party owns various interests. The income amounts shown above primarily include transactions related to these hotel properties. (b) In 1991, PMI entered into an agreement (the "Development Agreement") with ShoLodge, whereby ShoLodge was appointed the exclusive agent to develop and manage certain hotel properties. The Company has loans payable to ShoLodge of $18,361,000 at December 31, 1993 related to the development of Hotels (see Note 6). In January 1993, the Company and its wholly-owned subsidiary, Suites of America, Inc. ("SOA") entered into agreements with ShoLodge designed to enhance the growth of its AmeriSuites hotel chain from the six hotels owned at that time by adding an additional six hotels to be built and financed by ShoLodge. ShoLodge has completed development of three hotels, two of which the Company has acquired subject to mortgages with ShoLodge. In addition, ShoLodge has three hotels currently under construction. Upon completion of the new hotels and the exercise of an option by either ShoLodge or the Company, ShoLodge will contribute its fee or mortgage interests on six hotels to SOA and will own a 50% interest in SOA. Upon exercise of this option, the Development Agreement will terminate and ShoLodge will manage all 12 hotels in SOA pursuant to a new management agreement. The Company will retain ownership of the AmeriSuites brand name and all rights to license and develop the name for its own account. In conjunction with the agreement, ShoLodge has also relinquished its profit sharing interests of $2,862,000 on the initial six hotels for cash and the cancellation of a note receivable. The Company uses the ShoLodge reservation system for its Wellesley and AmeriSuites hotel properties. NOTE 10 -- COMMON STOCK AND COMMON STOCK EQUIVALENTS Pursuant to the Plan, on July 31, 1992 the Company began distributing shares of common stock to certain claimants and holders of PMI stock. The Plan provided for issuance of 33,000,000 shares of common stock and as of March 10, 1994, 29,124,324 shares of common stock were distributed. The remaining shares are to be distributed semi-annually to holders of previously allowed claims and pending final resolution of disputed claims (see Note 7). The consolidated financial statements have given full effect to the issuance of the maximum amount of 33,000,000 shares under the Plan. The number of shares ultimately distributed under the Plan could be less than 33,000,000 depending on the final outcome of the disputed claims. In addition to the shares distributed under the Plan, warrants to purchase 2,100,000 shares of the Company's common stock were issued to former shareholders of the Company's predecessor, PMI, in partial settlement of their bankruptcy interests. The warrants became exercisable on August 31, 1993 at an exercise price of $2.71 per share. The exercise price was determined from the average per share daily closing price of the Company's PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 AND 1992 (CONTINUED) common stock during the year following its reorganization on July 31, 1992. As of December 31, 1993, 45,880 shares have been exercised. On July 31, 1992, the Company adopted various stock option and performance incentive plans under which options to purchase up to 1,320,000 shares of common stock may be granted to directors, officers or key employees under terms determined by the Board of Directors. During 1993 and 1992, options to purchase 20,000 and 350,000 shares, respectively, were granted to officers and directors, 130,000 of which are exercisable at December 31, 1993. In addition, options to purchase 330,000 shares were granted to a former officer in 1992. Such options are currently exercisable and expire on July 31, 1995. During 1993, 30,000 of these options were exercised. The exercise prices of the above options are based on the average market price one year from the date of grant and have been determined to be $2.71 per share. Based on this exercise price, the amount of compensation expense attributable to these options was $225,000 for the year ended December 31, 1993. In June 1993, options to purchase 393,000 shares of common stock were granted to employees under the Company's stock option plan. The options were granted at $3.625, which approximates the fair market value at the date of grant. Generally, options can be exercised during a participant's employment with the Company in equal annual installments over a three-year period and expire six years after the date of grant. In August 1993, options to purchase 315,000 shares of common stock were granted to the members of the Company's Board of Directors. The options were granted at $3.20, which approximates the fair market value at the date of grant. One-third of these options became exercisable at the date of grant and the remaining options can be exercised in equal annual installments over a two year period. The options expire six years after the date of grant. Summary of the stock option plans are as follows: PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 AND 1992 (CONTINUED) NOTE 11 -- TRANSITION PERIOD FINANCIAL INFORMATION (UNAUDITED) Following the Effective Date, the Company elected to change its fiscal year end from June 30 to December 31. As described in Note 1, financial statements for periods prior to the Effective Date have been prepared on a different basis of accounting and are thus not comparable. Selected financial information for the six months ended December 31, 1992 and 1991, prepared on a pro-forma basis as if the Plan became effective on June 30, 1991, are as follows (in thousands, except per share amounts): NOTE 12 -- SUPPLEMENTAL CASH FLOW INFORMATION The following summarizes non-cash investing and financing activities for the year ended December 31, 1993 and the five months ended December 31, 1992 (in thousands): Cash paid for interest was $16,347,000 for the year ended December 31, 1993 and $2,981,000 for the five months ended December 31, 1992. Cash paid for income taxes was $2,697,000 for the year ended December 31, 1993 and $0 for the five months ended December 31, 1992. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Board of Directors and Stockholders of Prime Hospitality Corp.: We have audited the accompanying consolidated balance sheet of Prime Hospitality Corp. (a Delaware corporation) and subsidiaries ("the Company") as of July 31, 1992 and the related consolidated statements of operations, stockholders' equity and cash flows for the one month then ended. 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 audit. We conducted our audit 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 audit provides a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Prime Hospitality Corp. and subsidiaries as of July 31, 1992 and the results of their operations and their cash flows for the one month then ended in conformity with generally accepted accounting principles. As discussed in Note 8, the Company held an investment in a mortgage note receivable from certain entities with a face value of $100,890,000 that is valued at $25,000,000 at July 31, 1992. The realization of this investment is dependent primarily on the ability of the Company to recover such amount pursuant to the personal guarantees provided by two individuals who control the entities that are the obligors under the mortgage note and own the hotel properties that serve as the underlying collateral for the note. The Company has commenced a legal action to recover pursuant to such guarantees; however, the financial statements do not include any adjustments that might result from the outcome of this matter. Our audit was made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed in the index to financial statements and financial statement schedules are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. The schedules have been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN & CO. Roseland, New Jersey March 10, 1993 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Board of Directors and Stockholders of Prime Motor Inns, Inc. (Debtor-in-Possession) We have audited the consolidated balance sheet of Prime Motor Inns, Inc. and Subsidiaries (Debtors-in-Possession) as of June 30, 1992, and the related consolidated statements of operations, stockholders' equity (deficiency) and cash flows for the years ended June 30, 1992 and 1991. In connection with our audits of the consolidated financial statements, we also have audited the accompanying financial statement schedules for the years ended June 30, 1992 and 1991. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules 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 financial statements referred to above present fairly, in all material respects, the consolidated financial position of Prime Motor Inns, Inc. and Subsidiaries (Debtors-in-Possession) as of June 30, 1992, and their results of operations and cash flows for the years ended June 30, 1992 and 1991, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein for the years ended June 30, 1992 and 1991. As discussed in Note 8, the Company held an investment in a mortgage note receivable from certain entities with a face value of $100,890,000 that had been written down to $30,000,000 at June 30, 1992. The realization of the carrying value is dependent primarily on the ability of the Company to recover such amount pursuant to the personal guarantees provided by the two individuals who control the entities that are the obligors under the mortgage note and the owners of the hotel properties that serve as the underlying collateral for the loan. The Company has commenced a legal action to recover pursuant to such guarantees; however, the outcome of this action is not presently determinable. As discussed in Note 12, the Company has reflected pre-petition and certain post-petition claims in the consolidated balance sheet as of June 30, 1992 as liabilities subject to compromise based on its estimate of the aggregate amount that will ultimately be allowable for settlement upon consummation of the plan of reorganization; however, the aggregate amount claimed by creditors is substantially in excess of the liability recorded by the Company. The actual aggregate amount of allowable pre and post-petition claims cannot presently be determined. As discussed in Note 15, the Company and certain of its present and former officers and directors are defendants in certain consolidated class action complaints alleging federal securities law violations and other claims. The ultimate outcome of such litigation cannot presently be determined. The eventual outcome of the matters discussed in the three preceding paragraphs is not presently determinable and the consolidated financial statements as of June 30, 1992 and for the years ended June 30, 1992 and 1991 do not include any adjustments relating to the resolution of those uncertainties. As discussed in Note 2, the Company's plan of reorganization became effective on July 31, 1992, and it will implement the guidance as to the accounting for entities emerging from Chapter 11 set forth in Statement of Position 90-7, "Financial Reporting by Entities in Reorganization under the Bankruptcy Code" ("Fresh Start Reporting") as of that date. The Company has not presently determined the amounts that will be recorded under Fresh Start Reporting. However, the implementation of Fresh Start Reporting as a result of the Company's emergence from Chapter 11 will materially change the amounts reported in consolidated financial statements as of and for periods ending subsequent to July 31, 1992. As a result of the reorganization and the implementation of Fresh Start Reporting, assets and liabilities will be recorded at fair values and outstanding obligations relating to the claims of creditors will be discharged primarily in exchange for cash, new indebtedness and equity. The accompanying consolidated financial statements as of June 30, 1992 and for the years ended June 30, 1992 and 1991 do not give effect to any adjustments that will be made as a result of the Company's reorganization and emergence from Chapter 11. J.H. COHN & CO. Roseland, New Jersey September 24, 1992 PRIME HOSPITALITY CORP. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE DATA) FRESH START REPORTING WAS IMPLEMENTED AND THE PURCHASE METHOD OF ACCOUNTING WAS APPLIED TO RECORD THE FAIR VALUE OF ASSETS AND ASSUMED LIABILITIES OF THE REORGANIZED COMPANY AT JULY 31, 1992. ACCORDINGLY, THE ACCOMPANYING BALANCE SHEET AS OF JULY 31, 1992 IS NOT COMPARABLE IN ALL MATERIAL RESPECTS TO SUCH STATEMENT AS OF ANY DATE PRIOR TO JULY 31, 1992 SINCE THE BALANCE SHEET IS THAT OF A NEW ENTITY. See Accompanying Notes to Consolidated Financial Statements. PRIME HOSPITALITY CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) See Accompanying Notes to Consolidated Financial Statements. PRIME HOSPITALITY CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIENCY) (IN THOUSANDS, EXCEPT SHARE DATA) See Accompanying Notes to Consolidated Financial Statements. PRIME HOSPITALITY CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) See Accompanying Notes to Consolidated Financial Statements. PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JULY 31, 1992 AND JUNE 30, 1992 AND 1991 NOTE 1 -- REORGANIZATION AND EMERGENCE FROM CHAPTER 11 Prime Hospitality Corp. became the successor corporation to Prime Motor Inns, Inc. on July 31, 1992. As used herein, the "Company" refers to Prime Hospitality Corp. and subsidiaries, "PMI" refers to Prime Motor Inns, Inc. and subsidiaries and "Prime Motor Inns" refers to Prime Motor Inns, Inc., the parent company only. The accompanying consolidated financial statements and notes thereto reflect the activities of the Company as of and subsequent to July 31, 1992 and PMI prior to July 31, 1992. On September 18, 1990, Prime Motor Inns (predecessor to and former parent of the Company) and fifty of its subsidiaries (together with Prime Motor Inns, the "Debtors") filed voluntary petitions under title 11 of the United States Code ("Chapter 11") in the United States Bankruptcy Court, Southern District of Florida, Miami Division (the "Bankruptcy Court") and began operating as Debtors-In-Possession. On September 23, 1991, the Debtors filed their Joint Plan of Reorganization. The Debtors filed their Disclosure Statement for Debtors' Amended Joint Plan of Reorganization and their Amended Joint Plan of Reorganization on November 15, 1991. These plans and the disclosure statement were further amended and restated by the Disclosure Statement and the Second Amended Joint Plan of Reorganization of the Debtors dated January 16, 1992 (the "Plan"). The Plan was confirmed by the Bankruptcy Court on April 6, 1992. On July 31, 1992 (the "Effective Date"), the Debtors consummated the Plan and emerged from bankruptcy. On the Effective Date, Prime Motor Inns merged with and into the Company, which had been a wholly-owned subsidiary of Prime Motor Inns. The Company was the surviving corporation in the merger. In addition, certain of the Debtors and other subsidiaries of Prime Motor Inns that did not file petitions under Chapter 11 merged, consolidated or contributed substantially all of their assets to the Company or subsidiaries of the Company. On the Effective Date, the Company assumed the obligations of each combining Debtor under the Plan. The Company has distributed Secured Notes and Restructured Notes and is in the process of distributing cash, Tax Notes, Common Stock and Warrants in settlement of pre-petition claims and interests as such claims and interests are processed and settled. The American Institute of Certified Public Accountants has issued Statement of Position 90-7, "Financial Reporting by Entities in Reorganization Under the Bankruptcy Code" ("SOP 90-7"), which provides guidance for financial reporting by Chapter 11 debtors during and following their Chapter 11 cases. The accompanying historical consolidated financial statements of PMI for the period from September 18, 1990 to the Effective Date have been prepared in accordance with SOP 90-7 on the following basis: - Liabilities subject to compromise are segregated. - Transactions and events directly associated with the reorganization proceedings are reported separately. - Interest expense is reported only to the extent it will be paid. Also pursuant to SOP 90-7, the Company implemented Fresh Start Reporting (hereinafter defined) upon the emergence of the Debtors from bankruptcy as of the Effective Date (see Note 2). NOTE 2 -- FRESH START REPORTING SOP 90-7 provides for the implementation of Fresh Start Reporting upon the emergence of debtors from bankruptcy if the reorganization value (the approximate fair value) of the assets of the emerging entity immediately prior to emergence is less than the total of all post-petition liabilities and allowed pre-petition claims, and if the holders of existing voting shares immediately before the emergence from bankruptcy receive less than 50% of the voting shares of the emerging entity. A Fresh Start balance sheet reflects assets at their PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JULY 31, 1992 AND JUNE 30, 1992 AND 1991 (CONTINUED) estimated fair value upon the emergence from bankruptcy and liabilities, other than deferred taxes, at the present value of amounts to be paid determined at appropriate current interest rates. The Company met the criteria for implementation of, and implemented Fresh Start Reporting as of the Effective Date. Under Fresh Start Reporting, the consolidated balance sheet as of July 31, 1992 became the opening consolidated balance sheet of the Company. Since Fresh Start Reporting has been reflected in the accompanying consolidated balance sheet as of July 31, 1992, this consolidated balance sheet is not comparable in all material respects to any such financial statements as of any prior date or for any period prior to July 31, 1992, since the consolidated balance sheet as of July 31, 1992 is that of a new entity. The estimated reorganization value (the approximate fair value) of the assets of the emerging entity was determined by consideration of many factors and various valuation methods, including discounted cash flows and price/earnings and other applicable ratios believed by management to be representative of the Company's business and industry. Reorganization liabilities, consisting of Tax Notes, Restructured and Reinstated Notes, Senior Secured Notes and Junior Secured Notes distributed as of the Effective Date, have been recorded based on face values, which approximate the present values of amounts to be paid determined at appropriate current interest rates. Common Stock has been valued at the excess of the fair value of identifiable assets of the Company over the present value of liabilities. Other current liabilities, consisting of those arising from post-petition operating and other expenses not paid as of the Effective Date and obligations arising from certain loans to finance construction, will be paid in full under their original terms and have been presented in the following balance sheet at their historical carrying values. PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JULY 31, 1992 AND JUNE 30, 1992 AND 1991 (CONTINUED) The effects of consummating the Plan and implementing Fresh Start Reporting are set forth on PMI's historical consolidated balance sheet as of July 31, 1992 as follows: CONSOLIDATED FRESH START BALANCE SHEET AS OF JULY 31, 1992 (IN THOUSANDS, EXCEPT SHARE DATA) PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JULY 31, 1992 AND JUNE 30, 1992 AND 1991 (CONTINUED) CONSOLIDATED FRESH START BALANCE SHEET AS OF JULY 31, 1992 (IN THOUSANDS, EXCEPT SHARE DATA) PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JULY 31, 1992 AND JUNE 30, 1992 AND 1991 (CONTINUED) NOTES TO CONSOLIDATED FRESH START BALANCE SHEET (a) Reflects cash payments of $38,800,000 to creditors on or after the Effective Date in accordance with the terms of the Plan. (b) Represents mortgage notes, other notes receivable and property, which are offset against creditor claims on the Effective Date in accordance with the terms of the Plan. (c) Represents long-term debt in the principal amount of $257,300,000 distributed to creditors on or after the Effective Date in accordance with the terms of the Plan and the recognition of $6,500,000 of related gain on discharge of indebtedness. As part of the Plan, the Company distributed approximately $1,400,000 of Tax Notes, approximately $94,600,000 of Restructured and Reinstated Notes, approximately $91,300,000 of Senior Secured Notes and approximately $70,000,000 of Junior Secured Notes. Additionally, approximately $15,000,000 of construction financing related to hotel property development outstanding prior to consummation will be paid based on original terms. (d) Represents 32,300,000 shares of Common Stock with an estimated fair value of $132,800,000, which will be distributed to creditors on or after the Effective Date in accordance with the terms of the Plan and the recognition of $249,600,000 of related gain on discharge of indebtedness. (e) Represents 700,000 shares of Common Stock with an estimated fair value of $2,800,000, which was exchanged for all of the shares of Prime's old common stock outstanding on the Effective Date. (f) Represents adjustments to: record at fair value operating property, equipment and leasehold improvements, certain mortgages and other notes receivable and certain other assets and related liabilities; eliminate deferred income; and eliminate accumulated deficit in accordance with the provisions of SOP 90-7 for Fresh Start Reporting. The gain on discharge of indebtedness of $249,600,000 has been presented as an "Extraordinary Item" in the accompanying consolidated statement of operations for the one month ended July 31, 1992. NOTE 3 -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES A summary of the significant accounting policies used by the Company and PMI in the preparation of the accompanying consolidated financial statements follows: Business activities The Company focuses on three types of business activities: operation of owned and leased hotel properties; management services provided to hotel properties owned by third parties; and management of its portfolio of mortgages, notes and other financial assets. The Company retains all the revenues and pays all the expenses with respect to the owned and leased hotel properties. The Company derives management fees from the hotel properties it manages based on a fixed percentage of gross revenues, fees for services rendered and performance-related incentive payments. The Company's portfolio of mortgages, notes and other assets primarily are associated with hotel properties currently managed or formerly owned by the Company and PMI. The majority of the Company's hotel properties are moderately priced hotels comprised of 100 to 150 rooms primarily located in the Northeast and Florida, which are designed to attract business and leisure travelers desiring quality accommodations at affordable prices. The Company operates or manages many of the restaurants and cocktail lounges at its full service hotels. Its limited service hotels, such as Wellesley Inns and AmeriSuite hotels, generally do not have restaurants or cocktail lounges. PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JULY 31, 1992 AND JUNE 30, 1992 AND 1991 (CONTINUED) Most of the hotel properties are operated or managed by the Company in accordance with franchise agreements with national hotel chains, including Howard Johnson, Ramada, Marriott, Holiday Inn, Sheraton, Days Inn and Radisson. Additionally, the Company operates or manages the Wellesley hotel properties under its trademark "Wellesley Inns." The Company owns the trademark "AmeriSuites", and all of these hotel properties are managed for the Company by a related party. Principles of consolidation The consolidated financial statements include the accounts of the Company and PMI and all of their majority-owned subsidiaries. All material intercompany accounts and transactions have been eliminated in consolidation. Cash equivalents Cash equivalents are highly liquid unrestricted investments with a maturity of three months or less when acquired. Restricted cash Restricted cash consists primarily of highly liquid investments that serve as collateral for debt obligations included in liabilities subject to compromise and is classified as either short-term or long-term depending on the date the obligation is due. Mortgages and other notes receivable Mortgages and other notes receivable are reflected at the lower of face or market value at July 31, 1992. Generally, the carrying amount of the portfolio of mortgages and other notes receivable is reduced through write-offs and by maintaining an aggregate loan valuation reserve at a level that, in the opinion of management, is adequate to absorb potential losses in the portfolio. To determine the appropriate level for the loan valuation reserve, management evaluates various factors including: general and regional economic conditions; the credit worthiness of the borrower; the nature and level of any delinquencies in the payment of principal or interest; and the adequacy of the collateral. Interest on delinquent loans (including impaired loans that have required writedowns or specific reserves) is only recognized when cash is received. The amount of interest income recognized on mortgages and other notes receivable is generally based on the loan's effective interest rate and adjusted carrying value of the note. Property, equipment and leasehold improvements Property, equipment and leasehold improvements that the Company intends to continue to operate are stated at cost less accumulated depreciation and amortization at June 30, 1992 and 1991 and at fair market value as of July 31, 1992. Provision is made for depreciation and amortization using the straightline method over the estimated useful lives of the assets. The Company intends to sell or otherwise dispose of those remaining operating and non-operating properties that have generated losses or insufficient returns on investment. Properties identified for disposal are stated at their estimated net realizable value through valuation reserves or writedowns. Income recognition on property sales and deferred income Income is generally recognized when properties used in the hotel business are sold. However, income is deferred and recognized under installment or other appropriate methods when collectibility of the sales price is PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JULY 31, 1992 AND JUNE 30, 1992 AND 1991 (CONTINUED) not reasonably assured or other criteria for immediate profit recognition under generally accepted accounting principles are not satisfied. Gains from sales of properties under sale and leaseback transactions that are generally deferred pursuant to applicable accounting rules are amortized over the lives of the related leases. Gains from sales of properties and certain other assets acquired through business combinations accounted for as purchases are generally offset against the carrying value of the remaining purchased assets if the sale takes place within the allocation period (generally a period of one year or less) following the purchase. Construction income recognition and deferred income Revenues under long-term construction contracts are generally recognized under the percentage-of-completion method and include a portion of the earnings expected to be realized on the contract in the ratio of costs incurred to estimated total costs. Under certain circumstances, the recognition of income is deferred until continuing involvement, in the form of operating guarantees made to the owners of the hotel property subject to the contract, has expired. Income taxes The Company and its subsidiaries file a consolidated Federal income tax return. PMI adopted Financial Accounting Standards Board Statement of Financial Accounting Standards No. 109 ("FAS 109"), "Accounting for Income Taxes, "by applying FAS 109 to its consolidated financial statements commencing July 1, 1991. PMI used the "deferred method" of accounting for income taxes through June 30, 1991. Adoption of FAS 109 did not have a material effect on the consolidated financial statements. Deferred taxes have not been provided as of July 31, 1992 and June 30, 1992 due to the availability of significant net operating loss carryforwards and the uncertainty surrounding the ultimate realization of the future benefits, if any, to be derived from the temporary differences between the financial reporting basis and the tax basis of assets and liabilities. Income (loss) per common share Primary net income (loss) per common share is computed based on the weighted-average number of common shares and common share equivalents (stock options) outstanding during each year. The weighted-average number of common shares and common share equivalents used in computing primary net income (loss) per share was 33,028,000 for the month ended July 31, 1992 and the years ended June 30, 1992 and 1991. Fully diluted net income (loss) per common share includes, when dilutive, the effects of the elimination of interest expense and the issuance of additional common shares from the assumed conversion of the 6 5/8% convertible subordinated debentures due 2011 and the 7% convertible subordinated debentures due 2013 (collectively, the "Debentures"). The Debentures are included in the consolidated balance sheets as of June 30, 1992 and 1991 as liabilities subject to compromise. The effects of assuming the conversion of the Debentures were not dilutive in each of the two years in the period ended June 30, 1992, and for the one month ended July 31, 1992. Reclassifications Certain reclassifications have been made to the consolidated financial statements to conform them to the July 31, 1992 classifications. NOTE 4 -- ACQUISITIONS AND DISPOSITIONS In December 1989, PMI consummated its agreement with New World Development Co. Ltd. ("New World") to participate with and assist New World in its acquisition of the hotel business of Ramada, Inc. PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JULY 31, 1992 AND JUNE 30, 1992 AND 1991 (CONTINUED) ("Ramada"). Under the agreement, PMI loaned approximately $58,000,000 to New World (see Note 8) and acquired certain real estate, notes receivable, the Rodeway International Franchise System ("Rodeway") and certain other assets, and assumed certain liabilities, for aggregate cash consideration of approximately $54,000,000 plus closing adjustments. Such assets were sold in fiscal 1991 (see Note 5). PMI entered into a license agreement to operate the domestic Ramada franchise system and agreed to indemnify New World for certain potential tax liabilities associated with the license. The potential tax liabilities to New World, and all other claims by New World and PMI against each other, were settled on August 4, 1992 (see Note 8). NOTE 5 -- DISCONTINUED OPERATIONS On July 2, 1990, PMI consummated the sale of its Howard Johnson and Ramada franchise businesses (the "franchise segment") to an affiliate of Blackstone Capital Partners, L.P. for $170,000,000 in cash. On July 5, 1990, PMI sold its Rodeway franchise business and two Rodeway hotel properties to Manor Care, Inc. for $14,900,000 in cash. As a result, PMI effectively discontinued the operations of its franchise segment as of July 1, 1990. The gain on sale of the discontinued segment has been shown separately in the accompanying 1991 consolidated statement of operations, net of the related state income tax provision. NOTE 6 -- CASH AND CASH EQUIVALENTS Cash and cash equivalents are comprised of the following (in thousands): NOTE 7 -- RESTRICTED CASH -- LONG TERM Restricted cash consists of cash in bank of $360,000 and commercial paper of $872,000 at July 31, 1992. At June 30, 1992, restricted cash consists primarily of commercial paper of $43,947,000. NOTE 8 -- MORTGAGES AND OTHER NOTES RECEIVABLE Mortgages and other notes receivable are comprised of the following and are stated at face value, net of writedowns and valuation reserves as of June 30, 1992. As of July 31, 1992, these assets have been valued at their fair market value (in thousands): PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JULY 31, 1992 AND JUNE 30, 1992 AND 1991 (CONTINUED) - --------------- (a) The mortgage notes are secured by the Frenchman's Reef resort hotel, which is managed by the Company, and consist of first and second mortgages with face values of $53,383,000 and $25,613,000, respectively, with final scheduled principal payments of $51,976,000 and $25,613,000 due on July 31, 1995. The notes bear interest at a stated rate of 13%. Interest and principal payments on the first mortgage are payable in monthly installments. Interest and scheduled principal payments on the second mortgage note are payable only to the extent of available cash flow, as defined, with any unpaid interest due at maturity. Based on a valuation of the property, PMI wrote down the second mortgage to $11,400,000 as of June 30, 1990 and discontinued the accrual of interest. As a result of the continuing decline in economic conditions and operating cash flows, the balance of the second mortgage was written off in fiscal 1992. In connection with the adoption of Fresh Start Reporting at July 31, 1992, the Company has valued these notes at $50,000,000. During the one month ended July 31, 1992, the Company recognized $345,000 of interest income on these notes (an effective rate of approximately 8.3%), based on the current levels of cash flows generated from the property available to service the notes. The Company is in the process of renegotiating the terms of these notes based on the current level of cash flow generated by the property. (b) From 1988 through 1990, PMI loaned entities controlled by Allan Rose and Arthur Cohen (the "Rose and Cohen entities"), who at such time were significant Howard Johnson franchisees, an aggregate of $100,890,000 fully secured initially by property and/or personal guarantees. PMI was committed to make additional loans, also on a fully secured basis, to the Rose and Cohen entities of up to an aggregate of $130,000,000 if values of, and/or revenues generated by, certain hotel properties controlled by the Rose and Cohen entities attained specified levels. PMI was to receive a minimum annual return of 10% on all loans made to the Rose and Cohen entities and a maximum return of 20%. All loans and unpaid interest are payable on December 31, 1997. Due to the decline in value of the hotel properties pledged as collateral for the loan and the continuing decline in the hotel real estate market, PMI discontinued funding additional loans in fiscal 1990. Further, based on PMI's estimate of the value of the collateral and the personal guarantees of Rose and Cohen and discussions related to the possible early payment of the loan, PMI wrote down the loan to $50,000,000 as of June 30, 1990 and discontinued the accrual of interest. In 1992, certain of the Rose and Cohen entities owning a portion of the collateral that secures the loans filed for Chapter 11 protection in the United States Bankruptcy Court, Southern District of New York. Also during 1992, the Company commenced an adversary proceeding against Rose and Cohen. The complaint seeks to recover jointly and severally on the personal guarantees of $50,000,000 given by Rose and Cohen as part of the loan agreement. As a result of further evaluation of the collateral and the personal guarantees, PMI wrote down the loan to $30,000,000 as of June 30, 1992 and $25,000,000 as of July 31, 1992. (c) In April 1989, PMI loaned FCD Hospitality, Inc. ("FCD"), an unaffiliated company, approximately $74,000,000 in cash for the purpose of financing FCD's acquisition of the outstanding common stock of Servico, Inc. ("Servico"), an operator of hotels. The loan was secured by the common stock of Servico, FCD and certain FCD affiliates, and was originally due prior to June 30, 1990. Interest was due at the prime rate plus 1%. PMI also entered into an agreement with FCD pursuant to which PMI would provide management consulting services for approximately $63,000,000 through June 1990. Additionally, in April 1989, PMI purchased approximately $80,000,000 of Servico's outstanding 12 1/4% subordinated notes due April 15, 1997 for approximately $64,000,000 (80% of par value). PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JULY 31, 1992 AND JUNE 30, 1992 AND 1991 (CONTINUED) Subsequent to April 1989, PMI entered into certain other transactions including working capital loans and the sale of certain hotels to Servico. Servico also pledged a substantial portion of its hotel properties and mortgage notes receivable on hotel properties as collateral and/or in satisfaction of its commitments on the loan to FCD and the consulting agreement. On September 18, 1990, Servico and certain of its subsidiaries filed for Chapter 11 protection. After an extensive valuation and recovery analysis performed by PMI and Servico, PMI agreed to settle all claims and disputes with Servico and FCD in June 1991. Under the terms of the agreement, which was approved by the Bankruptcy Court, the FCD loan, the subordinated notes, loans related to sales of properties and working capital and all accrued interest relating to these notes and loans with a face value of $166,210,000 were forgiven. As part of the settlement, PMI retained ownership of certain mortgage notes receivable with a face value of approximately $30,000,000 that are secured by three hotel properties. The entity that owns one of the properties filed a voluntary petition under Chapter 11 of the United States Bankruptcy Code in December 1990. Subsequent to July 31, 1992, the Company has restructured the note receivable to receive payments based on the property's available cash flow. Based on the valuation of the mortgage notes on the three properties, PMI wrote down the FCD Loan and Servico notes to $16,757,000 as of June 30, 1990 and discontinued the accrual of interest. In connection with the adoption of Fresh Start Reporting, the Company has valued the notes at $19,756,000 at July 31, 1992. (d) In connection with the Ramada acquisition in December 1989, PMI agreed to loan New World $58,000,000 (see Note 4). Interest was payable quarterly at a rate of 11%. Principal was to be paid in installments beginning in 1995 with a final scheduled payment of $55,499,000 due on March 31, 2005. On August 4, 1992, after extensive negotiation and approval of a settlement by the Bankruptcy Court, the Company collected net proceeds of $42,000,000 plus accrued interest in full satisfaction of the $58,000,000 loan balance offset by liabilities subject to compromise related to the Ramada acquisition with a net carrying value of $16,000,000. The net proceeds were used to prepay a portion of the Senior Secured Notes issued on the Effective Date. (e) At July 31, 1992, the Company held mortgages and other notes receivable secured by 33 hotel properties operated by the Company under management or lease agreements. These notes currently bear interest at rates ranging from 8.5% to 14% and mature through 2014. The mortgages were primarily derived from the sales of hotel properties. Many of these properties had been unable to pay in full the annual debt service required under the terms of the original mortgages. The Company has restructured $33,530,000 of these mortgages to receive the majority of available cash and to receive a participation in the future excess cash flow of such hotel properties. The Company is also in process of restructuring another $9,500,000 of these mortgages. (f) Other notes receivable bear interest at effective rates ranging from 8% to 12%, mature through 2001 and are secured primarily by hotel properties. PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JULY 31, 1992 AND JUNE 30, 1992 AND 1991 (CONTINUED) NOTE 9 -- PROPERTY, EQUIPMENT AND LEASEHOLD IMPROVEMENTS Property, equipment and leasehold improvements consist of the following and are stated at cost (other than properties held for sale) at June 30, 1992 and at fair market value as of July 31, 1992 (in thousands): At July 31, 1992, the Company was the lessor of land and certain restaurant facilities in Company-owned hotels with an approximate aggregate book value of $12,338,000 pursuant to noncancelable operating leases expiring on various dates through 2013. Minimum future rentals under such leases are $8,095,000, of which $3,449,000 is to be received during the five year period ending June 30, 1997. Depreciation and amortization expense on property, equipment and leasehold improvements was $569,000, $6,867,000 and $7,867,000, for the one month ended July 31, 1992 and for the years ended June 30, 1992 and 1991, respectively. Capitalized interest was $0, $139,000 and $1,000,000 for the one month ended July 31, 1992 and for the years ended June 30, 1992 and 1991, respectively. PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JULY 31, 1992 AND JUNE 30, 1992 AND 1991 (CONTINUED) NOTE 10 -- OTHER CURRENT LIABILITIES Other current liabilities consist of obligations for the following (in thousands): NOTE 11 -- NOTES PAYABLE Notes payable consist of the following (in thousands): - --------------- (a) Notes payable to related party are payable to ShoLodge, Inc. ("ShoLodge"), a company controlled by a director. The notes are secured by three hotel properties with a book value of $17,354,000 that were constructed in 1992 and 1991. Interest is payable monthly at variable rates ranging from the prime interest rate (6% at July 31, 1992) plus 1% to the prime rate plus 2%. One promissory note for $3,000,000 is due in May 1993 and the remainder is due on demand (see Note 22). (b) Other notes payable are secured by a hotel property. Interest is payable at the prime rate plus 2%. The notes are due in May 1993. NOTE 12 -- LIABILITIES SUBJECT TO COMPROMISE As a result of the Chapter 11 filing (see Note 1), enforcement of certain unsecured claims against the Debtors in existence prior to the petition date were stayed while the Debtors continued business operations as debtors-in-possession. These claims are reflected in the accompanying consolidated balance sheets as of June 30, 1992, as liabilities subject to compromise. Additional unsecured claims classified as liabilities subject to compromise arose subsequent to the Petition Date resulting from rejection of executory contracts, including lease, management and franchise agreements, and from the determination by the Bankruptcy Court (or agreements by the parties in interest) to allow claims for contingencies and other disputed amounts. Enforcement of claims secured against the Debtors' assets ("secured claims") were also stayed although the holders of such claims have the right to move the Court for relief from the stay. Secured claims are secured primarily by liens on the Debtors' property, equipment and leasehold improvements and certain mortgages and other notes receivable. PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JULY 31, 1992 AND JUNE 30, 1992 AND 1991 (CONTINUED) Creditors have asserted pre-and post-petition claims against the Debtors alleging liabilities of approximately $9 billion plus unliquidated amounts. The Company projects that the claims asserted against the Debtors will be resolved and reduced to an amount that approximates PMI's estimate of $706,250,000 recognized as liabilities subject to compromise as of June 30, 1992. PMI has filed motions objecting to those claims that are: (a) duplicative; (b) superseded by amended claims; (c) erroneously asserted against multiple Debtors; (d) not obligations of any of the Debtors; or (e) filed after the Bar Date (as hereinafter defined). Additionally, PMI otherwise has disputed a substantial number of the claims asserted against the Debtors and has filed objections to such claims. The Bankruptcy Court established May 15, 1991 (the "Bar Date") as the deadline for filing proofs of claim, except certain specified claims, against the Debtors. A significant number of the bankruptcy claims have been resolved. As of March 1, 1993, unresolved bankruptcy claims of approximately $1 billion have been asserted against PMI. Approximately $767 million of these unresolved claims were filed by entities controlled by Allan Rose and Arthur Cohen (see Note 8). The Company has disputed a substantial number of these unresolved bankruptcy claims and has filed objections to such claims. In addition, a number of these claims have been resolved with the claimant and are awaiting approval by the Bankruptcy Court. The Company believes that substantially all of these claims will be dismissed, disallowed or deemed paid pursuant to the Plan and estimates that unresolved bankruptcy claims will be allowed in the amount of approximately $27 million. These claims will be settled as follows: claims of $18 million will be satisfied through the issuance of Secured Notes, Restructured Notes and Tax Notes; claims of $8 million will be satisfied through the distribution of the Company's Common Stock; and claims of $1 million will be satisfied through cash payments. In accordance with SOP 90-7, the July 31, 1992 consolidated financial statements have given full effect to the issuance of these Secured Notes, Restructured Notes and Tax Notes and the distribution of the Company's Common Stock. Liabilities have been provided for the anticipated cash payments. PMI's liabilities subject to compromise, stated at management's estimate of the total amount of allowed claims and not at the amounts for which claims will be settled, consist of the following (in thousands): The amounts listed above may be subject to future adjustments depending on further developments with respect to disputes or unresolved claims. Information as to the terms of the settlement of liabilities subject to compromise under the Plan as of or subsequent to the Effective Date through the distribution of cash, new indebtedness, new equity securities and/or offset against certain assets reflected in the accompanying consolidated balance sheets is set forth in Note 2. PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JULY 31, 1992 AND JUNE 30, 1992 AND 1991 (CONTINUED) PMI discontinued accruing interest on certain debt obligations as of the date such obligations were determined to be subject to compromise. Contractual interest not accrued and not reflected as an expense in the consolidated statements of operations, as a result of the Debtors' Chapter 11 filing, amounted to approximately $2,300,000 for the one month ended July 31, 1992 and $28,000,000 and $25,300,000 for the years ended June 30, 1992 and 1991, respectively. Total contractual interest is disclosed in the accompanying consolidated statements of operations. NOTE 13 -- LONG-TERM DEBT As a result of the Chapter 11 filing (see Notes 1 and 12), all long-term obligations of the Debtors in existence prior to the Petition Date were stayed and have been classified as liabilities subject to compromise at June 30, 1992. Long-term debt consists of the following (in thousands): - --------------- (a) Pursuant to the Plan, the Company issued two classes of Secured Notes which are identified as "Senior Secured Notes" and "Junior Secured Notes". Senior Secured Notes were issued in two series of notes which are identified as the "8.20% Fixed Rate Senior Secured Notes" and the "Adjustable Rate Senior Secured Notes" (collectively the "Senior Secured Notes"). Each series is identical except that the interest rate on the Adjustable Rate Senior Secured Notes will be periodically adjusted to one-half of one percent over the daily "prime rate" reported by Chemical Bank, with a maximum interest rate of 10.0% per annum. The aggregate principal amount of Senior Secured Notes issued under the Plan was $91,300,000, comprised of $30,100,000 of 8.20% Fixed Rate Secured Notes and $61,200,000 of Adjustable Rate Senior Notes. On August 11, 1992, the Company prepaid $17,900,000 of the 8.20% Fixed Rate Senior Secured Notes and $36,400,000 of the Adjustable Rate Senior Secured Notes from the proceeds of collections of portions of the collateral for the Senior Secured Notes. The prepaid amounts of $54,300,000 have been classified as current at July 31, 1992. PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JULY 31, 1992 AND JUNE 30, 1992 AND 1991 (CONTINUED) The other class of Secured Notes issued to satisfy claims was comprised of Junior Secured Notes that bear interest at a rate of 9.20% per annum and will mature on July 31, 2000. The aggregate principal amount of Junior Secured Notes issued under the Plan was $70,000,000. The collateral for the Secured Notes consists primarily of mortgages and other notes receivable and real property (the "Secured Note Collateral") with a book value of $143,191,000 as of July 31, 1992. Interest on the Secured Notes is payable semi-annually commencing January 31, 1993. The Secured Notes require that 85% of the cash proceeds from the Secured Note Collateral be applied first to interest, second to prepayment of the Senior Secured Notes and third to prepayment of the Junior Secured Notes. Any remaining principal balance of the Senior Secured Notes is due July 31, 1997. Aggregate principal payments on the Junior Secured Notes are required in order that one-third of the principal balance outstanding on December 31, 1996 is paid by July 31, 1998; two-thirds of that balance is paid by July 31, 1999; and all of that balance is paid by July 31, 2000. To the extent the cash proceeds from the Secured Note Collateral are insufficient to pay interest or required principal payments on the Secured Notes, the Company will be obligated to pay any deficiency out of its general corporate funds. The Secured Notes contain covenants which, among other things, require the Company to maintain a net worth of at least $100,000,000, limit expenditures related to the development of hotel properties through December 31, 1996 and preclude cash distributions to stockholders, including dividends and redemptions, until the Secured Notes have been paid in full. During March 1993, the Company repurchased $9,500,000 of the Junior Secured Notes for a purchase price of $7,400,000. The repurchase resulted in an extraordinary gain of $2,100,000, which will be reflected in the Company's first quarter 1993 consolidated financial statements. These notes have been classified as long-term debt at July 31, 1992 in accordance with their terms as repurchase was not contemplated at the balance sheet date. (b) Claims of taxing authorities were paid in Tax Notes or cash. Each Tax Note is in a face amount equal to the allowed claim and provides for annual payments of principal and interest until maturity on July 31, 1998. Such payments will be made in equal principal installments, plus simple interest from July 31, 1992 at the rate of 8.20% per annum, with payments to commence on July 31, 1993 and with additional payments to be made on each July 31 thereafter. (c) The Company has $20,734,000 of restructured notes issued to holders of oversecured and undersecured bankruptcy claims. Each restructured note matures on July 31, 2002 and is secured by a lien on the collateral which secured the underlying claim prior to bankruptcy. The notes are secured by mortgage notes receivable and hotel properties with a book value of $16,981,000 at July 31, 1992. The oversecured restructured notes bear interest at a rate of 9.20% per annum payable semi-annually in cash. Prior to maturity, principal amounts outstanding will be paid semi-annually based on a thirty-year amortization schedule. The Company has approximately $7,173,000 of these notes outstanding at July 31, 1992. During January 1993, the Company repurchased $1,700,000 of the oversecured restructured notes for a purchase price of $1,300,000. The repurchase resulted in an extraordinary gain of $400,000, which will be reflected in the Company's first quarter 1993 consolidated financial statements. These notes have been classified as current at July 31, 1992. The undersecured restructured notes bear interest at a rate of 8% per annum with interest payable semi-annually in cash. Semi-annual principal payments begin on July 31, 1996 based on a thirty-year PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JULY 31, 1992 AND JUNE 30, 1992 AND 1991 (CONTINUED) amortization schedule. The Company has approximately $13,561,000 of these notes outstanding at July 31, 1992. The Company has other mortgage notes and bonds payable of approximately $73,905,000 which are due through April 1, 2008 and bear interest at rates ranging from 4.68% to 10.5% at July 31, 1992. The notes are secured by mortgage notes receivable and hotel properties with a book value of $83,577,000 at July 31, 1992. (d) Construction financing obligations primarily consist of two loans payable to banks with an aggregate balance of $5,193,000 and a loan payable to ShoLodge of $3,570,000 at July 31, 1992. The loans payable to banks are secured by mortgages on two hotel properties with a book value of $13,963,000 at July 31, 1992. Principal is payable in monthly installments with the balances due by June 1994. Interest is payable monthly at the prime rate plus 2%. The loan payable to ShoLodge is secured by a hotel with a book value of $7,670,000 at July 31, 1992. Principal is payable in September 1993. Interest is payable monthly at the prime rate plus 2% (see Note 22). (e) At June 30, 1992, PMI's 6 5/8% convertible subordinated debentures due 2011 and 7% convertible subordinated debentures due 2013 were convertible at any time prior to maturity into common stock at $40.568 per share and $43.95 per share, respectively, and 5,451,342 shares of common stock were reserved for issuance upon such conversion. Sinking fund payments of $5,750,000 annually were required commencing April 1, 1997 for the 6 5/8% Debentures and June 1, 1999 for the 7% Debentures. All Debentures were subordinated to all existing and future senior indebtedness of PMI. (f) In April 1989, PMI borrowed approximately $140,000,000 from Morgan Bank pursuant to a demand note (the "Morgan Loan") with interest at the prime rate. The note was secured by the notes receivable from FCD and Servico and certain other assets. In September 1989, PMI entered into a $263,000,000 secured bank credit agreement (the "Credit Agreement"), expiring March 1991, in which borrowings (the "Bank Group Loan") were fully utilized by December 1989. Borrowings bear interest at the prime rate plus 1/2%. The borrowings were principally incurred to extinguish the Morgan Loan issued in connection with the Servico transaction ("Tranche A") and to finance PMI's portion of the Ramada acquisition ("Tranche B"). The Bank Group Loan was secured by the notes receivable from FCD and Servico, the net assets and common stock of subsidiaries acquired in the Ramada acquisition, the New World note, certain other mortgage notes receivable and certain other assets. In March 1990, PMI prepaid $1,000,000 of the Bank Group Loan with the proceeds of previously pledged mortgage notes receivable. In May 1990, PMI prepaid $40,000,000 of the Bank Group Loan from proceeds from the collection of a receivable related to the sale of a hotel property in fiscal 1989. In June 1990, PMI prepaid $1,000,000 of the Bank Group Loan with the proceeds of certain previously pledged mortgage notes receivable. In July 1990, PMI prepaid approximately $171,200,000 of the Bank Group Loan from the proceeds of the sale of the Howard Johnson, Ramada and Rodeway franchise businesses. In July 1990, the Credit Agreement was amended to convert $60,000,000 of $65,000,000 of unsecured demand loans then outstanding, which had been borrowed in fiscal 1990 to fund construction, into secured term loans ("Tranche C"). In addition, certain unsecured letter of credit reimbursement obligations were converted into Tranche C secured obligations. PMI also pledged additional collateral and certain then-existing defaults under the Bank Credit Agreement were waived. In July 1990, PMI paid the remaining $5,000,000 of unsecured demand notes then outstanding. PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JULY 31, 1992 AND JUNE 30, 1992 AND 1991 (CONTINUED) (g) Other mortgage notes and bonds payable consist of debt secured by properties operated by PMI or notes receivable held by PMI. Principal is due in installments through 2009. Interest rates are generally variable ranging from 5% to 15% at June 30, 1992. (h) Other debt as of June 30, 1992 consists of an unsecured note bearing interest at the rate of 17%. At July 31, 1992, maturities of long-term debt for the next five years ending July 31 are as follows (in thousands): NOTE 14 -- LEASE COMMITMENTS The Company leases various hotels under lease agreements with initial terms expiring at various dates from 1998 through 2019. The Company has options to renew certain of the leases for periods ranging from 1 to 94 years. Rental payments are based on minimum rentals plus a percentage of the hotel's revenues in excess of stipulated amounts. As a result of the Chapter 11 filing, all lease contracts were reviewed during 1991 and a determination was made as to whether to accept or reject these contracts. The commitments shown below reflect those lease contracts which the Company has assumed. The following is a schedule by year of future minimum lease payments required under the remaining operating leases for core properties that have terms in excess of one year as of July 31, 1992 (in thousands): Rental expense for all operating leases, including those with terms of less than one year, is comprised as follows (in thousands): PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JULY 31, 1992 AND JUNE 30, 1992 AND 1991 (CONTINUED) - --------------- (a) Rentals include approximately $6,769,000 of rent recognized under the leases with related parties in 1991. NOTE 15 -- CONTINGENCIES PMI and certain of its present and former officers and directors were named as defendants in purported class action lawsuits on behalf of purchasers of PMI's common stock and debentures. The lawsuits allege that PMI made materially false and misleading statements and omissions regarding its financial condition in violation of Federal securities laws and other claims. A settlement was consummated in February 1993 which was funded through insurance proceeds. The Company has responded to informal requests for information by the Staff of the United States Securities and Exchange Commission's Division of Enforcement relating to a number of significant transactions of PMI for the years 1985 through 1991. However, no formal allegations have been made by the Staff. In addition to the foregoing legal proceedings, the Company is involved in various other proceedings incidental to the normal course of its business. The Company believes that the resolutions of these contingencies will not have a material adverse effect on the Company's consolidated financial position or results of operations. NOTE 16 -- REORGANIZATION EXPENSES The net expenses incurred as a result of the Debtors' Chapter 11 filing on September 18, 1990 and subsequent reorganization efforts have been segregated from normal operating expenses and presented as reorganization expenses in the accompanying consolidated statements of operations for the one month ended July 31, 1992 and for the years ended June 30, 1992 and 1991. Reorganization expenses are comprised of the following (in thousands): PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JULY 31, 1992 AND JUNE 30, 1992 AND 1991 (CONTINUED) NOTE 17 -- VALUATION WRITEDOWNS AND RESERVES Valuation writedowns and reserves have been recorded in order to adjust the carrying value of assets and liabilities resulting from the restructuring of PMI's business and general economic conditions and primarily consist of the following (in thousands): The valuation writedowns and reserves for the year ended June 30, 1992 shown above were all recognized in the fourth quarter. In addition to the above, valuation writedowns and reserves of $-0-, $20,578,000 and $-0-were charged against deferred income for the one month ended July 31, 1992 and for the years ended June 30, 1992 and 1991, respectively. NOTE 18 -- INCOME TAXES Income taxes (credits) have been provided as follows (in thousands): PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JULY 31, 1992 AND JUNE 30, 1992 AND 1991 (CONTINUED) The difference between total income taxes (credits) and the amount computed by applying the Federal statutory income tax rate of 34% to income (loss) from continuing and discontinued operations before income taxes are as follows (in thousands): The tax effects of the temporary differences in the areas listed below resulted in deferred income tax provisions (credits) (in thousands): No Federal income tax was payable at July 31, 1992 due primarily to the utilization of net operating loss carryforwards. At July 31, 1992, the Company had net operating loss carryforwards of approximately $347,000,000 for Federal income tax purposes. Such tax net operating loss carryforwards, if not used as offsets to future taxable income, will expire beginning in 2005 and continuing through 2007. The amount of net operating loss carryforwards available for future utilization is limited to $130,500,000 during the carryforward period as a result of the change in ownership of the Company upon consummation of the Plan. In accordance with FAS 109, the Company has not recognized the future tax benefits associated with the net operating loss carryforwards or with other temporary differences. Accordingly, the Company has provided a valuation allowance of approximately $44,000,000 against the deferred tax assets as of July 31, 1992 and June 30, 1992. To the extent any available carryforwards or other benefits are utilized in periods subsequent to July 31, 1992, the tax benefit realized will be treated as a contribution to stockholders' equity and will have no effect on the income tax provision for financial reporting purposes. PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JULY 31, 1992 AND JUNE 30, 1992 AND 1991 (CONTINUED) PMI's Federal income tax returns for the years 1987 through 1991 are currently under examination by the Internal Revenue Service. The Company does not believe there will be any material adverse effects on the consolidated financial statements as a result of this examination. NOTE 19 -- COMMON STOCK AND COMMON STOCK EQUIVALENTS Pursuant to the Plan, on July 31, 1992, the Company began distributing 33,000,000 shares of Common Stock to certain claimants and holders of PMI stock. At March 2, 1993, 22,623,100 shares of Common Stock were distributed. The remaining shares are to be distributed semi-annually to holders of previously allowed claims and pending final resolution of disputed claims (see Note 12). In addition, holders of PMI stock will receive Warrants to purchase Common Stock exercisable into an aggregate of approximately 2,100,000 shares at an exercise price equal to the average per share daily closing price during the year ending July 31, 1993. On July 31, 1992, the Company adopted a stock option plan under which options to purchase up to 1,320,000 shares of Common Stock may be granted to directors, officers or key employees under terms determined by the Board of Directors. During 1992, options to purchase 350,000 shares were granted to officers and directors none of which are exercisable at July 31, 1992. In addition, options to purchase 330,000 shares were granted to a former officer. Such options are currently exercisable and expire on July 31, 1995. The exercise prices of the above options are dependent on the average market price one year from the date of grant and are, therefore, currently undeterminable. On July 31, 1992, the Company adopted a performance incentive plan under which stock options covering an additional 330,000 shares of Common Stock were reserved for grants to key employees at the discretion of management. No options have been issued under this plan. PMI had an employee incentive stock option plan which provided for grants of stock options covering an aggregate of 3,520,000 shares of common stock to officers and key employees. Under the terms of the plan, which expired on November 23, 1991, options were granted at a price not less than 100% of fair market value on the date of grant. Options generally were exercisable in cumulative installments of 33 1/3% after the option has been outstanding 18, 32 and 46 months from the date of grant and expired five years after the date of grant. A summary of the transactions under this plan follows: PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JULY 31, 1992 AND JUNE 30, 1992 AND 1991 (CONTINUED) NOTE 20 -- INTEREST AND DIVIDEND INCOME Included in interest and dividend income are the following (in thousands): NOTE 21 -- OTHER REVENUES Included in other revenues are the following (in thousands): NOTE 22 -- RELATED PARTY TRANSACTIONS The following summarizes significant financial information with respect to transactions with present and former officers, directors, their relatives and certain entities they control or in which they have a beneficial interest (in thousands): - --------------- (a) During 1990, PMI sold eight hotel properties to partnerships controlled by former officers and/or directors for aggregate consideration of $52,500,000 resulting in deferred gains of $4,000,000. The Company held mortgages and other notes receivable with a face value of $44,992,000 at July 31, 1992, which arose primarily from those hotel sales. The mortgages mature through 2005 and bear interest at rates ranging from 9.5% to 12.5%. At July 31, 1992, the carrying value of those mortgages was reduced to $6,081,000. The income amounts shown above primarily include transactions related to these properties. PRIME HOSPITALITY CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS JULY 31, 1992 AND JUNE 30, 1992 AND 1991 (CONTINUED) (b) In 1991, PMI entered into an agreement with ShoLodge, whereby Sholodge was appointed the exclusive agent to develop and manage certain hotel properties. Six hotels have been developed and opened to date. Development fees earned by ShoLodge of $-0-, $586,000 and $527,000 have been capitalized into property, equipment and leasehold improvements for the month ended July 1992, and the years ended June 1992 and June 1991, respectively. The Company has demand notes and loans payable to ShoLodge of $2,706,000 and $3,570,000, respectively, at July 31, 1992 concerning the development of hotels. Effective June 1992, the Company commenced using the ShoLodge reservation system for its Wellesley and AmeriSuite hotels. NOTE 23 -- SUPPLEMENTAL CASH FLOW INFORMATION PMI generally received mortgages and other notes as a portion of the total consideration paid by purchasers in connection with sales of hotel properties and as consideration for certain construction and development activities. Such noncash consideration is not reflected in the accompanying consolidated statements of cash flows. Investing activities involving such noncash proceeds are summarized below (in thousands): Noncash proceeds consisted of the following (in thousands): Cash paid for interest net of amounts capitalized, was $4,407,000 for the one month ended July 31, 1992 and $6,432,000 and $16,802,000 for the years ended June 30, 1992 and 1991, respectively. Cash paid for income taxes was $2,000 for the one month ended July 31, 1992 and $1,460,000 and $2,100,000 for the years ended June 30, 1992 and 1991, respectively. SCHEDULE II PRIME HOSPITALITY CORP. AND SUBSIDIARIES AMOUNTS RECEIVABLE FROM RELATED PARTIES, UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES DECEMBER 31, 1993 AND 1992 (IN THOUSANDS) - --------------- (a) 11%; secured by real property; payable in monthly installments of $16,994 including interest. During 1993, the Company began foreclosure proceedings on this receivable. (b) 10%; secured by real property; due September 1, 1996. SCHEDULE II PAGE 1 OF 2 PRIME HOSPITALITY CORP. AND SUBSIDIARIES AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES JULY 31, 1992 AND JUNE 30, 1992 AND 1991 (IN THOUSANDS) SCHEDULE II PAGE 2 OF 2 PRIME HOSPITALITY CORP. AND SUBSIDIARIES AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES JULY 31, 1992 AND JUNE 30, 1992 AND 1991 (IN THOUSANDS) (CONTINUED) (a) 11%; secured by real property; payable in monthly installments of $16,994 including interest. (b) 10%; secured by real property; due September 1, 1996. (c) 10%; secured by real and personal property; due December 1, 1998; payable in monthly installments of $115,859 including interest. In January 1993, the Company restructured the note as follows: (i) a senior note of $5,000,000 at 8.5%; due January 1, 2003; payable in monthly installments of $38,446 and (ii) a junior note of $5,950,000 at 6.0% due January 1, 2008; payable to the extent of available cash flow. The notes are owed by a partnership in which a former director of PMI has a controlling interest. Subsequent to July 31, 1992, this note is no longer classified as a related party receivable. (d) 9.5% to 11%; secured by real and personal property; due from March 1, 1999 to December 1, 2019; payable in total monthly installments of $277,252 including interest. In December 1992, the Company restructured these notes to receive the majority of available cash flow. (e) 9.25%; secured by real property; payable in monthly installments of $590; due July 1, 2017. (f) Prime rate; unsecured; payable on demand. (g) 9%; secured by real property; due September 5, 2011. (h) Prime rate; unsecured; payable on demand. (i) 11%; secured by personal property; payable in quarterly installments of $2,307 including interest; due January 1, 1991. SCHEDULE V PRIME HOSPITALITY CORP. AND SUBSIDIARIES PROPERTY, EQUIPMENT AND LEASEHOLD IMPROVEMENTS DECEMBER 31, 1993 AND 1992 (IN THOUSANDS) - --------------- (a) Transfer from notes receivable to land, hotels and furniture, fixtures and autos. (b) Represents a hotel conveyed to a third party in return for the assumption of the related debt by the third party. (c) Represents a transfer in exchange for a note receivable. See Notes to Consolidated Financial Statements as to depreciation method and useful lives. SCHEDULE V PRIME HOSPITALITY CORP. AND SUBSIDIARIES PAGE 1 OF 2 PROPERTY, EQUIPMENT AND LEASEHOLD IMPROVEMENTS JULY 31, 1992 AND JUNE 30, 1992 AND 1991 (IN THOUSANDS) SCHEDULE V PAGE 2 OF 2 PRIME HOSPITALITY CORP. AND SUBSIDIARIES PROPERTY, EQUIPMENT AND LEASEHOLD IMPROVEMENTS JULY 31, 1992 AND JUNE 30, 1992 AND 1991 (IN THOUSANDS) (CONTINUED) (a) Fresh-start reporting adjustments. (b) Distributions under the Plan. (c) Transfer from construction in progress to hotels, leasehold improvements and furniture, fixtures and autos. (d) Writeoffs and/or writedowns to net realizable value. (e) Transfer from operating land, hotels, furniture, fixtures and autos and/or construction in progress to property held for sale. See Notes to Consolidated Financial Statements as to depreciation method and useful lives. SCHEDULE VI PRIME HOSPITALITY CORP. AND SUBSIDIARIES ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, EQUIPMENT AND LEASEHOLD IMPROVEMENTS DECEMBER 31, 1993 AND 1992 (IN THOUSANDS) SCHEDULE VI PRIME HOSPITALITY CORP. AND SUBSIDIARIES ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, EQUIPMENT AND LEASEHOLD IMPROVEMENTS JULY 31, 1992 AND JUNE 30, 1992 AND 1991 (IN THOUSANDS) - --------------- (a) Fresh start reporting adjustments. SCHEDULE IX PRIME HOSPITALITY CORP. AND SUBSIDIARIES SHORT-TERM BORROWINGS JULY 31, 1992 AND JUNE 30, 1992 AND 1991 (IN THOUSANDS) - --------------- (a) The average amount outstanding during the period was computed on the basis of the outstanding daily principal balances. (b) The weighted average interest rate was computed by dividing the total interest expense on these obligations by the average balance of short-term obligations outstanding. SCHEDULE X PRIME HOSPITALITY CORP. AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION DECEMBER 31, 1993 AND 1992 (IN THOUSANDS) SCHEDULE X PRIME HOSPITALITY CORP. AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION JULY 31, 1992 AND JUNE 30, 1992 AND 1991 (IN THOUSANDS) 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. PRIME HOSPITALITY CORP. DATE: March 24, 1994. By: /s/ David A. Simon ------------------------ David A. Simon, President 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 indicated on March 24, 1994. Exhibit Index (2) (a) Reference is made to the Disclosure Statement for Debtors' Second Amended Joint Plan of Reorganization dated January 16, 1992, which includes the Debtors' Second Amended Plan of Reorganization as an exhibit thereto filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (3) (a) Reference is made to the Restated Certificate of Incorporation of the Company dated June 5, 1992 filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (b) Reference is made to the Restated Bylaws of the Company filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (4) (a) Reference is made to the Form of 8.20% Fixed Rate Senior Secured Note of the Company filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (b) Reference is made to the Form of Adjustable Rate Senior Secured Note of the Company filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (c) Reference is made to the Form of 9.20% Junior Secured Note of the Company filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (d) Reference is made to the Form of 8.20% Tax Note of the Company filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (e) Reference is made to the Form of 10.20% Secured UND Restructured Note of the Company filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (f) Reference is made to the Form of 8% Secured UND Restructured Note of the Company filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (g) Reference is made to the Form of 9.20% OVR Restructured Note of the Company filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (h) Reference is made to the Collateral Agency Agreement among the Company, U.S. Trust and the Secured Parties, dated as of July 31, 1992 filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (i) Reference is made to the Security Agreement between the Company and U.S. Trust, dated as of July 31, 1992, filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (j) Reference is made to the Subsidiary Guaranty from FR Delaware, Inc. to United States Trust Company of New York, dated as of July 31, 1992, filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (k) Reference is made to the Security Agreement between FR Delaware, Inc. and United States Trust Company of New York, dated as of July 31, 1992, filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (l) Reference is made to the Subsidiary Guaranty from Prime Note Collections Company, Inc. to United States Trust Company of New York, dated as of July 31, 1992, filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (m) Reference is made to the Security Agreement between Prime Note Collections Company, Inc. and United States Trust Company of New York, dated as of July 31, 1992, filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (n) Reference is made to a Form 8-A of the Company as filed on June 5, 1992 with the Securities and Exchange Commission, as amended by Amendment No. 1 and Amendment No. 2, which is incorporated herein by reference. (10) (a) Reference is made to the Agreement of Purchase and Sale between Flamboyant Investment Company, Ltd. and VMS Realty, Inc. dated June 3, 1985, and its related agreements, each of which was included as Exhibits to the Form 8-K dated August 14, 1985 of PMI, which are incorporated herein by reference. (b) Reference is made to PMI's Flexible Benefit Plan, filed as an Exhibit to the Form 10-Q dated February 12, 1988 of PMI, which is incorporated herein by reference. (c) Reference is made to the Employment Agreement dated as of July 31, 1992, between David A. Simon and the Company filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (d) Reference is made to the 1992 Performance Incentive Stock Option Plan of the Company dated as of July 31, 1992, filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (e) Reference is made to the 1992 Stock Option Plan of the Company filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (f) Reference is made to the 1992 Non-Qualified Stock Option Agreement between the Company and David A. Simon filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (g) Reference is made to the 1992 Non-Qualified Stock Option Agreement between the Company and David L. Barsky filed as an Exhibit to the Company's Form 10-K dated September 25, 1992, which is incorporated herein by reference. (i) Reference is made to the Employment Agreement dated as of December 31, 1992 between John Elwood and the Company filed as an Exhibit to the Company's Form 10-K dated March 26, 1993, which is incorporated herein by reference. (j) Reference is made to the 1992 Non-Qualified Stock Option Agreement between the Company and John Elwood filed as an Exhibit to the Company's Form 10-K dated March 26, 1993, which is incorporated herein by reference. (k) Employment Agreement dated as of March 1, 1993 between John Stetz and the Company. (l) Employment Agreement dated as of May 18, 1993 between Paul Hower. (m) Consolidated and Amended Settlement Agreement dated as of October 12, between Allan V. Rose and the Company. (11) Computation of Earnings Per Common Share. (21) Subsidiaries of the Company are as follows: (23) (a) Consent of Arthur Andersen & Co. (b) Consent of J.H. Cohn & Co.

1993 Item 1. BUSINESS As used in Item 1 of this report, the term "Company", except as otherwise indicated by the context, means The Lincoln Electric Company and its subsidiaries. The Lincoln Electric Company was incorporated under the laws of the State of Ohio in 1906. The Company is engaged primarily in the design, manufacture and sale of arc welding products which constitutes 88% of the Company's business. The Company also designs, manufactures and sells integral horsepower industrial electric motors, and some subsidiaries also sell industrial gases, regulators, and torches. The arc welding machines, power sources and automated wire feeding systems manufactured by the Company range in technology from basic units used for light manufacturing and maintenance to highly sophisticated machines for robotic applications, high production welding and fabrication. Three primary types of arc welding electrodes are produced: (1) coated manual or stick electrodes, (2) solid electrodes produced in coil form for continuous feeding in mechanized welding, and (3) cored electrodes produced in coil form for continuous feeding in mechanized welding. The integral horsepower electric motors manufactured by the Company range in size from 1/3 to 250 horsepower. See Note H to the consolidated financial statements with respect to acquisitions by the Company. The Company's products are sold in both domestic and international markets. In the domestic market, they are sold directly by the Company's own sales organization as well as by distributors. In the international markets, the Company's products are sold principally by foreign subsidiary companies. The Company also has an international sales organization comprised of international direct sales distributors, agents and dealers that operate in more than eighty-seven countries. The Company has manufacturing facilities located in the United States, Australia, Canada, Japan, Mexico, England, France, Ireland, Italy, the Netherlands, Norway and Spain. See Note G to the consolidated financial statements with respect to information concerning the Company's geographic segments. The Company is not dependent on a single customer or a few customers. The loss of any one customer would not have a material adverse effect on its business. The Company's business is not seasonal. Conditions in the arc welding industry are highly competitive. The Company is one of the largest manufacturers of consumables and machinery in a field of three or four major domestic competitors and numerous smaller competitors covering the industry. The Company continues to pursue strategies to heighten its competitiveness in international markets. Competition in the electric arc welding industry is on the basis of price, brand preference, product quality and performance, warranty, delivery, service and technical support. All of these factors have contributed to the Company's position as one of the leaders in the industry. Virtually all of the Company's products may be classified as standard commercial articles and are manufactured for stock. Normally, customer orders are filled directly from finished product stock and, therefore, the backlog of orders at any particular time is relatively negligible. The principal raw materials essential to the Company's business are various chemicals, steel, copper and aluminum, all of which are normally available for purchase in the open market. Item 1. BUSINESS (Continued) The Company's operations are not materially dependent upon patents, licenses, franchises or concessions. The Company's facilities are subject to federal, state and local environmental control regulations. To date, compliance with these environmental regulations has not had a material effect on the Company's earnings nor has it required the Company to make significant capital expenditures. Research activities relating to the development of new products and the improvement of existing products in 1993 were all Company-sponsored. These activities were primarily related to the development of new products utilizing the latest electronic technology. The number of professional employees engaged full-time in these research activities was 142. Refer to Note A to the consolidated financial statements with respect to costs of research and development. The number of persons employed by the Company worldwide, as an average for the year ended December 31, 1993, was 6,036. Effects of plant closures will reduce worldwide employment levels in 1994. Geographic segment information is included in Note G to the consolidated financial statements. Item 2. Item 2. PROPERTIES The Company's corporate headquarters and principal United States manufacturing facilities are located in the Cleveland, Ohio area. Total Cleveland area property consists of 230 acres, of which present manufacturing facilities comprise an area of approximately 2,698,000 square feet. Current utilization of existing facilities is estimated to be 91% of capacity. Item 2. PROPERTIES (Continued) Manufacturing facilities located in Germany, Venezuela, and Brazil were closed under the Company's restructuring program. All property relating to the Company's Cleveland, Ohio headquarters and manufacturing facilities is owned outright by the Company and is unencumbered. In addition, the Company maintains leases for its distribution centers. See Note K to the consolidated financial statements with respect to leases. Most of the Company's foreign subsidiaries own manufacturing facilities in the foreign country where they are located. Some of these subsidiaries' properties are encumbered by mortgage loans. See Note D to the consolidated financial statements with respect to long-term debt. Item 3. Item 3. LEGAL PROCEEDINGS The Company is subject, from time to time, to a variety of civil and administrative proceedings arising out of its normal operations including, without limitation, intellectual property related actions, employment-related actions and health, safety and environmental claims and proceedings under the laws governing workers' compensation. The Company does not believe that the outcome of such legal proceedings, solely or in aggregate, will have a material adverse effect upon the financial condition of the Company. Item 4. Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the quarter ended December 31, 1993. PART II Item 5. Item 5. MARKET FOR THE REGISTRANT'S COMMON CAPITAL STOCK AND RELATED STOCKHOLDER MATTERS The Company's Common Capital Stock is traded on the over-the-counter market. The number of record holders of Common Capital Stock at December 31, 1993 was 2,497. There is a limited public trading market for Common Capital Stock purchased through the Company's Employees' Stock Purchase Plan and for Class A Common Stock distributed under the Company's Employee Stock Ownership Plan. Shares purchased are subject to a right of refusal and other restrictions as set forth in the Employees' Stock Purchase Plan. Refer to Note B to the consolidated financial statements with respect to the rights of Class A Common Stock. Item 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS (Continued) Future dividends, which are subject to limitations under the Credit Agreement and the Senior Note Agreement, will be based on financial performance of the Company (see Note D to the consolidated financial statements for a further description of these limitations.) Item 6. Item 6. SELECTED FINANCIAL DATA See Note C to the consolidated financial statements with respect to restructuring charges in 1993 and 1992. All per share amounts have been adjusted for the ten-for-one stock split in 1993. Item 7. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS--(all dollar amounts are in thousands of dollars) RESULTS OF OPERATIONS Net sales decreased by less than 1% to $846,000 in 1993 from $853,000 in 1992 and increased 1.4% from 1991 sales of $833,900. Sales in 1993 for domestic companies were up 9.7% while sales of foreign companies were down 18.3% from 1992. Excluding sales resulting from acquisitions, 1992 domestic and foreign sales increased 6.0% and decreased 10.2%, respectively, from 1991. Approximately 45% of the increase in domestic sales in 1993 (90% in 1992) was attributable to an increase in volume. The remaining 55% in 1993 (10% in 1992) was due to increases in selling prices. Gross margin increased to $313,200 in 1993 (37.0% of sales) as compared to $299,900 in 1992 (35.2% of sales) and $312,100 in 1991 (37.4% of sales). The improvement of gross margin was attributable to price increases coupled with the effect of increased volume, which included the effect of domestic market share gains. These effects, however, were partially offset by diminishing gross margins of the non-U.S. operations. Distribution cost/selling, general and administrative expenses were $277,000 in 1993 (32.7% of sales) as compared to $299,200 in 1992 (35.1% of sales) and 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS--(Continued) $270,500 in 1991 (32.4% of sales). The reduction in distribution cost/selling, general and administrative expenses in 1993 was principally the result of management's response to the recessionary pressures existing throughout Europe. Additionally, comparable results were affected by the incurrence of certain nonrecurring and non-continuing operating costs. Such costs included asset write-downs, relocation costs, various other charges relating to cost reduction efforts totaling $3,700 and $18,900 in 1993 and 1992, respectively. In 1992, the increase in distribution cost/selling, general and administrative expenses was principally caused by a full year of operations of the Company's German subsidiary versus nine months in 1991, increased pension expense, and various adjustments discussed above. In 1991, distribution costs/selling, general and administration expenses were offset partially by the reversal of $6,200 of prior year charges relating to The Lincoln Electric Company 1988 Incentive Equity Plan. The Company's net loss was $38,100 in 1993 as compared with $45,800 in 1992 and net income of $14,400 in 1991. Results were affected adversely by restructuring charges relating principally to the European and South American operations. These charges totaled $40,900 net-of-tax ($3.77 per share) and $23,900 without tax benefit ($2.21 per share) for 1993 and 1992, respectively (see discussion below). The 1991 results of operations included no restructuring charges. Results for 1993 have also benefited from the cumulative effect of a change in method of accounting for income taxes, which increased net income $2,468 or $.23 per share. See Note A, "Accounting Policies," for additional information regarding the effects of the change in method in accounting for income taxes. The provision for income taxes reflects a net benefit of $6,400 on a loss before income taxes of $46,900 for 1993 which principally reflects tax benefits attributable to the plant closure and liquidation of a German subsidiary (see discussion below). For 1992, the provision for income taxes was $11,400 on a loss before income taxes of $34,400 compared to a provision of $20,000 on income before income taxes of $34,400 in 1991. The higher effective rates experienced in 1992 and 1991 were due principally to losses of foreign subsidiaries that were in net operating loss carryover positions. RESTRUCTURING CHARGES In 1992, the Company's restructuring program was initiated to improve efficiency and future financial results for its non-U.S. operations, principally its European markets. This decision resulted in a restructuring charge to 1992 operations of $23,900, without tax benefit. It became evident in 1993 that the 1992 restructuring charges were not sufficient to reverse operating results in Germany, as the Company's principal German subsidiary continued to incur significant losses, experiencing eroding sales levels within the context of depressed market conditions. Accordingly, the Board of Directors decided in early 1994 to terminate the manufacturing and sales operations of its Messer Lincoln subsidiary in Germany. The intent of the action was to eliminate substantial costs in manufacturing overhead and distribution expenses in Europe, and to enable the Company to redirect its resources toward more efficient and competitive facilities that will serve the European market. Similarly, the Board of Directors decided in early 1994 that overcapacity in the weak and turbulent economies of Brazil and Venezuela required the curtailment of production operations in such markets, even though sales, marketing and distribution activities in those countries will continue. 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS--(Continued) The above-referenced decisions, which will result in the termination of approximately 800 employees, resulted in pretax restructuring charges of $70,100 for 1993 ($40,900 after tax). See Note C to the consolidated financial statements, "Restructuring Charges," for additional information. As indicated earlier, operating results of the Company's highly efficient U.S. and Canadian operations showed increased levels of profitability and market share in 1993. Although consolidated results were affected adversely in 1992 and 1993 by restructuring charges, management believes the Company is well positioned now to maximize its opportunities in the worldwide markets it serves. RESEARCH AND DEVELOPMENT The Company decreased its expenditures for research activities during both 1993 and 1992. However, the Company believes the current level of research and development is adequate to maintain its product lines and introduce new products at an appropriate rate to sustain future growth. Excellence in research and development is a key success factor for the Company. LIQUIDITY AND CAPITAL RESOURCES In March 1993, the Company entered into a $230,000 three-year, unsecured, multi-currency Credit Agreement with ten banks. The funds were used to replace the Company's then existing revolving credit agreement, its long-term borrowing arrangements with foreign banks, and to refinance and consolidate certain other foreign short-term and long-term obligations. See Note D to the consolidated financial statements, "Short-Term and Long-Term Debt," for additional information regarding the borrowing arrangement. The Credit Agreement was amended in November 1993 in order to provide for more flexible terms to accommodate the Company's restructuring program. Total debt at December 31, 1993 was $250,300 compared to $248,600 at December 31, 1992. At December 31, 1993, debt was 64% of total capitalization (shareholders' equity and debt) compared with 56% at year-end 1992. Interest expense incurred was $17,600 in 1993 compared with $18,700 in 1992, reflecting slightly lower interest rates as compared with the prior year. This compares to interest expense of $15,700 in 1991, reflecting an increase in the average debt level. The Company's cash flows for the years 1991 through 1993 are presented in the consolidated statements of cash flows. Cash provided from operating activities during 1993 amounted to $28,700, an increase of $5,100 as compared with $23,600 for 1992. In addition to financing, certain operating losses in Europe, cash flows from operations and additional borrowings were used primarily for investments, capital expenditures and dividends to shareholders. In 1992, expenditures by the Company for the purchase of a small Mexican company and the additional investment in its Lincoln Norweld subsidiary totaled $37,300, compared to $48,700 in 1991 for the purchase of a German business. The ratio of current assets to current liabilities was 1.9 at the end of 1993, compared with 2.2 at the end of 1992 reflecting a satisfactory liquidity position. Net working capital was $149,900 at December 31, 1993, as compared with $172,700 at December 31, 1992. The reduction in working capital was primarily the result of the reduction of the carrying value of assets to their net realizable value and the increases in other current liabilities in connection with the restructuring expenses. Notes payable to banks increased to $23,200 at the end of 1993, from $12,600 at the end of 1992. 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS--(Continued) Capital expenditures in 1993 for property, plant and equipment totaled $19,100 (1992 - $34,800). These expenditures for property, plant and equipment represent the Company's commitment to its long-range objectives to enhance product quality and development, advance technology, expand capacity and reduce manufacturing costs. The Company is closely monitoring its capital outlays and commitments with such expenditures restricted to include only those projects showing potential for high internal rate of return with accelerated cash payback. In 1993, consistent with the prior year, the Company did not pay a special dividend, paying regular dividends of $7,800 for the full year. Future dividends, which are subject to limitations under the Credit Agreement and the Senior Note Agreement, will be based upon the financial performance of the Company (see Note D to the consolidated financial statements). The Credit Agreement and 8.98% Senior Note Agreement contain various financial covenants that place limitations on the payments of dividends, the purchase of unrestricted stock, capital expenditures, and the incurrence of additional indebtedness. While the operating losses for 1993 and 1992 have placed constraints on the Company's financial flexibility, the Company was in compliance with the financial covenants of the agreements at the end of 1993 and management believes that the Company will continue to meet such covenants throughout 1994. Management believes that the current financing arrangement and cash flow generated from operations will provide adequate funds to support the operations of the Company and satisfy both its capital requirements and regular dividend practices throughout the term of the Credit Agreement. ENVIRONMENTAL MATTERS The Company's U.S. facilities are subject to Federal, state and local environmental control regulations. To date, compliance with these environmental regulations has not had a material effect on the Company's earnings nor has it required the Company to make significant capital expenditures. It is the opinion of management that the Company is in material compliance with all regulatory requirements. IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS In May 1993, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities." This statement requires companies to present certain investments in marketable equity securities and many debt securities at fair value. SFAS No.115 is effective for fiscal years beginning after December 15, 1993. As the Company does not hold significant portfolios of debt and marketable equity securities nor is it the Company's principal business purpose to actively acquire and sell debt and equity securities to make a profit from short-term movements in market prices, adoption of SFAS No. 115 is not expected to have any substantial impact on the financial statements. In December 1990, the FASB issued new rules in SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," effective in 1993 domestically and effective for non-U.S. plans in 1995. In November 1992, the FASB issued Statement No. 112, "Employers' Accounting for Postemployment Benefits." The Company is required to implement the Statement in the first quarter of 1994. These statements have no impact on the consolidated financial position or results of operations because the Company does not provide for any postretirement or postemployment benefits other than pensions. Item 8. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The response to this item is submitted in a separate section of this report following the signature page. Item 9. Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III A definitive proxy statement will be filed pursuant to Regulation 14A of the Securities Exchange Act prior to April 29, 1994. Therefore, information required under this part will be incorporated herein by reference from such definitive proxy statement. PART IV Item 14. Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) (1) FINANCIAL STATEMENTS The following consolidated financial statements of the Company are included in a separate section of this report following the signature page: Statements of Consolidated Financial Condition--December 31, 1993 and 1992 Statements of Consolidated Operations--Years ended December 31, 1993, 1992 and 1991 Statements of Consolidated Shareholders' Equity--Years ended December 31, 1993, 1992 and 1991 Statements of Consolidated Cash Flows--Years ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements--December 31, 1993 Reports of Independent Auditors (a) (2) FINANCIAL STATEMENT SCHEDULES The following consolidated financial statement schedules of the Company are included in a separate section of this report following the signature page: Schedule II--Amounts Receivable from Related Parties and Underwriters, Promoters and Employees Other than Related Parties Schedule V--Property, Plant and Equipment Schedule VI--Accumulated Depreciation, Depletion, and Amortization of Property, Plant and Equipment Schedule VIII--Valuation and Qualifying Accounts Schedule IX--Short-Term Borrowings Schedule X--Supplementary Income Statement Information All other schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and therefore, have been omitted. Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (Continued) Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (Continued) Upon request, The Lincoln Electric Company will furnish to security holders copies of any exhibit to the Form 10-K report upon payment of a reasonable fee. Any requests should be made in writing to: Mr. Ellis F. Smolik, Secretary-Treasurer, The Lincoln Electric Company, 22801 St. Clair Avenue, Cleveland, Ohio 44117, Phone: (216) 481-8100. 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. THE LINCOLN ELECTRIC COMPANY ---------------------------- (Registrant) /s/ Ellis F. Smolik -------------------------- Ellis F. Smolik, Senior Vice President, Chief Financial Officer, Secretary-Treasurer and Director 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 indicated on March 30, 1994. ANNUAL REPORT ON FORM 10-K ITEM 8, ITEM 14(a)(1) AND (2) AND ITEM 14(d) FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA FINANCIAL STATEMENT SCHEDULES YEAR ENDED DECEMBER 31, 1993 THE LINCOLN ELECTRIC COMPANY AND SUBSIDIARIES REPORT OF INDEPENDENT AUDITORS Shareholders and Board of Directors The Lincoln Electric Company We have audited the consolidated financial statements of The Lincoln Electric Company and subsidiaries listed in the accompanying index to financial statements Item 14(a1). Our audits also included the financial statement schedules listed in the Index at Item 14 (a2). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We did not audit the consolidated financial statements of The Lincoln Electric Company (Australia) Proprietary Limited and subsidiaries and, for 1992 and 1991, the consolidated financial statements of Lincoln-Norweld B.V. and subsidiaries and the financial statements of Messer Lincoln GmbH and its subsidiary, all consolidated subsidiaries, which statements reflect total assets constituting 5% in 1993 and 41% in 1992 and total revenues constituting 5% in 1993 and 36% in 1992 and 1991 of the related consolidated totals. Those statements were audited by other auditors whose reports have been furnished to us, and our opinion, insofar as it relates to data included for The Lincoln Electric Company (Australia) Proprietary Limited and subsidiaries and, for 1992 and 1991, Lincoln-Norweld B.V. and subsidiaries and Messer Lincoln GmbH and its subsidiary, is based solely on the reports of the other auditors. 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 and the reports of other auditors provide a reasonable basis for our opinion. In our opinion, based on our audits and the reports of other auditors, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of The Lincoln Electric Company and subsidiaries at December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note A to the consolidated financial statements, effective January 1, 1993, the Company changed its method of accounting for income taxes. /s/ Ernst & Young ------------------------------ ERNST & YOUNG Cleveland, Ohio March 25, 1994 To the Board of Directors of The Lincoln Electric Company (Australia) Proprietary Limited REPORT OF INDEPENDENT ACCOUNTANTS --------------------------------- In our opinion, the consolidated balance sheets and the related consolidated statements of income and retained earnings and of cash flows (none of which are presented separately herein) present fairly, in all material respects, the financial position of The Lincoln Electric Company (Australia) Proprietary Limited and its subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. 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 of these statements in accordance with generally accepted auditing standards which 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, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. /s/ Price Waterhouse Parramatta, Australia March 9, 1994 See notes to consolidated financial statements. See notes to consolidated financial statements. See notes to consolidated financial statements. See notes to consolidated financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS THE LINCOLN ELECTRIC COMPANY AND SUBSIDIARIES (In thousands of dollars except per share data) December 31, 1993 NOTE A--ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION: The consolidated financial statements include the accounts of The Lincoln Electric Company and its subsidiaries (the "Company") after elimination of all significant intercompany accounts and transactions. CASH EQUIVALENTS: The Company considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents. INVENTORIES: Inventories are valued at the lower of cost or market. The Company determines cost by the last-in, first-out (LIFO) method, and subsidiary companies determine cost by the first-in, first-out (FIFO) method. At December 31, 1993 and 1992, approximately 45% and 34%, respectively, of total inventories were valued using the LIFO method. The excess of current cost over LIFO cost amounted to $48,490 at December 31, 1993 and $48,555 at December 31, 1992. During 1992, certain LIFO inventories were reduced, resulting in liquidations of LIFO inventory quantities carried at the lower costs of prior years, as compared with their 1992 costs. The effect of these liquidations was to reduce the 1992 net loss after tax, by $1,018 ($.09 per share). PROPERTY, PLANT AND EQUIPMENT: Property, plant and equipment, including facilities and equipment under capital leases, are stated at cost and include improvements which significantly extend the useful lives of existing plant and equipment. Depreciation and amortization are computed by both the accelerated and straight-line methods. In 1993, property, plant and equipment for manufacturing facilities that were closed were written down to their estimated net realizable value. RESEARCH AND DEVELOPMENT: Research and development costs, which are expensed as incurred, were $17,762 in 1993, $20,540 in 1992 and $21,311 in 1991. GOODWILL: The excess of the purchase price over the fair value of net assets acquired (goodwill) is amortized on a straight-line basis over periods not exceeding 40 years. Amounts are stated net of accumulated amortization of $2,363 and $2,170 in 1993 and 1992, respectively. TRANSLATION OF FOREIGN CURRENCIES: For subsidiaries in countries which do not have highly inflationary economies, asset and liability accounts are translated to U.S. dollars using exchange rates in effect at the balance sheet date and revenue and expense accounts are translated at average exchange rates. Translation adjustments are reflected as a component of shareholders' equity. For subsidiaries in countries with highly inflationary economies (Venezuela and Brazil) inventories, property, plant and equipment and related depreciation are translated to U.S. dollars at historical exchange rates. Other asset and liability accounts are translated at exchange rates in effect at the balance sheet date and revenues and expenses, excluding depreciation, are translated at average exchange rates. Translation adjustments for these subsidiaries, as well as transaction gains and losses of all other subsidiaries, are included in the statements of consolidated operations in distribution cost/selling, general and administrative expenses. The Company recorded transaction losses in 1993 of $228 and $859 in 1992. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--Continued THE LINCOLN ELECTRIC COMPANY AND SUBSIDIARIES (In thousands of dollars except per share data) December 31, 1993 NOTE A--ACCOUNTING POLICIES-(Continued) ACCOUNTING CHANGE: Effective January 1, 1993, the Company adopted FASB Statement No. 109, "Accounting for Income Taxes." Under Statement No. 109, the liability method is used in accounting for income taxes. Under this method, deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. Prior to the adoption of Statement No. 109, income tax expense was determined using the deferred method under which deferred tax expense was based on items of income and expense that were reported in different years in the financial statements and tax returns and were measured at the tax rate in effect in the year the difference originated. As permitted by Statement No. 109, the Company has elected not to restate the financial statements of any prior year. The cumulative effect of the change decreased the loss for 1993 by $2,468 or $.23 per share. NET INCOME (LOSS) PER SHARE: Net income (loss) per share is based on the average number of shares outstanding during the year as adjusted for the ten-for-one stock split discussed in Note B. RECLASSIFICATIONS: Certain reclassifications have been made to amounts previously presented to conform with the current reporting presentation. NOTE B--SHAREHOLDERS' EQUITY On May 25, 1993, the Company's shareholders approved an increase in the number of authorized shares to 17 million without par value in conjunction with a ten-for-one stock split of the Company's Common Capital and Class A Common Stock. This action became effective on June 1, 1993, for shareholders of record as of that date. A total of 9,343,305 shares of Common Capital Stock and 405,558 shares of Class A Common Capital Stock were issued in connection with the stock split. Additionally, 4,031,451 shares were issued for stock held in treasury. The stated value of the Common Capital and Class A Common Capital Stock remains unchanged at $.20 per share. As a result of the stock split, all per share and appropriate share amounts have been adjusted to reflect the stock split. The Lincoln Electric Company Employees' Stock Purchase Plan ("Plan") provides that employees may purchase shares of the Company's Common Capital Stock, when offered, at its estimated fair value. The Company also has the option to repurchase shares issued under the Plan at their estimated fair value. In 1992, the Company instituted a temporary suspension on the repurchase of all shares of stock issued and outstanding. Future repurchase of stock by the Company will be contingent upon authorization and resolution of the Board of Directors. At December 31, 1993, all unissued shares (4,618,550) were available for sale under the Plan of which 774,656 shares were reserved or subscribed. The Lincoln Electric Company 1988 Incentive Equity Plan ("Incentive Equity Plan") provided for the award or sale of Common Capital Stock to officers and other key employees of the Company and its subsidiaries. The first program, implemented under the Plan in 1988, which provided for deferred stock awards, was completed as of December 31, 1991. Shares remain available under the Incentive Equity Plan to officers and other key employees. Distribution of shares was based on certain specified performance and other conditions being satisfied. As a result of such conditions being fulfilled with respect to certain of the Company's subsidiaries, the Company awarded 32,000 shares; 10,660 distributed in each April of 1992 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--Continued THE LINCOLN ELECTRIC COMPANY AND SUBSIDIARIES (In thousands of dollars except per share data) December 31, 1993 NOTE B--SHAREHOLDERS' EQUITY--(Continued) and 1993, and 10,680 shares in April of 1994. Based on criteria established under the Plan, $7,000 of compensation expense was accrued in 1990, of which $6,219 was reversed into income in 1991. The Lincoln Electric Company Employee Stock Ownership Plan (the "ESOP") is a non-contributory profit-sharing plan established to provide deferred compensation benefits for all eligible employees. The cost of the plan is borne by the Company through contributions to an employee stock ownership trust. In May 1989, shareholders authorized 2,000,000 shares of new Class A Common Stock ("Class A Common Stock"), without par value. The Company's Common Capital Stock and Class A Common Stock are identical in all respects, except that holders of Class A Common Stock are subject to certain transfer restrictions and the Class A Common Stock is only issued to the ESOP. In 1993, the Company issued 49,220 shares (92,680 shares in 1992) of Class A Common Stock to the ESOP which were allocated to all eligible employees. The estimated fair value of the contributed shares, $916, was recorded as compensation expense ($2,060 in 1992 and $2,003 in 1991). The difference between the total stated capital amount of $.20 per share and the estimated fair value totaled $906 ($2,058 in 1992 and $2,001 in 1991) was recorded as additional paid-in-capital. At December 31, 1993, 1,500,160 authorized but unissued shares (1,549,380 shares at December 31, 1992) are available for issuance to the ESOP. NOTE C--RESTRUCTURING CHARGES The Company has substantially completed its plan to downsize and streamline certain foreign operations (principally in Europe) and close certain manufacturing facilities (principally in Europe and South America). Closings of the manufacturing facilities have been announced and the closings and redundancies will be completed in 1994. These decisions resulted in a restructuring charge of $70,100 ($40,900 after tax, or $3.77 per share) in 1993, which was comprised of (1) asset write-downs to net realizable value in the amount of $45,900 including goodwill of $8,900; (2) the recording of severance and other redundancy costs of $27,500; and (3) the recording of additional net settlement assets and liabilities of $3,300 including estimated losses through the final closing date. The cash outlays required to fund the restructuring will be substantially incurred in 1994, and will be funded by the liquidation of the affected companies' receivables, inventory and real estate and by the Company's other operations and outside sources of funding. Proceeds from the sale of certain of the property, plant and equipment with a net carrying value of approximately $11,000 is not expected to be realized until after 1994. In 1992, the Company recorded a restructuring charge of $23,900 (without tax benefit, or $2.21 per share) as a result of decisions that were made at that time to downsize and streamline certain foreign operations (principally in Europe). The 1992 restructuring charge was principally for severance pay, redundancies and other liabilities relating to the reorganization of the sales and distribution operations. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--Continued THE LINCOLN ELECTRIC COMPANY AND SUBSIDIARIES (In thousands of dollars) In March 1993, the Company entered into a $230,000 three-year, unsecured, multi-currency Credit Agreement with ten banks. The Credit Agreement, which expires January 1, 1996, replaced the Company's previous $75,000 revolving line of credit, and amounts outstanding at December 31, 1992 under the previous revolving line of credit ($30,000), certain notes payable to foreign banks ($25,000), various short-term borrowings of subsidiaries ($39,100), and various other long-term borrowings ($17,300). Borrowings outstanding at December 31, 1992 that were repaid from the proceeds of the Credit Agreement were classified in the consolidated balance sheet to reflect the terms of the Credit Agreement. Under the terms of the Credit Agreement, several pricing options are available and the interest rate on outstanding borrowings is determined based upon defined leverage rates for the pricing option selected. The interest rate can range from the LIBOR plus 1% to LIBOR plus 2% depending upon the defined leverage rate. The agreement also provides for commitment fees ranging from .375% to .5% per annum on the unused credit lines. Simultaneously, with the signing of the Credit Agreement, the interest rate on the $75,000 8.73% Senior Note due in 2003 was increased to 8.98% and the Senior Note Agreement was amended to change the financial covenants to conform to the covenants of the Credit Agreement, which requires a 1.6 to 1 consolidated current ratio at all times and the maintenance of consolidated tangible net worth of $125,000, plus 50% of net income, subsequent to January 1, 1993. In addition, there are requirements with respect to interest coverage and debt to tangible net worth ratios, and limitations on capital expenditures. Purchases of unrestricted stock and the payment of dividends are limited to 50% of cumulative net income from January 1, 1993, plus $25,000. At December 31, 1993, $17,200 was available for dividends and purchases of unrestricted stock, providing the Company complies with the other financial covenants of the agreements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--Continued THE LINCOLN ELECTRIC COMPANY AND SUBSIDIARIES (In thousands of dollars) December 31, 1993 NOTE D--SHORT-TERM AND LONG-TERM DEBT--(Continued) In November 1993, a number of the financial covenants contained in the Credit Agreement and in the Senior Note Agreement, were amended to allow for the costs of restructuring certain of the Company's foreign operations. The covenant related to consolidated tangible net worth was amended to require a minimum of $110,000 prior to June 30, 1994; $115,000 prior to September 30, 1994; $120,000 prior to December 31, 1994; and $125,000 plus 50% of net income subsequent to January 1, 1995, and the covenant related to the ratio of consolidated debt to consolidated tangible net worth was amended to require a ratio of 2.45 to 1 at December 31, 1993, reducing to 1.85 to 1 at July 1, 1994 and 1.35 to 1 at July 1, 1995 and thereafter. Maturities of long-term debt for the five years succeeding December 31, 1993 are $10,200 in 1994, $128,200 in 1995, $10,700 in 1996, $11,400 in 1997; $9,600 in 1998 and $57,000 thereafter. At December 31, 1993, certain foreign loans were collateralized by property and equipment which have a carrying value of approximately $21,400. In 1992, the Company terminated its interest rate swap agreement with a notational borrowing amount of $75,000 and received $2,586 which is being amortized over the original swap term (December 1994) as a yield adjustment to interest expense of the underlying $75,000 debt. Interest expense capitalized to property, plant and equipment was $71 in 1993 and $320 in 1992. Total interest paid was $19,000 in 1993, $17,500 in 1992, and $15,700 in 1991. In connection with the Company's expansion of its motor plant, which is expected to cost $19,800, the Company has received low interest rate loan commitments from certain governmental entities in the amount of $6,000, of which, $2,000 was received in March 1994. The Company has also applied for and expects to receive, $2,300 in governmental grants for the same project. NOTE E--INCOME TAXES Effective January 1, 1993, the Company adopted SFAS No. 109, "Accounting For Income Taxes". As permitted under the new Statement, prior years' financial statements have not been restated. The cumulative effect of adopting this statement as of January 1, 1993 is reported separately in the Statement of Consolidated Operations. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--Continued THE LINCOLN ELECTRIC COMPANY AND SUBSIDIARIES (In thousands of dollars) December 31, 1993 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--Continued THE LINCOLN ELECTRIC COMPANY AND SUBSIDIARIES (In thousands of dollars) December 31, 1993 NOTE E--INCOME TAXES--(Continued) Total income tax payments, net of refunds, were $19,387 in 1993, $16,542 in 1992 and $12,668 in 1991. At December 31, 1993, the Company's foreign subsidiaries had net operating loss carryforwards of approximately $44,875. The loss carryforwards expire in various years from 1994 through 2002, except for certain loss carryforwards of $571 for which there are no expiration dates. Income taxes currently payable amounted to approximately $8,698 at December 31, 1993. Income taxes currently refundable amounted to $1,400 at December 31, 1992. The Company does not provide deferred income taxes on unremitted earnings of foreign subsidiaries as such funds are deemed permanently reinvested to finance foreign expansion and meet operational needs on an ongoing basis. Upon distribution of those earnings in the form of dividends or otherwise, the Company would be subject to both U.S. income taxes subject to an adjustment for foreign tax credits and withholding taxes payable to the various foreign countries. Determination of the amount of unrecognized deferred U.S. income tax liability is not practicable because of the complexities associated with its calculation; however, unrecognized foreign tax credits and foreign withholding taxes paid upon distribution would be available to reduce some portion of the U.S. liability. NOTE F--RETIREMENT ANNUITY AND GUARANTEED CONTINUOUS EMPLOYMENT PLANS The Company and its subsidiaries maintain a number of defined benefit and defined contribution plans to provide retirement benefits for their employees in the United States as well as their employees in foreign countries. These plans are maintained and contributions are made in accordance with the Employee Retirement Income Security Act of 1974, local statutory law or as determined by the Board of Directors. The plans generally provide benefits based upon years of service and compensation. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--Continued THE LINCOLN ELECTRIC COMPANY AND SUBSIDIARIES (In thousands of dollars) December 31, 1993 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--Continued THE LINCOLN ELECTRIC COMPANY AND SUBSIDIARIES (In thousands of dollars) December 31, 1993 The increase in the actuarial present value of accumulated benefit obligations ("ABO") for the domestic plans is largely due to the change in the discount rate from 8.0% to 7.5% as well as the normal one year's accrual of benefits. In addition the increase in the ABO for the foreign plans is also primarily due to the change in the discount rate from 8.9% to 7.5%. Plan assets for the domestic plans consist principally of deposit administration contracts and an investment contract with an insurance company. Other assets held by the domestic plans not under insurance contracts are invested in equity and fixed income securities. Plan assets for the foreign plans are invested in foreign insurance contracts and foreign equity and fixed income securities. The Cleveland, Ohio area operations have a Guaranteed Continuous Employment Plan covering substantially all employees, which, in general, provides that the Company will provide work for at least 75% of every standard work week (presently 40 hours). This plan does not guarantee employment when the Company's ability to continue normal operations is seriously restricted by events beyond the NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--Continued THE LINCOLN ELECTRIC COMPANY AND SUBSIDIARIES (In thousands of dollars) December 31, 1993 NOTE F--RETIREMENT ANNUITY AND GUARANTEED CONTINUOUS EMPLOYMENT PLANS (Continued) control of the Company. The Company has reserved the right to terminate this plan effective at the end of a calendar year by giving notice of such termination not less than six months prior to the end of such year. In December 1990, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions", which was effective in 1993 domestically and will be effective for non-U.S. plans in 1995. In November 1992, the Financial Accounting Standards Board issued Statement No. 112, "Employers' Accounting for Postemployment Benefits." The Company is not required to implement this Statement until the first quarter of 1994. These Statements have no impact on the consolidated financial position or results of operations as the Company does not provide for any postretirement or postemployment benefits other than pensions. NOTE G--INDUSTRY AND GEOGRAPHIC SEGMENT INFORMATION Intercompany sales between geographic regions are accounted for at prices comparable to normal, customer sales and are eliminated in consolidation. NOTE H--ACQUISITIONS In June 1993, the Company acquired the outstanding minority interest in its subsidiary in Spain for approximately $8,500. In January and May of 1992, respectively, the Company purchased the remaining 29 percent interest in Lincoln Norweld and a small Mexican company for an aggregate of $37,000. In April 1991, the Company purchased the material assets of the German arc welding business (except orbital welding) of Messer Griesheim GmbH. All the above transactions NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--Continued THE LINCOLN ELECTRIC COMPANY AND SUBSIDIARIES (In thousands of dollars) December 31, 1993 NOTE H--ACQUISITIONS (Continued) and increases in equity ownership were accounted for as purchases and their results of operations and the increased interest in their results of operations, were included in the consolidated statements of operations from their respective dates of acquisition. NOTE I--FAIR VALUES OF FINANCIAL INSTRUMENTS The Company has various financial instruments, including cash and cash equivalents, forward exchange contracts for currencies, and short and long-term debt. The Company has determined the estimated fair value of these financial instruments by using available market information and appropriate valuation methodologies which require judgment. Accordingly, the use of different market assumptions or estimation methodologies could have a material effect on the estimated fair value amounts. The Company believes the carrying values of their financial instruments approximate their fair value. NOTE J--NOTES RECEIVABLE FROM EMPLOYEES Notes receivable from employees, which currently bear interest at 9%, include $294 ($532 in 1992) from officers of the Company. Loans are limited to 65% of the aggregate value of the pledged stock determined by the current offering price of the stock under the Employees' Stock Purchase Plan. NOTE K--0PERATING LEASES The Company leases sales offices, warehouses, office equipment and data processing equipment. Such leases, some of which are noncancellable, and in many cases, include renewals, expire at various dates. The Company pays most maintenance, insurance and tax expenses relating to leased assets. Rental expense was $9,864 in 1993, $9,840 in 1992 and $6,444 in 1991.

1993 ITEM 1. BUSINESS. 1.(A) GENERAL Heritage Media Corporation (the "Company", "Heritage", or "HMC"), through its ACTMEDIA, Inc. ("ACTMEDIA") subsidiary, is the world's largest independent provider of in-store marketing products and services, primarily to consumer packaged goods manufacturers with products in supermarkets and drug stores. Heritage also owns and operates six network-affiliated television stations and fourteen radio stations in seven major markets. ACTMEDIA offers advertisers a broad assortment of in-store advertising and promotional products which can be purchased separately or integrated to produce a cohesive in-store marketing program for a given product. ACTMEDIA's products and services include print advertisements on shopping carts, aisle directories and shelf facings, promotional products such as cooperative coupon and sampling programs, on-shelf electronic couponing, customized in-store demonstrations and merchandising, and audio in-store advertising. ACTMEDIA's in-store marketing business is part of the alternative media industry, which has grown rapidly at a time when advertising expenditure growth rates on traditional marketing have slowed. ACTMEDIA's revenues have grown from $116 million in 1989 to $216 million in 1993, a compounded annual growth rate of 17%. ACTMEDIA is the only in-store marketing participant with a full-time field management staff supervising its own national field service organization (up to approximately 15,000 available part-time employees). ACTMEDIA delivers its products and services in over 24,000 supermarkets and 12,000 drug stores. Heritage's principal strategy and goal for its in-store marketing business is to develop new in-store products or product enhancements, to pursue in-store opportunities in additional markets outside the U.S., to expand in-store marketing services to new classes of stores and to increase the utilization of its existing in-store products particularly the Instant Coupon Machine and its audio in-store product. The Company's strategy for its television broadcasting business is to emphasize obtaining local advertising revenues through market segmentation, focusing on local news programming and tightly controlling operating expenses. Heritage's strategy for its radio broadcasting business is to focus on the acquisition of underperforming stations and to improve their operations. 1.(B) BUSINESS SEGMENT INFORMATION The business segment information required by this item is set forth in Note 11 of Notes to Consolidated Financial Statements of Heritage, included herein. 1.(C) DESCRIPTION OF THE BUSINESS IN-STORE MARKETING Alternative media augments mass media advertising by reinforcing advertising and promotional messages to consumers where they congregate and, in the case of in-store marketing, where purchase decisions are made. The advent of the alternative media industry was prompted by the realization that traditional mass media vehicles (television, radio, and print advertisements) were becoming less effective due to changes in the profile of a typical shopper and his or her shopping patterns and to the proliferation of types of media used to communicate to the shopping public. Changing shopping patterns have led to shorter supermarket visits, usually without shopping lists, and declining brand loyalty. Industry sources estimate that a significant percentage (ranging from 40% to 66%) of brand purchase decisions are made in the supermarket. Economic trends also support the continued growth of in-store marketing because this medium is inexpensive in comparison to other marketing alternatives such as television, radio and traditional print advertisements. In-store marketing is based upon the foundation that the store is the only place where the product, the manufacturer's message and the consumer with an intent to buy all converge. In-store marketing products and services thus allow advertisers to communicate with consumers at or near the point-of-purchase before, or as, purchasing decisions are made. PRODUCTS AND SERVICES ACTMEDIA offers advertisers a broad assortment of in-store advertising and promotional products which can be purchased separately or integrated under the Company's "store domination" concept to produce a cohesive in-store marketing presentation for a given product or brand. ACTMEDIA's products and services include print advertising products, such as advertisements on shopping carts, aisle directories and shelf facings; promotional products, such as cooperative coupon and sampling programs; on-shelf electronic couponing; audio in-store advertising; and customized in-store demonstrations and merchandising. By linking sight, sound and one-on-one selling, ACTMEDIA provides its clients with an effective means to reach the consumer at the point-of-purchase. INSTANT COUPON MACHINE. The Instant Coupon Machine ("ICM"), which was developed by ACTMEDIA, is an electronic coupon dispenser that is mounted on shelf channels under or near featured products. Through independent market research sponsored by the Company, the ICM was shown to increase brand switching substantially and to encourage first-time purchases of featured products. In market testing, coupons featured in ACTMEDIA's ICM achieved an average redemption rate of 17%, versus reported redemption rates of approximately 2% for coupons in free-standing inserts, approximately 4% for coupons sent to consumers in direct mailings and less than 1% for run of press coupons. The Company's test results also indicated that unit sales increased an average of 35% over four weeks for products using the ICM. In addition to its high redemption rate, test marketing indicated that the ICM would generate significant unplanned purchases; approximately 56% of purchases made with coupons from the ICM were unplanned in 1992. In 1993 this rate had grown to 62%. The Company believes that the ICM is also effective in reaching shoppers who do not normally use coupons; in market tests approximately 47% of consumers who redeemed a coupon from the ICM stated that they never use or only occasionally use a coupon. The ICM holds 500 coupons and is marketed to advertisers on a category-exclusive basis at the shelf. The ICM is sold in four-week cycles. National rollout of the ICM commenced in February 1992. By the end of 1993 the ICM was available in approximately 8,700 grocery stores and 5,700 drug stores. In January 1992, the Company was granted a patent with respect to certain design features of the ICM. RETAILERS' CHOICE. ACTMEDIA's Retailers' Choice program provides cooperative in-store coupon and sampling programs for groups of advertisers, generally five times per year. Under these programs, ACTMEDIA's representatives distribute coupons, samples and premiums inside the entrance of approximately 12,500 stores nationwide. Up to 16.5 million co-op coupon booklets and up to 16.5 million solo coupons and samples are distributed directly to shopping customers per event. In addition, product awareness is reinforced through the placement of featured products on a free-standing Retailer's Choice display. Market tests indicate that these events typically result in 40% of coupon redeemers being new brand users or switchers. Of the Retailers' Choice coupons redeemed, research by the Company indicates approximately 18% are generally redeemed in the first day of an event, which contrasts positively to free-standing insert coupon rates of redemption. IMPACT. Impact is the nation's leading in-store supermarket demonstration program, offering advertisers complete turnkey service for their in-store events. Customized events, such as tastings, premiums, samplings and demonstrations, are conducted in up to 24,000 stores nationwide. All demonstrations are monitored every day by full-time and part-time supervisors at an average ratio of one supervisor to 15 demonstrators. Impact's regular part-time staff of demonstrators, who implement the programs, maintain a consistent professional appearance (with matching aprons and materials). Special display units are utilized in the programs and programs are sold on a store-day basis. Events are generally conducted at the front of the store but can be located elsewhere. Category exclusivity is offered by store chains on event days. CARTS. ACTMEDIA's 8" by 10", four-color advertisements, mounted in plastic frames on the inside and outside of shopping carts, offer advertisers continuous storewide category-exclusive advertising delivery of a print advertisement. Because the shopping cart ads circulate around the entire store with the shopper, these advertisements are an effective tool for advertisers to reinforce their messages. Shopping cart advertisements are available in approximately 8,000 supermarkets nationwide, offering coverage of approximately 80 areas of dominant influence ("ADI"). Shopping cart advertisements are sold in four-week cycles to a maximum of twelve advertisers per cycle and, according to a study by Simmons Research, reach store locations visited by more than 90 million shoppers per cycle. According to studies by Audits & Surveys, Inc. ("A&S") conducted from 1973 to 1993, the use of shopping cart advertisements increased average unit sales for the products advertised by approximately 10% in stores where they were utilized. AISLEVISION. AisleVision features 28" by 18" four-color advertisement posters inserted in stores' overhead aisle directory signs. The large size of AisleVision draws attention to the supermarket aisle in which the product is stocked and has the added benefit of being frequently used by shoppers during their shopping trips. ACTMEDIA's AisleVision is sold in approximately 7,000 stores nationwide, offering category-exclusive coverage of approximately 170 ADI's. AisleVision is sold in four-week cycles to a maximum of 18 advertisers per cycle. Studies conducted by A&S from 1985 to 1993 reported that the use of AisleVision increased average unit sales for the products advertised by approximately 8%. An enhancement, AisleAction, allows the manufacturer to include motion on the directory sign, enhancing shopper awareness of the sign. SHELFTALK/SHELFTAKE-ONE. ShelfTalk features advertisements placed in plastic frames mounted on supermarket or drug store shelves near its featured product. ShelfTake-One includes rebate offers or recipe ideas which consumers may remove from the plastic frame at the site of the featured product. These four-color, 5 1/4" by 4" ads placed perpendicular to the shelf and facing in both directions are an effective means of bringing attention to a product at the shelf level and reinforcing advertising messages at the point-of-purchase. ShelfTalk and ShelfTake-One are sold in approximately 10,000 supermarkets, offering coverage of approximately 180 ADI's, and in approximately 5,500 drug stores, covering approximately 160 ADI's. ShelfTalk and ShelfTake-One are sold in four week cycles on a category-exclusive basis at the shelf. Studies conducted by A&S from 1985 to 1993 reported that ShelfTalk resulted in an approximately 5% average unit sales gain for the products advertised in grocery stores and an approximately 11% average unit sales gain for the products advertised in drug stores. ACTRADIO. ACTRADIO, formerly POP (Point of Purchase) Radio, is the nation's largest advertiser-supported, in-store radio network. ACTRADIO delivers its in-store audio advertising in conjunction with music entertainment services provided by the nation's leading business music providers. Retailers participating in the ACTRADIO network generally receive a share of revenues from the sale of advertising time. At December 31, 1993 there were 7,555 chain supermarkets, 7,395 chain drug stores and 770 Toys 'R' Us/Kids 'R' Us toy and children clothing stores totaling 15,720 stores comprising the total network. ACTRADIO delivers over 800 million advertising impressions over a four week period reaching 68% of adults an average of 6.5 times according to recent Simmons data. This massive reach and frequency makes ACTRADIO an attractive alternative to traditional broadcast, published, or direct mail advertising. Advertisers can extend their message at the point of sale at a fraction of the CPM (cost per thousand) of traditional media. In addition to its advertising value, A&S studies from 1987 through 1992 show that ACTRADIO delivers an average sales gain of 9% with a brand sell ad, and over 20% when a promotional tag or price tag is added. Research conducted in 1992 also indicated that 94% of all shoppers are attentive to the brand sell commercials, and that over half of all shoppers claim it has a positive effect in their purchase choices. ACTRADIO sells advertising time to manufacturers in units of 15 second, 20 second, and 30 second commercials each hour with feature tagging available as an option. ACTRADIO is sold in four week cycles comprising a minimum of 336 broadcasting hours and is available on a national, regional or chain specific basis. Advertisers may run their existing broadcast advertisements or ACTRADIO will produce commercials for them. Each hour of customized programming for retailers includes 48 minutes of music (with a wide choice of formats), 10 minutes of advertising and two minutes of airtime provided to retailers for their own promotional messages. In 1993 ACTRADIO terminated its Joint Operating Agreement ("JOA") with MUZAK and entered into new marketing alliances with leading in-store music providers A.E.I., Muzak, and Broadcast International to create the largest in-store satellite delivered radio network in the United States. The alliances designate ACTRADIO as the music providers' exclusive national advertising agent for a select group of retailers which includes most of the leading national supermarket and drug chains. A similar arrangement with Digital Music Express ("DMX") is expected to be finalized in the near future in conjunction with the launch of DMX/DBS satellite music service. ACTRADIO and the music providers will jointly upgrade and expand the in-store satellite delivery systems across the entire network. As of December 31, 1993, over 40% of the network was satellite delivered, with the balance of the network being delivered via tape equipment. ACTRADIO anticipates the entire satellite network to be completed by the end of 1994 targeting an expanded store base of nearly 24,000 stores. The new name, ACTRADIO Network, adopted in January 1994 more closely aligns the in-store audio product with the wide array of other in-store marketing products and services offered by ACTMEDIA. FREEZERVISION. ACTMEDIA's FreezerVision offers advertisers a means to reinforce its advertising messages at the upright freezercase. FreezerVision is a triangle-shaped print advertisement, mounted in a plastic frame, on the outside of the glass freezercase door. FreezerVision offers highly visible, category-exclusive advertising coverage. FreezerVision is sold in four-week cycles and national retail sales of FreezerVision began in the fourth quarter of 1992. FreezerVision was available in approximately 2,000 supermarkets by the end of 1993. SELECT. In 1991, the Company also offers Select, a service which utilizes ACTMEDIA's part-time field force to perform in-store merchandising tasks for manufacturers. These tasks have included on-pack couponing and stickering, distribution checks and installation of point-of-purchase materials. IN-STORE NETWORK ACTMEDIA's in-store network delivers its products and services in over 24,000 supermarkets and 12,000 drug stores across the country, a network substantially larger than that of any other in-store marketing company. By contracting to purchase the Company's in-store advertising and promotional products, advertisers gain access to up to approximately 200 of the nation's 214 ADI's covering over 70% of the households in the United States. ACTMEDIA currently has contracts with approximately 300 store chains. ACTMEDIA's store contracts generally grant it the exclusive right to provide its customers with those in-store advertising services which are contractually specified. The contracts are of various durations, generally extending from three to five years and provide for a revenue-sharing arrangement with the stores. ACTMEDIA's store contract renewals are staggered and many of its relationships have been maintained for almost two decades. ACTMEDIA's advertising and promotional programs are executed through one of the nation's largest independent in-store distribution and service organizations, although certain chains require the Company to utilize their own employees. ACTMEDIA believes the training, supervision and size of its field service staff (approximately 300 full-time managers and up to approximately 15,000 available part-time employees) provide it with a significant competitive advantage as its competitors generally do not have a comparable field service staff. The Company is attempting to expand its in-store products to additional classes of trade, such as club stores, discount stores, mass merchandisers and convenience stores. CUSTOMER BASE ACTMEDIA's customer base includes approximately 250 companies and 700 brands. This customer base includes the 25 largest advertisers of consumer packaged goods. In 1993, the Company's largest customers included the following: During 1993, Procter & Gamble was the Company's most significant customer. The loss of this customer would materially and adversely affect the Company. ACTMEDIA's sales organization markets its services to consumer packaged goods brand managers, promotion managers and their advertising agencies. ACTMEDIA's sales force consists of approximately 40 representatives, who are compensated on a salary-plus-commission basis. In addition to its sales force for its base products, ACTRADIO has established a separate sales force. Sales representatives stress the benefits of in-store marketing services, including: (i) the exclusivity afforded advertisers for a specific merchandise category, a feature generally unavailable in television, radio, magazine or newspaper advertising; (ii) increases in sales volume; (iii) the ability to reach customers at the point-of-purchase where industry sources estimate that a significant number (ranging from 40% to 66%) of all brand buying decisions are made; and (iv) ACTMEDIA's ability to reach a significant number of consumers at costs per thousand that are significantly less than comparable television or print advertising. INTERNATIONAL OPERATIONS AND INVESTMENTS The Company has set the establishment of a significant business presence outside of the United States as an important priority for ACTMEDIA. The majority of the Company's advertisers are large, multinational companies for whom the use of in-store marketing products in overseas markets is expected to be a logical extension of their advertising and promotional budgets. In November 1990, the Company acquired one of Canada's largest in-store marketing companies (now renamed ACTMEDIA Canada), which primarily operated an in-store cart advertising program. In August 1991, ACTMEDIA Canada acquired a Canadian company whose services include in-store demonstrations, merchandising and information collection. The combination of these two companies has enabled ACTMEDIA to attain a significant market position in Canada comparable to ACTMEDIA's U.S. market position. In January 1992, the Company formed a joint venture named ACTMEDIA Europe in which it has a 65% interest and H. L. van Loon (of Amsterdam, The Netherlands) has a 35% interest. ACTMEDIA Europe simultaneously acquired Media Meervoud, N.V., a Dutch in-store marketing company engaged in both cart advertising and promotions, of which Mr. van Loon was the principal shareholder. During 1993, ACTMEDIA Asia was launched in a joint venture with Omnilink of Singapore. In February 1994, ACTMEDIA acquired in-store marketing companies in Australia and New Zealand. In addition to analyzing international acquisition opportunities in other countries, ACTMEDIA has commenced a program to license its name and train licensees in the methods of conducting in-store operations in countries where the in-store industry is too small for a direct ACTMEDIA presence. Although ACTMEDIA has presently entered into four such license agreements (covering Israel, Turkey, South Africa and Venezuela), revenues from licensed operations were not material in 1993. International sales in 1993 accounted for $17.7 million (approximately 8%) of the In-store revenues. DEVELOPMENT ACTMEDIA is actively pursuing, testing, and developing new product and new business opportunities. Growth opportunities exist in several areas including expanding ACTMEDIA's sampling and demonstration businesses outside the store as well as in-store through the marketing of non-packaged goods. Introducing ACTMEDIA's products into mass merchandisers and convenience store classes of trade remains a key focus area. ACTMEDIA is also pursuing in-store merchandising opportunities through leveraging its national field service organization. International in-store acquisitions continue to be evaluated as vehicles to introduce ACTMEDIA's products worldwide. COMPETITION The advertising and promotion industries are characterized by intense competition. ACTMEDIA competes directly with other point-of-purchase advertisers and coupon/sampling/distribution/demonstration companies and indirectly with all other media in the supply of local and national advertising and promotion services, including cable television, television, radio, magazines, outdoor advertising and newspapers. Also, certain store chains offer limited advertising and promotional products and services. The Company believes that the principal competitive factors affecting its in-store marketing business are the cost of its services and the ability to demonstrate the cost effectiveness of its services as well as the comprehensive scope, coverage and quality of the services provided. There are relatively few barriers to entry particularly at the local level for suppliers of many different types of marketing (including packaged goods manufacturers, advertising agencies, retailers or other companies). However, the development of a nationwide capacity to supply advertising or promotional programs would require sufficient field service personnel to distribute and service comparable advertising or promotional programs, and substantial time and effort could be required to obtain the comprehensive store relationships, contracts and execution systems developed by ACTMEDIA over the years. Although the Company believes that ACTMEDIA is the largest provider of in-store marketing services, other companies (some of which are affiliated with large companies) offer similar services. Moreover, the in-store marketing environment is characterized by rapid technological change, and future technological developments (if and when cost effective) may affect competition. BROADCASTING Heritage owns and operates six network-affiliated television stations (plus one affiliate licensed as a satellite station but operated as a partial stand-alone station), three AM/FM combination radio stations, two stand-alone FM radio stations, and two AM/FM/FM combination radio stations. TELEVISION The Television Group owns six network-affiliated television stations. The following table sets forth selected information relating to the television stations owned by Heritage: Heritage operates its television stations in accordance with a cost-benefit strategy that stresses primarily revenue and cash flow generation and secondarily audience share and ratings. The objective of this strategy is to deliver acceptable profit margins while maintaining a balance between the large programming investment usually required to maintain a number one ranking (with its resultant adverse effect on profit margins), and the unfavorable impact on revenues that results from lower audience ratings. Components of the Company's operating strategy include management's emphasis on obtaining local advertising revenues by market segmentation, which provides a competitive advertising advantage, focusing on local news programming and tightly controlling operating expenses. By emphasizing advertising sales from local businesses, the Company's stations produce a higher percentage of local business (approximately 63% local and 37% national) than the national average. The following table sets forth certain historical net revenue and direct expense information for Heritage's television stations. This information does not reflect any corporate, television group, or nonrecurring expenses, interest expense, or income taxes. The primary costs involved in owning and operating stations are salaries, programming, news expense, depreciation and amortization and commissions for advertising. Television station revenues are primarily derived from local/regional and national advertising and to a lesser extent network compensation, with a small percentage of revenue sometimes obtained from studio rental and programming-related activities. The majority of national and local/regional advertising contracts are short-term, generally running for only a few weeks. WEAR-TV, the ABC affiliate in Pensacola, is the only network affiliated station in the Pensacola-Mobile market which is physically located in Florida and benefits from the market's growth which comes primarily from Florida. In 1993, the station's newscast obtained the market's number one rating and the station began constructing a new studio facility in Pensacola which is scheduled for completion in March 1994. The Television Group's station in Plattsburgh/Burlington, WPTZ-TV, an NBC affiliate, also provides NBC programming to southern Quebec, including Montreal. Additionally, WPTZ-TV operates WNNE-TV, a satellite station serving portions of New Hampshire and Vermont, which allows advertisers to selectively air their messages over WPTZ-TV's entire market or segments of the market. WCHS-TV, an ABC affiliate, is the only network affiliate based in the capital city of Charleston, within the Charleston and Huntington market. The Company acquired KOKH-TV in Oklahoma City, Oklahoma on August 15, 1991 and sold its KAUT-TV station in the same market to a non-commercial licensee (while transferring KAUT's FOX network affiliation to KOKH). The acquisition of KOKH-TV has been very successful. The improved channel position, signal strength, elimination of a commercial station in the market, and the emergence of the Fox network have contributed to the significant revenue increase since the acquisition. In South Dakota, the Company operates two stations, KEVN-TV in Rapid City and KDLT-TV in Sioux Falls, both NBC affiliates. Three of the Company's stations, WEAR-TV, WPTZ-TV and WCHS-TV, which represent 73% of the operating income from Heritage's television operations, have developed specific market segmentation strategies based on their status as the sole network affiliate in one geographic area of a hyphenated market. This geographic advantage enables these stations to build strong local identities and leading positions in local news programming in their portions of these hyphenated markets. In addition, WPTZ-TV and KEVN-TV, both VHF stations, have a transmission advantage in their market areas compared to certain other network affiliates, but KDLT-TV suffers from a signal disadvantage because of the location of its tower. The Company has shaped its sales efforts around two central beliefs: (1) that national advertising spots and a station's relations with its clients are based on ratings, while the sales of local spots depends to a greater extent on the station's local sales force and their relations with clients and (2) that the local advertising segment is the fastest growing advertising segment. As a result of these beliefs, Heritage's stations generally maintain a larger, more experienced sales force but a smaller general staff than its competitors. The strength of the stations' sales forces and their orientation toward generating local advertising revenue have resulted in 63% of the stations' revenues being derived from local sources, against an industry average estimated at approximately 50%. RADIO The Radio Group owns and operates five AM and nine FM radio stations (including two FM "duopolies") in seven of the top 50 markets -- Seattle, WA; St. Louis, MO; Cincinnati, OH; Portland, OR; Milwaukee, WI; Kansas City, MO; and Rochester, NY. The following table sets forth certain information regarding Heritage's radio stations: The Company's strategy is to identify and acquire underperforming radio stations or groups and effect management and operational changes to increase their profitability. Implementation of this strategy typically involves the following four-step process: (1) instituting operational improvements, usually including a change in management personnel and additional capital investments when appropriate; (2) creating increases in audience ratings through programming and promotional changes; (3) improving revenue as a result of the turnaround process; and (4) increasing cash flow. Heritage radio stations strive to be top-rated in their programming formats, and universally program a mass appeal music format directed at a target audience of 25-to-54 year-olds. Presently, seven of the Company's nine FM stations are format leaders in their markets. In addition, Heritage stations are number one ranked among all stations in three of the Company's seven radio markets. The Federal Communications Commission ("FCC") limits radio ownership both in the number of stations commonly owned, operated, or controlled in any one market, and in total. In late 1992, the FCC relaxed its rules to increase the number of stations one entity can own in one market if certain requirements are met. This new combination is commonly known as a "duopoly". The Company acquired two FM stations in 1993 that created "duopolies". On July 22, 1993 it acquired WKLX-FM in Rochester, New York. Effective January 1, 1994, the Company acquired WEZW-FM in the Milwaukee market. Before the Heritage acquisition, the licensees of WKLX-FM and WEZW-FM maintained independent control over and complete responsibility for programming and operations of their respective stations. Heritage assumed management responsibilities (subject to certain FCC restrictions) pursuant to "Local Marketing Agreements" ("LMA's") approximately two months prior to the respective closing dates, and the financial results of the stations were consolidated beginning May 19, 1993, for WKLX, and November 1, 1993, for WEZW. WKLX programs an "oldies" format, similar to the Company's FM stations in Portland and Rochester. WEZW has a soft adult contemporary format that is complementary to that of the Company's WMYX in that market. Heritage announced on January 10, 1994 that it has agreed to acquire radio station KRJY-FM in St. Louis, MO. Heritage currently owns and operates WRTH-AM and WIL-FM in the St. Louis market. This acquisition, the Company's third "duopoly", received approval by the FCC in early March. The Company's acquisition and operating strategies have enabled its radio group to increase earnings before interest, taxes, depreciation and amortization ("EBITDA") from $.1 million in 1987, its first full year, to $9.4 million in 1993. The following table sets forth certain net revenue and direct expense information for Heritage's radio stations including the stations acquired in 1992 and 1993 and excluding a Los Angeles station sold in March 1991. This information does not reflect any corporate, radio group, or nonrecurring expenses, interest expense or income taxes. Also included in the 1993 financial results (but not included in the table above) are revenues of $419,000 and EBITDA of $174,700, from November, 1993, for WEZW-FM under the terms of an LMA Agreement. Each of Heritage's FM facilities is of the highest class of service permitted by the FCC (B or C) with comprehensive signal coverage of its markets. The AM stations operate as full-time facilities on regional or clear channels. COMPETITION The Company's television and radio stations compete for advertising revenues with other media companies in their respective markets, as well as with other advertising media, such as newspapers, magazines, outdoor advertising, local cable systems, direct mail and alternative media. Some competitors are part of larger companies with substantially greater financial resources than Heritage. Competition in the broadcasting industry occurs primarily in individual markets. Generally, a television broadcasting station in one market does not compete with stations in other market areas. Heritage's television stations are located in highly competitive markets. While the pattern of competition in the radio broadcasting industry is basically the same, it is not uncommon for radio stations outside of the market area to place a signal of sufficient strength within that area to gain a share of the audience. In addition to the element of management experience, factors that are material to competitive position include authorized power, assigned frequency, network affiliation, audience characteristics and local program acceptance, as well as strength of local competition. The broadcasting industry is continuously faced with technological change and innovation, the possible rise of popularity of competing entertainment and communications media, changes in labor conditions and governmental restrictions or actions of federal regulatory bodies, including the FCC and the Federal Trade Commission ("FTC"), any of which could possibly have a material effect on Heritage's operations and results. In recent years broadcast television stations have faced increasing competition from the other sources of television service, primarily cable television, and the ratings have reflected a decline in the viewing audience. These other sources can increase competition for a broadcasting station by bringing into its market distant broadcasting signals not otherwise available to the station's audience and also serving as a distribution system for non-broadcast programming. Programming is now being distributed to cable television systems by both terrestrial microwave systems and by satellite. Other sources of competition include home entertainment systems (including television game devices, video cassette recorder and playback systems and video discs), multi-point distribution systems, multichannel multi-point distribution systems and satellite master antenna television systems. Heritage's television stations will face competition from direct broadcast satellite services which transmit programming directly to homes equipped with special receiving antennas or to cable television systems for transmission to their subscribers. The likely entry of telephone companies into the video programming distribution business could increase the competition the Company's television stations face from other distributors of audio and video programming. The broadcasting industry is continuously faced with technological change and innovations, which could possibly have a material effect on the Company's broadcast operations and results. Commercial television broadcasting may face future competition from interactive video and data services that may provide two-way interaction with commercial video programming, along with information and data services that may be delivered by commercial television stations, cable television, direct broadcast satellites, multi-point distribution systems, multichannel multi-point distribution systems, or other future video delivery systems. FEDERAL REGULATION OF BROADCASTING Television and radio broadcasting are subject to the jurisdiction of the FCC, which acts under authority granted by the Communications Act of 1934, as amended (the "Communications Act"). The Communications Act prohibits radio or television broadcasting except in accordance with a license issued by the FCC. The Communications Act also empowers the FCC, among other things, to issue, renew, modify or revoke broadcasting licenses, to determine the location of stations, to regulate the equipment used by stations, to adopt such regulations as may be necessary to carry out the provisions of the Communications Act and to impose penalties for violation of such regulations. The following is a brief summary of certain provisions of the Communications Act and specific FCC regulations and policies. RENEWAL. Broadcasting licenses are issued for a maximum term of up to five years in the case of television stations and up to seven years in the case of radio stations, and are renewable upon application. In determining whether to renew a broadcast license, the FCC has authority to evaluate the licensee's compliance with the provisions of the Communications Act and the FCC's rules and policies. The FCC licenses for each of Heritage's radio and television stations expire at different times between April 1, 1994 and June 1, 1998. Applications to renew the licenses for stations WPTZ-TV, Plattsburgh, NY; and WNNE-TV, Hartford, VT are presently pending before the FCC. The Communications Act authorizes the filing of petitions to deny any license renewal applications during certain periods of time following the filing of renewal applications. Petitions to deny can be used by interested parties, including members of the public, to raise issues concerning a renewal applicant's qualifications. If a substantial and material question of fact concerning a renewal application is raised by the interested party, the FCC will hold an evidentiary hearing on the application. In recent years, there have been a number of petitions to deny filed against broadcast renewal applications challenging the licensee's compliance with the Commission's equal employment opportunity requirements. At the time the application is made for renewal of a broadcasting license, a person may file a competing application of authority to operate the station and replace the incumbent licensee. If a competing application is filed against a renewal application, the FCC is required to hold an evidentiary hearing on the renewal application. In the evidentiary hearing, the FCC recognizes a renewal expectancy for an incumbent licensee that has provided meritorious or substantial service to the audience located in its community of license during the preceding license term. In the vast majority of cases, broadcast licenses are renewed by the FCC even where there are petitions to deny or competing applications filed against broadcast license renewal applications. ACQUISITIONS OR SALES. The Communications Act prohibits the assignment of a license or the transfer of control of a licensee without the prior approval of the FCC. Applications to the FCC for such assignments or transfers are subject to petitions to deny by interested parties and are granted by the FCC only upon a finding that such action will serve the public interest, convenience and necessity. In determining whether to grant such applications, the FCC has authority to evaluate the same types of matters that it considers in evaluating a broadcast license renewal application. In the vast majority of cases where petitions to deny are filed against assignment or transfer applications, the applications are granted and the petitions are denied. On April 5, 1992, several local branches of the NAACP ("NAACP") filed a petition to deny with the FCC against Stations WRTH-AM and WIL-FM; Stations WBBF-AM and WBEE-FM; Stations KULL-AM and KRPM-FM; Stations WEMP-AM and WMYX-FM; and Station WEAR-TV (the"Licensees"), with respect to applications seeking FCC consent to permit James M. Hoak, Chairman of the Board of the Company, to relinquish "control" of the Company upon the conversion of all of Mr. Hoak's shares of Class B Common Stock into Class A Common Stock. On July 16, 1993, the NAACP's petition to deny was denied and the transfer of control applications for the Licensees were granted. On July 21, 1993, the transfer of control of the Licensees was consummated. On September 1, 1993, a petition for reconsideration ("Reconsideration Petition") was filed by the NAACP against the transfer of control applications for the Licensees. In the Reconsideration Petition, the NAACP alleges that the FCC erred in granting the transfer of control applications for the Licensees by summarily rejecting the NAACP's statistical evidence of discrimination without a rational explanation and failing to conduct the type of investigation required. The Company is vigorously opposing the NAACP allegations. While the Company cannot predict the outcome of this matter, the Company believes that the FCC's prior action approving the transfer of control for all of the Company's stations will be affirmed by the FCC without any conditions that will have a material adverse effect on the Company. OWNERSHIP RESTRICTIONS. Under the Communications Act, broadcast licenses may not be held by or transferred or assigned to an alien, a foreign entity, or any corporation of which any officer or director is an alien or of which more than one-fifth of the capital stock of record is owned or voted by aliens. In addition, the Communications Act provides that no broadcast license may be held by any corporation directly or indirectly controlled by any other corporation of which any officer or more than one-fourth of its directors are aliens, or of which more than one-fourth of the capital stock of record is owned or voted by aliens, if the FCC finds the public interest will be served by the refusal to grant such license. The FCC's local "multiple ownership" rules prohibit the grant of a license for a television station to any party if such party owns or has an ownership interest in another television station whose signal covers a portion of the same market served by the station owned, operated or controlled by such party. These rules prohibit the ownership of more than two AM and two FM stations in markets with 15 or more stations (provided that the combined audience share does not exceed 25 percent) and prohibit the ownership of more than three radio stations, no more than two of which are in the same service area, in markets with 14 or fewer stations (provided that the station owned in combination represents less than 50 percent of the stations in that market). In addition, the FCC's local multiple ownership rules prohibit station acquisitions that would result in the ownership interests in a radio and a television station in the same market. However, waivers can be obtained from the FCC for radio and television combinations upon an appropriate showing of good cause or if the stations are failing stations or are located in the top 25 markets where at least 30 separately owned or operated broadcast licensees remain after the proposed combination. The FCC's national television multiple ownership rules generally prohibit an individual or entity, that is not minority controlled, from having an ownership interest in more than 12 television station licenses. The national radio multiple ownership rules permit ownership of up to 18 AM and 18 FM radio stations with an automatic increase to 20 AM and 20 FM stations beginning in September 1994. The FCC's cross ownership rules prohibit radio and/or television licensees from acquiring new ownership interests in daily newspapers published in the same markets served by their broadcast stations; and television licensees may not own cable television systems in communities within the service contours of their television stations. In applying the FCC's multiple and cross ownership rules, the licensee will also have attributed to it any media interests of officers, directors and shareholders who own 5% or more of the licensee's voting stock, except that certain institutional investors who exert no control or influence over a licensee may own up to 10% of such outstanding voting stock before attribution results. These FCC rules do not require any changes in Heritage's present television and radio operations. REGULATORY CHANGES. Legislation was enacted recently by Congress called the Cable Television Consumer Protection and Competition Act of 1992 (the "Act") which imposes certain regulatory requirements on the operation of cable television systems. The Act provides television stations with the right to control the use of their signals on cable television systems. Each television station was required to elect prior to June 17, 1993 whether it wanted to avail itself of must-carry rights or, alternatively, to assert retransmission rights. If a television station elected to exercise its authority to grant retransmission consent, cable systems are required to obtain consent of that television station for the use of its signal and could be required to pay the television station by October 6, 1993 for such use. The Company believed that the preservation and continued cable carriage of the station's signal was more important than any potential negotiated consideration, and prior to the October 6 deadline elected must-carry for all its stations except the Fox affiliate, which successfully negotiated cable retransmission consents in association with the Fox Television Network. These elections remain in effect until October 1, 1996 when the stations again elect. The Act further requires mandatory cable carriage of all qualified local television stations not exercising their retransmission rights. Several challenges to the constitutionality of these requirements have been filed in Federal court including a challenge to the constitutionality of the must carry rights which is pending before the Supreme Court. The Company cannot predict the outcome of such challenges or the effect that the Act will have on the business of the Company if the constitutionality of the requirements is upheld. Legislation has been introduced from time to time which would amend the Communications Act in various respects and the FCC from time to time considers new regulations or amendments to its existing regulations. In addition, a number of proposals for regulatory changes are pending before the FCC and Congress. Such matters include proposals pending before the FCC to relax the rules governing the common ownership of television stations locally and nationally, to authorize a new type of wireless cable system, to authorize digital audio broadcasting and to authorize advanced (high definition) television systems. Certain of these changes will increase operating costs and/or increase the number of competing broadcast stations. Last year, the House and Senate passed campaign reform bills which reduce the rates that a television station can charge for advertising time sold to legally qualified candidates for public office. Differences between the two bills must be reconciled by a joint House and Senate Conference Committee before such legislation can be enacted. Adoption of such legislation could have a negative impact on a television station's revenues and cash flow during primary and general election periods. Heritage cannot predict whether such changes will be adopted or, if adopted, the effect that any such changes would have on the business of Heritage. EMPLOYEES Heritage and its subsidiaries employ approximately 1,300 full-time and up to 15,000 available part-time employees. Of this total, ACTMEDIA employs approximately 600 full-time and up to approximately 15,000 available part-time personnel. Substantially all of ACTMEDIA's part-time personnel are in field service staff. None of the In-store Marketing Group's employees are represented by a collective bargaining unit. Heritage's broadcast subsidiaries currently employ approximately 700 persons of whom 33 employees are represented by unions. The Company believes that it has a good relationship with its employees. ITEM 2. ITEM 2. PROPERTIES. Heritage's headquarters are located in Dallas, Texas. The lease agreement for the 8,202 square feet of office space in Dallas expires October 31, 1996. ACTMEDIA leases office facilities with an aggregate of approximately 65,000 square feet in Norwalk, Connecticut and 8,100 square feet in Des Plaines, Illinois with leases expiring in 2000 and 1998, respectively, and 41 field offices with an aggregate of approximately 84,000 square feet pursuant to leases with terms of three years or less. ACTRADIO leases approximately 5,800 square feet of space for its operations in New York City, New York pursuant to a lease expiring in 1995. The types of properties required to support each of Heritage's broadcast stations include offices, studios, transmitter sites and antenna sites. A station's studios are generally housed with its offices in downtown or business districts. Heritage's television stations own approximately 88 total acres in 8 locations upon which buildings with approximately 93,600 square feet of office and studio space are located. The stations own and lease approximately 148 and 11 acres, respectively, upon which the tower or transmitters are located. Heritage's radio stations own three AM transmitter sites totaling 58 acres. The stations lease approximately 50,000 square feet in seven locations upon which office and studio space is located. The stations also lease tower space at six locations totaling 31 acres. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. Heritage is subject to litigation in the ordinary course of business. It is not subject to any such legal proceedings which management believes are likely to result in any material losses being incurred. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Not applicable. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. Shares of the Company's Class A Common Stock have been listed on the American Stock Exchange ("AMEX") under the symbol "HTG" since 1988. No other class of Heritage's common equity is currently publicly traded. The following table sets forth the high and low closing prices of the Class A Common Stock for each quarterly period within the two most recent fiscal years on the AMEX. All share prices have been adjusted to give effect to a four-for-one reverse split of the Company's Class A Common Stock on March 30, 1992. On March 8, 1994 the last reported sale price of the Company's Class A Common Stock was $18.00 per share. At March 8, 1994 there were approximately 1,000 record holders of Class A Common Stock. Heritage has never paid cash dividends on shares of any class of its common stock. Heritage presently intends to retain its funds to support the growth of its business or to repay indebtedness or for other general corporate purposes and therefore does not anticipate paying cash dividends on shares of any class of its common stock in the foreseeable future. Additionally, the various financing agreements to which either Heritage or one or more of its subsidiaries is a party may effectively prohibit or sharply impact upon Heritage's ability to pay dividends. See Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Capitalization and Liquidity." ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. (In thousands, except per share data) Set forth below is selected consolidated financial data with respect to the Company for the years ended December 31, 1993, 1992, 1991, 1990, and 1989, which were derived from the audited consolidated financial statements of the Company. This data as of December 31, 1993 and 1992 and for each of the years in the three year period ended December 31, 1993 should be read in conjunction with the audited consolidated financial statements of the Company and its subsidiaries and the related notes thereto included elsewhere herein. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. GENERAL The Company's net revenues increased from $222.4 million in 1991 to $291.2 million in 1993, and its operating income increased from $22.3 million to $35.5 million over the same period. This growth is primarily attributable to growth from existing operations within the Company's in-store marketing and broadcast businesses complemented by the acquisition of certain in-store and broadcast properties. The Company reported net losses of $15.0 million and $18.6 million and net earnings of $.5 million for the years ended December 31, 1991, 1992 and 1993, respectively. The operating results before extraordinary items improved from a $19.3 million loss in 1991 to earnings of $77,000 in 1993. In August 1991, the Company purchased KOKH-TV, an independent television station serving Oklahoma City and simultaneously sold and donated its KAUT-TV station assets in this market to a non-commercial educational licensee. The Company retained its rights to broadcast programming provided by the FOX Broadcasting Company network over KOKH-TV. Also in August 1991, ACTMEDIA Canada acquired BLS Retail Resource Group, a Canadian in-store marketing company. On January 2, 1992, the Company acquired 65% of Media Meervoud, a Netherlands in-store marketing company ("MMV"). On June 1, 1992 the Company completed the acquisition of the broadcast assets of radio stations KCFX-FM and WOFX-FM. Also, during 1992, the Company wrote off its investment in Supermarket Visions, Ltd., a U.K. marketing company ("SVL"), as SVL ceased operations. On July 22, 1993 the Company completed the acquisition of the broadcast assets of radio station WKLX-FM. Heritage programmed and marketed the station under an LMA from May 19, 1993 to the completion of the acquisition. On October 25, 1993 the Company agreed to acquire radio station WEZW-FM. Heritage programmed and marketed the station under an LMA with the current owner from such date to the completion of the acquisition on January 1, 1994. The operating results of these stations, effective with the LMAs, are included in the consolidated financial statements. Due to the numerous acquisitions and dispositions, the results of operations from year to year are not comparable. See Note 2 of Notes to Consolidated Financial Statements for additional information concerning the Company's acquisitions, dispositions, and related transactions. RESULTS OF OPERATIONS: 1993 COMPARED TO 1992 Consolidated net revenues of $291.2 million represented a 16% increase over the 1992 revenues of $250.9 million. Cost of services of $151.1 million increased 10% in 1993 compared to 1992 due primarily to the increase in net revenues. Operating income of $35.5 million in 1993 exceeded the comparable 1992 period by 26%. The loss per share was $.29 versus $1.76 in 1992. The improvement in the Company's operating results for the 1993 period primarily reflects revenue growth from the Instant Coupon Machine by the In-store Marketing Group, increased local Television and Radio Group advertising revenues and positive contributions from the Radio acquisitions. The loss per share in 1993 was lower than 1992 due principally to $7.4 million of additional operating income, $6 million lower interest expense and increased average shares outstanding. The 1993 period included a $3 million nonrecurring charge for POP Radio, a $1.7 million writedown of Television broadcast program rights and a $.4 million extraordinary gain on the early extinguishment of debt. The 1992 period included a $3.3 million writeoff of the SVL investment and $3.6 million of extraordinary losses, net, recognized as a result of the Company's 1992 refinancing activities. All comparisons, unless otherwise noted, are for the year ended December 31, 1993 as compared to the comparable 1992 period. IN-STORE MARKETING. The In-store Marketing Group contributed $216.3 million of revenues in 1993, an increase of 16% compared to $186.4 million in 1992. The success of the ICM was a major contributor to this growth. The ICM generated $63 million of revenues in 1993, its first full year of operation, which tripled the $21 million level in 1992. Retailers' Choice (cooperative promotion program) revenues increased by 16%, primarily as a result of management's decision to increase the number of programs compared to 1992. Revenues generated per program registered a small decrease from $3.6 million in 1992 to $3.5 million in 1993. The International operations produced an additional $.5 million of revenues in 1993 to a total of $17.7 million. The International operations were impacted by the world-wide recession, particularly in Canada. Advertising revenues in 1993 declined 10% compared to 1992 reflecting the continuing trend toward promotion and the shift to ICM and away from the shelf-talk product. Total Impact revenues declined by 16% to $53 million in 1993. The number of programs has continued to decline from 141 in 1991 to 133 in 1992 and 108 in 1993. The demonstration business has also seen increased competition which has adversely affected pricing. Net revenues of the POP Radio product increased to $6.6 million in 1993 from $6.0 million in 1992. In 1993 the Company announced that POP Radio was terminating the MUZAK Joint Operating Agreement, forming marketing alliances with three large music network providers to accelerate the conversion to satellite delivery and expanding its in-store audio network by approximately 9,000 stores. As a result of launching this new program, the Company recorded a one-time nonrecurring charge of $3 million in the fourth quarter of 1993 reflecting the costs of closing a tape machine servicing center ($1.1 million), the write-off of obsolete delivery equipment ($1.5 million), and provisions for other costs ($.4 million). These actions will reduce the on-going operating costs and long-term capital requirements for POP Radio, and increase the size and quality of the in-store audio network. In-store Marketing operating income of $22.4 million increased by 36% from $16.4 million in the 1992 period due primarily to the increased 1993 revenues, store operations efficiencies, and reduced POP Radio losses. The operating margin increased to 12% in 1993, excluding the $3 million POP Radio charge, compared to 9% in 1992. The In-store Marketing Group contributed 74% of the Company's revenues and 63% of operating income in 1993, and it is expected that this group will contribute a higher percentage of the Company's revenues and operating income in 1994. TELEVISION. The Television Group generated $41.5 million of revenues in 1993, a 5% increase compared to $39.7 million in 1992. The Television Bureau of Advertising Time Sales Survey reported that industry-wide gross local revenues increased by 4.4% and national revenues were up 1% compared to 1992. The Television Group's local revenues increased 13% and national revenues improved 9% compared to the 1992 period. This favorable performance was substantially offset by the decline of political advertising from $2.3 million in 1992 to $.1 million in 1993. The revenue improvement was produced by the Oklahoma City and Pensacola stations. Pensacola benefited from local revenue growth of 9% and national revenue growth of 19%. The Oklahoma City station (KOKH-TV) generated revenues of $7.3 million in 1993 compared to $6.3 million in 1992 primarily as a result of a 21% increase in local revenues. The continuing emergence of the FOX network and the success of targeting programming to the age 18-49 audience has favorably impacted KOKH-TV's ratings. The group's 1993 results included a $1.7 million writedown of the carrying value of the rights to two television broadcast programs at two stations. Operating income of $12.4 million, excluding the writedown, increased by 9% compared to 1992 primarily as a result of higher revenues. The operating margin improved from 29% in 1992 to 30% in 1993 excluding the writedown. RADIO. Net revenues of the Radio Group increased by 35% from $24.7 million in 1992 to $33.4 million in 1993 as all of the Company's stations experienced increased revenues. The radio stations acquired in June 1992 contributed $3 million of the increase and the 1993 acquisitions contributed $1.5 million of revenues. Revenues for the stations owned for all of both periods increased 21% primarily as a result of improved station ratings. The St. Louis stations improved revenues from $4.9 million to $7 million in 1993 primarily due to the achievement by the FM station of the number one ranking in the market. Operating income grew from $3.3 million in 1992 to $6 million in 1993 primarily as a result of the improved revenues by the stations owned for all of both periods and an additional $.2 million contributed by the acquired stations. CORPORATE EXPENSES. Corporate expenses in 1993 of $3.6 million increased compared to $2.9 million in 1992 due primarily to increased investor relations activities and performance related compensation payments. OTHER OPERATING EXPENSES. As noted above, the 1993 period included a $1.7 million writedown of television program rights as a result of management's assessment of their realizable value (based upon projected future utilization of the programs) and the $3 million POP Radio nonrecurring expense. In-store new product development expenses were approximately $.8 million in 1992 and $1.1 million in 1993. DEPRECIATION AND AMORTIZATION. Depreciation and amortization of $28.2 million in 1993 increased by 8% compared to $26.1 million in 1992. The majority of the increase was due to higher depreciation associated with the capital expenditures to support the growth of Instant Coupon Machine revenues. INTEREST EXPENSE. Interest expense consists of the following: Deferred interest represents accretion of an 8% subordinated note and 13 1/2% subordinated debentures. The decrease in the deferred interest is primarily a result of the retirement of these debt instruments in 1992. The decrease in the current interest from 1992 to 1993 is due to lower debt levels and interest rates. OTHER EXPENSES. Included in the 1992 results of operations is a $3.3 million non-cash charge to reflect the net writeoff of the carrying value of SVL. NET INCOME (LOSS). Primarily as a result of an additional $12 million of operating income (excluding writedowns and nonrecurring charges) and $6 million lower interest expense, the Company improved its operating results from an $18.6 million loss in 1992 to $.5 million earnings in 1993. The loss per share in 1993 is due to the preferred dividend payments and settlement rights accretion. RESULTS OF OPERATIONS: 1992 COMPARED TO 1991 Consolidated net revenues of $250.9 million represented a 13% increase over the 1991 revenues of $222.4 million. Cost of services of $137.6 million increased 10% in 1992 compared to 1991 due to the increase in net revenues. Operating income of $28.1 million in 1992 exceeded the comparable 1991 period by 26%. The loss per share was $1.76 versus $1.97 in 1991. The year reflected a strengthening of advertiser spending compared to 1991 and political advertising revenues which were not material in 1991. The improvement in the Company's operating results for the 1992 period primarily reflects increased revenues from the successful launch of the Instant Coupon Machine by the In-store Marketing Group, $2.8 million of political advertising revenues, and improved advertising revenues. The loss per share in 1992 was lower than 1991 due principally to $5.8 million of additional operating income, $1.2 million lower interest expense and increased average shares outstanding. However, the write-off of the SVL investment and the extraordinary losses, net, recognized as a result of the Company's 1992 refinancing activities moderated the improvement. All comparisons, unless otherwise noted, are for the year ended December 31, 1992 as compared to the comparable 1991 period. IN-STORE MARKETING. The In-store Marketing Group contributed $186.4 million of revenues in 1992, an increase of 9%, compared to $171.1 million in 1991. The success of the national launch of the ICM in 1992 generated approximately $21 million of additional revenues. The International operations produced an additional $6.7 million of revenues in 1992 including $4.3 million of revenues attributed to a full year of the BLS Retail Resource Group acquired in August 1991 and MMV which contributed $3.3 million of revenues in 1992. Advertising revenues in 1992 were level with 1991 as a 53% increase in cart advertising revenues was offset by the shift to ICM and away from the shelf-talk product. Impact promotional services included 133 programs in 1992 versus 141 in 1991, a decrease of 6%, which decreased the number of days serviced by 10%. Total Impact revenues declined by 5%. Retailers' Choice (cooperative promotion program) revenues declined by 23%, partly as a result of management's decision to reduce the number of programs and also due to the packaged goods manufacturers' budget cutbacks. The revenues generated per program decreased from $3.9 million in 1991 to $3.6 million in 1992, a 7% decline. Net sales of the POP Radio product decreased to $6.0 million in 1992 from $8.9 million in 1991 and $20.2 million in 1990. In 1992 the following actions were taken to improve POP Radio: hiring a president to manage Pop Radio as a separate organization, continuing the upgrading of the technology to satellite delivery, improving the service, and negotiating with Muzak to take on the servicing aspects of the network. POP Radio hired several dedicated sales representatives and signed up regional representative firms to address markets that have not been penetrated by ACTMEDIA sales people. Operating income of $16.4 million increased by 11% from $14.8 million in the 1991 period due primarily to the increased 1992 revenues noted above. The operating margins were relatively level with 1991 as they were impacted by lower revenues from POP Radio and the lower margins generated by the emerging International operations. The In-store Marketing Group contributed 74% of the revenues and 58% of operating income in 1992. TELEVISION. The Television Group generated $39.7 million of revenues in 1992, a 12% increase compared to $35.3 million in 1991. The Television Bureau of Advertising Time Sales Survey reported that industry-wide gross local revenues and national revenues for 1992 increased by 6% compared to 1991. The Company's television group local revenues increased 11% and national revenues improved 11% compared to the 1991 period. Also, the Company's 1992 results included $2.3 million of political advertising versus $.3 million in 1991. The revenue improvement was produced primarily at the Oklahoma City, Plattsburgh/Hanover and Pensacola stations. Pensacola's 1991 results were impacted by the gulf war and by the major cutback by automobile advertisers. Plattsburgh also was impacted by the gulf war and the recession in New England and Canada. The Oklahoma City station generated revenues of $6.3 million in 1992 compared to $5 million in 1991 primarily as a result of the acquisition/ disposition and consolidation of the market in August 1991 and the emergence of the Fox network. Operating income of $11.4 million increased by 28% compared to 1991 primarily as a result of higher revenues. The operating margin improved from 25% in 1991 to 29% in 1992. RADIO. Net revenues of the Radio Group increased by 56% from $15.9 million in 1991 to $24.7 million in 1992. The radio stations acquired in June 1992 contributed $5.7 million of revenues. Revenues for the stations owned for all of both periods increased 20% primarily as a result of improved station ratings. Political revenues contributed $.5 million to the 1992 increase. Operating income grew from $1.3 million in 1991 to $3.3 million in 1992 primarily as a result of the improved revenues and $.2 million contributed by the acquired stations. CORPORATE EXPENSES. Corporate expenses in 1992 of $2.9 million increased by 11% compared to 1991 due primarily to the executive search fees for the POP Radio president and compensation consulting fees. OTHER OPERATING EXPENSES. Included in the 1991 period is a writedown of $.5 million of television program rights as a result of management's assessment of their realizable value (based upon projected future utilization of the programs). In-store new product development expenses were approximately $.8 million in 1992 and $.7 million in 1991. DEPRECIATION AND AMORTIZATION. Depreciation and amortization of $26.1 million in 1992 increased by 17% compared to $22.3 million in 1991. The majority of the increase was due to higher depreciation associated with the capital expenditures for the Instant Coupon Machine national launch and the Muzak equipment purchased in early 1992. INTEREST EXPENSE. Interest expense consists of the following: Deferred interest represents accretion of an 8% subordinated note and 13 1/2% subordinated debentures. The decrease in the deferred and increase in current interest is primarily a result of the retirement of these debt instruments in 1992. OTHER EXPENSES. Included in the 1992 results of operations is a $3.3 million non-cash charge to reflect the net write off of the carrying value of SVL. Included in the 1991 results is a $1.3 million non-cash charge for SVL which was based upon the Company's assessment of the impairment in such carrying value as a result of operating losses incurred by such company. Other expenses in 1991 also included a loss of $4.1 million in connection with the August 1991 disposition of station KAUT and non-cash income of $3.75 million related to the settlement of a pre-acquisition liability of ACTMEDIA. NET LOSS. Primarily as a result of the substantial interest expense (both current and deferred) of $37.5 million and $38.6 million in 1992 and 1991, respectively, relating to debt incurred in connection with the Company's acquisitions, the depreciation and amortization charges (relating primarily to goodwill and other intangibles which had a balance of $373.4 million at December 31, 1992), and the extraordinary loss of $3.6 million in 1992 associated with debt retirements, the Company reported net losses of $18.6 million and $15 million in 1992 and 1991, respectively. SEASONALITY AND INFLATION The advertising revenues of the Company vary over the calendar year, with the fourth quarter reflecting the highest revenues for the year. Stronger fourth quarter results are due in part to In-store having one extra 4-week cycle in the fourth quarter, increased retail advertising in the fall in preparation for the holiday season, and political advertising for broadcasting in election years. The slowdown in retail sales following the holiday season accounts for the relatively weaker results generally experienced in the first quarter. The Company believes inflation generally has had little effect on its results. CAPITALIZATION AND LIQUIDITY At December 31, 1993, the Company, through its Heritage Media Services, Inc. subsidiary ("HMSI"), had a $130 million bank credit facility (the "Credit Agreement"). HMSI is the Company's subsidiary which owns ACTMEDIA and the Company's broadcasting properties. The credit facility was comprised of an $80 million term loan which begins to amortize on December 31, 1994, and a $50 million reducing revolving credit facility which begins to decrease on December 31, 1994. At December 31, 1993, $80 million of the term loan facility and $30.5 million of the revolving credit facility were outstanding. At December 31, 1993, $19.5 million of additional borrowings were available under the Credit Agreement. Effective February 9, 1994, the revolving credit facility was increased to $75 million, thereby providing an additional $25 million availability under the Credit Agreement. The Credit Agreement includes a number of financial and other covenants, including the maintenance of certain operating and financial ratios and limitations on or prohibitions of dividends, indebtedness, liens, capital expenditures, asset sales and certain other items. Loans under the Credit Agreement are guaranteed by the Company and HMSI's domestic subsidiaries and are secured by a pledge of the capital stock of HMSI and its domestic subsidiaries. On June 22, 1992, HMSI issued $150 million of 11% senior secured notes (the "Senior Notes") due June 15, 2002. Interest on the Senior Notes is payable semi-annually. The Senior Notes rank on a parity with the obligations under HMSI's Credit Agreement, are guaranteed by the Company and HMSI's domestic subsidiaries and are secured by a pledge of capital stock of HMSI and its domestic subsidiaries. The Senior Notes include a number of financial and other covenants. On October 1, 1992 the Company issued $50 million of 11% senior subordinated notes (the "Subordinated Notes") due October 1, 2002. Interest on the Subordinated Notes is payable semi-annually. The Subordinated Notes are subordinate in right of payment to the prior payment in full of the Credit Agreement and the Senior Notes. In mid-1989, the Company issued approximately $7.55 million in equity settlement rights (the "Rights") (7.55 million Rights) in connection with the financing of the ACTMEDIA acquisition. At the time of issuance these Rights entitled the holders to approximately 18% of the fair market value of the business, properties and assets of ACTMEDIA as a going concern ("Net Equity") as determined in 1994 or 1996 in accordance with put/call features of the Rights purchase agreement. Depending on the circumstances under which the Rights are retired, the Company can pay this value in common stock or cash or subordinated notes convertible into common stock. To the extent such amount is paid in common stock, the valuation is required to be increased by 4%. At December 31, 1993, the amount of ACTMEDIA's indebtedness (substantially all of which is intercompany indebtedness) was approximately $160 million. During the past four years the Company acquired 1.6 million of the Rights at an average price of approximately $2.72 per Right in privately negotiated transactions, thereby reducing the outstanding Rights to 5.9 million or 14.1% of the Net Equity. The Rights mature seven years from the date of issuance (March 19, 1996), but they may be redeemed at the option of the holder ("put options") or the Company ("call options") at certain specified times during the period that they are outstanding. The initial put and call options become available in 1994. On or after April 19, 1994 (but prior to May 19, 1994), the Company is required to select an independent appraiser to determine the Net Equity. Upon completion of the appraisal process, the holders of the Rights will be notified of the appraised valuation of the Net Equity and the resultant valuation of the Rights. For a period of 30 days following such notification, the holders of the Rights may exercise a put option at such valuation. Also during that period, the Company may exercise a call option at such valuation. The put options may be paid in cash or, at the option of the Company, in Class A or Class C common stock, a combination of cash and common stock or, in certain circumstances, in subordinated notes convertible into common stock. The call options are to be paid in cash unless such payment would create an "adverse contractual effect" (defined generally as default under, or conflict with, agreements relating to the Company's indebtedness) for the Company, in which event, the Company may utilize the same payment process as described for the put option. To the extent that neither the put nor the call options are exercised prior to maturity date of the Rights, the Company is required to exercise a call option on that date under the terms set forth above, utilizing a valuation determined by an independent appraiser. To the extent the options are paid in cash, the Company will utilize cash provided by operations and/or borrowings against the Credit Agreement. The Rights were initially recorded at their estimated fair value at the date of issuance which approximated $7,550,000. From time to time the Company estimates the Net Equity and the resultant estimate of the value of the Rights. To the extent that such estimate of value exceeds the carrying value, such excess is being accreted by the interest method to accumulated deficit over the appropriate accounting period. At December 31, 1993, the carrying value was $19,514,000. The Company intends to increase this carrying value through additional accretion, to approximately $25,000,000 by June 30, 1994. The Company will continue to accrete the carrying value of the Rights to their estimated value until they are liquidated under one of the options discussed above. If, as a result of the independent appraisal process described above, a valuation is determined that is above or below the accreted carrying value, the Company will reflect such value through adjustment to the carrying value and to the accumulated deficit at June 30, 1994. Any such increase in the valuation would reduce the Company's net income per share or increase the net loss per share and any such decrease in the valuation would increase the Company's net income per share or reduce the net loss per share for the six months ending June 30, 1994, and, if the puts or calls are exercised, would similarly affect the amount of common stock to be issued (if the price were paid in common stock) or the indebtedness to be incurred (if the price were paid in cash). Based upon the foregoing debt and settlement right obligations, the Company is currently highly leveraged, and it is expected to continue to have a high level of debt for the foreseeable future. As of December 31, 1993, the Company had indebtedness (long-term debt, including current installments and notes payable) of approximately $315.0 million and stockholders' equity of approximately $86.6 million, and accordingly, a consolidated debt-to-equity ratio of 3.6 to 1. As a result of its leverage and in order to repay existing indebtedness, the Company will be required to generate substantial operating cash flow, refinance its indebtedness, make asset sales or effect some combination of the foregoing. The ability of the Company to meet these requirements will depend on, among other things, prevailing economic conditions and financial, business and other factors, some of which are beyond the control of the Company. Further, being primarily a holding company of operating companies through HMSI, the Company's ability to repay its indebtedness incurred at the parent company level will be limited by restrictions on the ability of HMSI under the Credit Agreement and the Senior Notes to declare and pay dividends to the Company. Under the credit agreement, at December 31, 1993, the total amount of dividends that could be paid by HMSI to the Company was $22.6 million. As a result of an amendment to the credit agreement dated February 9, the total amount of available dividends was increased to $50 million, if such dividends are required for the purchase or redemption of settlement rights. Under the Senior Note Indenture, at December 31, 1993, the total amount of dividends that could be paid by HMSI to the Company was $43.3 million. Such dividends are not permitted if, as a result of such payments, a default would occur under either the credit agreement or the Senior Note Indenture. As a result of the foregoing restrictions, consolidated net assets of HMSI totaling $136.3 million at December 31, 1993 are not available to the Company to pay dividends or repay debt. On February 1, 1994, the holders of all of the Company's Series B and Series C Convertible Preferred Stock converted their 161,945 preferred shares into 429,609 Class A common shares and 693,560 Class C common shares at the rate of 6.94 common shares for each preferred share thereby increasing the Company's common shares outstanding to 17.5 million and eliminating the Company's annual preferred dividend obligation of $1.8 million. The Company has focused its growth strategy on acquiring media and other communications-related properties it believes have the potential for long-term appreciation and aggressively managing the operations of these properties to improve their operating results. The Company has historically used cash flows from financing activities to fund its acquisitions and investments while the operations are expected to generate cash flow sufficient to fund their ongoing expenditure requirements. Cash flows provided by operating activities increased to $40.9 million in 1993 from $17.1 million in 1992. The improvement is primarily attributable to an additional $14 million of EBITDA, a $4 million decrease in interest payments in 1993 and improved receivables collections. In 1992 cash flows provided by operating activities decreased by $4.1 million compared to 1991 due to higher interest payments and receivable levels. In 1993 significant uses of cash in investing and financing activities included the following: $9.1 million for the retirement of debt and other liabilities, $2.8 million for purchase of settlement rights, $5.1 million for acquisitions and investments, and $18.5 million for capital expenditures. In 1992, cash flows from financing activities included $42.1 million of net proceeds from the issuance of additional Class A common stock. These proceeds were used primarily to fund the $30 million cash component of the Company's 8% subordinated note retirement and to fund the $7.9 million acquisition of the Kansas City and Cincinnati radio stations. Cash flows used for capital expenditures in investing activities during 1992 were generated by cash flows from operating activities. In 1991, cash flows from financing activities and cash flows used in investing activities reflect increased bank borrowings and proceeds from the issuance of the Series B and Series C Preferred Stock. The preferred stock proceeds were utilized, along with the proceeds from the sale of KDAY-AM, to purchase a portion of HMI's 13.5% debentures at a gain and to fund the cash component of the KOKH-TV and BLS Retail Resource Group acquisitions. Capital expenditures increased from $15.5 million in 1992 to $18.5 million in 1993. This increase was due primarily to the purchase of additional Instant Coupon Machines. Also, the Company completed two nonrecurring projects: the upgrade of the management information systems of the In-store Group and the construction of new broadcast facilities for the Pensacola television station. Capital requirements related to acquisitions for 1994 are expected to include approximately $2 million for the In-store Marketing Group's Australia and New Zealand acquisitions (completed in February 1994), $5 million for the Milwaukee radio station (completed in January 1994), and $7.2 million for the St. Louis radio station scheduled to close in March 1994. As a part of the commitment to the new marketing alliances, the Company made payments totaling $.8 million in 1993 and is expecting to make payments of $4 million in 1994 representing the Company's share of the cost of the network upgrade. These payments are for exclusive marketing rights which are amortized over the term of the retail chain agreements (five years). These requirements will be provided by funds generated from operations. NEW ACCOUNTING PRONOUNCEMENTS The Company does not presently provide post-retirement or post-employment benefits, as defined in FASB Statement No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" and No. 112, "Employers' Accounting for Postemployment Benefits." Accordingly, these Statements will not impact the Company's consolidated financial statements. In addition, adoption of FASB Statement No. 114, "Accounting by Creditors for Impairment of a Loan", which is effective for financial statements for fiscal years beginning after December 15, 1994, is not anticipated to have a material effect on the Company's consolidated financial statements. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The consolidated financial statements of Heritage Media Corporation and Subsidiaries as of December 31, 1993 and 1992 and for the years ended December 31, 1993, 1992 and 1991 are included on pages through herein. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. Certain information in response to this item is incorporated by reference to the disclosure contained under the heading "Directors and Executive Officers" in the Proxy Statement. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. Certain information in response to this item is incorporated by reference to the disclosure contained under the heading "Directors and Executive Officers" in the Proxy Statement. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. Information in response to this item is incorporated by reference to the disclosure contained under the headings "Principal Stockholders" and "Directors and Executive Officers" in the Proxy Statement. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Information in response to this item is incorporated by reference to the disclosure contained under the heading "Directors and Executive Officers" in the Proxy Statement. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) The following documents are filed as a part of this report: (1) Financial Statements: Financial Statements to this form are listed in the "Index to Consolidated Financial Statements" at page. (2) Schedules: Financial statement schedules to this form are listed in the "Index to Consolidated Financial Statements" at page herein. (3) Exhibits: See "Exhibit Index" included herein. Registrant agrees to furnish, upon the request of the Commission, a copy of all constituent instruments defining the rights of holders of long-term debt of Registrant and its consolidated subsidiaries. (b) Reports on Form 8-K. None. HERITAGE MEDIA CORPORATION INDEX TO EXHIBITS 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 on March 8, 1994. HERITAGE MEDIA CORPORATION By _______/s/_DAVID N. WALTHALL_______ David N. Walthall PRESIDENT AND DIRECTOR 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 dates indicated. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS All other schedules have been omitted because the required information is inapplicable, immaterial or is presented in the financial statements or related notes. INDEPENDENT AUDITORS' REPORT The Board of Directors and Stockholders Heritage Media Corporation: We have audited the consolidated financial statements of Heritage Media Corporation and subsidiaries as listed in the accompanying index. In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedules as listed in the accompanying index. These consolidated financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules 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 Heritage Media Corporation and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. KPMG PEAT MARWICK Dallas, Texas February 25, 1994 HERITAGE MEDIA CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS DECEMBER 31, 1993 AND 1992 (DOLLARS IN THOUSANDS) ASSETS See accompanying notes to consolidated financial statements. HERITAGE MEDIA CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLARS IN THOUSANDS, EXCEPT SHARE INFORMATION) See accompanying notes to consolidated financial statements. HERITAGE MEDIA CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLARS IN THOUSANDS) See accompanying notes to consolidated financial statements. HERITAGE MEDIA CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLARS IN THOUSANDS) See accompanying notes to consolidated financial statements. HERITAGE MEDIA CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (1) ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Heritage Media Corporation ("HMC" or "the Company") was incorporated on August 7, 1987 and began operations on August 11, 1987. The Company, through Heritage Media Services, Inc. ("HMSI"), a wholly-owned subsidiary, operates in three segments -- in-store marketing and television and radio broadcasting. The Company's in-store marketing operations are conducted in the United States, Canada and The Netherlands. Broadcasting operations are conducted in the United States. Aggregate assets and revenues of the Company's foreign operations comprise less than 10% of the Company's total assets and revenues. (A) PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of the Company and all of its subsidiaries. All significant itercompany transactions and accounts have been eliminated in consolidation. (B) ACQUISITIONS, GOODWILL AND OTHER INTANGIBLES The cost of acquired companies is allocated first to identifiable assets and liabilities based on estimated fair market values. The excess of cost over identifiable assets and liabilities is recorded as goodwill and amortized over a period of 40 years. Costs allocated to identifiable intangible assets are amortized over the remaining life of the asset as determined by underlying contract terms or independent appraisals. Useful lives of license agreements and other intangibles are 25 and 4-10 years, respectively. Goodwill and other intangibles at December 31, 1993 and 1992 are summarized as follows (thousands of dollars): The Company continually reevaluates the propriety of the carrying amount of goodwill and other intangibles as well as the related amortization period to determine whether current events and circumstances warrant adjustments to the carrying values and/or revised estimates of useful lives. This evaluation is based on the Company's projection of the undiscounted operating income before depreciation, amortization, nonrecurring charges and interest for each of the Company's operating segments over the remaining lives of the amortization periods of related goodwill and intangible assets. The projections are based on the historical trend line of actual results since the commencement of operations in the respective segment and adjusted for expected changes in operating results. To the extent such projections indicate that the undiscounted operating income (as defined above) is not expected to be adequate to recover the carrying amounts of related intangibles, such carrying amounts are written down by charges to expense. At this time, the Company believes that no significant impairment of the goodwill and other intangibles has occurred and that no reduction of the estimated useful lives is warranted. (C) CASH EQUIVALENTS For purposes of the statements of cash flows, the Company considers all highly liquid debt instruments purchased with an original maturity of three months or less to be cash equivalents. HERITAGE MEDIA CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (1) ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) (D) INVENTORY Inventory consists of display devices used in the Company's in-store marketing programs. Such amounts are stated at the lower of average cost or market. (E) PROPERTY AND EQUIPMENT Property and equipment is recorded at cost. Depreciation is provided by the straight-line method over the estimated useful lives of the assets. The useful lives of the Company's property and equipment at December 31, 1993 are summarized as follows: The Company continually reevaluates the propriety of the carrying amount of property and equipment and the estimated useful lives used for depreciation. As a result, the Company prospectively changed its estimates of the useful lives of certain in-store marketing and broadcasting equipment during 1992. These changes resulted in additional depreciation expense and net loss per share of approximately $1,100,000 and $.08, respectively, for the year ended December 31, 1992. During the year ended December 31, 1993, the Company recorded a writedown of in-store marketing equipment of $1,685,000 in connection with certain changes in the Company's in-store radio marketing delivery system (see note 8). (F) BROADCAST PROGRAM RIGHTS Broadcast program rights are recorded as assets and liabilities when the programs are available for telecasting. The assets are carried at the lower of cost or estimated net realizable value and are classified as current or noncurrent based upon the expected use of the programs in succeeding years. The contract liabilities are classified as current or noncurrent in accordance with contract payment terms. Costs are charged to operations by the straight-line method over the contract period. The Company continually reevaluates the propriety of the carrying amounts of broadcast program rights assets to determine if circumstances warrant adjustments to the carrying values. As a result, the Company recorded writedowns of program rights of $1,678,000 and $490,000 during the years ended December 31, 1993 and 1991, respectively. The estimated fair value of broadcast program rights liabilities do not differ significantly from their carrying amounts at December 31, 1993 and 1992. (G) DEFERRED FINANCE COSTS Deferred finance costs are recorded at cost and are amortized using the interest method over the period of the related debt agreement. (H) DISCOUNTS ON LONG-TERM DEBT The original discounts on certain notes payable are being accreted over the term of the notes by charges to interest expense using the interest method. (I) REVENUES Revenues from in-store marketing are derived primarily from providing advertising space, promotion and production services in retail stores and by selling advertising time to national advertisers HERITAGE MEDIA CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (1) ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) on an in-store music entertainment network. Revenues from in-store marketing are recognized over the contract period of the related advertising program and those from advertisements on the in-store music network are recognized when the commercial is aired. Television and radio broadcasting revenues are primarily derived from local, regional and national advertising and network compensation. Advertising revenues are recognized upon the airing of commercials, while network revenues are recognized monthly as earned. Revenues are presented net of advertising agency and national sales representatives' commissions. (J) BARTER TRANSACTIONS The Company exchanges unsold advertising time for products and services. These transactions are reported at the estimated fair market value of the product or service received. Barter revenues are recorded when the commercials are broadcast and barter expenses are recorded when merchandise or services are used. If merchandise or services are received prior to the broadcast of a commercial, a liability is recorded. Likewise, a receivable is recorded if a commercial is broadcast before the goods or services are received. Barter amounts are not significant to the Company's consolidated financial statements. (K) LOSS PER SHARE The net loss per common share is computed by dividing net income (loss), adjusted for accretion and premium or discount on retirement of the settlement rights and dividends on preferred stock for applicable years, by the weighted average number of Class A and Class C common shares, and one-half of the weighted average number of Class B common shares, outstanding during each year, after giving retroactive effect to a one-for-four reverse stock split in March 1992 (note 6). Common stock purchase options, preferred stock and settlement rights have been excluded from the computation as their effect is antidilutive. Following is a reconciliation of net loss to net loss applicable to common stock for the years ended December 31, 1993, 1992 and 1991: Assuming the conversion of all outstanding preferred shares into Class A and C common shares (see note 6) had occurred on January 1, 1993, pro forma loss per common share before extraordinary item and pro forma net loss per common share for the year ended December 31, 1993 would have been $.19 and $.17, respectively. (L) INCOME TAXES During 1992 and 1991, deferred income taxes are provided for the effects of items reported for tax purposes in periods different from those used for financial reporting purposes in accordance with Accounting Principles Board Opinion No. 11. In February 1993, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS 109"). Application of SFAS 109, which is required for fiscal years beginning after December 15, 1993, required the Company to change, effective January 1, 1993, from the deferred method to the asset and liability method of HERITAGE MEDIA CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (1) ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) accounting for income taxes. Under the asset and liability method, deferred income taxes are provided by applying enacted statutory rates in effect at the balance sheet date to differences between the book and tax bases of assets and liabilities. The resulting deferred tax liabilities, and assets in some cases, are adjusted to reflect changes in tax laws or rates as they occur. The Company implemented the provisions of SFAS 109 in the first quarter of 1993 without restating prior years' financial statements. This change did not have a significant effect on the Company's consolidated financial statements. (M) FOREIGN CURRENCY TRANSLATION For foreign operations, the balance sheet accounts are translated at the current year-end exchange rate and income statement items are translated at the average exchange rate for the year. Resulting translation adjustments are presented as a separate component of stockholders' equity. Foreign transaction exchange gains and losses are recognized as income or expense; such amounts were not material in 1993, 1992 or 1991. (N) RECLASSIFICATIONS Certain reclassifications have been made in the prior years' consolidated financial statements to conform to the 1993 presentation. (2) ACQUISITIONS AND DISPOSITIONS In December 1990, the Company began investing in Supermarket Visions, Ltd. ("SVL"), an in-store marketing company operating in the United Kingdom. Cash investments in SVL preferred stock and advances totaled $994,000 and $344,000 during 1992 and 1991, respectively. During 1992 and 1991, the Company recorded $2,162,000 and $1,300,000 of writedowns of the carrying amount of the Company's investment in SVL. Also during 1992, the Company recorded additional costs of $1,098,000 incurred during the shutdown of SVL. SVL ceased operations in September 1992 and was liquidated in the fourth quarter of 1992. All such writedowns and shutdown costs are included in other expense, net for the respective years. On March 26, 1991, the Company sold a radio station for $5,066,000 cash. The book value of the station was written down to approximately $5,000,000 at December 31, 1990 based on estimated sale proceeds. A gain of approximately $66,000 representing a partial recovery of previous writedowns is reflected in other expense, net in the consolidated statement of operations for the year ended December 31, 1991. On August 15, 1991, the Company sold certain assets of a television station for $1,485,000. The Company also donated certain assets of the station to a charitable organization. The loss on sale and the charitable donation totaled $4,071,000 and is reflected in other expense, net in the consolidated statement of operations for the year ended December 31, 1991. Sale proceeds consisted of $285,000 cash and a note receivable of $1,200,000. Concurrently, the Company purchased a television station in the same market for $7,007,000. The purchase was financed with cash from operations of $2,059,000, a $4,623,000 note payable and 25,000 shares of the Company's Class A common stock with a fair market value of $13 per share. On August 15, 1991, the Company purchased a Canadian in-store marketing company for $3,711,000 consisting of an initial cash payment of $2,252,000 and an obligation for a minimum contingent payment, based on earnings through 1994, of $1,459,000 payable over three years. If the acquired company attains certain predetermined earnings goals, the Company may be obligated to make an additional payment not to exceed $1,053,000 in July 1994. Such payment, to the extent made, will be recognized as additional goodwill. HERITAGE MEDIA CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (2) ACQUISITIONS AND DISPOSITIONS (CONTINUED) On October 18, 1991, the Company entered into a joint venture agreement to purchase in-store marketing companies in Europe for an initial investment of $511,000. In April 1992, the Company invested an additional $2.2 million in the joint venture which concurrently acquired a 65% interest in an in-store marketing company in The Netherlands. On February 28, 1992, the Company amended its Joint Operating Agreement with Muzak Limited Partnership whereby the Company purchased various in-store marketing assets for a purchase price of $5,000,000. Consideration paid by the Company consisted of $850,000 cash and a $4,150,000 note payable due in fluctuating quarterly installments with the balance due on January 31, 1999. On June 1, 1992, the Company purchased the assets of two radio stations for cash of $7,895,000. On July 22, 1993, the Company purchased the assets of a radio station for cash of $4,918,000. The Company began operating the station on May 14, 1993 under a time brokerage agreement. On January 6, 1994, the Company purchased the assets of a radio station for cash of $5,600,000. As of December 31, 1993, the Company had made escrow deposits of $560,000 relating to this acquisition, reducing its remaining purchase commitment to $5,040,000. The Company began operating the station on October 25, 1993 under a time brokerage agreement. On January 10, 1994, the Company agreed to purchase the assets of a radio station for $7,200,000. Completion of the purchase is pending the consent of the Federal Communications Commission ("FCC"). During 1991, the Company recognized noncash income of $3,750,000 related to the settlement of a preacquisition liability of Actmedia, Inc. ("Actmedia"), an in-store marketing subsidiary of the Company. Such amount is included in other expense, net in the accompanying consolidated statement of operations. During 1993, the Company reached a settlement with the Internal Revenue Service ("IRS") in regards to certain preacquisition tax liabilities of Actmedia. The Company had previously recorded federal tax liability purchase reserves of approximately $3,900,000. As a result of the settlement, the Company paid approximately $800,000 to the IRS and reversed the remaining reserves to goodwill. The acquisitions discussed above were recognized in the consolidated financial statements as follows (thousands of dollars): The following summary presents unaudited pro forma consolidated results of operations for the Company and its subsidiaries assuming (a) the acquisitions and dispositions of (i) the radio stations acquired during 1993 and 1992, (ii) The Netherlands in-store marketing company acquired during 1992, and (iii) the United Kingdom in-store marketing company disposed of in 1992 and (b) the HERITAGE MEDIA CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (2) ACQUISITIONS AND DISPOSITIONS (CONTINUED) refinancing transactions discussed in note 4, the 1993 and 1992 settlement rights purchases discussed in note 5 and the conversion of preferred stock discussed in note 6 had occurred at the beginning of the respective periods (thousands of dollars, except per share information): The pro forma amounts assume that the financing requirements of the acquisitions were met by the use of funds from the offering of common stock completed in 1992 and the actual debt issuances incurred in connection with the in-store marketing company and radio station acquisitions and the purchase of settlement rights, assuming that all such financings were completed at the beginning of the respective periods. The pro forma amounts are not necessarily indicative of what the results would actually have been if the transactions had been consummated earlier and are not intended to be an indication of operating results expected to be achieved in the future. (3) ACCRUED EXPENSES Accrued expenses at December 31, 1993 and 1992 are summarized as follows: (4) LONG-TERM DEBT Long-term debt at December 31, 1993 and 1992 is summarized as follows: (a) On June 22, 1992, HMSI issued $150 million of 11% Senior Secured Notes ("the Senior Notes") due June 15, 2002. The Senior Notes are redeemable, in whole or in part, at HMSI's option at any time on or after June 15, 1997, at amounts decreasing from 105.5% to 100% of par on June 15, 1999. The Senior Notes rank on a parity with the obligations of HMSI under its credit agreement, are guaranteed by HMC and HMSI's domestic subsidiaries and are secured by a pledge of capital HERITAGE MEDIA CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (4) LONG-TERM DEBT (CONTINUED) stock of HMSI and its domestic subsidiaries. The fair market value of the Senior Notes based on quoted market rates is $164,250,000 and $153,000,000 at December 31, 1993 and 1992, respectively. (b) In conjunction with the issuance of the Senior Notes, HMSI entered into a credit agreement with a group of banks providing for an $80 million term loan and a reducing revolving credit facility of up to $50 million (increased to $75 million effective February 9, 1994). Quarterly principal payments under the credit agreement commence on December 31, 1994 and continue until June 1999. At December 31, 1993, $19.5 million of additional borrowings were available under the credit agreement. HMSI pays an annual commitment fee equal to 0.5% of the unadvanced portion of the credit agreement. Loans under the credit agreement bear interest at rates based on the agent bank's base rate, a Eurodollar rate or a CD rate plus a margin depending on HMSI's ratio of consolidated total debt to operating cash flow (as defined). At December 31, 1993, the weighted average interest rate was 4.98% under the Eurodollar option. The loans under the credit agreement are secured by the stock of substantially all subsidiaries of the Company and by the assets of HMSI, Actmedia and certain other subsidiaries. The initial borrowings under the credit agreement, together with proceeds obtained from the issuance of the Senior Notes were used to prepay balances outstanding under HMSI's previous credit agreement. HMSI recognized an extraordinary loss of $2,242,000 on this refinancing. As the credit agreement bears interest at current market rates, its carrying amount approximates its fair market value at December 31, 1993 and 1992. (c) On August 11, 1987, the Company issued a $75 million, 8% subordinated note due July 31, 1994. Interest on this note was deferred and payable at maturity. The note was discounted for financial statement purposes by $24.6 million using a 14% interest rate. On April 15, 1992, the Company retired the 8% subordinated note with an accreted balance of $95,384,000 through the payment of $30,000,000 of cash obtained from the issuance of Class A common stock (note 6), the issuance of 1,335,721 shares of Class C common stock at $9.75 per share and the issuance of a new $50 million, 12% subordinated note ("the New Note"). The $30,000,000 payment is included in the amounts disclosed as cash paid for interest in the statement of cash flows for the year ended December 31, 1992. As a result of this transaction, the Company recognized an extraordinary gain of approximately $2,360,000. On October 1, 1992, the Company retired the New Note through the issuance of $50 million of 11% Senior Subordinated Notes ("the Notes") due October 1, 2002. The Notes are redeemable, in whole or in part, at the Company's option at any time on or after October 1, 1997, at amounts decreasing from 105.5% to 100% of par at October 1, 1999. The Notes are subordinated to the Senior Notes, HMSI's credit agreement and all other indebtedness of the Company and its subsidiaries. The Company recognized an extraordinary loss of $1,526,000 on this refinancing. The fair market value of the Notes based on quoted market rates is $54,500,000 and $47,375,000 at December 31, 1993 and 1992, respectively. (d) Other debt bears interest at varying rates and consists primarily of notes payable, capital lease obligations and industrial development revenue bonds due in varying amounts through 1999. On August 11, 1987, Heritage Media, Inc. ("HMI"), a wholly-owned subsidiary of the Company, issued $74.1 million of subordinated original issue discount debentures in a private placement. During 1992 and 1991, the Company extinguished outstanding HMI debentures with face amounts of $37,183,000 and $23,517,000, respectively, prior to scheduled maturity. These extinguishments resulted in extraordinary losses of $2,186,000 in 1992 and extraordinary gains of $4,320,000 in 1991. HERITAGE MEDIA CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (4) LONG-TERM DEBT (CONTINUED) On July 14, 1993, the Company retired a subordinated note payable prior to the scheduled maturity with a face value of $3,235,000 by a cash payment of $2,800,000. As a result of this transaction, the Company recognized an extraordinary gain of approximately $435,000. The loan agreements described above require the Company and/or its subsidiaries to comply with various financial and other covenants, including the maintenance of certain operating and financial ratios and they contain substantial limitations on, or prohibitions of, dividends, additional indebtedness, liens, capital expenditures, asset sales and certain other items. The Company is currently highly leveraged, and it is expected to continue to have a high level of debt for the foreseeable future. As a result of its leverage and in order to repay existing indebtedness, the Company will be required to generate substantial operating cash flow, refinance its indebtedness, make asset sales or effect some combination of the foregoing. The ability of the Company to meet these requirements will depend on, among other things, prevailing economic conditions and financial, business and other factors, some of which are beyond the control of the Company. Further, being primarily a holding company of operating companies through HMSI, the Company's ability to repay its indebtedness incurred at the parent company level will be limited by restrictions on the ability of HMSI under the credit agreement to declare and pay dividends to the Company. Under the credit agreement, at December 31, 1993, the total amount of dividends that could be paid by HMSI to the Company was $22,600,000. As a result of an amendment to the credit agreement dated February 9, 1994, the total amount of such dividends was increased to $50,000,000, if such dividends are required for the purchase or redemption of settlement rights (note 5). Under the Senior Note Indenture, at December 31, 1993, the total amount of dividends that could be paid by HMSI to the Company was $43,300,000. Such dividends are not permitted if, as a result of such payments, a default would occur under either the credit agreement or the Senior Note Indenture. As a result of the foregoing restrictions, consolidated net assets of HMSI (note 12) totaling approximately $136,300,000 at December 31, 1993 are not available to the Company to pay dividends or repay debt. Aggregate annual maturities of long-term debt for the years ending December 31, 1994 through 1998 are $2,076,000; $8,290,000; $14,668,000; $28,140,000; and $32,544,000, respectively. Interest expense for the years ended December 31, 1993, 1992 and 1991 is summarized as follows: (5) SETTLEMENT RIGHTS Approximately 7,553,000 settlement rights were originally issued in connection with the Actmedia acquisition in 1989. These rights originally entitled the holders to receive cash or Class A or Class C common stock having a value equal to approximately 18% of the fair market value of the business, properties and assets of Actmedia as a going concern ("Net Equity") at specified future dates. At December 31, 1993, the amount of Actmedia's indebtedness (substantially all of which is intercompany indebtedness) was approximately $160,000,000. Through a series of private transactions, the Company has purchased 1,631,000 settlement rights during the past four years for an HERITAGE MEDIA CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (5) SETTLEMENT RIGHTS (CONTINUED) aggregate purchase price of $4,434,000 (at an average cost of $2.72 per right). As a result of these purchases, at December 31, 1993, there were approximately 5,922,000 settlement rights outstanding representing approximately 14.1% of Actmedia's Net Equity. The settlement rights mature seven years from the date of issuance (March 19, 1996), but they may be redeemed at the option of the holder ("put options") or the Company ("call options") at certain specified times during the period that they are outstanding. The initial put and call options become exercisable in 1994. On or after April 19, 1994 (but prior to May 19, 1994), the Company will select an independent appraiser to determine the fair market value of the Net Equity of Actmedia. Upon completion of the appraisal process, the holders of the settlement rights will be notified of the appraised valuation of the Net Equity and the resultant valuation of the settlement rights. For a period of 30 days following such notification, the holders of the settlement rights may exercise a put option, or the Company may exercise a call option, at such valuation. The put options may be paid in cash or, at the option of the Company, in Class A or Class C common stock, a combination of cash and common stock or, in certain circumstances, in subordinated notes convertible into common stock. The call options are to be paid in cash unless such payment would create adverse financial consequences for the Company, in which event the Company may utilize the same payment process as described for the put option. To the extent that neither the put nor the call options are exercised prior to maturity of the settlement rights, the Company is required to exercise a call option on that date under the terms set forth above, utilizing a valuation determined by an independent appraiser. The settlement rights were initially recorded at their estimated fair value at the date of issuance which approximated $7,553,000. From time to time the Company estimates the value of Actmedia Net Equity and the resultant estimate of the value of the settlement rights. To the extent that such estimate of value exceeds the carrying value, such excess is being accreted by the interest method to accumulated deficit over the appropriate accounting period. At December 31, 1993, the aggregate carrying value was $19,514,000. The Company intends to increase this carrying value, through additional accretion, to approximately $25,000,000 by June 30, 1994 and will continue to accrete the carrying value of the settlement rights to their estimated value until they are liquidated under one of the options discussed above. If, as a result of the independent appraisal process described above, a valuation is determined that is above or below the accreted carrying value, the Company will reflect such value through adjustment to the carrying value and to the accumulated deficit on June 30, 1994. (6) STOCKHOLDERS' EQUITY Each share of Class A common stock is entitled to one vote. Class C common shares generally are nonvoting; however, Class A and Class C common shares each may vote as a class on certain matters affecting their rights or preferences or as otherwise provided under Iowa law. Any dividends which are declared on any class of common stock must also be declared at an equivalent rate on the other classes of common stock. Class C common stock can be converted, at the holder's option, at any time, into Class A shares. On March 30, 1992, the common shareholders approved a one-for-four reverse split of the Company's common stock. All per share information and numbers of shares in the accompanying consolidated financial statements and notes thereto have been retroactively restated to reflect the results of this split. Additionally, the shareholders approved the elimination of the Class B common stock effective upon the conversion of each share of Class B common stock to one-half share of Class A common stock. During 1992, 400,000 shares of Class B common stock were converted to Class A HERITAGE MEDIA CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (6) STOCKHOLDERS' EQUITY (CONTINUED) common stock and the 1,600,000 shares of Class B common stock outstanding at December 31, 1992 were converted to Class A common stock upon approval by the FCC on July 20, 1993. Thereafter, the authorization of Class B Common Stock was eliminated from the Company's charter. On April 23, 1992, the Company issued 4,500,000 shares of Class A common stock in a public offering at $10 per share for net proceeds of $41,892,000. The Company used $30,000,000 of the proceeds to retire the $75 million, 8% subordinated note due July 31, 1994 (note 4). Remaining proceeds were used to reduce outstanding borowings under the Company's credit agreement. The Company has authorized 60,000,000 shares of preferred stock which can be issued in series with varying preferences and conversion features as determined by the Company's Board of Directors. In February 1992, the Company issued 22,117 shares of Series B preferred stock and 139,828 shares of Series C preferred stock at $100 per share. The shares were issued in exchange for cash of $14,778,000 and $1,416,900 of outstanding HMI debentures. The Company incurred issuance costs of $196,000 on this transaction. Each share of preferred stock accrues cumulative dividends at an annual rate of $11 per share, payable quarterly. Unpaid dividends accrue an amount equal to 11% per annum. At December 31, 1993, there were no dividends in arrears on the preferred stock. Each share of Series B preferred stock is convertible at the option of the holder into 6.9356 shares of Class A common stock. Each share of Series C preferred stock is convertible at the option of the holder into 6.9356 shares of Class A or Class C common stock. The liquidation preference is $100 per share plus accrued dividends. On February 1, 1994, the Company redeemed all outstanding shares of preferred stock by the issuance of 429,609 shares of Class A and 693,560 shares of Class C common stock. Also, on February 1, 1994, the holder of approximately 2.2 million shares of Class C common stock indicated its intention to convert the Class C shares into Class A shares and exercise its rights to require the Company to register the Class A shares in a secondary public offering. The offering is expected to occur in the first half of 1994. (7) EMPLOYEE BENEFIT PLANS The Company has a nonqualified employee incentive stock option plan under which options to purchase a total of 1,500,000 shares of the Company's Class A common stock may be granted to key employees, officers and directors. The purchase price may not be less than market value at the date of grant without approval of the Board of Directors. The options granted under such plan are exercisable beginning two years from date of grant and expire ten years from date of grant. On July 15, 1992, the Board of Directors approved, and the Company implemented, an option exchange program whereby Company employees, officers and directors were provided an opportunity to exchange existing options for new options on a reduced number of shares. The exercise price of the new options was $7.50 which represented the market price of the Company's Class A common stock on July 14, 1992. Vesting positions were not affected by the exchange. Under this program, 541,479 options issued prior to July 15, 1992 were exchanged for 288,136 new options. HERITAGE MEDIA CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (7) EMPLOYEE BENEFIT PLANS (CONTINUED) Following is a summary of activity in the option plan and agreements discussed above for the years ended December 31, 1991, 1992 and 1993: At December 31, 1993, 238,143 options outstanding under the option plan and agreements discussed above were exercisable and 582,103 shares were available for grant. The Company has a Retirement Savings Plan ("the Plan") whereby participants may contribute portions of their annual compensation to the Plan and certain contributions may be made at the discretion of the Company based on criteria set forth in the Plan agreement. Participants are generally 100% vested in Company contributions after five years of employment with the Company. For the years ended December 31, 1993, 1992 and 1991, Company expenses under the Plan were approximately $809,000, $501,000 and $250,000, respectively. The Company has a Stock Appreciation Rights Plan ("the SAR Plan") under the terms of which certain Actmedia employees may be granted a total of 250,000 stock appreciation units. The units entitle the holders, in the aggregate, to receive an amount equal to 2.5% of the increase, as defined, in the net value of Actmedia from the date of grant to December 31, 1994. At December 31, 1993, approximately 224,000 stock appreciation units were outstanding. Participants vest in such units over a five-year period and the cost of the SAR Plan is being charged to expense over the vesting period. For the years ended December 31, 1993, 1992 and 1991, compensation expense accrued under the SAR Plan was $500,000, $550,000 and $350,000, respectively. The Company does not provide post-employment or post-retirement benefits. (8) OTHER NONRECURRING COSTS In 1993, the Company made the decision to upgrade its existing in-store marketing radio network to a satellite-based delivery system. As a result, certain personnel and facilities utilized by the former HERITAGE MEDIA CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (8) OTHER NONRECURRING COSTS (CONTINUED) tape-based system will no longer be needed in the Company's operations. During the fourth quarter of 1993, the Company recorded a provision for the following writedowns and costs in connection with the change (thousands of dollars): The system upgrades began in October 1993 and are expected to continue through 1994. As of December 31, 1993, the Company had incurred or paid approximately $2,000,000 of the costs set forth above. The Company is also expected to incur capital costs of approximately $4,000,000 in 1994 in connection with the system upgrades. Such costs will be amortized over the five-year term of the related exclusive marketing rights agreements. (9) INCOME TAXES As discussed in note 1, the Company adopted SFAS 109 as of January 1, 1993. As a result of this change in accounting for income taxes, the Company recorded deferred tax assets (net of a valuation allowance of $26,908,000) and corresponding deferred tax liabilities of $7,319,000 on January 1, 1993. Total income tax expense for the years ended December 31, 1993, 1992 and 1991 of $2,944,000, $1,580,000 and $446,000, respectively, was allocated entirely to continuing operations and consisted primarily of current state income taxes. Income tax expense (benefit) differed from the amounts computed by applying the statutory U.S. federal income tax rates to income (loss) before income taxes and extraordinary items as a result of the following (thousands of dollars): HERITAGE MEDIA CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (9) INCOME TAXES (CONTINUED) The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and liabilities at December 31, 1993 are presented below (thousands of dollars): Deferred tax assets and liabilities are computed by applying the U.S. federal income tax rates in effect to the gross amounts of temporary differences and other tax attributes, such as net operating loss and capital loss carryforwards. Deferred tax assets and liabilities relating to state income taxes are not material. The Company expects the net deferred tax assets at December 31, 1993 to be realized as a result of the reversal during the carryforward period of existing taxable temporary differences giving rise to deferred tax liabilities. At December 31, 1993, the Company has net operating loss carryforwards for federal income tax purposes of approximately $56,300,000 which are available to offset future taxable income, if any, through 2007. Additionally, the Company has restricted net operating loss carryforwards of approximately $12,845,000 that can only be used to offset future taxable income, if any, of certain subsidiaries of the Company, through 2005. The Company has capital loss carryforwards of approximately $7,200,000 which are available to offset future capital gains, if any, through 1997. (10) COMMITMENTS AND CONTINGENCIES (A) LEASES AND CONTRACTS The Company and its subsidiaries lease certain real property, transportation and other equipment under noncancellable operating leases expiring at various dates through 1999. The Company also has long-term contractual obligations to two major broadcast ratings firms that provide monthly ratings services. Minimum commitments under all noncancellable leases and contracts for the years ending December 31, 1994 through 1998 are approximately $7,668,000, $7,068,000, $6,227,000, $3,664,000 and $2,913,000, respectively. Lease, rental and contractual expense payments for the years ended December 31, 1993, 1992 and 1991 amounted to approximately $7,907,000, $5,423,000 and $5,469,000, respectively. (B) BROADCAST PROGRAM RIGHTS The Company has entered into contracts for broadcast program rights that expire at various dates during the next five years. Contracts totaling approximately $1,966,000 relate to programs which are not currently available for use and, therefore, are not reflected as assets or liabilities in the HERITAGE MEDIA CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (10) COMMITMENTS AND CONTINGENCIES (CONTINUED) accompanying consolidated balance sheet at December 31, 1993. The aggregate minimum payments under contracts for programs currently available (those included on the consolidated balance sheet at December 31, 1993) and programs not currently available (those not included on the consolidated balance sheet at December 31, 1993) are approximately $2,581,000, $1,542,000, $510,000, $540,000 and $441,000 for the years ending December 31, 1994 through 1998, respectively. The Company entered into contracts for broadcast program rights of approximately $2,084,000, $2,181,000 and $2,314,000 during the years ended December 31, 1993, 1992 and 1991, respectively. (C) GUARANTEED STORE COMMISSIONS The Company has contractual obligations with certain supermarket chains for terms of a year or more to pay minimum store commission guarantees to these chains in connection with the chains' participation in one or more of the Company's advertising programs. Revenues derived from the Company's advertising programs are normally adequate to generate store commissions which exceed the minimum guarantees and such commission amounts are charged to operations as incurred. To the extent, however, that the store commissions generated by advertising programs are not expected to be sufficient to cover the minimum guarantees, a provision for the difference is charged to operations at the time such determination is made. Future minimum store commission guarantees for the years ending December 31, 1994 through 1998 are approximately $1,451,000, $670,000, $158,000, $129,000, and $54,000, respectively. (D) LITIGATION The Company is a party to lawsuits which are generally incidental to its business. Management of the Company does not believe the resolution of such matters will have a significant effect on its financial position or results of operations. HERITAGE MEDIA CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (11) SEGMENT INFORMATION Information relating to the Company's business segments as of and for the years ended December 31, 1993, 1992 and 1991 is as follows: (a) Includes nonrecurring expenses of $3,000,000 relating to the shut-down of certain in-store marketing facilities. HERITAGE MEDIA CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (11) SEGMENT INFORMATION (CONTINUED) (b) Includes writedowns of program rights of $1,678,000 and $490,000 in 1993 and 1991, respectively. (c) Includes amounts relating to fixed assets obtained in acquisitions, fixed asset additions from barter agreements, and translation adjustments of $1,270,000, $6,567,000 and $5,640,000 in 1993, 1992 and 1991, respectively. In 1993, one customer in the in-store marketing segment accounted for 10% of the Company's net revenues for the year, and in 1992 and 1991 one customer in each year accounted for 11% of the Company's net revenues. (12) SUMMARIZED FINANCIAL DATA OF HMSI Following is summarized financial information for HMSI, the issuer of the Senior Notes and the obligor on credit agreement borrowings (note 4). The Senior Notes and such borrowings are fully and unconditionally guaranteed by the Company and the subsidiaries of HMSI, other than subsidiaries organized outside the United States. Financial information of the guarantors is not presented as the guarantors will be jointly and severally liable on the Senior Notes and the aggregate net assets, earnings and equity of the guarantors are substantially equivalent to the net assets, earnings and equity of the Company and its subsidiaries. HERITAGE MEDIA CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (13) QUARTERLY FINANCIAL DATA (UNAUDITED) Gross profit represents net revenues less cost of services. Operating income is defined as net revenue less cost of services; selling, general and administrative expenses; depreciation and amortization; writedown of program rights; product development costs and other nonrecurring charges. Actmedia reports its operations on a 13-cycle basis whereby the results of operations of three, four-week periods are reported in each of the first three quarters of the fiscal year and four, four-week periods are reported in the fourth quarter of the fiscal year. Extraordinary gains and losses during 1993 and 1992 relate to early extinguishments of debt. Results of the fourth quarter of 1993 include $3,000,000 of nonrecurring charges relating to the upgrade of the Company's in-store marketing radio network. Results for the third quarter of 1992 include $2,700,000 of writedowns of the carrying amount of the Company's investment in SVL. Additional 1992 writedowns of such carrying amount totaling $560,000 did not have a significant impact on the financial results of the quarter in which they were recognized. SCHEDULE III HERITAGE MEDIA CORPORATION FINANCIAL INFORMATION OF REGISTRANT CONDENSED BALANCE SHEETS DECEMBER 31, 1993 AND 1992 (DOLLARS IN THOUSANDS) ASSETS See accompanying notes to condensed financial information. SCHEDULE III (CONTINUED) HERITAGE MEDIA CORPORATION FINANCIAL INFORMATION OF REGISTRANT CONDENSED STATEMENTS OF OPERATIONS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLARS IN THOUSANDS) See accompanying notes to condensed financial information. SCHEDULE III (CONTINUED) HERITAGE MEDIA CORPORATION FINANCIAL INFORMATION OF REGISTRANT CONDENSED STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLARS IN THOUSANDS) See accompanying notes to condensed financial information. HERITAGE MEDIA CORPORATION NOTES TO CONDENSED FINANCIAL INFORMATION DECEMBER 31, 1993, 1992 AND 1991 (1) GENERAL The accompanying condensed financial information of Heritage Media Corporation ("Registrant" or the "Company") should be read in conjunction with the consolidated financial statements of the Registrant included in the Registrant's Annual Report on Form 10-K for the year ended December 31, 1993. Heritage Media Corporation is primarily a holding company; however, the Company also owned one television station until August 1991 (see note 2). (2) ACQUISITIONS AND DISPOSITIONS In December 1990, the Company began investing in Supermarket Visions, Ltd. ("SVL"), an in-store marketing company operating in the United Kingdom. Cash investments in SVL preferred stock and advances totaled $994,000 and $344,000 during 1992 and 1991, respectively. During 1991 and 1992, the Company recorded $1,300,000 and $2,162,000 of writedowns of the carrying amount of the Company's investment in SVL. Also during 1992, the Company recorded additional costs of $1,098,000 incurred during the shutdown of SVL. SVL ceased operations in September 1992 and was liquidated in the fourth quarter of 1992. All such writedowns and shutdown costs are included in other expense, net for the respective years. On August 15, 1991, the Company sold certain assets of a television station with a total book value of $5,556,000 for $1,485,000. The loss on sale of $4,071,000 is reflected in other expense, net in the consolidated statement of operations for the year ended December 31, 1991. Sale proceeds consisted of $285,000 cash and a note receivable of $1,200,000. Concurrently, the Company purchased a television station in the same market for $7,007,000. The purchase was financed with cash from operations of $2,059,000, the $4,623,000 note payable and 25,000 shares of the Company's Class A common stock at $13 per share. On October 18, 1991, the Company entered into a joint venture agreement to purchase in-store marketing companies in Europe for an initial investment of $511,000. In April 1992, the Company paid $2.2 million to acquire a 65% interest in an in-store marketing company in The Netherlands. On February 28, 1992, the Company amended its Joint Operating Agreement with Muzak Limited Partnership whereby the Company purchased various in-store marketing assets for a purchase price of $5,000,000. Consideration paid by the Company consisted of $850,000 cash and a $4,150,000 note payable due in fluctuating quarterly installments with the balance due on January 31, 1999. (3) LONG-TERM DEBT Long-term debt at December 31, 1993 and 1992 is summarized as follows: On August 11, 1987, the Company issued a $75 million, 8% subordinated note due July 31, 1994. Interest on this note was deferred and payable at maturity. The note was discounted for financial statement purposes by $24.6 million using a 14% interest rate. On April 15, 1992, the Company retired the 8% subordinated note with an accreted balance of $95,384,000 through the payment of HERITAGE MEDIA CORPORATION NOTES TO CONDENSED FINANCIAL INFORMATION (CONTINUED) DECEMBER 31, 1993, 1992 AND 1991 (3) LONG-TERM DEBT (CONTINUED) $30,000,000 of cash obtained from the issuance of Class A common stock (note 5), the issuance of 1,335,721 shares of Class C common stock at $9.75 per share and the issuance of a new $50 million, 12% subordinated note ("the New Note"). As a result of this transaction, the Company recognized an extraordinary gain of approximately $2,360,000. On October 1, 1992, the Company retired the New Note through the issuance of $50 million of 11% Senior Subordinated Notes ("the Notes") due October 1, 2002. The Notes are redeemable, in whole or in part, at the Company's option at any time on or after October 1, 1997, at amounts decreasing from 105.5% to 100% of par at October 1, 1999. The Notes are subordinated to all other indebtedness of the Company and its subsidiaries except that the Notes are senior to a $4,623,000 note payable dated August 15, 1991 issued in connection with the acquisition of a television station (note 2). The Company recognized an extraordinary loss of $1,526,000 on this refinancing. Debt agreements of the Company's subsidiaries prohibit or limit their ability to pay dividends to the Company. However, these agreements permit the payment of dividends sufficient to meet the Company's obligations under the Notes. SCHEDULE V HERITAGE MEDIA CORPORATION AND SUBSIDIARIES PROPERTY AND EQUIPMENT YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLARS IN THOUSANDS) SCHEDULE VI HERITAGE MEDIA CORPORATION AND SUBSIDIARIES ACCUMULATED DEPRECIATION OF PROPERTY AND EQUIPMENT YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLARS IN THOUSANDS) SCHEDULE VIII HERITAGE MEDIA CORPORATION AND SUBSIDIARIES ALLOWANCE FOR DOUBTFUL ACCOUNTS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLARS IN THOUSANDS) SCHEDULE X HERITAGE MEDIA CORPORATION AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLARS IN THOUSANDS)

1993 Item 1. BUSINESS THE SYSTEM SYSTEM ORGANIZATION New England Electric System (NEES) is a voluntary association created under Massachusetts law on January 2, 1926, and is a registered holding company under the Public Utility Holding Company Act of 1935 (the 1935 Act). NEES owns voting stock in the amounts indicated of the following companies, which together constitute the System. % Voting Securities State of Type of Owned by Name of Company Organization Business NEES --------------- ------------ --------- ---------- Subsidiaries: Granite State Electric Company N.H. Retail 100 (Granite State) Electric Massachusetts Electric Company Mass. Retail 100 (Mass. Electric) Electric The Narragansett Electric Company R.I. Retail 100 (Narragansett) Electric Narragansett Energy Resources R.I. Wholesale 100 Company (Resources) Electric Generation New England Electric Resources, Inc. Mass. Consulting 100 (NEERI) Services New England Electric Transmission N.H. Electric 100 Corporation (NEET) Transmission New England Energy Incorporated Mass. Oil and Gas 100 (NEEI) Exploration & Development New England Hydro-Transmission N.H. Electric 53.97(a) Corporation (N.H. Hydro) Transmission New England Hydro-Transmission Mass. Electric 53.97(a) Electric Company, Inc. Transmission (Mass. Hydro) New England Power Company (NEP) Mass. Wholesale 98.80(b) Electric Generation & Transmission New England Power Service Company Mass. Service 100 (Service Company) Company (a) The common stock of these subsidiaries is owned by NEES and certain participants (or their parent companies) in Phase II of the Hydro-Quebec project. See Interconnection with Quebec, page 21. (b) Holders of common stock and 6% Cumulative Preferred Stock of NEP have general voting rights. The 6% Cumulative Preferred Stock represents 1.20% of the total voting power. In 1993, the System was realigned into two strategic business units, a wholesale business unit and a retail business unit. The facilities of NEES' three retail electric subsidiaries, Mass. Electric, Narragansett, and Granite State (collectively referred to as the Retail Companies), and of its principal wholesale electric subsidiary, NEP, constitute a single integrated electric utility system that is directly interconnected with other utilities in New England and New York State, and indirectly interconnected with utilities in Canada. See ELECTRIC UTILITY OPERATIONS, page 3. NEET owns and operates a portion of an international transmission interconnection between the electric systems of Hydro-Quebec and New England. Mass. Hydro and N.H. Hydro own and operate facilities in connection with an expanded second phase of this interconnection. See Interconnection with Quebec, page 21. NEEI is engaged in various activities relating to fuel supply for the System. These activities presently include participation (principally through a partnership with a non-affiliated oil company) in domestic oil and gas exploration, development, and production (see OIL AND GAS OPERATIONS, page 43) and the sale to NEP of fuel purchased in the open market. Resources is a general partner, with a 20% interest, in each of two partnerships formed in connection with the Ocean State Power project. See Ocean State Power, page 21. The Service Company has contracted with NEES and its subsidiaries to provide, at cost, such administrative, engineering, construction, legal, and financial services as the companies request. The Service Company also provides maintenance and construction services under contract to certain non-affiliated utility customers. Profits from these contracts are used to reduce the cost of services to affiliated companies. NEERI is a wholly-owned, non-utility subsidiary of NEES which provides consulting services domestically and internationally to non-affiliates. EMPLOYEES As of December 31, 1993, NEES subsidiaries had approximately 5,000 employees. As of that date, the total number of employees was approximately 840 at NEP, 1,800 at Mass. Electric, 760 at Narragansett, 80 at Granite State, and 1,500 at the Service Company. Of the 5,000 employees, approximately 3,300 are members of labor organizations. Collective bargaining agreements with the Brotherhood of Utility Workers of New England, Inc., the International Brotherhood of Electrical Workers, and the Utility Workers Union of America, AFL-CIO expire in May 1995. FINANCIAL INFORMATION ABOUT BUSINESS SEGMENTS The business of the System is conducted in two primary business segments, electric utility operations and oil and gas operations. The financial information with respect to Electric Utility Operations is as follows: Year Ended December 31 (thousands of dollars) 1993 1992 1991 - ---------------------- ---- ---- ---- Operating revenues $2,187,040 $2,138,302 $2,056,798 Operating income 332,843 341,650 317,487 Total assets 4,460,652 4,177,781 3,964,569 Capital expenditures 304,659 241,872 209,674 The financial information with respect to Oil and Gas Operations is as follows: Year Ended December 31 (thousands of dollars) 1993 1992 1991 - ---------------------- ---- ---- ---- Operating revenues $ 46,938 $ 43,374 $ 37,580 Pre-tax loss passed (46,355) (54,607) (39,303) on to customers Total assets 335,226 407,015 485,508 Capital expenditures 18,965 21,262 32,969 ELECTRIC UTILITY OPERATIONS GENERAL NEP's business is principally generating, purchasing, transmitting, and selling electric energy in wholesale quantities. In 1993, 95% of NEP's revenue from the sale of electricity was derived from sales for resale to affiliated companies and 5% from sales for resale to municipal and other utilities. NEP is the wholesale supplier of the electric energy requirements of the Retail Companies. Narragansett, however, receives credits against its purchases of power from NEP for the cost of generation from its Providence units, which are integrated with NEP's facilities to achieve maximum economy and reliability. Discussions of NEP's generating properties, load growth, energy mix, and fuel supplies include the related properties of Narragansett. For details of sales of energy and operating revenue for the last five years, see OPERATING STATISTICS on page 28 of the New England Power Company 1993 Annual Report to Stockholders (the NEP 1993 Annual Report). The combined service area of the Retail Companies constitutes the retail service area of the System and covers more than 4,400 square miles with a population of about 3,000,000 (1990 census). See Map, page 17. The largest cities served are Worcester, Mass. (population 170,000) and Providence, R.I. (population 161,000). Mass. Electric and Narragansett are engaged principally in the distribution and sale of electricity at retail. Mass. Electric provides approximately 930,000 customers with electric service at retail in a service area comprising approximately 43% of the area of The Commonwealth of Massachusetts. The population of the service area is about 2,160,000 or 36% of the total population of the Commonwealth (1990 Census). Mass. Electric's territory consists of 149 cities and towns including rural, suburban, and urban communities with Worcester, Lawrence, Lowell, and Quincy being the largest cities served. The economy of the area is diversified. Principal industries served by Mass. Electric include electrical and industrial machinery, computer manufacturing and related products, plastic goods, fabricated metals and paper, and chemical products. In addition, a broad range of professional, banking, high-technology, medical, and educational concerns is served. During 1993, 41% of Mass. Electric's revenue from the sale of electricity was derived from residential customers, 36% from commercial customers, 22% from industrial customers, and 1% from others. In 1993, the 20 largest customers of Mass. Electric accounted for less than 8% of its electric revenue. For details of sales of energy and operating revenue for the last five years, see OPERATING STATISTICS on page 26 of Mass. Electric's 1993 Annual Report to Stockholders (the Mass. Electric 1993 Annual Report). Narragansett provides approximately 323,000 customers with electric service at retail. Its service territory, which includes urban, suburban, and rural areas, covers about 839 square miles or 80% of the area of Rhode Island, and encompasses 27 cities and towns including the cities of Providence, East Providence, Cranston, and Warwick. The population of the area is about 725,000 (1990 Census) which represents about 72% of the total population of the state. The economy of the territory is diversified. Principal industries served by Narragansett produce fabricated metal products, jewelry, silverware, electrical and industrial machinery, transportation equipment, textiles, and chemical and allied products. In addition, a broad range of professional, banking, medical, and educational institutions is served. During 1993, 42% of Narragansett's revenue from the sale of electricity was derived from residential customers, 40% from commercial customers, 16% from industrial customers, and 2% from others. In 1993, the 20 largest customers of Narragansett accounted for approximately 11% of its electric revenue. For details of sales of energy and operating revenue for the last five years see OPERATING STATISTICS on page 23 of Narragansett's 1993 Annual Report to Stockholders (the Narragansett 1993 Annual Report). Granite State provides approximately 35,000 customers with electric service at retail in the State of New Hampshire in an area having a population of about 73,000 (1990 Census), including the city of Lebanon and the towns of Hanover, Pelham, Salem and surrounding communities. During 1993, 48% of Granite State's revenue from the sale of electricity was derived from commercial customers, 39% from residential customers, 12% from industrial customers, and 1% from others. In 1993, the 10 largest customers of Granite State accounted for about 20% of its electric revenue. Granite State is not subject to the reporting requirements of the Securities Exchange Act of 1934, and its financial impact on the System is relatively small. Information on Granite State is provided herein solely for the purpose of furnishing a more complete description of System operations. The electric utility business of NEP and the Retail Companies is not highly seasonal. For NEP and the Retail Companies, industrial customers are broadly distributed among standardized industrial classifications. No single industrial classification exceeds 4% of operating revenue, and no single customer of the System contributes more than 1% of operating revenue. Kilowatthour (KWH) sales billed to ultimate customers in 1993 increased by 1.4% over 1992. A return to more normal weather conditions in 1993 was largely offset by the fact that 1992 included an extra day for leap year. KWH sales billed to ultimate customers increased 0.4% in 1992. COMPETITIVE CONDITIONS The electric utility business is being subjected to increasing competitive pressures, stemming from a combination of increasing electric rates, improved technologies and new regulations, and legislation intended to foster competition. Recently, this competition has been most prominent in the bulk power market in which non-utility generating sources have noticeably increased their market share. For example, in 1984, less than 1% of NEP's capacity was supplied by non-utility generation sources. By the end of 1993, non-utility power purchases accounted for 380 MW or 7% of NEP's total capacity. In addition to competition from non- utility generators, the presence of excess generating capacity in New England has resulted in the sale of bulk power by utilities at prices less than the total costs of owning and operating such generating capacity. Electric utilities are also facing increased competition in the retail market. Currently, retail competition comes from alternative fuel suppliers (principally natural gas companies) for heating and cooling, customer-owned generation to displace purchases from electric utilities, and direct competition among electric utilities to attract major new manufacturing facilities to their service territories. In the future, the potential exists for electric utilities and non-utility generators to sell electricity to retail customers of other electric utilities. The NEES companies are responding to current and anticipated competitive pressures in a variety of ways including cost control and a corporate reorganization into separate retail and wholesale business units. The wholesale business unit is positioning itself for increased competition through such means as terminating certain purchased power contracts, past and future shutdowns of uneconomic generating stations, and rapid amortization of certain plant assets. NEP's rates currently include approximately $100 million per year associated with the recovery of certain Seabrook Nuclear Generating Station Unit 1 (Seabrook 1) costs under a 1988 rate settlement and coal conversion expenditures at NEP's Salem Harbor station. The recovery of these costs will be completed prior to the end of 1995. The retail business unit's response to competition includes the development of value-added services for customers and the offering of economic development rates to encourage businesses to locate in our service territory. In its recent rate settlement, Mass. Electric was able to change the standard terms under which it offers service to commercial and industrial customers to extend the notice period a customer must give from one to two years before purchasing electricity from others or generating any additional electricity for the customer's own use. In addition, Mass. Electric began offering a discount from base rates in return for a contract requiring the customer to provide five years written notice before purchasing electricity from others or generating any additional electricity for the customer's own use. The discount is available to customers with average monthly peak demands over 500 kilowatts. Electric utility rates are generally based on a utility's costs. Therefore, electric utilities are subject to certain accounting standards that are not applicable to other business enterprises in general. These accounting rules allow regulated entities, in appropriate circumstances, to establish regulatory assets and to defer the income statement impact of certain costs that are expected to be recovered in future rates. The effects of competition could ultimately cause the operations of the NEES companies, or a portion thereof, to cease meeting the criteria for application of these accounting rules. While the NEES companies do not expect to cease meeting these criteria in the near future, if this were to occur, accounting standards of enterprises in general would apply and immediate recognition of any previously deferred costs would be necessary in the year in which these criteria were no longer applicable. RATES General In 1993, 74% of the System's electric utility revenues was attributable to NEP, whose rates are subject to regulation by the Federal Energy Regulatory Commission (FERC). The rates of Mass. Electric, Narragansett, and Granite State are subject to the respective jurisdictions of the state regulatory commissions in Massachusetts, Rhode Island, and New Hampshire. The rates of each of the Retail Companies contain a purchased power cost adjustment clause (PPCA). The PPCA is designed to allow the Retail Companies to pass on to their customers increases in purchased power expense resulting from increases allowed by the FERC in NEP's rates. The Retail Companies are also required to reflect rate decreases or refunds. PPCA changes become effective on the dates specified in the filing of the adjustments with the state regulatory commission (not earlier than 30 days after such filing) unless the state regulatory commission orders otherwise. There have been, on occasion, regulatory delays in permitting PPCA increases. Effective March 1, 1993, Narragansett and Granite State received approval for PPCA clauses that fully reconcile on an annual basis purchased power expenses incurred by the companies against purchased power related revenues. Under the doctrine of Narragansett v. Burke, a case decided by the Rhode Island Supreme Court in 1977, NEP's wholesale rates must be accepted as allowable expenses for rate-making purposes by state commissions in retail rate proceedings. In 1986 and 1988 the U.S. Supreme Court reaffirmed this doctrine in two cases that did not involve NEP. However, the Narragansett v. Burke doctrine has been indirectly challenged by a number of state regulatory commissions which have held that federal preemption of the regulation of wholesale electric rates does not preclude the state commission from reviewing the prudence of a utility's decision to purchase power under a FERC-approved rate, and from disallowing costs if it finds that the purchase was an imprudent choice among alternative sources. In a 1985 opinion, the New Hampshire Supreme Court took this position on the issue of state regulation of wholesale power purchases. Also, legislation has been filed from time to time in Congress that would have eroded or repealed the doctrine. If state commissions were to refuse to allow the Retail Companies to include the full cost of power purchased from NEP in their rates, System earnings could be adversely affected. The rates of NEP and the Retail Companies contain fuel adjustment clauses that allow the rates to be adjusted to reflect changes in the cost of fuel. NEP's fuel clause is on a current basis. Mass. Electric has a fuel clause billing procedure that provides for monthly billing of estimated quarterly fuel costs, while Narragansett's and Granite State's fuel costs are estimated on a semi-annual basis. Billings are adjusted in the subsequent period for any excess or deficiency in fuel cost recovery. The FERC rules allow up to 50% of construction work in progress (CWIP) to be included in rate base in addition to CWIP already allowed in rate base for fuel conversion projects or pollution control facilities. This rule allows NEP the option of recovering currently through rates a portion of the costs of financing its construction program, rather than recording allowance for funds used during construction (AFDC) on that portion. The FERC rules with regard to canceled plants provide that utilities may recover in rates only 50% of prudently incurred canceled plant costs. However, the FERC allows utilities to include the recoverable amount in rate base and earn a return on the unamortized balance. NEP is recovering the cost of the conversion to coal of three units at Salem Harbor Station by means of an oil conservation adjustment (OCA), a FERC-approved rate. The OCA is designed to amortize the conversion costs by the mid-1990s. Through 1993, NEP has recovered approximately 84% of the conversion costs. The Retail Companies have OCA provisions designed to pass on to their customers amounts billed through NEP's OCA, which totaled $24.6 million for 1993. NEP Rates No NEP rate cases were filed with the FERC during 1993. Seabrook 1 Nuclear Unit NEP owns approximately 10% of Seabrook 1, a 1,150 MW nuclear generating unit, that entered commercial service on June 30, 1990. NEP's rate recovery of its investment in Seabrook 1 was resolved through two separate rate settlement agreements. The pre-1988 portion of NEP's investment is being recovered over a period of seven years and five months ending in July 1995. NEP's investment in Seabrook 1 since January 1, 1988, which amounts to approximately $50 million at December 31, 1993, is being recovered over its useful life. W-92 Rate Case In May 1992, the FERC approved a settlement of NEP's W-92 rate case under which base rates were increased by $39.7 million, effective March 1992. The entire increase was attributable to costs associated with the commercial operation of Unit 2 of the Ocean State Power (OSP) generating facility. These costs had been collected through NEP's fuel clause since the unit entered service in late 1991. The settlement also incorporated new depreciation rates proposed in NEP's filing, which reduced NEP's overall revenue requirement by $18 million. Mass. Electric Rates Rate schedules applicable to electric services rendered by Mass. Electric are on file with the Massachusetts Department of Public Utilities (MDPU). In November 1993, the MDPU approved a rate agreement filed by Mass. Electric, the Massachusetts Attorney General, and two groups of large commercial and industrial customers. Under the agreement, Mass. Electric began implementing an 11- month general rate decrease effective December 1, 1993 of $26 million (on an annual basis) from the level of rates then in effect. This rate reduction will continue in effect until October 31, 1994, after which rates will increase to the previously approved levels. The agreement also provided for rate discounts of up to $4 million available for the period ending October 31, 1994 for large commercial and industrial customers who agree to give a five-year notice to Mass. Electric before they purchase power from another supplier or generate any additional power themselves. These discounts will increase after October 31, 1994 to a level of $11 million per year if all eligible customers participate. Mass. Electric also agreed not to increase its base rates above currently approved levels before October 1, 1995. The decrease in revenues will be offset by the recognition for accounting purposes of revenues for electricity delivered but not yet billed. The agreement also resolved all issues associated with providing funds and securing rate recovery for environmental cleanup costs of Massachusetts manufactured gas waste sites formerly owned by Mass. Electric and its affiliates, as well as certain other Mass. Electric environmental cleanup costs (see Hazardous Substances, page 30). The rate agreement allows for these costs to be met by establishing a special interest bearing fund on Mass. Electric's books. On a consolidated basis, the fund's initial balance of $30 million comes from previously recorded environmental reserves and is not recoverable from customers. The establishment of the fund's initial balance at Mass. Electric resulted in a one-time charge to fourth quarter earnings of $9 million, before tax. Annual contributions of $3 million, adjusted for inflation, will be added to the fund by Mass. Electric and will be recoverable in rates. In addition, any shortfalls in the fund will be paid by Mass. Electric and be recovered through rates over seven years, without interest. Lastly, the agreement provided for the rate recovery of $8 million of certain storm restoration and other costs previously charged to expense. Effective October 1992, the MDPU authorized a $45.6 million annual increase in rates for Mass. Electric. This general rate increase included $2.5 million representing the first step of a four-year phase-in of Mass. Electric's tax deductible costs associated with post-retirement benefits other than pensions (PBOPs). A second $2.5 million increase took effect October 1, 1993. Narragansett Rates Rate schedules applicable to electric services rendered by Narragansett are on file with the Rhode Island Public Utilities Commission (RIPUC) and the Rhode Island Division of Public Utilities and Carriers. Effective March 1993, Narragansett implemented a new rate design which reallocated costs among its various rate classes, but which are not expected to affect total revenues over a twelve month period. Among other things, the new rates reduced the seasonality of the rates applicable to Narragansett's larger commercial and industrial customers. This change will result in lower revenues in summer months and higher revenues in other months when compared to Narragansett's prior rate design. Effective May 1992, the RIPUC authorized a $3.5 million annual increase in rates for Narragansett. In addition, effective January 1993, the RIPUC approved a $1.5 million increase in rates for Narragansett representing the first step of a three-year phase-in of Narragansett's recovery of costs associated with PBOPs. A second $1.5 million increase took effect in January 1994. Effective April 1991, the RIPUC approved Narragansett's settlement of a $13 million rate increase. Granite State Rates Effective March 1993, the New Hampshire Public Utilities Commission (NHPUC) authorized a $2.0 million rate increase for Granite State, with a retroactive adjustment to September 15, 1992 to reflect the difference between the authorized amount and the $1.4 million Granite State had been collecting on an interim basis since September 15, 1992. Effective July 1, 1993, the NHPUC approved a $0.7 million increase in rates for Granite State to recover costs associated with PBOPs. Recovery of Demand-Side Management Expenditures The three Retail Companies offer conservation and load management programs, usually referred to in the industry as Demand- Side Management (DSM) programs, which are designed to help customers use electricity efficiently, as a part of meeting the System's future resource needs and customers' needs for energy services. See RESOURCE PLANNING, page 36. The Retail Companies file their DSM programs regularly with their respective regulatory agencies and have received approval to recover in rates estimated DSM expenditures on a current basis. The rates provide for reconciling estimated expenditures to actual DSM expenditures, with interest. Mass. Electric's expenditures subject to the reconciliation mechanism were $47 million, $44 million, and $55 million in 1993, 1992, and 1991, respectively. Narragansett's expenditures subject to the reconciliation mechanism were $12 million, $12 million, and $19 million in 1993, 1992, and 1991, respectively. Since 1990, the Retail Companies have been allowed to earn incentives based on the results of their DSM programs. The Retail Companies must be able to demonstrate the electricity savings produced by their DSM programs to their respective state regulatory agencies before incentives are recorded. Mass. Electric recorded $6.7 million, $8.6 million, and $6.0 million of before-tax incentives in 1993, 1992, and 1991, respectively. Narragansett recorded $0.5 million, $1.3 million, and $1.6 million of before-tax incentives in 1993, 1992, and 1991, respectively. The Retail Companies have received regulatory approvals that will give them the opportunity to continue to earn incentives based on 1994 DSM program results. GENERATION Energy Mix The following table displays the contributions of various fuel sources and other generation to total net generation of electricity by NEP during the past three years, as well as an estimate for 1994: % of Net Generation -------------------------- Estimated Actual --------- ---------------- 1994 1993 1992 1991 ---- ---- ---- ---- Coal 37 38 41 44 Nuclear 18 18 18 18 Gas (1) 16 16 15 11 Oil 11 11 10 11 Hydroelectric 6 6 6 7 Hydro-Quebec 6 5 4 3 Renewable Non-Utility Generation (2) 6 6 6 6 --- --- --- --- 100 100 100 100 (1) Gas includes both utility and non-utility generation. (2) Waste to energy and hydro. Electric Utility Properties The electric utility properties of the System companies consist of NEP's and Narragansett's fossil-fuel base load and intermediate load steam generating units, conventional and pumped storage hydroelectric stations, internal combustion peaking units, portions of fossil fuel and nuclear generating units, the ownership interests of NEET, Mass. Hydro, and N.H. Hydro in the Hydro-Quebec Interconnection, and an integrated system of transmission lines, substations, and distribution facilities. See MAP - ELECTRIC UTILITY PROPERTIES, page 17. NEP's integrated system consists of 2,290 circuit miles of transmission lines, 116 substations with an aggregate capacity of 13,265,588 kVA, and 7 pole or conduit miles of distribution lines. The properties of Mass. Electric and Narragansett include substations and distribution and transmission lines, which are interconnected with transmission and other facilities of NEP. At December 31, 1993, Mass. Electric owned 282 substations, which had an aggregate capacity of 2,859,309 kVA, 147,090 line transformers with the capacity of 7,489,447 kVA, and 15,948 pole or conduit miles of distribution lines. Mass. Electric also owns 81 circuit miles of transmission lines. At December 31, 1993, Narragansett owned 248 substations, which had an aggregate capacity of 2,838,927 kVA, 53,100 line transformers with the capacity of 2,239,554 kVA, and 4,492 pole or conduit miles of distribution lines. Narragansett, in addition, owns 325 circuit miles of transmission lines. Substantially all of the properties and franchises of Mass. Electric, Narragansett, and NEP are subject to the liens of indentures under which mortgage bonds have been issued. For details of the mortgage liens on these properties see the long-term debt note in Notes to Financial Statements in each of these companies' respective 1993 Annual Report. The properties of NEET are subject to a mortgage under its financing arrangements. (a) These units currently burn coal, but are also capable of burning oil. (b) For a discussion of the Manchester Street Station repowering project, see Manchester Street Station Repowering on page 37. (c) Includes (i) an interest in a jointly owned oil-fired unit in Yarmouth, Maine, and (ii) diesel units at various locations. (d) See Hydroelectric Project Licensing, page 28. (e) See Nuclear Units, page 21. (f) Capability includes contracted purchases (1,312 MW) less contract sales (164 MW). Net generation includes the effects of the above contracted purchases and economy interchanges through the New England Power Exchange (including Hydro-Quebec purchases and purchases from non-utility generation). For further information see Non-Utility Generation Sources, page 20. NEP and Narragansett are members of the New England Power Pool (NEPOOL), a group of over 90 New England utilities that comprises virtually all of New England's electric generation. Mass. Electric and Granite State participate in NEPOOL through NEP. The NEPOOL Agreement provides for coordination of the planning and operation of the generation and transmission facilities of its members. The NEPOOL Agreement incorporates generating capacity reserve obligations, provisions regarding the use of major transmission lines, and provisions for payment for facilities usage. The NEPOOL Agreement further provides for New England-wide central dispatch of generation through the New England Power Exchange. Through NEPOOL, operating and capital economies are achieved and reserves are established on a region-wide rather than an individual company basis. The electric energy available to NEES subsidiaries and other members is determined by the aggregate available to NEPOOL. The 1993 NEPOOL peak demand of 19,570 MW occurred on July 8, 1993. The maximum demand to date of 19,742 MW occurred on July 19, 1991. The 1993 summer peak for the System of 4,081 MW occurred on July 8, 1993. This was below the previous all time peak load of 4,250 MW which occurred on July 19, 1991. The 1993-1994 winter peak of 4,121 MW occurred on January 19, 1994. For a discussion of resource planning, see RESOURCE PLANNING, page 36. MAP (Displays electric utility properties of NEES subsidiaries) Fuel for Generation NEP burned the following amounts of coal, residual oil, and gas during the past three years: 1993 1992 1991 ---- ---- ---- Coal (in millions of tons) 3.2 3.3 3.6 Oil (in millions of barrels) 5.0 4.9 6.4 Natural Gas (in billions of cubic feet) 0.7 3.2 1.7 Coal Procurement Program Depending on coal-fired generating unit availability and the degree to which the units are dispatched, NEP's 1994 coal requirements should range between 3.0 and 3.2 million tons. NEP obtains its domestic coal under contracts of varying lengths and on a spot basis from domestic coal producers in Kentucky, West Virginia, and Pennsylvania, and from mines in Colombia and Venezuela. Three different rail systems (CSX, Norfolk Southern, and Conrail) transport coal from domestic sources to loading ports on the east coast. NEP's coal is transported from east coast ports by ocean-going collier to Brayton Point and Salem Harbor. NEP has a term charter with the Energy Independence, a self-unloading collier, which carries all of NEP's U.S. coal and a portion of foreign coal. NEP also charters other coal-carrying vessels for the balance of foreign coal. As protection against interruptions in coal deliveries, NEP maintained coal inventories at its generating stations during 1993 in the range of 40 to 60 days. A United Mine Workers strike lasting the second half of 1993 interrupted one long-term contract which was replaced prior to its 1994 expiration. To meet environmental requirements, NEP uses coal with a relatively low sulphur and ash content. NEP's average price for coal burned, including transportation costs, calculated on a 26 million Btu per ton basis, was $44.72 per ton in 1991, $44.15 in 1992, and $43.53 per ton in 1993. Based on a 42 gallon barrel of oil producing 6.3 million Btu's, these coal prices were equivalent to approximately $10.83 per barrel of oil in 1991, $10.70 in 1992 and $10.57 per barrel of oil in 1993. Oil Procurement Program The System's 1994 oil requirements are expected to be approximately 5.0 million barrels. The System obtains its oil requirements through contracts with oil suppliers and purchases on the spot market. Current contracts provide for minimum annual purchases of 2.6 million barrels at market related prices. The System currently has a total storage capacity for approximately 2.3 million barrels of residual and diesel fuel oil. The System's average cost of oil burned, calculated on a 6.3 million Btu per barrel basis, was $11.82 in 1991, $12.68 in 1992, and $13.30 in 1993. Natural Gas NEP uses natural gas at both Brayton 4 and Manchester Street Stations when gas is priced less than residual fuel oil. At Brayton 4, natural gas currently displaces 2.2% sulphur residual fuel oil. At Manchester Street Station, gas currently displaces 1.0% sulphur residual fuel oil. In 1993, approximately 0.7 billion cubic feet of gas were consumed at an average cost of $2.58 per thousand cubic feet excluding pipeline demand charges. This gas price was equivalent to approximately $16.25 per barrel of oil. Firm year-round gas deliveries to Manchester Street Station are planned as part of its repowering project. The repowered facility would use up to 95 million cubic feet of natural gas per day. See Manchester Street Station Repowering, page 37. NEP has contracted with six pipeline companies for transportation of natural gas from supply regions to these two generating stations: (1) 60 million cubic feet per day from Western Canada via TransCanada PipeLines, Ltd. (TransCanada), Iroquois Gas Transmission System, Tennessee Gas Pipeline Company and Algonquin Gas Transmission Company, and (2) 60 million cubic feet per day from the U.S. Mid-Continent region via ANR Pipeline Company, Columbia Gas Transmission Company and Algonquin. (a) NEP has entered into a firm service agreement with TransCanada. Service commenced on November 1, 1992. (b) NEP has entered into a firm service agreement with Iroquois. Service commenced on November 1, 1993. (c) NEP has entered into a firm service agreement with Tennessee. Service commenced on November 1, 1993. (d) NEP has entered into a firm service agreement with Algonquin for delivery of Canadian gas. Service commenced on November 1, 1993. Additional service for a portion of the domestic gas is expected to commence in December 1994. NEP has also entered into a firm service agreement for deliveries of gas to its Brayton Point Station. All facilities for this service have been constructed and in service since December of 1991. (e) ANR has constructed substantially all facilities necessary to serve NEP. NEP has entered into a firm service agreement with ANR. Service is expected to commence in December 1994. (f) Columbia has received and accepted a FERC certificate to construct facilities for service to NEP. NEP has entered into a firm service agreement with Columbia. Service is expected to commence in December 1994. NEP has also signed contracts with four Canadian gas suppliers for a total of 60 million cubic feet per day. NEP has not yet signed supply arrangements with Mid-Continent producers. The pipeline agreements require minimum fixed payments. NEP's minimum net payments are currently estimated to be approximately $45 million in 1994, $65 million in 1995, and $70 million each in 1996, 1997, and 1998. The amount of the fixed payments are subject to FERC regulation and will depend on FERC actions affecting the rates on each of the pipelines. As part of its W-12 rate settlement, NEP is recovering 50% of the fixed pipeline capacity payments through its current fuel clause and deferring the recovery of the remaining 50% until the Manchester Street repowering project is completed. NEP has deferred payments of approximately $13 million as of December 31, 1993. Nuclear Fuel Supply As noted above, NEP participates with other New England utilities in the ownership of several nuclear units. See Nuclear Units, page 21. The utilities responsible for supply for these units are not experiencing any difficulty in obtaining commitments for the supply of each element of the nuclear fuel cycle. Non-Utility Generation Sources The System companies purchase a portion of the electricity generated by, or provide back-up or standard service to, 139 small power producers or cogenerators (a total of 3,185,101 MWh of purchases in 1993). As of December 31, 1993, these non-utility generation sources include 32 low-head hydroelectric plants, 51 wind or solar generators, seven waste to energy facilities, and 49 cogenerators. The total capacity of these sources is as follows: In Service Future Projects (12/31/93) Under Contract Source (MW) (MW) ------ ---------- --------------- Hydro 43 - Wind - 20 Waste to Energy 169 33 Cogeneration 303 40 Independent Power Producers - 83* ---- --- Total 515 176 * Milford Power was accepted for dispatch by NEPOOL on January 20, 1994. The in-service amount includes 377 MW of capacity and 138 MW treated as load reductions and excludes the Ocean State Power contracts discussed below. Ocean State Power Ocean State Power (OSP) and Ocean State Power II (OSP II) are general partnerships that own and operate a two unit gas-fired combined cycle electric power plant in Burrillville, R.I. Resources is a general partner with a 20% interest in both OSP and OSP II and had an equity investment of approximately $40 million at December 31, 1993. The first unit began commercial operation on December 31, 1990 and the second unit went into service on October 1, 1991. The two units have a combined winter net electrical capability of approximately 562 MW. Each unit's capacity and energy output is sold under 20-year unit power agreements to a group of New England utilities, including NEP, which has contracts for 48.5% of the output of each unit. NEP is required to make certain minimum fixed payments to cover capital and fixed operating costs of these units in amounts estimated to be $70 million per year. Interconnection with Quebec NEET, Mass. Hydro, and New Hampshire Hydro own and operate, on behalf of NEPOOL participants in the project, a 450 kV direct current (DC) transmission line and related terminals to interconnect the New England and Quebec transmission systems (the Interconnection). The transfer capability of the Interconnection is 2,000 MW. NEPOOL members purchase from and sell energy to Hydro-Quebec pursuant to several agreements. The principal agreement calls for NEPOOL members to purchase 7 billion KWH of energy each year for ten years (the Firm Energy Contract). Purchases under the Firm Energy Contract totaled over 6.4 billion KWH in 1993. NEP is a participant in both the Phase I and Phase II projects of the Interconnection. NEP's participation percentage in both projects is approximately 18%. NEP and the other participants have entered into support agreements that end in 2020, to pay monthly their proportionate share of the total cost of constructing, owning, and operating the transmission facilities. NEP accounts for these support agreements as capital leases and accordingly recorded approximately $78 million in utility plant at December 31, 1993. Under the support agreements, NEP has agreed, in conjunction with any Phase II project debt financing, to guarantee its share of project debt. At December 31, 1993, NEP had guaranteed approximately $34 million. In the event any Interconnection facilities are abandoned for any reason, each participant is contractually committed to pay its pro-rata share of the net investment in the abandoned facilities. Nuclear Units General NEP is a stockholder of Yankee Atomic Electric Company (Yankee Atomic), Vermont Yankee Nuclear Power Corporation (Vermont Yankee), Maine Yankee Atomic Power Company (Maine Yankee), and Connecticut Yankee Atomic Power Company (Connecticut Yankee). Each of these companies (collectively referred to as the Yankee Companies) owns a single nuclear generating unit. In addition, NEP is a joint owner of the Millstone 3 nuclear generating unit in Connecticut and the Seabrook 1 nuclear generating unit in New Hampshire. Millstone 3 and Seabrook 1 are operated by subsidiaries of Northeast Utilities (NU). NEP pays its proportionate share of costs and receives its proportionate share of each unit's output. NEP's interest and investment in each of the Yankee Companies, Millstone 3, and Seabrook 1 and the net capability of each plant are as follows: Equity Net Investment Capability (12/31/93) Interest (MW) (in millions) -------- ---------- ------------- Yankee Atomic 30.0% * $ 7 Vermont Yankee 20.0% 93 10 Maine Yankee 20.0% 158 14 Connecticut Yankee 15.0% 87 15 ---- ---- Subtotal 338 $ 46 Net Investment in Plant** (12/31/93) (in millions) ------------- Millstone 3 12.2% 140 $405 Seabrook 1 9.9% 115 149 ---- Subtotal 255 ---- Total 593 ==== *Operations ceased **Excludes nuclear fuel NEP has a 30% ownership interest in Yankee Atomic which owns a 185 megawatt nuclear generating station in Rowe, Massachusetts. The station began commercial service in 1960. In February 1992, the Yankee Atomic board of directors decided to permanently cease power operation of, and in time, decommission the facility. In March 1993, the FERC approved a settlement agreement that allows Yankee Atomic to recover all but $3 million of its approximately $50 million remaining investment in the plant over the period extending to July 2000, when the plant's Nuclear Regulatory Commission (NRC) operating license would have expired. Yankee Atomic recorded the $3 million before-tax write-down in 1992. The settlement agreement also allows Yankee Atomic to earn a return on the unrecovered balance during the recovery period and to recover other costs, including an increased level of decommissioning costs, over this same period. Decommissioning cost recovery increased from $6 million per year to $27 million per year for the period 1993 to 1995. This level of recovery is subject to review in 1996. NEP has recorded an estimate of its entire future payment obligations to Yankee Atomic as a liability on its balance sheet and an offsetting regulatory asset reflecting its expected future rate recovery of such costs. This liability and related regulatory asset amounted to approximately $104 million each at December 31, 1993. NEP purchases the output of the other Yankee nuclear electric generating plants in the same percentages as its stock ownership of the Yankee Companies, less small entitlements taken by municipal utilities for Maine Yankee and Vermont Yankee. NEP has power contracts with each Yankee Company that require NEP to pay an amount equal to its share of total fixed and operating costs (including decommissioning costs) of the plant plus a return on equity. The stockholders of three Yankee Companies (Vermont Yankee, Maine Yankee and Connecticut Yankee) have agreed, subject to regulatory approval, to provide capital requirements in the same proportion as their ownership percentages of the particular Yankee Company. Pursuant to the terms of a lending agreement, Yankee Atomic will not pay dividends to its shareholders, including NEP, until such lender is paid in full. There is widespread concern about the safety of nuclear generating plants. The NRC regularly reviews the adequacy of its comprehensive requirements for nuclear plants. Many local, state, and national public officials have expressed their opposition to nuclear power in general and to the continued operation of nuclear power plants. It is possible that this controversy will result in cost increases and modifications to, or premature shutdown of, the operating nuclear units in which NEP has an interest. On three occasions (most recently in 1987), referenda appeared on the ballot in Maine that, if passed, would have required the prompt shutdown of Maine Yankee. All the referenda were defeated. There is no assurance that similar measures will not appear on future ballots. Pending before FERC is an initial decision of an administrative law judge disallowing full rate recovery for the unamortized portion of a nuclear plant to be retired before the end of its operating license. The decision, if affirmed, would result in rate recovery of less than the full investment in a nuclear plant retired from service prior to the end of its operating license. The amount of the disallowance would depend upon the plant's historic capacity factor and the number of years remaining on its operating license. Decommissioning Each of the Yankee Companies includes charges for all or a portion of decommissioning costs in its cost of energy. These charges vary depending upon rate treatment, the method of decommissioning assumed, economic assumptions, site and unit specific variables, and other factors. Any increase in these charges is subject to FERC approval. Each of the operating nuclear units has established decommissioning trust funds or escrow funds into which payments are being made to meet the projected cost of decommissioning its plant. If any of the units were shut down prior to the end of its operating license, the funds collected for decommissioning to that point would be insufficient. Estimates of NEP's pro-rata share (based on ownership) of decommissioning costs, NEP's share of the actual book values of decommissioning fund balances set aside for each unit at December 31, 1993 (in millions of dollars), and the expiration date of the operating license of each plant are as follows: NEP's share of ----------------------------- Estimated Decommissioning Fund License Costs Balances (1) Expiration Unit (in 1993 $) (12/31/93) Date ---- --------------- ------------ ---------- Yankee Atomic (2) $78 $26 -- Connecticut Yankee $49 $18 2007 Maine Yankee $63 $19 2008 Vermont Yankee $57 $20 2012 Millstone 3 $50 $10 2025 Seabrook 1 $36 $ 3 2026 (1) Certain additional amounts are anticipated to be available through tax deductions. (2) The estimated cost of decommissioning for Yankee Atomic does not reflect the benefit of the component removal project (CRP) for which decommissioning funds were spent in 1993. Additional expenditures for CRP will be made in 1994. NEP is currently collecting through rates amounts for decommissioning based upon cost estimates and funding methodologies authorized by FERC. Such estimates are determined periodically for each plant and may not reflect the current projected cost of decommissioning. There is no assurance that decommissioning costs actually incurred by the Yankee Companies, Millstone 3 or Seabrook 1 will not substantially exceed these amounts. For example, current decommissioning cost estimates assume the availability of permanent repositories for both low-level and high-level nuclear waste which do not currently exist. NRC rules require that reasonable assurance be provided that adequate funds will be available for the decommissioning of commercial nuclear power plants. The rule establishes minimum funding levels that licensees must satisfy. Each of the units in which NEP has an interest has filed a report with the NRC providing assurance that funds will be available to decommission the facility. A Maine statute provides that if both Maine Yankee and its decommissioning trust fund have insufficient assets to pay for the plant decommissioning, the owners of Maine Yankee are jointly and severally liable for the shortfall. The definition of owner under the statute covers NEP and may cover companies affiliated with it. NEP and the Retail Companies cannot determine, at this time, the constitutionality, applicability, or effect of this statute. If NEP or the Retail Companies were required to make payments under this statute, they would assess their legal remedies at that time. In any event, NEP and the Retail Companies would attempt to recover through rates any payments required. If any claim in excess of NEP's ownership share were enforced against a NEES company, that company would seek reimbursement from any other Maine Yankee stockholder which failed to pay its share of such costs. The Energy Policy Act of 1992 assesses the domestic nuclear power industry for a portion of costs associated with the decontamination and decommissioning of the Department of Energy's (DOE) uranium enrichment facilities. An annual assessment of $150 million (escalated for inflation) on the domestic nuclear power industry will be allocated to each plant based upon the amount of DOE uranium enrichment services utilized in the past. The total DOE assessment, which began in October 1992, will remain in place for up to 15 years and will amount to $2.25 billion (escalated). The Yankees, Millstone 3 and Seabrook have been assessed and initial billings indicate NEP's obligation for such costs over the next 14 years will be approximately $29 million. In accordance with the provisions of the Energy Policy Act, these costs are being recovered through NEP's fuel clause. High-Level Waste Disposal The Nuclear Waste Policy Act of 1982 provides a framework and timetable for selection of sites for repositories of high-level radioactive waste (spent nuclear fuel) from United States nuclear plants. The DOE has entered into contracts with the Yankee Companies, the Millstone 3 joint owners, and the Seabrook 1 joint owners for acceptance of title to, and transportation and storage of, this waste. Under these contracts, each operating unit will pay fees to the DOE to cover the development and creation of waste repositories. Fees for fuel burned since April 1983 have been collected by the DOE on an ongoing basis at the rate of one tenth of a cent per KWH of net generation. Fees for generation up through April 1983 were determined by the DOE as follows: $13.2 million for Yankee Atomic, $48.7 million for Connecticut Yankee, $50.4 million for Maine Yankee, and $39.3 million for Vermont Yankee. Neither Millstone 3 nor Seabrook 1 has been assessed any fees for fuel burned through April 1983, because they did not enter commercial operation until 1986 and 1990, respectively. The Yankee Companies had several options to pay these fees. Yankee Atomic paid its fee to the DOE for the period through April 1983. The other three Yankee Companies elected to defer payment until a future date, thereby incurring interest expense. However, payment to the DOE must occur prior to the first delivery of spent fuel. Connecticut, Maine, and Vermont Yankee have segregated a portion of their respective DOE obligations in external accounts. The remainder of the funds have been used to support general capital requirements. All expect to separately fund in full in external accounts their DOE obligation (including accrued interest) prior to payment to the DOE. To the extent that any of the three Yankee Companies is unable to fully meet its DOE obligation at the prescribed time, NEP might be required to provide additional funds. Prior to such time that the DOE takes delivery of a plant's spent nuclear fuel, it is stored on site in spent fuel pools. Connecticut Yankee and Maine Yankee have adequate existing storage through the late 1990's. Millstone 3 will be able to maintain a full core discharge capability through the end of its current license. Seabrook 1's current licensed storage capacity is adequate until at least 2010. Vermont Yankee is able to maintain a full core discharge capability until 2001. Yankee Atomic has adequate on-site storage capacity for all its spent fuel. Federal legislation enacted in December 1987 directed the DOE to proceed with the studies necessary to develop and operate a permanent high-level waste disposal site at Yucca Mountain, Nevada. There is local opposition to development of this site. Although originally scheduled to open in 1998, the DOE announced in November 1989 that the permanent disposal site is not expected to open before 2010, a date the DOE has defined as optimistic. The legislation also provides for the development of a Monitored Retrievable Storage (MRS) facility and abandons plans to identify and select a second, permanent disposal site. An MRS facility would provide temporary storage for high-level waste prior to eventual permanent disposal. It is not known when an MRS facility would begin accepting deliveries. Additional delays due to political and technical problems are likely. It is extremely unlikely deliveries would be accepted prior to 1999. Federal authorities have deferred indefinitely the commercial reprocessing of spent nuclear fuel. Low-Level Waste Disposal In 1986, the Low-Level Radioactive Waste Policy Amendments Act was enacted by Congress. This statute sets a time limit of December 31, 1992, beyond which disposal of low-level waste at any of the three existing sites is impermissible. Under the statute, individual states are responsible for finding local sites for disposal or forming regional disposal compacts by defined milestone dates. As of December 1991, all of the states in which NEP holds an interest in a nuclear facility had met the 1990 milestone which required the filing of a facility operating license application or Governor's certification that the state will provide for storage, disposal, and management of waste generated after 1992. Although New Hampshire met the 1990 milestone, the arrangements made by the state did not encompass low-level waste generated by Seabrook 1 and it is currently prohibited from shipping its low-level waste out of the state. Connecticut Yankee, Millstone 3, Vermont Yankee, Maine Yankee and Yankee Atomic are currently allowed to ship low-level radioactive waste to the existing disposal site in South Carolina. The 1992 milestone required each state to file a facility operating license application. None of the states in which NEP holds an interest in a nuclear facility has met this milestone. Failure to meet this milestone means that those states may be subject to surcharges on waste shipped out of state. Disposal costs could increase significantly. Since January 1, 1993, the South Carolina low-level waste disposal site has been the only site open to accept low-level waste from NEP's units. The South Carolina site will remain open until June 30, 1994 to generators whose states are making progress toward developing their own disposal facilities. Effective June 30, 1994, the South Carolina low-level waste disposal site will be closed permanently to non- regional wastes. However, all of the nuclear facilities in which NEP has an interest have temporary storage facilities on site to meet short-term low-level radioactive waste storage requirements. Price-Anderson Act The Price-Anderson Act limits the amount of liability claims that would have to be paid in the event of a single incident at a nuclear plant to $9.2 billion (based upon 114 licensed reactors). The maximum amount of commercially available insurance coverage to pay such claims is only $200 million. The remaining $9.0 billion would be provided by an assessment of up to $79.3 million per incident levied on each of the nuclear units in the United States, subject to a maximum assessment of $10 million per incident per nuclear unit in any year. The maximum assessment, which was most recently calculated in 1993, is to be adjusted at least every five years to reflect inflationary changes. NEP's current interest in the Yankees, Millstone 3, and Seabrook 1 would subject NEP to an $81.8 million maximum assessment per incident. NEP's payment of any such assessment would be limited to a maximum of $10.3 million per incident per year. As a result of the permanent cessation of power operation of the Yankee Atomic plant, Yankee Atomic has petitioned the NRC for an exemption from obligations under the Price-Anderson Act. Other Items Federal legislation requires emergency response plans, approved by federal authorities, for nuclear generating units. The Yankee Companies, Seabrook 1, and Millstone 3 are not currently experiencing difficulty in maintaining approval of their emergency response plans. REGULATORY AND ENVIRONMENTAL MATTERS Regulation Numerous activities of NEES and its subsidiaries are subject to regulation by various federal agencies. Under the 1935 Act, many transactions of NEES and its subsidiaries are subject to the jurisdiction of the Securities and Exchange Commission (SEC). Under the Federal Power Act, certain electric subsidiaries of NEES are subject to the jurisdiction of the FERC with respect to rates, accounting, and hydroelectric facilities. In addition, the NRC has broad jurisdiction over nuclear units and federal environmental agencies have broad jurisdiction over environmental matters. The electric utility subsidiaries of NEES are also subject to the jurisdiction of regulatory bodies of the states and municipalities in which they operate. For more information, see: RATES, page 8, Nuclear Units, page 21, RESOURCE PLANNING, page 36, Fuel for Generation, page 18, Environmental Requirements, page 29, and OIL AND GAS OPERATIONS, page 43. Hydroelectric Project Licensing NEP is the largest operator of conventional hydroelectric facilities in New England. NEP's hydroelectric projects are licensed by the FERC. These licenses expire periodically and the projects must be relicensed at that time. NEP's present licenses expire over a period from 2001 to 2020 excluding the Deerfield River Project discussed below. Upon expiration of a FERC license for a hydro project, the project may be taken over by the United States or licensed to the existing, or a new licensee. If the project were taken over, the existing licensee would receive an amount equal to the lesser of (i) fair value of the project or (ii) original cost less depreciation and amounts held in amortization reserves, plus in either case severance damages. The net book value of NEP's hydroelectric projects was $245 million as of December 31, 1993. In the event that a new license is not issued when the existing license expires, FERC must issue annual licenses to the existing licensee which will allow the project to continue operation until a new license is issued. A new license for a project may incorporate operational restrictions and requirements for additional non-power facilities (e.g., recreational facilities) that could affect operation of the project, and may also require additional capital investment. For example, NEP has previously received new licenses for projects on the Connecticut River that involved construction of an extensive system of fish ladders. The license for the 84 MW Deerfield River Project expired at the end of 1993. NEP filed an application for a new license in 1991, which is still under review. Several advocacy groups have intervened proposing operational modifications which would reduce the energy output of the project substantially. FERC has issued NEP an annual license to continue operation of the project under the terms and conditions of the expired license until a new license issues or other disposition of the project takes place. The next NEP project to require a new license will be the 368 MW Fifteen Mile Falls Project on the Connecticut River in New Hampshire and Vermont. This license expires in 2001. The formal process of preparing an application for a new license will begin in 1996. FERC has recently issued a Notice of Inquiry regarding the decommissioning of licensed hydroelectric projects. Responses to this notice are still under review at FERC. Some parties have advocated positions in this docket that would draw into question recovery of investment and severance damages in the event of project decommissioning. Depending upon the scope of any project decommissioning regulations, the associated costs could be substantial. Environmental Requirements Existing Operations The NEES subsidiaries are subject to federal, state, and local environmental regulation of, among other things: wetlands and flood plains; air and water quality; storage, transportation, and disposal of hazardous wastes and substances; underground storage tanks; and land-use. It is likely that the stringency of environmental regulation affecting the System and its operations will increase in the future. Siting and Construction Activities for New Facilities All New England states require, in certain circumstances, regulatory approval for site selection or construction of electric generating and major transmission facilities. Connecticut, Maine, Massachusetts, New Hampshire, and Rhode Island also have programs of coastal zone management that might restrict construction of power plants and other electrical facilities in, or potentially affecting, coastal areas. All agencies of the federal government must prepare a detailed statement of the environmental impact of all major federal actions significantly affecting the quality of the environment. The New England states have environmental laws which require project proponents to prepare reports of the environmental impact of certain proposed actions for review by various agencies. Except for the planned Manchester Street Repowering Project, the System is not currently constructing generating plants or major transmission facilities. Environmental Expenditures Total System capital expenditures for environmental protection facilities have been substantial. System capital expenditures for such facilities amounted to approximately $29 million in 1991, $31 million in 1992, and $23 million in 1993, including expenditures by NEP of $25 million, $28 million, and $14 million, respectively, for those years. The System estimates that total capital expenditures for environmental protection facilities will be approximately $65 million in 1994 ($50 million by NEP) and $25 million in 1995 ($15 million by NEP). Hazardous Substances The United States Environmental Protection Agency (EPA) has established a comprehensive program for the management of hazardous waste. The program allows individual states to establish their own programs in coordination with the EPA; Massachusetts, New Hampshire, Vermont, and Rhode Island have established such programs. Both the EPA and Massachusetts regulations cover certain operations at Brayton Point and Salem Harbor. Other System activities, including hydroelectric and transmission and distribution operations, also involve some wastes that are subject to EPA and state hazardous waste regulation. In addition, numerous System facilities are subject to federal and state underground storage tank regulations. The EPA regulates the manufacture, distribution, use, and disposal of polychlorinated biphenyls (PCB), which are found in dielectric fluid used in some electrical equipment. The System has completed the removal from service of all PCB transformers and capacitors. Some electrical equipment contaminated with PCBs remains in service. At sites where PCB equipment has been operated, removal, disposal, and replacement of contaminated soils may be required. The Federal Comprehensive Environmental Response, Compensation and Liability Act, more commonly known as the "Superfund" law, imposes strict, joint and several liability, regardless of fault, for remediation of property contaminated with hazardous substances. Parties liable include past and present site owners and operators, transporters that brought wastes to the site, and entities that generated or arranged for disposal or treatment of wastes ultimately disposed of at the site. A number of states, including Massachusetts, have enacted similar laws. The electric utility industry typically utilizes and/or generates in its operations a range of potentially hazardous products and by-products. These products or by-products may not have previously been considered hazardous, and may not currently be considered hazardous, but may be identified as such by federal, state, or local authorities in the future. NEES subsidiaries currently have in place an environmental audit program intended to enhance compliance with existing federal, state, and local requirements regarding the handling of potentially hazardous products and by-products. Federal and state environmental agencies, as well as private parties, have contacted or initiated legal proceedings against NEES and certain subsidiaries regarding liability for cleanup of sites alleged to contain hazardous waste or substances. NEES and/or its subsidiaries have been named as a potentially responsible party (PRP) by either the EPA or the Massachusetts Department of Environmental Protection (DEP) for 18 sites (6 for NEP, 13 for Mass. Electric, and 2 for Narragansett) at which hazardous waste is alleged to have been disposed. NEES and its subsidiaries are also aware of other sites which they may be held responsible for remediating and it is likely that, in the future, NEES and its subsidiaries will become involved in additional proceedings demanding contribution for the cost of remediating additional hazardous waste sites. The most prevalent types of hazardous waste sites that NEES and its subsidiaries have been connected with are former manufactured gas locations. Until the early 1970s, NEES was a combined electric and gas holding company system. Gas was manufactured from coal and oil until the early 1970s to supply areas in which natural gas was not yet available or for peaking purposes. Among the waste byproducts of that process were coal and oil tars. The NEES companies are currently aware of approximately 40 locations at which gas may have been manufactured and/or stored. Of the manufactured gas locations, 17 have been listed for investigation by the DEP. Two manufactured gas plant locations that have been the subject of extensive litigation are discussed in more detail below: the Pine Street Canal Superfund site in Burlington, Vermont and a site located in Lynn, Massachusetts. Approximately 18 parties, including NEES, have been notified by the EPA that they are PRPs for cleanup of the Pine Street Canal site, at which coal tar and other materials were deposited. Between 1931 and 1951, NEES and its predecessor owned all of the common stock of Green Mountain Power Corporation. Prior to, during, and after that time, gas was manufactured at the Pine Street Canal site. The EPA had brought a lawsuit against NEES and other parties to recover all of the EPA's past and future response costs at this site. In 1990, the litigation ended with the filing of a final consent decree with the court. Under the terms of the settlement, to which 14 entities were party, the EPA recovered its past response costs. NEES recorded its share of these costs in 1989. NEES remains a PRP for ongoing and future response costs. In November 1992, the EPA proposed a cleanup plan estimated by the EPA to cost $50 million. In June 1993, the EPA withdrew this cleanup plan in response to public concern about the plan and the cost. It is not known at this time what the ultimate cleanup plan will be, how much it will cost, or what portion NEES will have to pay. On May 26, 1993, the United States Court of Appeals for the First Circuit affirmed on appeal an earlier adverse decision against NEES and two of its subsidiaries, Mass. Electric and New England Power Service Company, with respect to the Lynn, Massachusetts site which was once owned by an electric and gas utility formerly owned by NEES. The electric operations of this subsidiary were merged into Mass. Electric. The decision held NEES and these subsidiaries liable for cleanup of the properties involved in the case. Although the circumstances differ from location to location, the Court of Appeals opinion has adverse implications for the potential liability of NEES and its subsidiaries with respect to other gas manufacturing locations operated by gas utilities once owned by NEES. In November 1993, the MDPU approved a rate agreement filed by Mass. Electric (see RATES, page 8) that resolved all rate recovery issues related to Massachusetts manufactured gas sites formerly owned by NEES or its subsidiaries as well as certain other Massachusetts hazardous waste sites. The agreement allows for these costs to be met by establishing a special fund on Mass. Electric's books. On a consolidated basis, the fund's initial balance of $30 million comes from previously recorded environmental reserves and is not recoverable from customers. NEES had previously established approximately $40 million of reserves related to Massachusetts manufactured gas locations earlier in 1993 and in prior years. The establishment of the fund's initial balance at Mass. Electric resulted in a one-time charge to fourth quarter earnings of $9 million, before tax. The agreement also provides that contributions of $3 million, adjusted for inflation, be added to the fund each year by Mass. Electric and be recoverable in rates. Under the agreement, any shortfalls in the fund will be paid by Mass. Electric and be recovered through rates over seven years, without interest. Predicting the potential costs to investigate and remediate hazardous waste sites continues to be difficult. Factors such as the evolving nature of remediation technology and regulatory requirements and the particular characteristics of each site, including, for example the size of the site, the nature and amount of waste disposed at the site, and the surrounding geography and land use, make precise estimates difficult. There are also significant uncertainties as to the portion, if any, of the investigation and remediation costs of any particular hazardous waste site that may ultimately be borne by NEES or its subsidiaries. At year end 1993, NEES had total reserves for environmental response costs of $56 million and a related regulatory asset of $19 million. NEES and each of its subsidiaries believe that hazardous waste liabilities for all sites of which each is aware, and which are not covered by a rate agreement, will not be material (10% of common equity) to their respective financial positions. Where appropriate, the NEES companies intend to seek recovery from their insurers and from other PRPs, but it is uncertain whether, and to what extent, such efforts would be successful. NEP, in burning coal and oil to produce electricity, produces approximately 308,000 tons per year of coal ash and other coal combustion by-products and 18,500 tons per year of oil ash. In August 1993, the EPA determined that coal combustion byproducts would not be regulated as a hazardous waste. The EPA is expected to issue regulations regarding oil ash treatment in 1997. The EPA and the New England states in which System companies operate regulate the removal and disposal of material containing asbestos. Asbestos insulation is found extensively on power plant equipment and, to a lesser extent, in buildings and underground electric cable. System companies routinely remove and dispose of asbestos insulation during equipment maintenance. Electric and Magnetic Fields (EMF) In recent years, concerns have been raised about whether EMF, which occur near transmission and distribution lines as well as near household wiring and appliances, cause or contribute to adverse health effects. Numerous studies on the effects of these fields, some of them sponsored by electric utilities (including NEES companies), have been conducted and are continuing. Some of the studies have suggested associations between certain EMF and various types of cancer, while other studies have not substantiated such associations. In February 1993, the EPA called for significant additional research on EMF. It is impossible to predict the ultimate impact on NEES subsidiaries and the electric utility industry if further investigations were to demonstrate that the present electricity delivery system is contributing to increased risk of cancer or other health problems. Several state courts have recognized a cause of action for damage to property values in transmission line condemnation cases based on the fear that power lines cause cancer. It is difficult to predict what impact there would be on the NEES companies if this cause of action is recognized in the states in which NEES companies operate and in contexts other than condemnation cases. Bills have been introduced in the Rhode Island Legislature to require transmission lines to be placed underground. In July 1993, two bills passed by the legislature restricting the construction of overhead transmission lines were vetoed by the governor. EMF- related legislation has also been introduced in Massachusetts. Air Under federal regulations, each New England state has issued a state implementation plan that limits air pollutants emitted from facilities such as generating stations. These implementation plans are intended to ensure continued maintenance of national and state ambient air quality standards, where such standards are currently met. The plans are also intended to bring areas not currently meeting standards into compliance. In 1985, the Massachusetts legislature enacted an acid rain law that requires that sulphur dioxide (SO2) emissions from fossil fuel generating stations be reduced. Regulations implementing the statute were adopted in 1989. Emission reductions required by the regulations must be fully implemented by January 1, 1995, and will require NEP to use more costly lower sulphur oil and coal and make capital expenditures. Use of natural gas at Brayton 4 is one of NEP's methods for helping to meet the requirements of the acid rain law. See Fuel for Generation - Natural Gas, page 19. NEP may also use emission credits for conservation from non-combustion energy sources and cogeneration technology toward meeting the law's requirements. NEP produces approximately 50% of its electricity at eight older thermal generating units located in Massachusetts. The 1990 amendments to the federal Clean Air Act require a significant reduction in the nation's SO2 and nitrogen oxide (NOx) emissions by the year 2000. Under the amendments, NEP is not subject to Phase 1 of the acid rain provisions of the federal law that will become effective in 1995. However, NEP is subject to the Massachusetts SO2 acid rain law that will become effective in 1995. Phase 2 of the federal acid rain requirements, effective in 2000, will apply to NEP and its units. Under the federal Clean Air Act, state environmental agencies in ozone non-attainment areas were required to develop regulations (also known as Reasonably Available Control Technology requirements, or RACT) that will become effective in 1995 to address the first phase of ozone air quality attainment. These regulations were adopted in Massachusetts in September 1993. The RACT regulations require control technologies (such as low NOx burners) to reduce NOx emissions, an ozone precursor. Additional control measures may be necessary to ensure attainment of the ozone standard. These measures would have to be developed by the states in 1994 and fully implemented no later than 1999. The extent of these additional control measures is unknown at this time, but could range from minor additions to the RACT requirements to extensive emission reduction requirements, such as costly add-on controls or fuel switching. To date, NEP has expended approximately $7 million of one-time operation and maintenance costs and $50 million of capital costs in connection with Massachusetts and federal Clean Air Act compliance requirements. NEP expects to incur additional one-time operation and maintenance costs of approximately $18 million and capital costs of approximately $70 million in 1994 and 1995 to comply with the federal and state clean air requirements that will become effective in 1995. In addition, as a result of federal and state clean air requirements, NEP will begin incurring increased fuel costs which are estimated to reach an annual level of $13 million by 1995. The generation of electricity from fossil fuels may emit trace amounts of hazardous air pollutants as defined in the Clean Air Act Amendments of 1990. The Act mandates a study of the potential dangers of hazardous air pollutant emissions from electric utility plants. Such research is currently under way and is expected to be complete in 1995. The study conclusions could result in new emission standards and the need for additional costly controls on NEP plants. At this time, NEES and its subsidiaries cannot estimate the impact that findings of this research might have on operations. The federal Clean Air Act Amendments of 1990 and the Rio Convention on global climate change have increased the public focus on industrial emissions to the air. Electric utilities' use of fossil fuels is a significant source of emissions which evoke concerns about such issues as acid rain, ozone levels, global warming, small particulates, and hazardous air pollutants. Should the 1999 ozone attainment requirements be extensive or additional Clean Air Act Amendments or other environmental requirements be imposed, continued operation of certain existing generating units of NEP beyond 1999 could be uneconomical. NEP believes that premature retirement of substantially all of its older thermal generating units would cause substantial rate increases. Water The federal Clean Water Act prohibits the discharge of any pollutant (including heat), except in compliance with a discharge permit issued by the states or the EPA for a term of no more than five years. NEP and Narragansett have received required permits for all their steam-generating plants. NEET has received its required surface water discharge permits for all of its current operations. Occasional violations of the terms of these permits have occurred. NEES facilities store substantial amounts of oil and are required to have spill prevention control and counter-measure (SPCC) plans. Currently, major System facilities such as Brayton Point and Salem Harbor have up-to-date SPCC plans. A comprehensive study of smaller facilities has been completed to determine the appropriate plans for these facilities and a five-year implementation plan has been developed. Nuclear The NRC, along with other federal and state agencies, has extensive regulations pertaining to environmental aspects of nuclear reactors. Safety aspects of nuclear reactors, including design controls and inspection programs to mitigate any possibility of nuclear accidents and to reduce any damages therefrom, are also subject to NRC regulation. See Nuclear Units, page 21. RESOURCE PLANNING Load Forecasts and History The Retail Companies currently forecast an increase in KWH sales of 1.4% in 1994. The System has been projecting that, in the absence of significant energy conservation by its customers, annual weather-normalized peak load growth over the next 15 years will average approximately 2.3%. Peak load growth would be limited to about 1.1% annually over this period if planned DSM programs described below are successfully implemented. These projections are being updated. During the late 1980s unusually high load growth caused a tight capacity situation to develop for both the System and the New England region. More recently, the sluggish regional economy plus the addition of new generating facilities in the region alleviated concerns about inadequate resources for the next several years. Future resource additions from the Manchester Street repowering project described below and contracts with non-utility generators along with the continued demand-side management programs are expected to meet NEP's resource needs until approximately 2000. Additional new capacity may be required in that time frame. A return to the high load growth of the late 1980s, the cancellation of future planned capacity, or the shutdown of existing capacity could necessitate additional generation or power purchase contracts on the supply-side, or demand-side conservation and load management programs, in order to meet customer demands. Corporate Plans NEES has a history of planning for change to meet resource requirements and other goals. NEES' current plan, called NEESPLAN 4, was completed in 1993. NEESPLAN 4 attempts to reconcile the increasing importance and cost of environmental impact mitigation and utilities' traditional obligation to serve, with growing competition at all levels in the industry. NEESPLAN 4 also addresses planning methodology and implements a resource strategy that restricts commitments to those necessary to meet highly certain loads, and develops options on future resources to meet less certain loads and meet future fuel diversity needs. The new plan also strengthens the emission reduction goals previously established by the System and calls for CO2, SOx, and NOx reductions by 2000 to 20%, 60%, and 60%, respectively, below 1990 levels. Most of this reduction will come from current plans and commitments, including demand-side management, the Manchester Street repowering, increased use of natural gas and lower sulphur fuels, the installation of emission control equipment, low NOx burners, combustion controls, and other new power sources entering the energy mix through the year 2000. Many of these actions are being taken to comply with state and federal environmental laws. See Environmental Requirements, page 29. The remaining improvement will come from actions beyond current commitments. They may include further fuel conversions or efficiency improvements in power plants and the transmission and distribution system, as well as competitively acquired renewable resources and greenhouse gas offsets. NEP is currently participating in an experimental project investigating greenhouse gas offsets which involves funding the use of improved forestry techniques in Malaysia to limit unnecessary destruction of forests. Past NEES plans have concerned similar challenging issues the System faced and continues to address. In 1979, NEES instituted NEESPLAN, the key objectives of which were to keep customer costs to a minimum and to reduce the System's reliance on foreign oil. In 1985, NEES announced an updated plan, NEESPLAN II, the objectives of which were to provide an adequate supply of electricity to customers at the lowest possible cost and to encourage customers to use electricity efficiently. NEESPLAN 3, announced in 1990, continued these objectives and directly addressed the environmental impacts of providing electricity service. Demand-Side Management As mentioned above, the System believes that DSM programs are an important part of meeting its resource goals. Since 1987, the System has put in place a series of customer programs for encouraging electric conservation and load management. Through these DSM programs, the System has achieved over 825,000 MWh of annual energy savings. During 1993, the System spent a total of $76 million on DSM programs and related expenses. The System has budgeted to spend up to $103 million in 1994. Recovery of these expenditures through rates on a current, as incurred, basis has been approved by the various regulatory commissions. See RATES, page 8. Manchester Street Station Repowering The NEES subsidiaries' major construction project is the repowering of the Manchester Street Station, a 140 MW electric generating station in Providence, R.I. During 1993, construction continued on the joint Narragansett/NEP project. The project began in 1992 and remains on schedule and within budget, with an expected in-service date of late 1995. Narragansett and NEP operate three steam electric generating units of approximately 50 MW each which went into service at Manchester Street Station in the 1940s. During 1992, NEP acquired a 90% interest in the site and the Station in anticipation of the repowering project. As part of the repowering project, three new combustion turbines and heat recovery steam generators will be added to the Station, replacing the existing boilers. The existing steam turbines will be replaced with new and more efficient turbines of slightly larger capacity. The fuel for generation, which is now primarily residual oil, will be replaced with natural gas, using distillate oil as an emergency backup. See Fuel for Generation, page 18. Repowering will more than triple the power generation capacity of Manchester Street Station, and substantially increase the plant's thermal efficiency. It is expected that the plant's capacity factor will also increase. Certain air emissions are projected to decrease relative to historical levels because of the change in fuels and the increase in efficiency. Substantial additions to Narragansett's high voltage transmission network will be necessary in order to accommodate the output of the plant. Two 7-mile 115 kV underground transmission cables (located primarily in public ways) are under construction to connect the repowered station to existing 115 kV lines at a new substation. Total cost for the generating station, scheduled for completion in late 1995, is estimated to be approximately $525 million, including AFDC. In addition, related transmission work, which is principally the responsibility of Narragansett, is estimated to cost approximately $75 million and is scheduled for completion in late 1994. At December 31, 1993, $161 million, including AFDC, has been spent on the project which includes the related transmission work. Substantial commitments have been made relative to future planned expenditures for this project. Regulation The activities and specific projects in the System's resource plans are subject to regulation by state and federal authorities. Approval by these agencies is necessary to site and license new facilities and to recover the costs for new DSM programs and non- utility resources. See Regulation, page 28. Research and Development Expenditures for the System's research and development activities totaled $9.5 million, $8.9 million, and $8.8 million in 1993, 1992, and 1991, respectively. Total expenditures are expected to be about $12 million in 1994. About 50% of these expenditures support the Electric Power Research Institute, which conducts research and development activities on behalf of its sponsors and provides NEES companies with access to a wide range of relevant research results at minimum cost. The System also directly funds research projects of a more site-specific concern to the System and its customers. These projects include: - creating options to allow the use of economically-priced fossil fuels without adversely affecting plant performance, and to insure safe, reliable and environmentally sound production of electric energy at the lowest cost; - developing and assessing new information and methods to understand and reduce the environmental impacts of System operations including investigation of offset methods for counterbalancing greenhouse gas emissions away from the source; - developing, assessing and demonstrating new generation technologies and fuels that will ensure economic, efficient and environmentally sound production of electric energy in the future; - creating options to maintain electric service quality and reliability for customers at the lowest cost; and - developing conservation, load control, and rate design measures that will help customers use electric energy more efficiently. Construction and Financing Estimated construction expenditures (including nuclear fuel) for the System's electric utility companies are shown below for 1994 through 1996. The System conducts a continuing review of its construction and financing programs. These programs and the estimates shown below are subject to revision based upon changes in assumptions as to System load growth, rates of inflation, receipt of adequate and timely rate relief, the availability and timing of regulatory approvals, new environmental and legal or regulatory requirements, total costs of major projects, and the availability and costs of external sources of capital. The anticipated capital requirements for oil and gas operations are not included in the table below. See OIL AND GAS OPERATIONS page 43. Estimated Construction Expenditures ----------------------------------- 1994 1995 1996 Total ---- ---- ---- ----- (In Millions - excluding AFDC) NEP - --- Manchester St. Station Generation $145 $ 95 $ 40 $ 280 Manchester St. Station Substation 10 0 0 10 Other Generation (1) 70 50 60 180 Other Transmission 15 15 20 50 ---- ---- ---- ------ Total NEP $240 $160 $120 $ 520 ---- ---- ---- ------ Mass. Electric - -------------- Distribution $ 90 $ 90 $ 95 $ 275 Narragansett - ------------ Manchester St. Station Generation $ 15 $ 15 $ 5 $ 35 Manchester St. Station Transmission/ 30 0 0 30 Substation Other Transmission 15 15 15 45 Distribution 20 25 25 70 ---- ---- ---- ------ Total Narragansett $ 80 $ 55 $ 45 $ 180 ---- ---- ---- ------ Granite State - ------------- Distribution $ 5 $ 5 $ 5 $ 15 ---- ---- ---- ------ Other $ 10 $ 0 $ 0 $ 10 - ----- ---- ---- ---- ------ Combined Total - -------------- Manchester St. Station Generation $160 $110 $ 45 $ 315 Manchester St. Station Transmission/ 40 0 0 40 Substation Other Generation (1) 70 50 60 180 Other Transmission 40 30 35 105 Distribution 115 120 125 360 ---- ---- ---- ------ Grand Total $425 $310 $265 $1,000 ---- ---- ---- ------ (1) Includes Nuclear Fuel Financing The proportion of construction expenditures estimated to be financed by internally generated funds during the period from 1994 to 1996 is: NEP 80% Mass. Electric 80% Narragansett 70% Granite State 80% The general practice of the operating subsidiaries of NEES has been to finance construction expenditures in excess of internally generated funds initially by issuing unsecured short-term debt. This short-term debt is subsequently reduced through sales by such subsidiaries of long-term debt securities and preferred stock, and through capital contributions from NEES to the subsidiaries. NEES, in turn, generally has financed capital contributions to the operating subsidiaries through retained earnings and the sale of additional NEES shares. Since April 1991, NEES has been meeting all of the requirements of its dividend reinvestment and common share purchase plan and employee share plans through open market purchases. Under these plans, NEES may revert to the issuance of new common shares at any time. The ability of NEP and the Retail Companies to issue short-term debt is limited by regulatory restrictions, by provisions contained in their charters, and by certain debt and other instruments. Under the charters or by-laws of NEP, Mass. Electric, and Narragansett, short-term debt is limited to 10% of capitalization. The preferred stockholders authorized these limitations to be increased to 20% of capitalization until the late 1990's, at which time the limits will revert to 10% of capitalization. The following table summarizes the short-term debt limits at December 31, 1993, and the amount of outstanding short-term debt at such date. ($ millions) Limit Outstanding ----- ----------- NEP 315 51 Mass. Electric 139 38 Narragansett 75 20 Granite State 10 - In order to issue additional long-term debt and preferred stock, NEP and the Retail Companies must comply with earnings coverage requirements contained in their respective mortgages, note agreements, and preference provisions. The most restrictive of these provisions in each instance generally requires (1) for the issuance of additional mortgage bonds by NEP, Mass. Electric, and Narragansett, for purposes other than the refunding of certain outstanding mortgage bonds, a minimum earnings coverage (before income tax) of twice the pro forma annual interest charges on mortgage bonds, and (2) for the issuance of additional preferred stock by NEP, Mass. Electric, and Narragansett, minimum gross income coverage (after income tax) of one and one-half times pro forma annual interest charges and preferred stock dividends, in each case for a period of twelve consecutive calendar months within the fifteen calendar months immediately preceding the proposed new issue. The respective long-term debt and preferred stock coverages of NEP and the Retail Companies under their respective mortgage indentures, note agreements, and preference provisions, are stated in the following table for the past three years: Coverage ----------------------- 1993 1992 1991 ---- ---- ---- NEP - --- General and Refunding Mortgage Bonds 4.66 4.15 4.02 Preferred Stock 2.76 2.80 2.71 Mass. Electric - -------------- First Mortgage Bonds 3.15 3.60 3.07 Preferred Stock 2.02 2.14 2.12 Narragansett - ------------ First Mortgage Bonds 2.47 3.79 2.98 Preferred Stock 1.78 2.52 2.06 Granite State - ------------- Notes (1) 2.41 2.53 1.98 (1) As defined under the most restrictive note agreement. OIL AND GAS OPERATIONS GENERAL Since 1974, NEEI has engaged in oil and gas exploration and development, primarily through a partnership with Samedan Oil Corporation (Samedan), a subsidiary of Noble Affiliates, Inc. NEEI's oil and gas activities are regulated by the SEC under the 1935 Act. Under the terms of the Samedan-NEEI partnership agreement, Samedan is the managing partner and oversees all partnership operations including the sale of production. Effective January 1, 1987, NEEI decided not to acquire new oil and gas prospects due to prevailing and expected oil and natural gas market conditions. This decision did not affect NEEI's interests and commitments in oil and gas properties owned as of December 31, 1986 by the Samedan-NEEI partnership. Samedan continues to explore, develop, and manage these properties on behalf of the partnership. Thus, the results of NEEI's operations are substantially affected by the performance of Samedan. Samedan may elect to terminate the partnership at the end of any calendar year upon one year's prior notice. NEEI is required to obtain SEC approval for further investment in these oil and gas properties. On December 21, 1993, the SEC issued an order authorizing NEEI to invest up to $10 million in its partnership with Samedan during 1994. The SEC has reserved jurisdiction over an additional $5 million of spending authority. NEEI is winding down its oil and gas program. The level of expenditures for exploration and development of existing properties has declined as a result of the decision not to acquire new oil and gas prospects after December 31, 1986. NEEI's activities are primarily rate-regulated and consist of all prospects entered into prior to 1984. Savings and losses from this rate-regulated program are being passed on to NEP and ultimately to retail customers, under an intercompany pricing policy (Pricing Policy) approved by the SEC. Due to precipitate declines in oil and gas prices, NEEI has incurred operating losses since 1986 and expects to generate substantial additional losses in the future. NEP's ability to pass such losses on to its customers was favorably resolved in NEP's 1988 FERC rate settlement. This settlement covered all costs incurred by or resulting from commitments made by NEEI through March 1, 1988. Other subsequent costs incurred by NEEI are subject to normal regulatory review. NEEI follows the full cost method of accounting for its oil and gas operations, under which capitalized costs (including interest paid to banks) relating to wells and leases determined to be either commercial or non-commercial are amortized using the unit of production method. Due to the Pricing Policy, NEEI's rate-regulated program has not been subject to certain SEC accounting rules, applicable to non-rate-regulated companies, which limit the costs of oil and gas property that can be capitalized. The Pricing Policy has allowed NEEI to capitalize all costs incurred in connection with fuel exploration activities of its rate regulated program, including interest paid to banks of which $9 million, $14 million, and $22 million was capitalized in 1993, 1992, and 1991, respectively. In the absence of the Pricing Policy, the SEC's full cost "ceiling test" rule requires non-rate regulated companies to write-down capitalized costs to a level which approximates the present value of their proved oil and gas reserves. Based on NEEI's 1993 average oil and gas selling prices and NEEI's proved reserves at December 31, 1993, if this test were applied, it would have resulted in a write-down of approximately $138 million after-tax. RESULTS OF OPERATIONS Revenues from natural gas sales were approximately 13% higher in 1993 than 1992 even though NEEI's natural gas production declined by about 9%. NEEI expects 1994 natural gas revenues to be slightly higher than 1993 revenues on slightly lower total production. NEEI's 1993 oil and gas exploration and development expenditures were $9 million. NEEI's estimated proved reserves decreased from 17.3 million barrels of oil and gas equivalent at December 31, 1992, to 15.1 million barrels of oil and gas equivalent at December 31, 1993. Production, primarily from offshore Gulf properties, decreased reserves by 3.8 million equivalent barrels. Additions and revisions primarily on offshore Gulf properties increased reserves by 1.6 million equivalent barrels. Prices received by NEEI for its natural gas varied considerably during 1993, from approximately $1.31/MCF to $2.90/MCF, due principally to seasonal fluctuations and regional variations in gas prices. NEEI's overall average gas price in 1993 was $1.96/MCF. The results of NEEI's oil and gas program will continue to be affected by developments in the world oil market and the domestic market for natural gas, including actions by the federal government and by foreign governments, which may affect the price of oil and gas, the terms of contracts under which gas is sold, and changes in regulation of the domestic interstate gas pipelines. The following table summarizes NEEI's crude oil and condensate production in barrels, natural gas production in MCF, and the average sales price per barrel of oil and per MCF of natural gas produced by NEEI during the years ended December 1993, 1992, and 1991, and the average production (lifting) cost per dollar of gross revenues. Years Ended December 31, ---------------------------------- 1993 1992 1991 ---- ---- ---- Crude oil and condensate production (barrels) 477,545 506,428 435,890 Natural gas production 19,696,944 21,514,986 17,904,015 (MCF) Average sales price per barrel of oil and $17.05 $19.34 $22.80 condensate Average sales price per MCF of natural gas $1.96 $1.59 $1.61 Average production cost (including severance taxes) per dollar of gross revenue $0.14 $0.17 $0.18 OIL AND GAS PROPERTIES During 1993, principal producing properties, representing 58% of NEEI's 1993 revenues, were (i) a 50% working interest in Brazos Blocks A-52, A-53, A-65, and A-37 located in federal waters offshore Texas, (ii) a 12% working interest in Main Pass Blocks 107 and 108, located in federal waters offshore Louisiana, (iii) a 25% working interest in Main Pass Blocks 93, 102, and 90, located in federal waters offshore Louisiana, (iv) a 20% working interest in Matagorda Island 587, located in federal waters offshore Texas, and (v) a 15% working interest in Eugene Island Block 28, located in federal waters offshore Louisiana. Other major producing properties during 1993 included a 20% working interest in Vermilion Block 114, located in federal waters offshore Louisiana, a 15% working interest in High Island Blocks 21, 22, and 34, located in federal waters offshore Texas, and a 15% working interest in West Delta 18/33, located in federal waters offshore Louisiana. As used in the tables below, (i) a productive well is an exploratory or a development well that is not a dry well, (ii) a dry well is an exploratory or development well found to be incapable of producing either oil or gas in commercial quantities, (iii) "gross" refers to the total acres or wells in which NEEI has a working interest, and (iv) "net," as applied to acres or wells, refers to gross acres or wells multiplied by the percentage working interest owned by NEEI. The following table shows the approximate undeveloped acreage held by NEEI as of December 31, 1993. Undeveloped acreage is acreage on which wells have not been drilled or completed to a point that would permit the production of commercial quantities of oil and gas, regardless of whether such acreage contains proved reserves. Location Gross Acres Net Acres -------- ----------- --------- Offshore-Gulf of Mexico 124,209 21,676 Other 278,203 49,756 ------- ------ Total 402,412 71,432 During the years ended December 31, 1993, 1992, and 1991 NEEI participated in the completion of the following net exploratory and development wells: Net Exploratory Wells Net Development Wells --------------------- --------------------- Year Ended Productive* Dry Productive* Dry ---------- ---------- --- ---------- --- December 31, 1993 0 2 0 0 December 31, 1992 2 0 0 0 December 31, 1991 1 4 3 5 * Includes depleted wells The following table summarizes the total gross and net productive wells and the approximate total gross and net developed acres, both as of December 31, 1993: Oil Gas Developed Acres --- --- --------------- Gross Net Gross Net Gross Net ----- --- ----- --- ----- --- 139 16 557 64 312,492 57,400 At December 31, 1993, NEEI was in the process of drilling or completing 4 gross and 0 net wells. CAPITAL REQUIREMENTS AND FINANCING Estimated expenditures in 1994 for NEEI's exploration and development program are approximately $10 million which is the amount authorized by the SEC. In addition, NEEI's estimated 1994 interest costs are approximately $10 million. Internal funds are expected to provide 100% of NEEI's capital requirements for 1994. In 1989, NEEI refinanced its outstanding borrowings through a credit agreement which currently provides for borrowings of up to $275 million. Borrowings under this credit agreement are principally secured by a pledge of NEEI's rights with respect to NEP under the Pricing Policy covering the rate-regulated program. The amount available for borrowing under the revolving credit agreement decreases by varying amounts annually, beginning December 31, 1995 and expiring December 31, 1998. NEEI MAP Major Oil and Gas Properties EXECUTIVE OFFICERS NEES - ---- All executive officers are elected to continue in office subject to Article 19 of the Agreement and Declaration of Trust until the first meeting of the Board of Directors following the next annual meeting of shareholders, or the special meeting of shareholders held in lieu of such annual meeting, and until their successors are chosen and qualified. The executive officers also serve as officers and/or directors of various subsidiary companies. John W. Rowe - Age: 48 - President and Chief Executive Officer since 1989 - Elected Chairman of NEP in 1993 - President of NEP from 1991 to 1993 - Chairman of NEP from 1989 to 1991 - President and Chief Executive Officer of Central Maine Power Company from 1984 to 1989. Frederic E. Greenman - Age: 57 - Senior Vice President since 1987 - General Counsel since 1985 - Secretary since 1984 - Vice President of NEP since 1979. Alfred D. Houston - Age: 53 - Elected Executive Vice President in 1994 - Senior Vice President-Finance from 1987 to 1994 - Vice President-Finance from 1985 to 1987 - Vice President of NEP since 1987 - Vice President of Narragansett since 1976 - Treasurer of Narragansett since 1977. John W. Newsham - Age 61 - Vice President since 1991 - Executive Vice President of NEP since 1993 - Vice President of NEP and Director of Thermal Production from 1987 to 1993. Richard P. Sergel - Age: 44 - Vice President since 1992 - Treasurer from 1990 to 1991 - Chairman of Mass. Electric and Narragansett since 1993 - Treasurer of NEP and Mass. Electric from 1990 to 1991 - Vice President of the Service Company since 1988 - Director of Rates from 1982 to 1990. Jeffrey D. Tranen - Age: 47 - Vice President since 1991 - President of NEP since 1993 - Vice President of NEP from 1984 to 1993 - Vice President of Mass. Hydro, N.H. Hydro, and NEET from 1987 to 1991 - President of Mass. Hydro, N.H. Hydro, and NEET since 1991. Michael E. Jesanis - Age: 37 - Treasurer since 1992 - Director of Corporate Finance from 1990 to 1991 - Manager, Financial Planning from 1986 to 1990. NEP - --- The Treasurer is elected by the stockholders to hold office until the next annual meeting of stockholders and until the successor is duly chosen and qualified. The other executive officers are elected by the Board of Directors to hold office subject to the pleasure of the directors and until the first meeting of directors after the next annual meeting of stockholders and until their successors are duly chosen and qualified. Certain officers of NEP are, or at various times in the past have been, officers and/or directors of the System companies with which NEP has entered into contracts and had other business relations. Jeffrey D. Tranen* - President since 1993 - Vice President from 1984 to 1993. John W. Rowe* - Chairman since 1993 - President from 1991 to 1993 - Chairman from 1989 to 1991. John W. Newsham* - Executive Vice President since 1993 - Vice President from 1987 to 1993. Lawrence E. Bailey - Age: 50 - Vice President since 1989 - Plant Manager of Brayton Point Station from 1987 to 1991. Jeffrey A. Donahue - Age: 35 - Vice President since 1993 - various engineering positions with the Service Company since 1983 - Director of Construction since 1992 - Chief Electrical Engineer since 1991. Frederic E. Greenman* - Vice President since 1979. Alfred D. Houston* - Vice President since 1987 - Treasurer from 1983 to 1987. John F. Malley - Age: 45 - Vice President since 1992 - Manager of Generation Planning for the Service Company from 1986 to 1991. Arnold H. Turner - Age: 53 - Vice President since 1989 - Director of Planning and Power Supply since 1985. Jeffrey W. VanSant - Age: 40 - Vice President since 1993 - Manager of Oil and Gas Exploration and Development for the Service Company from 1985 to 1993 - Manager of Oil and Gas Procurement from 1992 to 1993 - Manager of Natural Gas Supply from 1989 to 1992. Michael E. Jesanis* - Treasurer since 1992. Howard W. McDowell - Age: 50 - Controller since 1987 - Controller of Mass. Electric and Narragansett since 1987 - Treasurer of Granite State since 1984. *Please refer to the material supplied under the caption EXECUTIVE OFFICERS - NEES for other information regarding this officer. Mass. Electric - -------------- The Treasurer is elected by the stockholders to hold office until the next annual meeting of stockholders and until the successor is duly chosen and qualified. The other executive officers are elected by the board of directors to hold office subject to the pleasure of the directors and until the first meeting of the directors after the next annual meeting of stockholders. Certain officers of Mass. Electric are, or at various times in the past have been, officers and directors of System companies with which Mass. Electric has entered into contracts and had other business relations. Richard P. Sergel - Chairman since 1993 - Reference is made to the material supplied under the caption EXECUTIVE OFFICERS - NEES for other information regarding Mr. Sergel. John H. Dickson - Age: 51 - President since 1990 - Treasurer from 1985 to 1990 - Treasurer of NEES from 1985 to 1990 - Treasurer of NEP from 1987 to 1990 - Vice President of NEEI from 1982 to 1990 - Treasurer of NEEI from 1983 to 1990. David L. Holt - Age: 45 - Executive Vice President since 1993 - Vice President of NEP from 1992 to 1993 - Chief Engineer and Director of Engineering for the Service Company since 1991 - Chief Electrical Engineer for the Service Company from 1986 to 1991. John C. Amoroso - Age: 55 - Vice President since 1993 - District Manager, Southeast District from 1992 to 1993 - Manager, Southeast District from 1985 to 1992. Gregory A. Hale - Age: 43 - Vice President since 1993 - Senior Counsel for the Service Company from 1988 to 1993. Cheryl A. LaFleur - Age: 39 - Vice President since 1993 - Vice President of the Service Company from 1992 to 1993 - Assistant to the NEES Chairman and President from 1990 to 1991 - Senior Counsel for the Service Company from 1989 to 1991. Charles H. Moser - Age: 53 - Vice President since 1993 - Chief Protection and Planning Engineer for the Service Company from 1984 to 1993. Lydia M. Pastuszek - Age: 40 - Vice President since 1993 - Vice President of NEP from 1990 to 1993 - President of Granite State since 1990 - Assistant to the President of Granite State from 1989 to 1990 - Director of Demand Planning for the Service Company from 1985 to 1989. Anthony C. Pini - Age: 41 - Vice President since 1993 - Assistant Controller for the Service Company from 1985 to 1993. Nancy H. Sala - Age: 42 - Vice President since 1992 - Central District Manager since 1992 - Assistant to the President of Mass. Electric from 1990 to 1992 - Manager of the Central District for Mass. Electric from 1989 to 1990 - Manager of Petroleum Supply and NEEI Shipping for the Service Company from 1986 - 1989. Dennis E. Snay - Age: 52 - Vice President and Merrimack Valley District Manager since 1990 - Assistant to President of Mass. Electric from 1984 to 1990. Michael E. Jesanis - Treasurer since 1992 - Reference is made to the material supplied under the caption EXECUTIVE OFFICERS - NEES for other information regarding Mr. Jesanis. Howard W. McDowell - Controller since 1987 and Assistant Treasurer since 1977 - Reference is made to the material supplied under the caption EXECUTIVE OFFICERS - NEP for other information regarding Mr. McDowell. Narragansett - ------------ Officers are elected by the board of directors or appointed, as appropriate, to serve until the meeting of directors following the annual meeting of stockholders, and until their successors are chosen and qualified. Officers other than the President, Treasurer, and Secretary, serve also at the pleasure of the directors. Certain officers of Narragansett are, or at various times in the past have been, officers and directors of System companies with which Narragansett has entered into contracts and had other business relations. Richard P. Sergel - Chairman since 1993 - Reference is made to the material supplied under the caption EXECUTIVE OFFICERS - NEES for other information regarding Mr. Sergel. Robert L. McCabe - Age: 53 - President since 1986. William Watkins, Jr. - Age 61 - Executive Vice President since 1992 - Vice President of the Service Company from 1981 to 1992. Francis X. Beirne - Age: 50 - Vice President since 1993 - Manager, Southern District from 1988 to 1993 - District Manager, Customer Service from 1983 - 1988. Richard W. Frost - Age: 54 - Vice President since 1993 - Division Superintendent of Transmission and Distribution from 1986 to 1990 - District Manager - Southern District from 1990 to 1993. Alfred D. Houston - Vice President since 1976 - Treasurer since 1977 - Reference is made to the material supplied under the caption EXECUTIVE OFFICERS - NEES for other information regarding Mr. Houston. James V. Mahoney - Age: 48 - Vice President and Director of Business Services since 1993 - President of NEEI from 1992 to 1993 - Vice President of the Service Company from 1989 to 1993 - Director of Fuel Supply for the Service Company from 1985 to 1993. Howard W. McDowell - Controller since 1987 - Reference is made to the material supplied under the caption EXECUTIVE OFFICERS - NEP for other information regarding Mr. McDowell. Item 2. Item 2. PROPERTIES See Item 1. Business - ELECTRIC UTILITY PROPERTIES, page 13 and OIL AND GAS PROPERTIES, page 45. Item 3. Item 3. LEGAL PROCEEDINGS In February 1993, a jury in Salem Massachusetts Superior Court assessed damages of $7.5 million, including interest, against Mass. Electric in a case arising from the installation by Mass. Electric of an allegedly undersized transformer for the plaintiff's manufacturing facility. Mass. Electric settled this case with its general liability insurance carrier and the plaintiff in 1993. See Item 1. RATES, page 8; Nuclear Units, page 21; Hydro Electric Project Licensing, page 28; Environmental Requirements, page 29; OIL AND GAS OPERATIONS, page 43. Item 4. Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the last quarter of 1993. PART II Item 5. Item 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED SECURITY HOLDER MATTERS NEES information in response to the disclosure requirements specified by this Item 5. appears under the captions in the NEES Annual Report indicated below: Required Information Annual Report Caption -------------------- --------------------- (a) Market Information Shareholder Information (b) Holders Shareholder Information (c) Dividends Financial Highlights The information referred to above is incorporated by reference in this Item 5. NEP, Mass. Electric, and Narragansett - The information required by this item is not applicable as the common stock of all these companies is held solely by NEES. Information pertaining to payment of dividends and restrictions on payment of dividends is incorporated herein by reference to each company's 1993 Annual Report. Item 6. Item 6. SELECTED FINANCIAL DATA NEES ---- The information required by this item is incorporated herein by reference to page 21 of the NEES 1993 Annual Report. NEP --- The information required by this item is incorporated herein by reference to page 29 of the NEP 1993 Annual Report. Mass. Electric -------------- The information required by this item is incorporated herein by reference to page 27 of the Mass. Electric 1993 Annual Report. Narragansett ------------ The information required by this item is incorporated herein by reference to page 24 of the Narragansett 1993 Annual Report. Item 7. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. NEES ---- The information required by this item is incorporated herein by reference to pages 12 through 20 of the NEES 1993 Annual Report. NEP --- The information required by this item is incorporated herein by reference to pages 4 through 9 of the NEP 1993 Annual Report. Mass. Electric -------------- The information required by this item is incorporated herein by reference to pages 4 through 10 of the Mass. Electric 1993 Annual Report. Narragansett ------------ The information required by this item is incorporated herein by reference to pages 4 through 9 of the Narragansett 1993 Annual Report. Item 8. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA NEES ---- The information required by this item is incorporated herein by reference to pages 21 through 40 of the NEES 1993 Annual Report. NEP --- The information required by this item is incorporated herein by reference to pages 3, 10 through 27, and 29 of the NEP 1993 Annual Report. Mass. Electric -------------- The information required by this item is incorporated herein by reference to pages 3, 11 through 25, and 27 of the Mass. Electric 1993 Annual Report. Narragansett ------------ The information required by this item is incorporated herein by reference to pages 3, 10 through 22, and 24 of the Narragansett 1993 Annual Report. Item 9. Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE NEES, NEP, Mass. Electric, and Narragansett - None. PART III Item 10. Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT NEES ---- The information required by this item is incorporated herein by reference to the material under the caption ELECTION OF DIRECTORS in the definitive proxy statement of NEES, dated March 10, 1994, for the 1994 Annual Meeting of Shareholders, provided that the information under the headings "Compensation Committee Report on Executive Compensation" and "Corporate Performance" are not so incorporated. Reference is also made to the information under the caption EXECUTIVE OFFICERS - NEES in Part I of this report. NEP --- The names of the directors of NEP, their ages, and a brief account of their business experience during the past five years appear below. Information required by this item for Executive Officers is provided under the caption EXECUTIVE OFFICERS - NEP in Part I of this report. Directors are elected to hold office until the next annual meeting of stockholders or special meeting held in lieu thereof and until their respective successors are chosen and qualified. Joan T. Bok - Director since 1979 - Age: 64 - Chairman of the Board of NEES - Vice Chairman of the Company from 1993 to 1994 - Chairman or Vice Chairman of the Company from 1988 to 1994 - Vice Chairman of the Company from 1989 to 1991 - Chairman of NEES from 1984 to 1994 (Chairman, President, and Chief Executive Officer from July 26, 1988 until February 13, 1989). Directorships of NEES System companies: New England Electric System, Massachusetts Electric Company, The Narragansett Electric Company, Narragansett Energy Resources Company, New England Electric Resources, Inc., New England Electric Transmission Corporation, New England Energy Incorporated, New England Hydro Finance Company, Inc., New England Hydro-Transmission Corporation, New England Hydro-Transmission Electric Company, Inc., and New England Power Service Company. Other directorships: Avery Dennison Corporation, John Hancock Mutual Life Insurance Company, Monsanto Company, and the Federal Reserve Bank of Boston. Frederic E. Greenman* - Director since 1986. Directorships of NEES System companies and affiliates: Narragansett Energy Resources Company, New England Electric Resources, Inc., New England Electric Transmission Corporation, New England Energy Incorporated, New England Hydro Finance Company, Inc., New England Hydro-Transmission Corporation, New England Hydro-Transmission Electric Company, Inc., New England Power Service Company, Yankee Atomic Electric Company, Connecticut Yankee Atomic Power Company, Maine Yankee Atomic Power Company, and Vermont Yankee Nuclear Power Corporation. Alfred D. Houston* - Director since 1984. Directorships of NEES System companies: Narragansett Energy Resources Company, New England Electric Transmission Corporation, New England Energy Incorporated, New England Hydro Finance Company, Inc., New England Hydro-Transmission Corporation, New England Hydro-Transmission Electric Company, Inc., and New England Power Service Company. John W. Newsham* - Director since 1991. Directorships of NEES System companies: Narragansett Energy Resources Company, New England Electric Resources, Inc., and New England Power Service Company. John W. Rowe* - Director since 1989. Directorships of NEES System companies and affiliates: New England Electric System, Massachusetts Electric Company, The Narragansett Electric Company, Narragansett Energy Resources Company, New England Electric Resources, Inc., New England Electric Transmission Corporation, New England Energy Incorporated, New England Hydro Finance Company, Inc., New England Hydro-Transmission Corporation, New England Hydro-Transmission Electric Company, Inc., New England Power Service Company, and Maine Yankee Atomic Power Company. Other directorships: Bank of Boston Corporation and UNUM Corporation. Jeffrey D. Tranen* - Director since 1991. Directorships of NEES System affiliates: Narragansett Energy Resources Company, New England Electric Resources, Inc., New England Electric Transmission Corporation, New England Energy Incorporated, New England Hydro Finance Company, Inc., New England Hydro-Transmission Corporation, New England Hydro-Transmission Electric Company, Inc., and New England Power Service Company. *Please refer to the material supplied under the caption EXECUTIVE OFFICERS - NEES and EXECUTIVE OFFICERS - NEP in Part I of this report for other information regarding this director. Mass. Electric -------------- The names of the directors of Mass. Electric, their ages, and a brief account of their business experience during the past five years appear below. Information required by this item for Executive Officers is provided under the caption EXECUTIVE OFFICERS - - Mass. Electric in Part I of this report. Directors are elected to hold office until the next annual meeting of stockholders or special meeting held in lieu thereof and until their respective successors are chosen and qualified. Urville J. Beaumont - Director since 1984 - Age: 61 - Treasurer and Director, law firm of Beaumont & Campbell, P.A. Joan T. Bok* - Director since 1979. Sally L. Collins - Director since 1976 - Age: 58 - Health Services Administrator at Kollmorgen Corporation EOD since January 1989 - Former Director of Medical Services at Oxbow Health Associates, Inc., Hadley, Mass. - Former member of Mass. Electric Customer Advisory Council. John H. Dickson - Director since 1990 - Reference is made to material supplied under the caption EXECUTIVE OFFICERS - Mass. Electric for other information regarding Mr. Dickson. Other directorship: Worcester Business Development Corporation. Charles B. Housen - Director since 1979 - Age: 61 - Chairman, President, and Director of Erving Industries, Inc., Erving, Mass. Dr. Kathryn A. McCarthy - Director since 1973 - Age: 69 - Research Professor of Physics at Tufts University, Medford, Mass. - Senior Vice President and Provost at Tufts from 1973 to 1979 - Other directorships: State Mutual Life Assurance Company of America. Patricia McGovern - Elected Director in 1994 - Age: 52 - Of Counsel to law firm of Goulston & Storrs, P.C. since 1993 - Massachusetts State Senator and Chair of the Senate Ways and Means Committee from 1984 to 1992. John F. Reilly - Director since 1988 - Age: 61 - President and CEO of Fred C. Church, Inc., Lowell, Mass. - Other as directorships: Colonial Gas Company and NE Insurance Co., Ltd. John W. Rowe* - Director since 1989. Richard P. Sergel* - Director since 1993. Richard M. Shribman - Director since 1979 - Age: 68 - Treasurer of Norick Realty Corporation, Salem, Mass. - President of Norick Realty Corporation until 1992 - Other directorships: Eastern Bank. Roslyn M. Watson - Director since 1992 - Age: 44 - President of Watson Ventures (commercial real estate development and management) Boston, Mass. - Vice President of the Gunwyn Company (commercial real estate development) Cambridge, Mass. from 1990 - 1993 and Project Manager from 1986 - 1990 - Other directorships: The Boston Company Funds. *Please refer to the material supplied under the caption EXECUTIVE OFFICERS - NEES in Part I of this report and/or the material supplied under the caption DIRECTORS AND OFFICERS OF THE REGISTRANT - NEP in this Item for other information regarding this director. Narragansett ------------ The names of the directors of Narragansett, their ages, and a brief account of their business experience during the past five years appear below. Information required by this item for Executive Officers is provided under the caption EXECUTIVE OFFICERS - - Narragansett in Part I of this report. Directors are elected to hold office until the next annual meeting of stockholders or special meeting held in lieu thereof and until their respective successors are chosen and qualified. Joan T. Bok* - Director since 1979. Stephen A. Cardi - Director since 1979 - Age: 52 - Treasurer and Director of Cardi Corporation (construction), Warwick, R.I. Frances H. Gammell - Director since 1992 - Age: 44 - Director, Vice President of Finance, and Secretary of Original Bradford Soap Works, Inc. Joseph J. Kirby - Director since 1988 - Age: 62 - President of Washington Trust Bancorp, Inc., Westerly, R.I. and President and Director of the Washington Trust Company. Robert L. McCabe - President and Director of Narragansett since 1986 - Other directorship: Citizens Savings Bank - Please refer to the material supplied under the caption EXECUTIVE OFFICERS - Narragansett in Part I of this report for other information regarding Mr. McCabe. John W. Rowe* - Director since 1989. Richard P. Sergel* - Chairman and Director since 1993. William E. Trueheart - Director since 1989 - Age: 50 - President of Bryant College, Smithfield, Rhode Island - Executive Vice President of Bryant College from 1986 to 1989 - Other directorships: Fleet National Bank. John A. Wilson, Jr. - Director since 1971 - Age: 62 - Former Consultant to and President of Wanskuck Co., Providence, R.I., - Former Consultant to Hinckley, Allen, Snyder & Comen (attorneys), Providence, R.I. *Please refer to the material supplied under the caption DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT - NEP in this Item for other information regarding this director. Section 16(a) of the Securities Exchange Act of 1934 requires the System's officers and directors, and persons who own more than 10% of a registered class of the System's equity securities, to file reports on Forms 3, 4, and 5 of share ownership and changes in share ownership with the SEC and the New York Stock Exchange and to furnish the System with copies of all Section 16(a) forms they file. Based solely on Mass. Electric's and Narragansett's review of the copies of such forms received by them, or written representations from certain reporting persons that such forms were not required for those persons, Mass. Electric and Narragansett believe that, during 1993, all filing requirements applicable to its officers, directors, and 10% beneficial owners were complied with, except that one report on Form 3 was filed late for each of Mr. Beirne, Mr. Frost, and Mr. Mahoney. Item 11. Item 11. EXECUTIVE COMPENSATION NEES ---- The information required by this item is incorporated herein by reference to the material under the captions BOARD STRUCTURE AND COMPENSATION, EXECUTIVE COMPENSATION, PAYMENTS UPON A CHANGE IN CONTROL, PLAN SUMMARIES, and RETIREMENT PLANS in the definitive proxy statement of NEES, dated March 10, 1994, for the 1994 Annual Meeting of Shareholders, provided that the information under the headings "Compensation Committee Report on Executive Compensation" and "Corporate Performance" are not so incorporated. NEP, MASS. ELECTRIC, AND NARRAGANSETT ------------------------------------- EXECUTIVE COMPENSATION The following tables give information with respect to all compensation (whether paid directly by NEP, Mass. Electric, or Narragansett or billed to it as hourly charges) for services in all capacities for NEP, Mass. Electric, or Narragansett for the years 1991 through 1993 to or for the benefit of the Chief Executive Officer and the four other most highly compensated executive officers for each company. NEP SUMMARY COMPENSATION TABLE Long-Term Compensa- Annual Compensation (b) tion -------------------------- --------- Other Name and Annual Restricted All Other Principal Compensa- Share Compensa- Position Year Salary Bonus tion Awards tion (a) ($) ($)(c) ($)(d) ($)(e) ($)(f) - ---------- ---- ------- ------ --------- ---------- --------- John W. 1993 181,269 112,095 2,318 54,256 2,386(g) Rowe 1992 184,532 69,205 2,318 56,479 2,340 Chairman 1991 160,202 67,618 2,188 58,394 2,153 Joan T. 1993 154,428 92,949 3,323 46,245 3,444(h) Bok 1992 157,705 59,310 2,899 48,274 3,326 Vice 1991 155,392 66,005 3,135 56,641 3,615 Chairman Jeffrey D. 1993 159,936 112,105 2,974 32,753 3,563(i) Tranen 1992 120,843 52,286 2,307 23,732 2,670 President 1991 129,725 45,832 2,240 20,970 2,595 Frederic E. 1993 123,648 75,058 2,131 22,811 3,110(j) Greenman 1992 133,223 50,258 2,361 26,960 3,298 Vice 1991 125,237 43,804 2,516 24,028 3,145 President Lawrence E. 1993 135,123 61,283 101 21,286 3,790(k) Bailey 1992 129,711 47,737 101 20,985 2,594 Vice 1991 122,928 32,588 102 14,474 2,459 President (a) Certain officers of NEP are also officers of NEES and various other System companies. (b) Includes deferred compensation in category and year earned. (c) The bonus figure represents cash bonuses under an incentive compensation plan, special bonuses, the goals program award, and the variable portion of the incentive thrift plan match by NEP. See description under Plan Summaries. (d) Includes amounts reimbursed by NEP for the payment of taxes. (e) These shares receive the same dividends as the other common shares of NEES. The shares become unrestricted after five years. See also Payments Upon a Change in Control, below. As of December 31, 1993, the following executive officers held the amount of restricted shares with the value indicated: Mr. Rowe 11,807 shares, $461,949 value; Mrs. Bok 10,241 shares, $400,679 value; Mr. Greenman 3,220 shares, $125,983 value; Mr. Tranen 2,193 shares, $85,019 value; and Mr. Bailey 1,369 shares, $53,562 value. These amounts do not include the restricted share awards for 1993 which were not determined until February 1994. The value was calculated by multiplying the closing market price on December 31, 1993 by the number of shares. (f) Includes NEP contributions to life insurance and the incentive thrift plan that are not bonus contributions. See description under Plan Summaries. The life insurance contribution is calculated based on the value of term life insurance for the named individuals. The premium costs for most of these policies have been or will be recovered by NEP. (g) For Mr. Rowe, the amount and type of compensation in 1993 is as follows: $1,879 for contributions to the thrift plan and $507 for life insurance. (h) For Mrs. Bok, the amount and type of compensation in 1993 is as follows: $1,937 for contributions to the thrift plan and $1,507 for life insurance. (i) For Mr. Tranen, the amount and type of compensation in 1993 is as follows: $3,198 for contributions to the thrift plan and $365 for life insurance. (j) For Mr. Greenman, the amount and type of compensation in 1993 is as follows: $2,478 for contributions to the thrift plan and $637 for life insurance. (k) For Mr. Bailey, the amount and type of compensation in 1993 is as follows: $2,702 for contributions to the thrift plan and $1,088 for life insurance. MASS. ELECTRIC SUMMARY COMPENSATION TABLE Long-Term Compensa- Annual Compensation (b) tion -------------------------- --------- Other Name and Annual Restricted All Other Principal Compensa- Share Compensa- Position Year Salary Bonus tion Awards tion (a) ($) ($)(c) ($)(d) ($)(e) ($)(f) - ---------- ---- ------- ------ --------- ---------- --------- Richard P. 1993 93,628 71,187 1,657 20,713 2,036(h) Sergel (g) Chairman John H. 1993 156,900 116,399 3,005 28,103 3,623(i) Dickson 1992 150,469 61,561 3,087 27,801 3,442 President 1991 141,720 51,451 2,389 23,606 3,255 and CEO Nancy H. 1993 102,860 43,386 103 13,370 2,378(j) Sala (g) 1992 96,785 20,508 103 8,326 1,936 Vice President Dennis E. 1993 105,768 29,175 101 11,173 3,025(k) Snay 1992 101,208 28,448 103 12,207 2,024 Vice 1991 94,862 23,320 103 10,001 1,897 President Cheryl A. 1993 71,488 43,373 68 13,206 1,575(l) LaFleur (g) Vice President (a) Certain officers of Mass. Electric are also officers of NEES and various other System companies. (b) Includes deferred compensation in category and year earned. (c) The bonus figure represents cash bonuses under an incentive compensation plan, special bonuses, the goals program award, and the variable portion of the incentive thrift plan match by Mass. Electric. See description under Plan Summaries. (d) Includes amounts reimbursed by Mass. Electric for the payment of taxes. (e) These shares receive the same dividends as the other common shares of NEES. The shares become unrestricted after five years. See also Payments Upon a Change in Control, below. As of December 31, 1993, the following executive officers held the amount of restricted shares with the value indicated: Mr. Sergel 2,022 shares, $79,110 value; Mr. Dickson 2,190 shares, $85,683 value; Ms. Sala 360 shares, $14,085 value; Mr. Snay 859 shares, $33,608 value; and Ms. LaFleur 824 shares, $32,239 value. These amounts do not include the restricted share awards for 1993 which were not determined until February 1994. The value was calculated by multiplying the closing market price on December 31, 1993 by the number of shares. (f) Includes Mass. Electric contributions to life insurance and the incentive thrift plan that are not bonus contributions. See description under Plan Summaries. The life insurance contribution is calculated based on the value of term life insurance for the named individuals. The premium costs for most of these policies have been or will be recovered by Mass. Electric. (g) Mr. Sergel and Ms. LaFleur were elected as officers of Mass. Electric in 1993, and Ms. Sala was elected in 1992. Compensation data is provided for the years in which they have served as officers. (h) For Mr. Sergel, the type and amount of compensation in 1993 is as follows: $1,873 for contributions to the thrift plan and $163 for life insurance. (i) For Mr. Dickson, the type and amount of compensation in 1993 is as follows: $3,138 for contributions to the thrift plan and $485 for life insurance. (j) For Ms. Sala, the type and amount of compensation in 1993 is as follows: $2,057 for contributions to the thrift plan and $321 for life insurance. (k) For Mr. Snay, the type and amount of compensation in 1993 is as follows: $2,115 for contributions to the thrift plan and $910 for life insurance. (l) For Ms. LaFleur, the type and amount of compensation in 1993 is as follows: $1,430 for contributions to the thrift plan and $145 for life insurance. NARRAGANSETT SUMMARY COMPENSATION TABLE Long-Term Compensa- Annual Compensation (b) tion -------------------------- --------- Other Name and Annual Restricted All Other Principal Compensa- Share Compensa- Position Year Salary Bonus tion Awards tion (a) ($) ($)(c) ($)(d) ($)(e) ($)(f) - ---------- ---- ------- ------ --------- ---------- --------- Richard P. 1993 48,207 36,653 854 10,665 1,048(h) Sergel (g) Chairman Robert L. 1993 139,632 98,654 2,408 22,617 3,771(i) McCabe 1992 134,536 54,109 2,041 25,076 2,603 President 1991 128,863 40,428 1,306 18,024 2,388 and CEO William 1993 118,501 39,403 101 13,370 5,847(j) Watkins, 1992 65,586 17,315 66 7,350 1,312 Jr. (g) Executive Vice President Richard W. 1993 96,408 28,667 103 11,211 2,628(k) Frost (g) Vice President Francis X. 1993 87,300 10,580 113 2,462 1,859(l) Beirne (g) Vice President (a) Certain officers of Narragansett are also officers of NEES and various other System companies. (b) Includes deferred compensation in category and year earned. (c) The bonus figure represents cash bonuses under an incentive compensation plan, special bonuses, the goals program award, and the variable portion of the incentive thrift plan match by Narragansett. See description under Plan Summaries. (d) Includes amounts reimbursed by Narragansett for the payment of taxes. (e) These shares receive the same dividends as the other common shares of NEES. The shares become unrestricted after five years. See also Payments Upon a Change in Control, below. As of December 31, 1993, the following executive officers held the amount of restricted shares with the value indicated: Mr. Sergel 2,022 shares, $79,110 value; Mr. McCabe 2,082 shares, $81,458 value; Mr. Watkins 954 shares, $37,325 value; Mr. Frost 942 shares, $36,855 value; and Mr. Beirne 206 shares, $8,059 value. These amounts do not include the restricted share awards for 1993 which were not determined until February 1994. The value was calculated by multiplying the closing market price on December 31, 1993 by the number of shares. (f) Includes Narragansett contributions to life insurance and the incentive thrift plan that are not bonus contributions. See description under Plan Summaries. The life insurance contribution is calculated based on the value of term life insurance for the named individuals. The premium costs for most of these policies have been or will be recovered by Narragansett. (g) Messrs. Sergel, Frost, and Beirne were elected as officers of Narragansett in 1993, and Mr. Watkins was elected in 1992. Compensation data is provided for the years in which they have served as officers. (h) For Mr. Sergel, the type and amount of compensation in 1993 is as follows: $964 for contributions to the thrift plan and $84 for life insurance. (i) For Mr. McCabe, the type and amount of compensation in 1993 is as follows: $2,682 for contributions to the thrift plan and $1,089 for life insurance. (j) For Mr. Watkins, the type and amount of compensation in 1993 is as follows: $2,370 for contributions to the thrift plan and $3,477 for life insurance. (k) For Mr. Frost, the type and amount of compensation in 1993 is as follows: $1,928 for contributions to the thrift plan and $700 for life insurance. (l) For Mr. Beirne, the type and amount of compensation in 1993 is as follows: $1,746 for contributions to the thrift plan and $113 for life insurance. Directors' Compensation Members of the Mass. Electric and Narragansett Boards of Directors, except Dickson, McCabe, Rowe, and Sergel receive a quarterly retainer of $1,250, a meeting fee of $600 plus expenses, and 50 NEES common shares each year. Since all members of the NEP Board are employees of NEES System companies, no fees are paid for service on the Board except as noted below for Mrs. Bok. Mrs. Bok retired as an employee of the NEES companies on January 1, 1994 (remaining as Chairman of NEES and a director for NEES subsidiaries). Mrs. Bok has agreed to waive the normal fees and annual retainers otherwise payable for services by non- employees on NEES subsidiary boards and will receive in lieu thereof a single annual stipend of $60,000. Mrs. Bok also became a consultant to NEES as of January 1, 1994. Under the terms of her contract, she will receive an annual retainer of $100,000. No payments were made in 1993 pursuant to these arrangements. Mass. Electric and Narragansett permit directors to defer all or a portion of their retainers and meeting fees. Special accounts are maintained on Mass. Electric's and Narragansett's books showing the amounts deferred and the interest accrued thereon. Other NEP, Mass. Electric, and Narragansett do not have any share option plans. The NEES Compensation Committee administers certain of the incentive compensation plans, and the Management Committee administers the others (including the incentive share plan). Retirement Plans The following table shows estimated annual benefits payable to executive officers under the qualified pension plan and the supplemental retirement plan, assuming retirement at age 65 in 1994. PENSION TABLE Five-Year Average 15 Years 20 Years 25 Years 30 Years 35 Years 40 Years Compensa- of of of of of of tion Service Service Service Service Service Service - --------- -------- -------- -------- -------- -------- -------- $100,000 28,000 36,600 45,000 53,400 58,900 61,600 $150,000 43,000 56,300 69,300 82,200 90,300 94,800 $200,000 58,000 76,000 93,500 111,000 122,100 128,100 $250,000 73,000 95,700 117,800 139,800 153,800 161,300 $300,000 88,100 115,400 142,000 168,600 185,500 194,500 $350,000 103,100 135,100 166,300 197,400 217,200 227,700 $400,000 118,100 154,800 190,500 226,200 249,000 261,000 $450,000 133,100 174,500 214,800 255,000 280,700 294,200 For purposes of the retirement plans, Messrs. Rowe, Tranen, Greenman, and Bailey currently have 16, 24, 30, and 25 credited years of service, respectively. Mr. Sergel, Mr. Dickson, Ms. Sala, Mr. Snay, and Ms. LaFleur currently have 15, 20, 24, 30, and 7 credited years of service, respectively. Messrs. McCabe, Watkins, Frost, and Beirne currently have 25, 21, 31, and 22 credited years of service, respectively. At the time she retired from NEP, Mrs. Bok had 38 credited years of service, and she commenced receiving the described benefits under the pension plans and the life insurance program. As a non-employee, she no longer accrues service credit or additional benefits under these plans. Benefits under the pension plans are computed using formulae based on percentages of highest average compensation computed over five consecutive years. The compensation covered by the pension plan includes salary, bonus, and restricted share awards. The benefits listed in the pension table are not subject to deduction for Social Security and are shown without any joint and survivor benefits. The Pension Table above does not include annuity payments to be received in lieu of life insurance. The policies are described above under Plan Summaries. In February 1993, NEP announced a voluntary early retirement program available to all non-union employees over age 55 with 10 or more years of service as of June 30, 1993. Mrs. Bok accepted the offer. The program offered either an annuity or a lump sum equal to the greater value of either one week's base pay times the number of years of service plus two weeks base pay or an additional five years of service and five years of age. In accordance with the terms of the offer, Mrs. Bok received an additional annuity of $12,611 from a supplemental pension plan and a lump sum of $110,896 from the qualified plan. Mrs. Bok had not been eligible for a bonus under the prior incentive compensation plan. In lieu thereof she will receive a limited cost of living (consumer price index) adjustment to her benefits from the qualified pension plan and the supplemental retirement plan. Since this plan serves to adjust the pension benefit only after retirement, there will be no supplement paid under the plan until at least 1995. Senior executives receive the same post-retirement health benefits as those offered non-union employees who retire with a combination of age and years of service equal to 85. PAYMENTS UPON A CHANGE OF CONTROL The incentive compensation plans would provide a payment of 40% of base compensation in the event of a "change in control" as defined in the plans. This payout would be made in lieu of any cash bonuses under the plans for the year in which the "change in control" occurs. A similar payment is provided for the previous plan year if awards for that year had not yet been distributed. A "change in control" is defined, generally, as an occurrence of certain events that either evidence a merger or acquisition of NEES or cause a significant change in the makeup of the NEES board of directors over a short period of time. Upon the occurrence of a "change in control," restrictions on all shares issued to participants under the incentive share plan would cease and the participants would receive an award of shares for that year, determined in the usual manner, based upon the cash awards described in the preceding paragraph. NEP, MASS. ELECTRIC, AND NARRAGANSETT PLAN SUMMARIES A brief description of the various plans through which compensation and benefits are provided to the named executive officers is presented below to better enable shareholders to understand the information presented in the tables shown earlier. The amounts of compensation and benefits provided to the named executive officers under the plans described below (and charged to NEP, Mass. Electric, or Narragansett) are presented in the Summary Compensation Tables. Goals Program The goals program covers all employees who have completed one year of service with any NEES subsidiary. Goals are established annually. For 1993, these goals related to earnings per share, customer costs, safety, absenteeism, conservation, generating station availability, transmission reliability, environmental and OSHA compliance, and customer favorability attitudes. Some goals apply to all employees, while others apply to particular functional groups. Depending upon the number of goals met, and provided the minimum goal for earnings per share is met, employees may earn a cash bonus of 1% to 4-1/2% of their compensation. Incentive Thrift Plan The incentive thrift plan (a 401(k) program) provides for a match of one-half of up to the first 4% of base compensation contributed to the System's incentive thrift plan (shown under All Other Compensation in the Summary Compensation Tables) and, based on an incentive formula tied to earnings per share, may fully match the first 4% of base compensation contributed (the additional amount, if any, is shown under Bonus in the Summary Compensation Tables). Under Federal law, contributions to these plans are restricted. In 1993, the salary reduction amount was limited to $8,994. Life Insurance NEES has established for certain senior executives life insurance plans funded by individual policies. The combined death benefit under these insurance plans is three times the participant's annual salary. After termination of employment, participants may elect, commencing at age 55 or later, to receive an annuity income equal to 40% of annual salary. In that event, the life insurance is reduced over fifteen years to an amount equal to the participant's final annual salary. Due to changes in the tax law, this plan was closed to new participants, and an alternative was established with only a life insurance benefit. The individuals listed in the NEP summary compensation table are in one or the other of these plans. Mass. Electric and Narragansett each have two executive officers eligible to participate in one or the other of these plans. Item 12. Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT NEES ---- The information required by this item is incorporated herein by reference to the material under the caption TOTAL COMMON EQUITY BASED HOLDINGS in the definitive proxy statement of NEES, dated March 10, 1994, for the 1994 Annual Meeting of Shareholders, provided that the information under the headings "Compensation Committee Report on Executive Compensation" and "Corporate Performance" are not so incorporated. NEP, Mass. Electric, and Narragansett ------------------------------------- NEES owns 100% of the voting securities of Mass. Electric and Narragansett. NEES owns 98.80% of the voting securities of NEP. SECURITY OWNERSHIP The following tables list the holdings of NEES common shares as of March 10, 1994 by NEP, Mass. Electric, and Narragansett directors, the executive officers named in the Summary Compensation Tables, and all directors and executive officers, as a group. NEP --- Name Shares Beneficially Owned (a) ---- ----------------------------- Lawrence E. Bailey 1,953 Joan T. Bok 25,162 Frederic E. Greenman 10,632 Alfred D. Houston 10,953 John W. Newsham 10,270 John W. Rowe 20,419 Richard P. Sergel 6,702 Jeffrey D. Tranen 6,604 All directors and executive officers, as a group (13 persons) 115,340 (b) (a) Includes restricted shares and allocated shares in employee benefit plans. (b) This is less than 1% of the total number of shares of NEES outstanding. Mass. Electric -------------- Name Shares Beneficially Owned ---- ------------------------- Urville J. Beaumont 104 (a) Joan T. Bok 25,162 (b) Sally L. Collins 105 John H. Dickson 7,883 (b) Charles B. Housen 52 Cheryl A. LaFleur 1,796 (b) Kathryn A. McCarthy 100 Patricia McGovern 0 John F. Reilly 105 John W. Rowe 20,419 (b) Nancy H. Sala 5,459 (b),(c) Richard P. Sergel 6,702 (b) Richard M. Shribman 105 Dennis E. Snay 3,720 (b) Roslyn M. Watson 205 All directors and executive officers, as a group (23 persons) 105,713 (d) (a) Mr. Beaumont disclaims a beneficial ownership interest in these shares held under an irrevocable trust. (b) Includes restricted shares and allocated shares in employee benefit plans. (c) Ms. Sala disclaims a beneficial ownership interest in 205 shares held under the Uniform Gift to Minors Act. (d) This is less than 1% of the total number of shares of NEES outstanding. Narragansett ------------ Name Shares Beneficially Owned ---- ------------------------- Francis X. Beirne 2,956 (a) Joan T. Bok 25,162 (a) Stephen A. Cardi 104 Richard W. Frost 4,521 (a) Frances H. Gammell 105 Joseph J. Kirby 105 Robert L. McCabe 7,671 (a) John W. Rowe 20,419 (a) Richard P. Sergel 6,702 (a) William E. Trueheart 105 William Watkins, Jr. 7,143 (a) John A. Wilson, Jr. 508 All directors and executive officers, as a group (15 persons) 95,477 (b) (a) Includes restricted shares and allocated shares in employee benefit plans. (b) This is less than 1% of the total number of shares of NEES outstanding. Item 13. Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The construction company of Mr. Stephen A. Cardi, a director of Narragansett, was awarded two contracts by New England Power Company for construction work at its Brayton Point Station. The contract amounts totalled $600,000 and $1,000,000, respectively. Reference is made to Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT and Item 11. EXECUTIVE COMPENSATION. PART IV Item 14. Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K List of Exhibits Unless otherwise indicated, the exhibits listed below are incorporated by reference to the appropriate exhibit numbers and the Commission file numbers indicated in parentheses. NEES ---- (3) Agreement and Declaration of Trust dated January 2, 1926, as amended through April 28, 1987 (Exhibit 3 to 1987 Form 10-K, File No. 1-3446). (4) Instruments Defining the Rights of Security Holders (a) Massachusetts Electric Company First Mortgage Indenture and Deed of Trust, dated as of July 1, 1949, and twenty supplements thereto (Exhibit 7-A, File No. 1-8019; Exhibit 7-B, File No. 2-8836; Exhibit 4-C, File No. 2-9593; Exhibit 4 to 1980 Form 10-K, File No. 2-8019; Exhibit 4 to 1982 Form 10-K, File No. 0-5464; Exhibit 4 to 1986 Form 10-K, File No. 0-5464; Exhibit 4(a) to 1988 Form 10-K, File No. 1-3446; Exhibit 4(a) to 1989 Form 10-K, File No. 1-3446; Exhibit 4(a) to 1992 Form 10-K, File No. 1-3446; Twentieth Supplemental Indenture dated as of September 1, 1993 (filed herewith). (b) The Narragansett Electric Company First Mortgage Indenture and Deed of Trust, dated as of September 1, 1944, and twenty-one supplements thereto (Exhibit 7-1, File No. 2-7042; Exhibit 7-B, File No. 2-7490; Exhibit 4-C, File No. 2-9423; Exhibit 4-D, File No. 2-10056; Exhibit 4 to 1980 Form 10-K, File No. 0-898; Exhibit 4 to 1982 Form 10-K, File No. 0-898; Exhibit 4 to 1983 Form 10-K, File No. 0-898; Exhibit 4 to 1985 Form 10-K, File No. 0-898; Exhibit 4 to 1986 Form 10-K, File No. 0-898; Exhibit 4 to 1987 Form 10-K, File No. 0-898; Exhibit 4 to 1991 Form 10-K, File No. 0-898); Exhibit 4(b) to 1992 Form 10-K, File No. 1-3446; Twenty-First Supplemental Indenture dated as of October 1, 1993 (filed herewith). (c) The Narragansett Electric Company Preference Provisions, as amended, dated March 23, 1993 (filed herewith). (d) New England Power Company Indentures General and Refunding Mortgage Indenture and Deed of Trust dated as of January 1, 1977 and nineteen supplements thereto (Exhibit 4(b) to 1980 Form 10-K, File No. 0-1229; Exhibit 4(b) to 1982 Form 10-K, File No. 0-1229; Exhibit 4(b) to 1983 Form 10-K, File No. 0-1229; Exhibit 4(b) to 1985 Form 10-K, File No. 0-1229; Exhibit 4(b) to 1986 Form 10-K, File No. 0-1229; Exhibit 4(c)(ii) to 1988 Form 10-K, File No. 1-3446; Exhibit 4(c)(ii) to 1989 Form 10-K, File No. 1-3446; Exhibit 4(c)(ii) to 1990 Form 10-K, File No. 1-3446; Exhibit 4(c)(ii) to 1991 Form 10-K, File No. 1-3446; Exhibit 4(c)(ii) to 1992 Form 10-K, File No. 1-3446; Nineteenth Supplemental Indenture dated as of August 1, 1993 (filed herewith). (10) Material Contracts (a) Boston Edison Company et al. and New England Power Company: Amended REMVEC Agreement dated August 12, 1977 (Exhibit 5-4(d), File No. 2-61881). (b) The Connecticut Light and Power Company et al. and New England Power Company: Sharing Agreement for Joint Ownership, Construction and Operation of Millstone Unit No. 3 dated as of September 1, 1973, and Amendment dated as of August 1, 1974 (Exhibit 10-5, File No. 2-52820); Amendments dated as of December 15, 1975 and April 1, 1986; (Exhibit 10(b), to 1990 Form 10-K, File No. 1-3446). Transmission Support Agreement dated August 9, 1974; Instrument of Transfer to NEP with respect to the 1979 Connecticut Nuclear Unit, and Assumption of Obligations, dated December 17, 1975 (Exhibit 10-6(b), File No. 2-57831). (c) Connecticut Yankee Atomic Power Company et al. and New England Power Company: Stockholders Agreement dated July 1, 1964 (Exhibit 13-9-A, File No. 2-23006); Power Purchase Contract dated July 1, 1964 (Exhibit 13-9-B, File No. 2-23006); Supplementary Power Contract dated as of April 1, 1987 (Exhibit 10(c) to 1987 Form 10-K, File No. 1-3446); Capital Funds Agreement dated September 1, 1964 (Exhibit 13-9-C, File No. 2-23006); Transmission Agreement dated October 1, 1964 (Exhibit 13-9-D, File No. 2-23006); Agreement revising Transmission Agreement dated July 1, 1979 (Exhibit to 1979 Form 10-K, File No. 1-3446); Guarantee Agreement dated as of November 13, 1981 (Exhibit 10(d) to 1981 Form 10-K, File No. 1-3446); Guarantee Agreement dated as of August 1, 1985 (Exhibit 10(c) to 1985 Form 10-K, File No. 1-3446). (d) Maine Yankee Atomic Power Company et al. and New England Power Company: Capital Funds Agreement dated May 20, 1968 and Power Purchase Contract dated May 20, 1968 (Exhibit 4-5, File No. 2-29145); Amendments dated as of January 1, 1984, March 1, 1984 (Exhibit 10(d) to 1983 Form 10-K, File No. 1-3446), October 1, 1984, and August 1, 1985 (Exhibit 10(d) to 1985 Form 10-K, File No. 1-3446); Stockholders Agreement dated May 20, 1968 (Exhibit 10-20, File No. 2-34267); Additional Power Contract dated as of February 1, 1984 (Exhibit 10(d) to 1985 Form 10-K, File No. 1-3446); Guarantee Agreement dated as of September 23, 1985 (Exhibit 10(d) to 1985 Form 10-K, File No. 1-3446). (e) New England Energy Incorporated Contracts (i) Capital Funds Agreement with NEES dated November 1, 1974 (Exhibit 10-29(b), File No. 2-52969); Amendment dated July 1, 1976, and Amendment dated July 26, 1979 (Exhibit 10(g)(i) to 1980 Form 10-K, File No. 1-3446); Amendment dated August 26, 1981 (Exhibit 10(f)(i) to 1981 Form 10-K, File No. 1-3446); Amendment dated March 26, 1985 (Exhibit 10(e)(i) to 1985 Form 10-K, File No. 1-3446); Amendment dated as of April 28, 1989 (Exhibit 10 (e)(i) to 1989 Form 10-K, File No. 1-3446); Amendment dated as of June 1, 1990 (Exhibit 10(e)(i) to 1990 Form 10-K, File No. 1-3446). (ii) Loan Agreement with NEES dated July 19, 1978 and effective November 1, 1974, and Amendment dated July 26, 1979 (Exhibit 10(g)(iii) to 1980 Form 10-K, File No. 1-3446); Amendment dated August 26, 1981 (Exhibit 10(f)(ii) to 1981 Form 10-K, File No. 1-3446); Amendment dated March 26, 1985 (Exhibit 10(e)(ii) to 1985 Form 10-K, File No. 1-3446); Amendment dated as of April 28, 1989 (Exhibit 10(e)(ii) to 1989 Form 10-K, File No. 1-3446); Amendment dated as of June 1, 1990 (Exhibit 10(e)(ii) to 1990 Form 10-K, File No. 1-3446). (iii) Fuel Purchase Contract with New England Power Company dated July 26, 1979, and Amendment dated August 26, 1981 (Exhibit 10(f)(iii) to 1981 Form 10-K, File No. 1-3446); Amendment dated March 26, 1985, and Amendment effective January 1, 1984 (Exhibit 10(e)(iii) to 1985 Form 10-K, File No. 1-3446); Amendment dated as of April 28, 1989 (Exhibit 10(e)(iii) to 1989 Form 10-K, File No. 1-3446). (iv) Partnership Agreement with Samedan Oil Corporation as Amended and Restated on February 5, 1985 (Exhibit 10(e)(iv) to 1984 Form 10-K, File No. 1-3446); Amendment dated as of January 14, 1992 (Exhibit 10(e)(iv) to 1991 Form 10-K, File No. 1-3446). (v) Credit Agreement dated as of April 28, 1989 (Exhibit 10(e)(v) to 1989 Form 10-K, File No. 1-3446); Amendment dated as of June 1, 1990 (Exhibit 10(e)(v) to 1990 Form 10-K, File No. 1-3446); Amendment dated as of August 1, 1992 (Exhibit 10(e)(v) to 1992 Form 10-K, File No. 1-3446). (vi) Capital Maintenance Agreement dated November 15, 1985, and Assignment and Security Agreement dated November 15, 1985 (Exhibit 10(e)(vi) to 1985 Form 10-K, File No. 1-3446); Amendment dated as of April 28, 1989 (Exhibit 10(e)(vi) to 1989 Form 10-K, File No. 1-3446). (f) New England Power Company and New England Electric Transmission Corporation et al.: Phase I Terminal Facility Support Agreement dated as of December 1, 1981 (Exhibit 10(g) to 1981 Form 10-K, File No. 1-3446); Amendments dated as of June 1, 1982, and November 1, 1982 (Exhibit 10(f) to 1982 Form 10-K, File No. 1-3446); Agreement with respect to Use of the Quebec Interconnection dated as of December 1, 1981 (Exhibit 10(g) to 1981 Form 10-K, File No. 1-3446); Amendments dated as of May 1, 1982, and November 1, 1982 (Exhibit 10(f) to 1982 Form 10-K, File No. 1-3446); Amendment dated as of January 1, 1986 (Exhibit (10)(f) 1986 Form 10-K, File No. 1-3446); Agreement for Reinforcement and Improvement of New England Power Company's Transmission System dated as of April 1, 1983 (Exhibit 10(f) to 1983 Form 10-K, File No. 1-3446); Lease dated as of May 16, 1983 (Exhibit 10(f) to 1983 Form 10-K, File No. 1-3446); Upper Development - Lower Development Transmission Line Support Agreement dated as of May 16, 1983 (Exhibit 10(f) to 1983 Form 10-K, File No. 1-3446). (g) New England Electric Transmission Corporation and PruCapital Management, Inc. et al: Note Agreement dated as of September 1, 1986 (Exhibit 10(g) to 1986 Form 10-K, File No. 1-3446); Mortgage, Deed of Trust and Security Agreement dated as of September 1, 1986 (Exhibit 10(g) to 1986 Form 10-K, File No. 1-3446); Equity Funding Agreement with New England Electric System dated as of December 1, 1985 (Exhibit 10(g) to 1991 Form 10-K, File No. 1-3446). (h) Vermont Electric Transmission Company, Inc. et al. and New England Power Company: Phase I Vermont Transmission Line Support Agreement dated as of December 1, 1981; Amendments dated as of June 1, 1982, and November 1, 1982 (Exhibit 10(g) to 1982 Form 10-K, File No. 1-3446); Amendment dated as of January 1, 1986 (Exhibit 10(h) to 1986 Form 10-K, File No. 1-3446). (i) New England Power Pool Agreement: (Exhibit 4(e), File No. 2-43025); Amendments dated July 1, 1972, and March 1, 1973 (Exhibit 10-15, File No. 2-48543); Amendment dated March 15, 1974 (Exhibit 10-5, File No. 2-52775); Amendment dated June 1, 1975 (Exhibit 10-14, File No. 2-57831); Amendment dated September 1, 1975 (Exhibit 10-13, File No. 2-59182); Amendments dated December 31, 1976, January 31, 1977, July 1, 1977, and August 1, 1977 (Exhibit 10-16, File No. 2-61881); Amendments dated August 15, 1978, January 3, 1980, and February 1980 (Exhibit 10-3, File No. 2-68283); Amendment dated September 1, 1981 (Exhibit 10(h) to 1981 Form 10-K, File No. 1-3446); Amendment dated as of December 1, 1981 (Exhibit 10(h) to 1982 Form 10-K, File No. 1-3446); Amendments dated June 1, 1982, June 15, 1983, and October 1, 1983 (Exhibit 10(i) to 1983 Form 10-K, File No. 1-3446); Amendments dated August 1, 1985, August 15, 1985, September 1, 1985, and January 1, 1986 (Exhibit 10(i) to 1985 Form 10-K, File No. 1-3446); Amendment dated September 1, 1986 (Exhibit 10(i) to 1986 Form 10-K, File No. 1-3446); Amendment dated April 30, 1987 (Exhibit 10(i) to 1987 Form 10-K, File No. 1-3446); Amendments dated March 1, 1988 and May 1, 1988 (Exhibit 10(i) to 1988 Form 10-K, File No. 1-3446); Amendment dated March 15, 1989 (Exhibit 10(i) to 1989 Form 10-K, File No. 1-3446); Amendment dated October 1, 1990 (Exhibit 10(i) to 1990 Form 10-K, File No. 1-3446); Amendment dated as of September 15, 1992 (Exhibit 10(i) to 1992 Form 10-K, File No. 1-3446). (j) Public Service Company of New Hampshire et al. and New England Power Company: Agreement for Joint Ownership, Construction and Operation of New Hampshire Nuclear Units dated as of May 1, 1973; Amendments dated May 24, 1974, June 21, 1974, September 25, 1974 and October 25, 1974 (Exhibit 10-18(b), File No. 2-52820); Amendment dated January 31, 1975 (Exhibit 10-16(b), File No. 2-57831); Amendments dated April 18, 1979, April 25, 1979, June 8, 1979, October 11, 1979, December 15, 1979, June 16, 1980, December 31, 1980 (Exhibit 10(i) to 1980 Form 10-K, File No. 1-3446); Amendments dated June 1, 1982, April 27, 1984, June 15, 1984 (Exhibit 10(j) to 1984 Form 10-K, File No. 1-3446); Amendments dated March 8, 1985, March 14, 1986, May 1, 1986 and September 19, 1986 (Exhibit 10(j) to 1986 Form 10-K, File No. 1-3446); Amendment dated November 12, 1987 (Exhibit 10(j) to 1987 Form 10-K, File No. 1-3446); Amendment dated January 13, 1989 (Exhibit 10(j) to 1989 Form 10-K, File No. 1-3446); Amendment dated as of November 1, 1990 (Exhibit 10(j) to 1991 Form 10-K, File No. 1- 3446). Transmission Support Agreement dated as of May 1, 1973 (Exhibit 10-23, File No. 2-49184); Instrument of Transfer to NEP with respect to the New Hampshire Nuclear Units and Assumptions of Obligations dated December 17, 1975 and Agreement Among Participants in New Hampshire Nuclear Units, certain Massachusetts Municipal Systems and Massachusetts Municipal Wholesale Electric Company dated May 28, 1976 (Exhibit 10-16(c), File No. 2-57831); Seventh Amendment To and Restated Agreement for Seabrook Project Disbursing Agent (Exhibit 10(j) to 1991 Form 10-K, File No. 1-3446); Amendments dated as of June 29, 1992 (Exhibit 10(j) to 1992 Form 10-K, File No. 1-3446); Seabrook Project Managing Agent Operating Agreement dated as of June 29, 1992, and amendment to Seabrook Project Managing Agent Agreement dated as of June 29, 1992 (Exhibit 10(j) to 1992 Form 10-K, File No. 1-3446). (k) Vermont Yankee Nuclear Power Corporation et al. and New England Power Company: Capital Funds Agreement dated February 1, 1968, Amendment dated March 12, 1968, and Power Purchase Contract dated February 1, 1968 (Exhibit 4-6, File No. 2-29145); Amendments dated as of June 1, 1972 and April 15, 1983 (Exhibit 10(k) to 1983 Form 10-K, File No. 1-3446) and April 24, 1985 (Exhibit 10(k) to 1985 Form 10-K, File No. 1-3446); Amendment dated as of June 1, 1985 (Exhibit 10(k) to 1987 Form 10-K, File No. 1-3446); Amendments dated as of May 6, 1988 (Exhibit 10(k) to 1988 Form 10-K, File No. 1-3446); Amendment dated as of June 15, 1989 (Exhibit 10(k) to 1989 Form 10-K, File No. 1-3446); Additional Power Contract dated as of February 1, 1984 (Exhibit 10(k) to 1983 Form 10-K, File No. 1-3446); Guarantee Agreement dated as of November 5, 1981 (Exhibit 10(j) to 1981 Form 10-K, File No. 1-3446). (l) Yankee Atomic Electric Company et al. and New England Power Company: Amended and Restated Power Contract dated April 1, 1985 (Exhibit 10(l) to 1985 Form 10-K, File No. 1-3446); Amendment dated May 6, 1988 (Exhibit 10(l) to 1988 Form 10-K, File No. 1-3446); Amendments dated as of June 26, 1989 and July 1, 1989 (Exhibit 10 (l) to 1989 Form 10-K, File No. 1-3446); Amendment dated as of February 1, 1992 (Exhibit 10(l) to 1992 Form 10-K, File No. 1- 3446). *(m) New England Electric Companies' Deferred Compensation Plan as amended dated December 8, 1986 (Exhibit 10(m) to 1986 Form 10-K, File No. 1-3446). *(n) New England Electric System Companies Retirement Supplement Plan as amended dated April 1, 1991 (Exhibit 10(n) to 1991 Form 10-K, File No. 1-3446). *(o) New England Electric Companies' Executive Supplemental Retirement Plan as amended dated April 1, 1991 (Exhibit 10(o) to 1991 Form 10-K, File No. 1-3446). *(p) New England Electric Companies' Incentive Compensation Plan as amended dated January 1, 1992 (Exhibit 10(q) to 1992 Form 10-K, File No. 1-3446). *(q) New England Electric Companies' Senior Incentive Compensation Plan as amended dated November 26, 1991 (Exhibit 10(q) to 1991 Form 10-K, File No. 1- 3446). *(r) New England Electric Companies' Incentive Compensation Plan II as amended dated September 3, 1992 (Exhibit 10(r) to 1992 Form 10-K, File No. 1-3446). *(s) New England Electric System Directors Deferred Compensation Plan as amended dated November 24, 1992 (Exhibit 10(s) to 1992 Form 10-K, File No. 1-3446). *(t) Forms of Life Insurance Program (Exhibit 10(s) to 1986 Form 10-K, File No. 1-3446); and Form of Life Insurance (Collateral Assignment) (Exhibit 10(t) to 1991 Form 10-K, File No. 1-3446). (u) New England Power Company and New England Hydro-Transmission Electric Company, Inc. et al: Phase II Massachusetts Transmission Facilities Support Agreement dated as of June 1, 1985 (Exhibit 10(t) to 1986 Form 10-K, File No. 1-3446); Amendment dated as of May 1, 1986 (Exhibit 10(t) to 1986 Form 10-K, File No. 1-3446); Amendments dated as of February 1, 1987, June 1, 1987, September 1, 1987, and October 1, 1987 (Exhibit 10(u) to 1987 Form 10-K, File No. 1-3446); Amendment dated as of August 1, 1988 (Exhibit 10(u) to 1988 Form 10-K, File No. 1-3446); Amendment dated January 1, 1989 (Exhibit 10(u) to 1990 Form 10-K, File No. 1-3446). (v) New England Power Company and New England Hydro-Transmission Corporation et al: Phase II New Hampshire Transmission Facilities Support Agreement dated as of June 1, 1985 (Exhibit 10(u) to 1986 Form 10-K, File No. 1-3446); Amendment dated as of May 1, 1986 (Exhibit 10(u) to 1986 Form 10-K, File No. 1-3446); Amendments dated as of February 1, 1987, June 1, 1987, September 1, 1987, and October 1, 1987 (Exhibit 10(v) to 1987 Form 10-K, File No. 1-3446); Amendment dated as of August 1,1988 (Exhibit 10(v) to 1988 Form 10-K, File No. 1-3446); Amendments dated January 1, 1989 and January 1, 1990 (Exhibit 10(v) to 1990 Form 10-K, File No. 1-3446). (w) New England Power Company et al: Phase II New England Power AC Facilities Support Agreement dated as of June 1, 1985 (Exhibit 10(v) to 1986 Form 10-K, File No. 1-3446); Amendment dated as of May 1, 1986 (Exhibit 10(v) to 1986 Form 10-K, File No. 1-3446); Amendments dated as of February 1, 1987, June 1, 1987, and September 1, 1987 (Exhibit 10(w) to 1987 Form 10-K, File No. 1-3446); Amendment dated as of August 1, 1988 (Exhibit 10(w) to 1988 Form 10-K, File No. 1-3446). (x) New England Hydro-Transmission Electric Company, Inc. and New England Electric System et al: Equity Funding Agreement dated as of June 1, 1985 (Exhibit 10(w) to 1986 Form 10-K, File No. 1-3446); Amendment dated as of May 1, 1986 (Exhibit 10(w) to 1986 Form 10-K, File No. 1-3446); Amendment dated as of September 1, 1987 (Exhibit 10(x) to 1987 Form 10-K, File No. 1-3446); Amendment dated as of August 1, 1988 (Exhibit 10(x) to 1988 Form 10-K, File No. 1-3446). (y) New England Hydro-Transmission Corporation and New England Electric System et al: Equity Funding Agreement dated as of June 1, 1985 (Exhibit 10(x) to 1986 Form 10-K, File No. 1-3446); Amendment dated as of May 1, 1986 (Exhibit 10(x) to 1986 Form 10-K, File No. 1-3446); Amendment dated as of September 1, 1987 (Exhibit 10(y) to 1987 Form 10-K, File No. 1-3446); Amendment dated as of August 1, 1988 (Exhibit 10(y) to 1988 Form 10-K, File No. 1-3446). (aa) Ocean State Power, et al., and Narragansett Energy Resources Company: Equity Contribution Agreement dated as of December 29, 1988 (Exhibit 10(aa) to 1988 Form 10-K, File No. 1-3446); Amendment dated as of September 29, 1989 (Exhibit 10 (aa) to 1989 Form 10-K File No. 1-3446); Ocean State Power, et al., and New England Electric System: Equity Contribution Support Agreement dated as of December 29, 1988 (Exhibit 10(aa) to 1988 Form 10-K, File No. 1-3446); Amendment dated as of September 29, 1989 (Exhibit 10 (aa) to 1989 Form 10-K, File No. 1-3446); Ocean State Power II, et al., and Narragansett Energy Resources Company:Equity Contribution Agreement dated as of September 29, 1989 (Exhibit 10 (aa) to 1989 Form 10-K File No. 1-3446); Ocean State Power II, et al., and New England Electric System: Equity Contribution Support Agreement dated as of September 29, 1989 (Exhibit 10 (aa) to 1989 Form 10-K File No. 1-3446). *(bb) New England Power Service Company and Joan T. Bok: Service Credit Letter dated October 21, 1982 (Exhibit 10(cc) to 1992 Form 10-K, File No. 1-3446). *(cc) New England Electric System and John W. Rowe: Service Credit Letter dated December 5, 1988 (Exhibit 10(dd) to 1992 Form 10-K, File No. 1-3446). *(dd) New England Power Service Company and the Company: Form of Supplemental Pension Service Credit Agreement (Exhibit 10(ee) to 1992 Form 10-K, File No. 1-3446). * Compensation related plan, contract, or arrangement. (13) 1993 Annual Report to Shareholders (filed herewith). (18) Coopers & Lybrand Preferability Letter dated February 25, 1994 (filed herewith). (22) Subsidiary list appears in Part I of this document. (25) Power of Attorney (filed herewith). NEP --- (3) (a) Articles of Organization as amended through June 27, 1987 (Exhibit 3(a) to 1988 Form 10-K, File No. 0-1229). (b) By-laws of the Company as amended June 25, 1987 (Exhibit 3 to 1987 Form 10-K, File No. 0-1229). (4) General and Refunding Mortgage Indenture and Deed of Trust dated as of January 1, 1977 and nineteen supplements thereto (Exhibit 4(b) to 1980 Form 10-K, File No. 0-1229; Exhibit 4(b) to 1982 Form 10-K, File No. 0-1229; Exhibit 4(b) to 1983 Form 10-K, File No. 0-1229; Exhibit 4(b) to 1985 Form 10-K, File No. 0-1229; Exhibit 4(b) to 1986 Form 10-K, File No. 0-1229; Exhibit 4(b) to 1986 Form 10-K, File No. 0-1229; Exhibit 4(b) to 1988 Form 10-K, File No. 0-1229; Exhibit 4(c)(ii) to 1989 NEES Form 10-K, File No. 1-3446; Exhibit 4(c)(ii) to 1990 NEES Form 10-K, File No. 1-3446; Exhibit 4(c)(ii) to 1991 NEES Form 10-K, File No. 1-3446; Exhibit 4(c)(ii) to 1992 NEES Form 10-K, File No. 1-3446; Exhibit 4(c) to 1993 NEES Form 10-K, File No. 1-3446). (10) Material Contracts (a) Boston Edison Company et al. and the Company: Amended REMVEC Agreement dated August 12, 1977 (Exhibit 5-4(d), File No. 2-61881). (b) The Connecticut Light and Power Company et al. and the Company: Sharing Agreement for Joint Ownership, Construction and Operation of Millstone Unit No. 3 dated as of September 1, 1973, and Amendment dated as of August 1, 1974 (Exhibit 10-5, File No. 2-52820); Amendments dated as of December 15, 1975 and April 1, 1986 (Exhibit 10(b) to NEES' 1990 Form 10-K File No. 1-3446). Transmission Support Agreement dated August 9, 1974; Instrument of Transfer to the Company with respect to the 1979 Connecticut Nuclear Unit, and Assumption of Obligations, dated December 17, 1975 (Exhibit 10-6(b), File No. 2-57831). (c) Connecticut Yankee Atomic Power Company et al. and the Company: Stockholders Agreement dated July 1, 1964 (Exhibit 13-9-A, File No. 2-2006); Power Purchase Contract dated July 1, 1964 (Exhibit 13-9-B, File No. 2-23006); Supplementary Power Contract dated as of April 1, 1987 (Exhibit 10(c) to 1987 Form 10-K, File No. 0-1229); Capital Funds Agreement dated September 1, 1964 (Exhibit 13-9-C, File No. 2-23006); Transmission Agreement dated October 1, 1964 (Exhibit 13-9-D, File No. 2-23006); Agreement revising Transmission Agreement dated July 1, 1979 (Exhibit to NEES' 1979 Form 10-K, File No. 1-3446); Five Year Capital Contribution Agreement dated November 1, 1980 (Exhibit 10(e) to NEES' 1980 Form 10-K, File No. 1-3446); Guarantee Agreement dated as of November 13, 1981 (Exhibit 10(d) to NEES' 1981 Form 10-K, File No. 1-3446); Guarantee Agreement dated as of August 1, 1985 (Exhibit 10(c) to NEES' 1985 Form 10-K, File No. 1-3446). (d) Maine Yankee Atomic Power Company et al. and the Company: Capital Funds Agreement dated May 20, 1968 and Power Purchase Contract dated May 20, 1968 (Exhibit 4-5, File No. 2-29145); Amendments dated as of January 1, 1984, March 1, 1984 (Exhibit 10(d) to NEES' 1983 Form 10-K, File No. 1-3446); October 1, 1984, and August 1, 1985 (Exhibit 10(d) to NEES' 1985 Form 10-K, File No. 1-3446); Stockholders Agreement dated May 20, 1968 (Exhibit 10-20; File No. 2-34267); Additional Power Contract dated as of February 1, 1984 (Exhibit 10(d) to NEES' 1985 Form 10-K, File No. 1-3446); Guarantee Agreement dated as of September 23, 1985 (Exhibit 10(d) to NEES' 1985 Form 10-K, File No. 1-3446). (e) Mass. Electric and the Company: Primary Service for Resale dated February 15, 1974 (Exhibit 5-17(a), File No. 2-52969); Amendment of Service Agreement dated June 22, 1983 (Exhibit 10(b) to Mass. Electric's 1986 Form 10-K, File No. 0-5464); Amendment of Service Agreement effective November 1, 1993 (filed herewith). (f) The Narragansett Electric Company and the Company: Primary Service for Resale dated February 15, 1974 (Exhibit 4-1(b), File No. 2-51292); Amendment of Service Agreement dated July 26, 1990 (Exhibit 4(f) to New England Power Company's 1990 Form 10-K, File No. 0-1229). Amendment of Service Agreement dated July 24, 1991 (Exhibit 10(f) to 1991 Form 10-K, File No. 0-1229); Amendment of Service Agreement effective November 1, 1993 (filed herewith). (g) Time Charter between Intercoastal Bulk Carriers, Inc., and New England Power Company dated as of December 27, 1989 (Exhibit 10(g) to 1989 Form 10-K, File No. 1-3446). (h) New England Electric Transmission Corporation et al. and the Company: Phase I Terminal Facility Support Agreement dated as of December 1, 1981 (Exhibit 10(g) to NEES' 1981 Form 10-K, File No. 1-3446); Amendments dated as of June 1, 1982 and November 1, 1982 (Exhibit 10(f) to NEES' 1982 Form 10-K, File No. 1-3446); Agreement with respect to Use of the Quebec Interconnection dated as of December 1, 1981 (Exhibit 10(g) to NEES' 1981 Form 10-K, File No. 1-3446); Amendments dated as of May 1, 1982 and November 1, 1982 (Exhibit 10(f) to NEES' 1982 Form 10-K, File No. 1-3446); Amendment dated as of January 1, 1986 (Exhibit 10(f) to NEES' 1986 Form 10-K, File No. 1-3446); Agreement for Reinforcement and Improvement of the Company's Transmission System dated as of April 1, 1983 (Exhibit 10(f) to NEES' 1983 Form 10-K, File No. 1-3446); Lease dated as of May 16, 1983 (Exhibit 10(f) to NEES' 1983 Form 10-K, File No. 1-3446); Upper Development-Lower Development Transmission Line Support Agreement dated as of May 16, 1983 (Exhibit 10(f) to NEES' 1983 Form 10-K, File No. 1-3446). (i) Vermont Electric Transmission Company, Inc. et al. and the Company: Phase I Vermont Transmission Line Support Agreement dated as of December 1, 1981; Amendments dated as of June 1, 1982 and November 1, 1982 (Exhibit 10(g) to NEES' 1982 Form 10-K, File No. 1-3446); Amendment dated as of January 1, 1986 (Exhibit 10(h) to NEES' 1986 Form 10-K, File No. 1-3446). (j) New England Energy Incorporated and the Company: Fuel Purchase Contract dated July 26, 1979, and Amendment dated August 26, 1981 (Exhibit 10(f)(iii) to NEES' 1981 Form 10-K, File No. 1-3446); Amendment dated March 26, 1985, and Amendment effective January 1, 1984 (Exhibit 10(e)(iii) to NEES' 1985 Form 10-K, File No. 1-3446); Amendment dated as of April 28, 1989 (Exhibit 10(e)(iii) to 1989 NEES Form 10-K, File No. 1-3446). (k) New England Power Pool Agreement: (Exhibit 4(e), File No. 2-43025); Amendments dated July 1, 1972, March 1, 1973 (Exhibit 10-15, File No. 2-48543);Amendment dated March 15, 1974 (Exhibit 10-5, File No. 2-52775); Amendment dated June 1, 1975 (Exhibit 10-14, File No. 2-57831); Amendment dated September 1, 1975 (Exhibit 10-13, File No. 2-59182); Amendments dated December 31, 1976, January 31, 1977, July 1, 1977, and August 1, 1977 (Exhibit 10-16, File No. 2-61881); Amendments dated August 15, 1978, January 3, 1980, and February 1980 (Exhibit 10-3, File No. 2-68283); Amendment dated September 1, 1981 (Exhibit 10(h) to NEES' 1981 Form 10-K, File No. 1-3446); Amendment dated December 1, 1981 (Exhibit 10(h) to NEES' 1982 Form 10-K, File No. 1-3446); Amendments dated June 1, 1982, June 15, 1983, and October 1, 1983 (Exhibit 10(i) to NEES' 1983 Form 10-K, File 1-3446); Amendments dated August 1, 1985, August 15, 1985, September 1, 1985, and January 1, 1986 (Exhibit 10(i) to NEES' 1985 Form 10-K, File No. 1-3446); Amendment dated September 1, 1986 (Exhibit 10(i) to NEES' 1986 Form 10-K, File No. 1-3446); Amendment dated April 30, 1987 (Exhibit 10(i) to NEES' 1987 Form 10-K, File No. 1-3446); Amendments dated March 1, 1988 and May 1, 1988 (Exhibit 10(i) to NEES' 1988 Form 10-K, File No. 1-3446); Amendment dated March 15, 1989 (Exhibit 10(i) to 1989 NEES Form 10-K, File No. 1-3446); Amendment dated October 1, 1990 (Exhibit 10 (i) to 1990 NEES Form 10-K, File No. 1-3446); Amendment dated October 1, 1990 Exhibit 10(i) to 1990 NEES Form 10-K, File No. 1-3446); Amendment dated as of September 15, 1992 (Exhibit 10(i) to 1992 NEES Form 10-K, File No. 1-3446). (l) New England Power Service Company and the Company: Specimen of Service Contract (Exhibit 10(l) to 1988 Form 10-K, File No. 0-1229). (m) Public Service Company of New Hampshire et al. and the Company: Agreement for Joint Ownership, Construction and Operation of New Hampshire Nuclear Units dated as of May 1, 1973; Amendments dated May 24, 1974, June 21, 1974, September 25, 1974 and October 25, 1974 (Exhibit 10-18(b), File No. 2-52820); Amendment dated January 31, 1975 (Exhibit 10-16(b), File No. 2-57831); Amendments dated April 18, 1979, April 25, 1979, June 8, 1979, October 11, 1979, December 15, 1979, June 16, 1980, and December 31, 1980 (Exhibit 10(i) to NEES' 1980 Form 10-K, File No. 1-3446); Amendments dated June 1, 1982, April 27, 1984, and June 15, 1984 (Exhibit 10(j) to NEES' 1984 Form 10-K, File No. 1-3446); Amendments dated March 8, 1985, March 14, 1986, May 1, 1986, and September 19, 1986 (Exhibit 10(j) to NEES' 1986 Form 10-K, File No. 1-3446); Amendment dated November 12, 1987 (Exhibit 10(j) to NEES' 1987 Form 10-K, File No. 1-3446); Amendment dated January 13, 1989 (Exhibit 10(j) to NEES' 1990 Form 10-K, File No. 1-3446); Seventh Amendment as of November 1, 1990 (Exhibit 10(m) to NEES' 1991 Form 10-K, File No. 1-3446). Transmission Support Agreement dated as of May 1, 1973 (Exhibit 10-23, File No. 2-49184); Instrument of Transfer to the Company with respect to the New Hampshire Nuclear Units and Assumptions of Obligations dated December 17, 1975 and Agreement Among Participants in New Hampshire Nuclear Units, certain Massachusetts Municipal Systems and Massachusetts Municipal Wholesale Electric Company dated May 28, 1976 (Exhibit 16(c), File No. 2-57831); Seventh Amendment To and Restated Agreement for Seabrook Project Disbursing Agent dated as of November 1, 1990 (Exhibit 10(m) to NEES' 1991 Form 10-K, File No. 1-3446); Amendments dated as of June 29, 1992 (Exhibit 10(j) to NEES' 1992 Form 10-K, File No. 1- 3446). Settlement Agreement dated as of July 19, 1990 between Northeast Utilities Service Company and the Company (Exhibit 10(m) to NEES' 1991 Form 10-K, File No. 1-3446). Seabrook Project Managing Agent Operating Agreement dated as of June 29, 1992, Amendment to Seabrook Project Managing Agent Operating Agreement dated as of June 29, 1992 (Exhibit 10(j) to NEES' 1992 Form 10-K, File No. 1- 3446). (n) Vermont Yankee Nuclear Power Corporation et al. and the Company: Capital Funds Agreement dated February 1, 1968, Amendment dated March 12, 1968 and Power Purchase Contract dated February 1, 1968 (Exhibit 4-6, File No. 2-29145); Amendments dated as of June 1, 1972, April 15, 1983 (Exhibit 10(k) to NEES' 1983 Form 10-K, File No. 0-1229) and April 24, 1985 (Exhibit 10(n) to NEES' 1985 Form 10-K, File No. 1-3446); Amendment dated as of June 1, 1985 (Exhibit 10(n) to 1988 Form 10-K, File No. 0-1229); Amendments dated May 6, 1988 (Exhibit 10(n) to 1988 Form 10-K, File No. 0-1229); Amendment dated as of June 15, 1989 (Exhibit 10(k) to 1989 NEES Form 10-K, File No. 1-3446); Additional Power Contract dated as of February 1, 1984 (Exhibit 10(k) to NEES' 1983 Form 10-K, File No. 1-3446); Guarantee Agreement dated as of November 5, 1981 (Exhibit 10(j) to NEES' 1981 Form 10-K, File No. 1-3446). (o) Yankee Atomic Electric Company et al. and the Company: Amended and Restated Power Contract dated April 1, 1985 (Exhibit 10(l) to NEES' 1985 Form 10-K, File No. 1-3446); Amendment dated May 6, 1988 (Exhibit 10(l) to NEES' 1988 Form 10-K, File No. 1-3446); Amendments dated as of June 26, 1989 and July 1, 1989 (Exhibit 10(l) to 1989 NEES Form 10-K, File No. 1-3446); Amendment dated as of February 1, 1992 (Exhibit 10(l) to 1992 NEES Form 10-K, File No. 1-3446). *(p) New England Electric Companies' Deferred Compensation Plan as amended dated December 8, 1986 (Exhibit 10(m) to NEES' 1986 Form 10-K, File No. 1-3446). *(q) New England Electric System Companies Retirement Supplement Plan as amended dated April 1, 1991 (Exhibit 10(n) to NEES' 1991 Form 10-K, File No. 1-3446). *(r) New England Electric Companies' Executive Supplemental Retirement Plan as amended dated April 1, 1991 (Exhibit 10(o) to NEES' 1991 Form 10-K, File No. 1-3446). *(s) New England Electric Companies' Incentive Compensation Plan as amended dated January 1, 1992 (Exhibit 10(p) to NEES' 1992 Form 10-K, File No. 1-3446); New England Electric Companies' Senior Incentive Compensation Plan as amended dated November 26, 1991 (Exhibit 10(q) to NEES' 1991 Form 10-K, File No. 1-3446). *(t) Forms of Life Insurance Program: (Exhibit 10(s) to NEES' 1986 Form 10-K, File No. 1-3446); and Form of Life Insurance (Collateral Assignment) (Exhibit 10(t) to NEES' 1991 Form 10-K, File No. 1-3446). *(u) New England Electric Companies' Incentive Compensation Plan II as amended dated September 1, 1992 (Exhibit 10 (r) to NEES' 1992 Form 10-K, File No. 1-3446). (v) New England Hydro-Transmission Electric Company, Inc. et al. and the Company: Phase II Massachusetts Transmission Facilities Support Agreement dated as of June 1, 1985 (Exhibit 10(t) to NEES' 1986 Form 10-K, File No. 1-3446); Amendment dated as of May 1, 1986 (Exhibit 10(t) to NEES' 1986 Form 10-K, File No. 1-3446); Amendments dated as of February 1, 1987, June 1, 1987, September 1, 1987, and October 1, 1987 (Exhibit 10(u) to NEES' 1987 Form 10-K, File No. 1-3446); Amendment dated as of August 1, 1988 (Exhibit 10(u) to NEES' 1988 Form 10-K, File No. 1-3446); Amendment dated January 1, 1989 (Exhibit 10 (u) to NEES' 1990 Form 10-K, File No. 1-3446). (w) New England Hydro-Transmission Corporation et al. and the Company: Phase II New Hampshire Transmission Facilities Support Agreement dated as of June 1, 1985 (Exhibit 10(u) to NEES' 1986 Form 10-K, File No. 1-3446); Amendment dated as of May 1, 1986 (Exhibit 10(u) to NEES' 1986 Form 10-K, File No. 1-3446); Amendments dated as of February 1, 1987, June 1, 1987, September 1, 1987, and October 1, 1987 (Exhibit 10(v) to NEES' 1987 Form 10-K, File No. 1-3446). Amendment dated as of August 1, 1988 (Exhibit 10(v) to NEES' 1988 Form 10-K, File No. 1-3446); Amendments dated January 1, 1989 and January 1, 1990 (Exhibit 10 (v) to NEES' 1990 Form 10-K, File No. 1-3446). (x) Vermont Electric Power Company et al. and the Company: Phase II New England Power AC Facilities Support Agreement dated as of June 1, 1985 (Exhibit 10(v) to NEES' 1986 Form 10-K, File No. 1-3446); Amendment dated as of May 1, 1986 (Exhibit 10(v) to NEES' 1986 Form 10-K, File No. 1-3446). Amendments dated as of February 1, 1987, June 1, 1987, and September 1, 1987 (Exhibit 10(w) to NEES' 1987 Form 10-K, File No. 1-3446); Amendment dated as of August 1, 1988 (Exhibit 10(w) to NEES' 1988 Form 10-K, File No. 1-3446). (y) TransCanada Pipelines Limited and the Company: Firm Service Contract for Firm Transportation Service for natural gas dated as of January 6, 1992; Amendments dated as of March 2, 1992 and October 30, 1992 (Exhibit 10(y) to 1992 Form 10-K, File No. 0-1229). (z) TransCanada Pipelines Limited and the Company: Firm Service Contract for Firm Transportation Service for natural gas dated as of October 30, 1992 (Exhibit 10(z) to 1992 Form 10-K, File No. 0-1229). (aa) Algonquin Gas Transmission Company and the Company: X-38 Service Agreement for Firm Transportation of natural gas dated July 3, 1992; Amendment dated July 31, 1992 (Exhibit 10(aa) to 1992 Form 10-K, File No. 0-1229). (bb) ANR Pipeline Company and the Company: Gas Transportation Agreement dated July 18, 1990 (Exhibit 10(bb) to 1992 Form 10-K, File No. 0-1229). (cc) Columbia Gas Transmission Corporation and the Company: Service Agreement for Service under FTS Rate Schedule dated June 13, 1991 (filed herewith). (dd) Iroquois Gas Transmission System, L.P. and the Company: Gas Transportation Contract for Firm Reserved Service dated as of June 5, 1991 (Exhibit 10(dd) to 1992 Form 10-K, File No. 0-1229). (ee) Tennessee Gas Pipeline Company and the Company: Firm Natural Gas Transportation Agreement dated July 9, 1992 (Exhibit 10(ee) to 1992 Form 10-K, File No. 0-1229). *(ff) New England Power Service Company and Joan T. Bok: Service Credit Letter dated October 21, 1982 (Exhibit 10(cc) to 1992 NEES Form 10-K, File No. 1-3446). *(gg) New England Electric System and John W. Rowe: Service Credit Letter dated December 5, 1988 (Exhibit 10(dd) to 1992 NEES Form 10-K, File No. 1-3446). *(hh) New England Power Service Company and the Company: Form of Supplemental Pension Service Credit Agreement (Exhibit 10(ee) to 1992 NEES Form 10-K, File No. 1-3446). * Compensation related plan, contract, or arrangement. (12) Statement re computation of ratios for incorporation by reference into NEP registration statements on Form S-3, Commission File Nos. 33-48257, 33-48897, and 33-49193 (filed herewith). (13) 1993 Annual Report to Stockholders (filed herewith). (22) Subsidiary list (filed herewith). (25) Power of Attorney (filed herewith). Mass. Electric -------------- (3) (a) Articles of Organization of the Company as amended March 5, 1993, August 11, 1993, September 20, 1993, and November 15, 1993 (filed herewith). (b) By-Laws of the Company as amended February 4, 1993, July 30, 1993, and September 15, 1993 (filed herewith). (4) First Mortgage Indenture and Deed of Trust, dated as of July 1, 1949, and twenty supplements thereto (Exhibit 7-A, File No. 1-8019; Exhibit 7-B, File No. 2-8836; Exhibit 4-C, File No. 2-9593; Exhibit 4 to 1980 Form 10-K, File No. 2-8019; Exhibit 4 to 1982 Form 10-K, File No. 0-5464; Exhibit 4 to 1986 Form 10-K, File No. 0-5464); Exhibit 4 to 1988 Form 10-K, File No. 0-5464; Exhibit 4(a) to 1989 NEES Form 10-K, File No. 1-3446; Exhibit 4(a) to 1992 NEES Form 10-K, File No. 1-3446; Exhibit 4(a) to 1993 NEES Form 10-K, File No. 1-3446). (10) Material Contracts (a) Boston Edison Company et al. and Company: Amended REMVEC Agreement dated August 12, 1977 (Exhibit 5-4(d), File No. 2-61881). (b) New England Power Company and the Company: Primary Service for Resale dated February 15, 1974 (Exhibit 5-17(a), File No. 2-52969); Amendment of Service Agreement dated July 22, 1983 (Exhibit 10(b) to 1986 Form 10-K, File No. 0-5464); Amendment of Service Agreement effective November 1, 1993 (Exhibit 10(e) to 1993 NEP Form 10-K, File No. 0- 1229). (c) New England Power Pool Agreement: (Exhibit 4(e), File No. 2-43025); Amendments dated July 1, 1972, and March 1, 1973 (Exhibit 10-15, File No. 2-48543); Amendment dated March 15, 1974 (Exhibit 10-5, File No. 2-52775); Amendment dated June 1, 1975 (Exhibit 10-14, File No. 2-57831); Amendment dated September 1, 1975 (Exhibit 10-13, File No. 2-59182); Amendments dated December 31, 1976, January 31, 1977, July 1, 1977, and August 1, 1977 (Exhibit 10-16, File No. 2-61881); Amendments dated August 15, 1978, January 3, 1980, and February 1980 (Exhibit 10-3, File No. 2-68283); Amendment dated September 1, 1981 (Exhibit 10(h) to NEES' 1981 Form 10-K, File No. 1-3446); Amendment dated as of December 1, 1981 (Exhibit 10(h) to NEES' 1982 Form 10-K, File No. 1-3446); Amendments dated June 1, 1982, June 15, 1983, and October 1, 1983 (Exhibit 10(i) to NEES' 1983 Form 10-K, File No. 1-3446); Amendments dated August 1, 1985, August 15, 1985, September 1, 1985, and January 1, 1986 (Exhibit 10(i) to NEES' 1985 Form 10-K, File No. 1-3446); Amendment dated September 1, 1986 (Exhibit 10(i) to NEES' 1986 Form 10-K, File No. 1-3446); Amendments dated April 30, 1987 (Exhibit 10(i) to NEES' 1987 Form 10-K, File No. 1-3446); Amendments dated March 1, 1988 and May 1, 1988 (Exhibit 10(i) to NEES' 1988 Form 10-K, File No. 1-3446); Amendment dated March 15, 1989 (Exhibit 10(i) to 1989 NEES Form 10-K, File No. 1-3446). Amendment dated October 1, 1990 (Exhibit 10(i) to 1990 NEES Form 10-K, File No. 1-3446); Amendment dated as of September 15, 1992 (Exhibit 10(i) to 1992 NEES Form 10-K, File No. 1-3446). (d) New England Power Service Company and the Company: Specimen of Service Contract (Exhibit 10(d) to 1988 Form 10-K, File No. 0-5464). (e) New England Telephone and Telegraph Company and the Company: Specimen of Joint Ownership Agreement for Wood Poles (Exhibit 4(e), File No. 2-24458). *(f) New England Electric Companies' Deferred Compensation Plan as amended dated December 8, 1986 (Exhibit 10(m) to NEES' 1986 Form 10-K, File No. 1-3446). *(g) New England Electric System Companies Retirement Supplement Plan as amended dated April 1, 1991 (Exhibit 10(n) to NEES' 1991 Form 10-K, File No. 1-3446). *(h) New England Electric Companies' Executive Supplemental Retirement Plan as amended dated April 1, 1991 (Exhibit 10(o) to NEES' 1991 Form 10-K, File No. 1-3446). *(i) New England Electric Companies' Incentive Compensation Plan as amended dated January 1, 1992 (Exhibit 10(p) to NEES' 1992 Form 10-K, File No. 1-3446). *(j) New England Electric Companies' Form of Deferred Compensation Agreement for Directors (Exhibit 10(p) to NEES' 1980 Form 10-K, File No. 1-3446). *(k) New England Electric Companies' Senior Incentive Compensation Plan as amended dated November 26, 1991 (Exhibit 10(q) to NEES' 1991 Form 10-K, File No. 1-3446). *(l) Forms of Life Insurance Program: (Exhibit 10(s) to NEES' 1986 Form 10-K, File No. 1-3446); and Form of Life Insurance (Collateral Assignment) (Exhibit 10(t) to NEES' 1991 Form 10-K, File No. 1-3446). *(m) New England Electric Companies' Incentive Compensation Plan II as amended dated September 1, 1992 (Exhibit 10(r) to NEES' 1992 Form 10-K, File No. 1-3446). *(n) New England Power Service Company and the Company: Form of Supplemental Pension Service Credit Agreement (Exhibit 10(ee) to 1992 NEES Form 10-K, File No. 1-3446). * Compensation related plan, contract, or arrangement. (12) Statement re computation of ratios for incorporation by reference into the Mass. Electric registration statement on Form S-3, Commission File No. 33-49251 (filed herewith). (13) 1993 Annual Report to Stockholders (filed herewith). (18) Coopers & Lybrand Preferability Letter dated February 25, 1994 (Exhibit 18 to 1993 NEES Form 10-K, File No. 1-3446). (25) Power of Attorney (filed herewith). Narragansett ------------ (3) (a) Articles of Incorporation as amended June 9, 1988 (Exhibit 3(a) to 1988 Form 10-K, File No. 0-898). (b) By-Laws of the Company (Exhibit 3 to 1980 Form 10-K, File No. 0-898). (4) (a) First Mortgage Indenture and Deed of Trust, dated as of September 1, 1944, and twenty-one supplements thereto (Exhibit 7-1, File No. 2-7042; Exhibit 7-B, File No. 2-7490; Exhibit 4-C, File No. 2-9423; Exhibit 4-D, File No. 2-10056; Exhibit 4 to 1980 Form 10-K, File No. 0-898; Exhibit 4 to 1982 Form 10-K, File No. 0-898; Exhibit 4 to 1983 Form 10-K, File No. 0-898; Exhibit 4 to 1985 Form 10-K, File No. 0-898; Exhibit 4 to 1986 Form 10-K, File No. 0-898; Exhibit 4 to 1987 Form 10-K, File No. 0-898; Exhibit 4(b) to 1991 NEES Form 10-K, File No. 1-3446; Exhibit 4(b) to 1992 NEES Form 10-K, File No. 1-3446; Exhibit 4(b) to 1993 NEES Form 10-K, File No. 1-3446). (b) The Narragansett Electric Company Preference Provisions, as amended, dated March 23, 1993 (Exhibit 4(c) to 1993 NEES Form 10-K, File No. 1- 3446). (10) Material Contracts (a) Boston Edison Company et al. and the Company: Amended REMVEC Agreement dated August 12, 1977 (Exhibit 5-4(d), File No. 2-61881). (b) New England Power Company and the Company: Primary Service for Resale dated February 15, 1974 (Exhibit 4-1(b), File No. 2-51292); Amendment of Service Agreement dated July 26, 1990 (Exhibit 10(f) to 1990 NEP Form 10-K, File No. 0-1229); Amendment of Service Agreement dated July 24, 1991 (Exhibit 4(f) to 1991 NEP Form 10-K, File No. 0-1229); Amendment of Service Agreement effective November 1, 1993 (Exhibit 10(f) to 1993 NEP Form 10-K, File No. 0-1229). (c) New England Power Pool Agreement: (Exhibit 4(e), File No. 2-43025); Amendments dated July 1, 1972, and March 1, 1973 (Exhibit 10-15, File No. 2-48543); Amendment dated March 15, 1974 (Exhibit 10-5, File No. 2-52775); Amendment dated June 1, 1975 (Exhibit 10-14, File No. 2-57831); Amendment dated September 1, 1975 (Exhibit 10-13, File No. 2-59182); Amendments dated December 31, 1976, January 31, 1977, July 1, 1977, and August 1, 1977 (Exhibit 10-16, File No. 2-61881); Amendments dated August 15, 1978, January 3, 1980, and February 1980 (Exhibit 10-3, File No. 2-68283); Amendment dated September 1, 1981 (Exhibit 10(h) to NEES' 1981 Form 10-K, File No. 1-3446); Amendment dated December 1, 1981 (Exhibit 10(h) to NEES' 1982 Form 10-K, File No. 1-3446); Amendments dated June 1, 1982, June 15, 1983, and October 1, 1983 (Exhibit 10(i) to NEES' 1983 Form 10-K, File No. 1-3446); Amendments dated August 1, 1985, August 15, 1985, September 1, 1985, and January 1, 1986 (Exhibit 10 (i) to NEES' 1985 Form 10-K, File No. 1-3446); Amendment dated September 1, 1986 (Exhibit 10(i) to NEES' 1986 Form 10-K, File No. 1-3446); Amendment dated April 30, 1987 (Exhibit 10(i) to NEES' 1987 Form 10-K, File No. 1-3446); Amendments dated March 1, 1988 and May 1, 1988 (Exhibit 10(i) to NEES' 1988 Form 10-K, File No. 1-3446); Amendment dated March 15, 1989 (Exhibit 10(i) to 1989 NEES Form 10-K, File No. 1-3446). Amendment dated October 1, 1990 (Exhibit 10(i) to 1990 NEES' Form 10-K, File No. 1-3446); Amendment dated as of September 15, 1992 (Exhibit 10(i) to NEES' 1992 Form 10-K, File No. 1-3446. (d) New England Power Service Company and the Company: Specimen of Service Contract (Exhibit 10(d) to 1989 Form 10-K, File No. 0-898). (e) New England Telephone and Telegraph Company and the Company: Specimen of Joint Ownership Agreement for Wood Poles (Exhibit 3(d), File No. 2-24458). *(f) New England Electric Companies' Deferred Compensation Plan for Officers, as amended December 8, 1986 (Exhibit 10(m) to NEES' 1986 Form 10-K, File No. 1-3446). *(g) New England Electric System Companies Retirement Supplement Plan, as amended April 1, 1991 (Exhibit 10(n) to NEES' 1991 Form 10-K, File No. 1-3446). *(h) New England Electric Companies' Executive Supplemental Retirement Plan, as amended dated April 1, 1991 (Exhibit 10(o) to NEES' 1991 Form 10-K, File No. 1-3446). *(i) New England Companies' Incentive Compensation Plan, as amended dated January 1, 1992 (Exhibit 10(p) to NEES' 1992 Form 10-K, File No. 1-3446). *(j) New England Electric Companies' Form of Deferred Compensation Agreement for Directors (Exhibit 10(p) to NEES' 1980 Form 10-K, File No. 1-3446). *(k) New England Electric Companies' Senior Incentive Compensation Plan as amended dated November 26, 1991 (Exhibit 10(q) to NEES' 1991 Form 10-K, File No. 1-3446). *(l) Forms of Life Insurance Program (Exhibit 10(s) to NEES' 1986 Form 10-K, File No. 1-3446); and Form of Life Insurance (Collateral Assignment) (Exhibit 10(t) to NEES' 1991 Form 10-K, File No. 1-3446). *(m) New England Electric Companies' Incentive Compensation Plan II as amended dated September 1, 1992 (Exhibit 10(r) to NEES' 1992 Form 10-K, File No. 1-3446). *(n) New England Power Service Company and the Company: Form of Supplemental Pension Service Credit Agreement (Exhibit 10(ee) to 1992 NEES Form 10-K, File No. 1-3446). * Compensation related plan, contract, or arrangement. (12) Statement re computation of ratios for incorporation by reference into the Narragansett registration statement on Form S-3, Commission File No. 33-45052 (filed herewith). (13) 1993 Annual Report to Stockholders (filed herewith). (25) Power of Attorney (filed herewith). Financial Statement Schedules See Index to Financial Statements and Financial Statement Schedules for NEES, NEP, Mass. Electric, and Narragansett on pages 100, 109, 115, and 121, respectively. Reports on Form 8-K NEES ---- NEES filed reports on Form 8-K dated October 14, 1993 and November 30, 1993, both of which contained Item 5. NEP --- None. Mass. Electric -------------- Mass. Electric filed reports on Form 8-K dated October 14, 1993 and November 30, 1993, both of which contained Item 5. Narragansett ------------ None. NEW ENGLAND ELECTRIC SYSTEM 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. NEW ENGLAND ELECTRIC SYSTEM* s/John W. Rowe John W. Rowe President and Chief Executive Officer March 28, 1994 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. (Signature and Title) Principal Executive Officer s/John W. Rowe John W. Rowe President and Chief Executive Officer Principal Financial Officer s/Alfred D. Houston Alfred D. Houston Executive Vice President and Chief Financial Officer Principal Accounting Officer s/Michael E. Jesanis Michael E. Jesanis Treasurer Directors (a majority) Joan T. Bok Paul L. Joskow John M. Kucharski Edward H. Ladd Joshua A. McClure s/John G. Cochrane Malcolm McLane All by: Felix A. Mirando, Jr. John G. Cochrane John W. Rowe Attorney-in-fact George M. Sage Charles E. Soule Anne Wexler James Q. Wilson James R. Winoker Date (as to all signatures on this page) March 28, 1994 *The name "New England Electric System" means the trustee or trustees for the time being (as trustee or trustees but not personally) under an agreement and declaration of trust dated January 2, 1926, as amended, which is hereby referred to, and a copy of which as amended has been filed with the Secretary of the Commonwealth of Massachusetts. Any agreement, obligation or liability made, entered into or incurred by or on behalf of New England Electric System binds only its trust estate, and no shareholder, director, trustee, officer or agent thereof assumes or shall be held to any liability therefor. NEW ENGLAND POWER COMPANY 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. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company. NEW ENGLAND POWER COMPANY s/Jeffrey D. Tranen Jeffrey D. Tranen President 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. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company. (Signature and Title) Principal Executive Officer s/Jeffrey D. Tranen Jeffrey D. Tranen President Principal Financial Officer s/Michael E. Jesanis Michael E. Jesanis Treasurer Principal Accounting Officer s/Howard W. McDowell Howard W. McDowell Controller Directors (a majority) Joan T. Bok Frederic E. Greenman Alfred D. Houston s/John G. Cochrane John W. Newsham All by: John W. Rowe John G. Cochrane Jeffrey D. Tranen Attorney-in-fact Date (as to all signatures on this page) March 28, 1994 MASSACHUSETTS ELECTRIC COMPANY 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. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company. MASSACHUSETTS ELECTRIC COMPANY s/John H. Dickson John H. Dickson President 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. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company. (Signature and Title) Principal Executive Officer s/John H. Dickson John H. Dickson President Principal Financial Officer s/Michael E. Jesanis Michael E. Jesanis Treasurer Principal Accounting Officer s/Howard W. McDowell Howard W. McDowell Controller Directors (a majority) Urville J. Beaumont Joan T. Bok Sally L. Collins John H. Dickson s/John G. Cochrane Charles B. Housen All by: Kathryn A. McCarthy John G. Cochrane Patricia McGovern Attorney-in-fact John F. Reilly John W. Rowe Richard P. Sergel Richard M. Shribman Roslyn M. Watson Date (as to all signatures on this page) March 28, 1994 THE NARRAGANSETT ELECTRIC COMPANY 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. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company. THE NARRAGANSETT ELECTRIC COMPANY s/Robert L. McCabe Robert L. McCabe President 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. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company. (Signature and Title) Principal Executive Officer s/Robert L. McCabe Robert L. McCabe President Principal Financial Officer s/Alfred D. Houston Alfred D. Houston Vice President and Treasurer Principal Accounting Officer s/Howard W. McDowell Howard W. McDowell Controller Directors (a majority) Joan T. Bok Stephen A. Cardi Frances H. Gammell s/John G. Cochrane Joseph J. Kirby All by: Robert L. McCabe John G. Cochrane John W. Rowe Attorney-in-fact Richard P. Sergel William E. Trueheart John A. Wilson, Jr. Date (as to all signatures on this page) March 28, 1994 CONSENT OF INDEPENDENT ACCOUNTANTS We consent to the incorporation by reference in the registration statements of New England Electric System on Form S-3 of the Dividend Reinvestment and Common Share Purchase Plan (File No. 33-12313) and on Forms S-8 of the New England Electric System Companies Employees' Share Ownership Plan (File No. 2-89648), the New England Electric System Companies Incentive Thrift Plan (File No. 33-26066), the New England Electric System Companies Incentive Thrift Plan II (File No. 33-35470), the NEES Goals Program (File No. 2-94447) and the Yankee Atomic Electric Company Thrift Plan (File No. 2-67531) of our reports dated February 25, 1994 on our audits of the consolidated financial statements and financial statement schedules of New England Electric System and subsidiaries as of December 31, 1993 and 1992 and for each of the three years in the period ended December 31, 1993, which reports are incorporated by reference or included in this Annual Report on Form 10-K. We also consent to the incorporation by reference in the registration statements of New England Power Company on Forms S-3 (File Nos. 33-48257, 33-48897, and 33-49193), Massachusetts Electric Company on Form S-3 (File No. 33-49251) and The Narragansett Electric Company on Form S-3 (File No. 33-45052) of our reports dated February 25, 1994 on our audits of the financial statements and financial statement schedules of New England Power Company, Massachusetts Electric Company and The Narragansett Electric Company, respectively, as of December 31, 1993 and 1992 and for each of the three years in the period ended December 31, 1993, which reports are incorporated by reference or included in this Annual Report on Form 10-K. s/ Coopers & Lybrand Boston, Massachusetts COOPERS & LYBRAND March 25, 1994 REPORT OF INDEPENDENT ACCOUNTANTS Our reports on the consolidated financial statements of New England Electric System and subsidiaries and on the financial statements of certain of its subsidiaries, listed in item 14 herein, which financial statements and reports are included in the respective 1993 Annual Reports to Shareholders, have been incorporated by reference in this Form 10K. In connection with our audits of such financial statements, we have also audited the related financial statement schedules listed in Item 14 herein. In our opinion, the financial statement schedules referred to above, when considered in relation to the corresponding basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. s/ Coopers & Lybrand Boston, Massachusetts COOPERS & LYBRAND February 25, 1994 NEW ENGLAND ELECTRIC SYSTEM AND SUBSIDIARIES CONSOLIDATED --------------------------------------------------------- SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION Year Ended December 31, 1993, 1992, and 1991

1993 ITEM 1. BUSINESS. GENERAL Worthen Banking Corporation (hereinafter referred to as "WBC", "Company" or "Registrant" and includes WBC's subsidiaries and affiliates unless the context otherwise requires), was incorporated in the State of Arkansas in August 1968 to buy, sell, own and operate banks and to offer a diversified range of commercial banking, trust and other financial services to retail and commercial customers. The Company is the second largest multi-bank holding company in Arkansas with corporate headquarters located in the Worthen National Bank Building in Little Rock, Arkansas. Operations of the Company are conducted through bank and nonbank subsidiaries and affiliates. The existing and future activities of the Company are limited by the Bank Holding Company Act of 1956, as amended, which generally prohibits a bank holding company from acquiring or engaging in any businesses other than banking, managing or controlling banks, and furnishing or performing certain bank related services and activities. The Company is primarily engaged in buying, selling, owning, managing and operating commercial banks and other financial services companies and its subsidiaries are primarily engaged in the commercial banking, trust and securities brokerage businesses. The income and other operating results of the nonbank subsidiaries and affiliates as compared to the consolidated operating results of the Company, are not substantial enough to require financial and other information concerning industry segments to be included in this Annual Report on Form 10-K. The Company commenced active operations in March, 1969 with the acquisition of a controlling interest in Worthen National Bank of Arkansas, Little Rock, Arkansas ("WNBA") and became a multi-bank holding company upon the acquisition of a controlling interest in Worthen National Bank of Hot Springs, Arkansas ("WNB-Hot Springs") in October, 1970. In 1971, the Arkansas legislature enacted a law prohibiting the acquisition of additional banks, which law remained in effect until the passage of Act 128 of 1983, the Arkansas Bank Holding Company Act of 1983. Act 128, which permits the acquisition of additional banks in accordance with certain guidelines, became effective September 30, 1983. During fiscal year 1993, WBC owned eleven banks, which were located in Arkansas and the Austin, Texas area. All of these are national banks, chartered pursuant to the laws of the United States. Since its organization and commencement of operations, WBC's revenues and net income or net losses have resulted principally from its banking subsidiaries. In addition to commercial banking, WBC also provides, through its subsidiaries and affiliates, mortgage banking, appraisal services, trust services, credit life and disability insurance, investment advisory services, full service and discount brokerage services, data processing and other related financial services. On May 7, 1993, Worthen Banking Corporation acquired 100% of the stock of The Union of Arkansas Corporation ("Union") with the issuance of 4,550,000 shares of WBC common stock to the Union stockholders. Union's principal subsidiary bank, Union National Bank of Arkansas ("Union-Little Rock"), was merged with WNBA on May 28, 1993. Union-Little Rock was a commercial bank with approximately $595 million in assets, $482 million in deposits and $54 million in equity operating from twenty-two locations in central and southern Arkansas and had two mortgage banking subsidiaries. Union's only other banking subsidiary was Union National Bank of Texas ("Union-Texas") operating out of six locations in Austin, Texas. Union-Texas had approximately $120 million in assets, $112 million in deposits and $6 million in equity at December 31, 1992. Union-Texas has been renamed Worthen National Bank of Texas. This transaction was accounted for using the pooling-of-interests method of accounting. On September 10, 1993, the Company acquired 100% of First Bentonville Bancshares, Inc., the parent corporation of First Bank of Bentonville, Arkansas ("FirstBank"). WBC paid approximately $3.9 million in cash, $4.1 million in debt repayment and 250,000 newly-issued shares of WBC's common stock. For the year ended December 31, 1992, FirstBank reported total assets of $88,546,000, net interest income of $2,826,000 and net income of $805,000. FirstBank was merged into Worthen National Bank of Northwest Arkansas on October 31, 1993. This acquisition was accounted for as a purchase and the results of operations of FirstBank are included in the Company's consolidated financial statements from the date of purchase. Each subsidiary of the Company operates with a high degree of autonomy. WBC, as the corporate parent, provides various technical and advisory services and establishes general policy for the management and coordination of the resources of its subsidiaries to more effectively service the credit and financial services needs of the subsidiaries' customers and communities. The Company coordinates the activities of its subsidiaries in certain areas, including without limitation, credit policy, accounting, internal auditing, regulatory compliance, loan review, investment coordination, asset/liability management, public relations, and business development. However, the subsidiaries operate under the direct supervision and day-to-day management of their own directors and officers who formulate their own policies subject to the Company's general policy guidelines and regulatory compliance. WBC's principal sources of income are dividends and management service fees paid by its subsidiaries. Dividend payments are determined quarterly in relation to subsidiary income, assets, deposit growth and capital position in compliance with regulatory guidelines and, in certain cases, prior regulatory approval. Management service fees represent reimbursements received for services performed by the corporate parent. COMMERCIAL BANKING SUBSIDIARIES The Company's principal source of income is derived from its eleven subsidiary commercial banks and through certain of its nonbank subsidiaries. The main offices of these subsidiaries are located in Batesville, Camden, Conway, Fayetteville, Harrison, Hot Springs, Little Rock, Newark, Pine Bluff and Russellville, Arkansas and Austin, Texas. All offer a broad range of commercial bank services to the markets and communities which they serve, as well as provide other related financial services in a majority of locations. BANK RELATED SUBSIDIARIES AND AFFILIATES The Company's non-bank subsidiaries include: 1) a full service and discount brokerage company, which is a registered broker dealer and investment adviser, whose business is conducted at a majority of the Company's banking subsidiaries throughout the state; 2) a mortgage banking company whose business is originating and servicing mortgage loans; 3) a credit life insurance company which insures or reinsures credit life and accident and health insurance; 4) a data processing and operations support company which provides data processing and transmission services, item processing and similar functions for the Company's banking subsidiaries; 5) a trust company which provides trust administration and operations; 6) an appraisal company whose business is appraising property proposed to be offered as loan collateral; and 7) two small and relatively inactive companies related to industrial lending and real estate development. SUPERVISION AND REGULATION The following summaries of statutes and regulations affecting bank holding companies and their commercial banking subsidiaries do not purport to be complete but are given to provide a general overview. The summaries are qualified in their entirety by reference to the provisions of the statutes and regulations summarized. STATE USURY LAW Prior to its amendment in 1982, the Constitution of the State of Arkansas limited the rate of interest which could be charged on borrowed funds to 10% per annum simple interest, and provided for forfeiture of principal and interest in the event that a greater amount of interest was charged or received. The effect of that constitutional limitation had been mitigated to some extent by Public Law 96-221 (the "Deregulation Act") under which the United States Congress, pursuant to the Supremacy Clause of the United States Constitution, pre-empted state constitutions and state usury laws in regard to business-and agricultural loans over $1,000 in amount and in regard to first mortgage residential real estate loans. Under the Deregulation Act, WBC's lending affiliates were permitted to make business and agricultural loans at 5% over the applicable Federal Reserve Bank discount rate and first mortgage residential real estate loans without any percentage limitation. The usury pre-emptive provisions of the Deregulation Act expired generally on April 15, 1985, although loans made prior to that date continue to be governed by the provisions of the Deregulation Act The first mortgage real estate loan preemption in the Deregulation Act continues in effect and will constitute a permanent preemption of the Constitution of the State of Arkansas in regard to first mortgage residential real estate loans. In 1982, The Interest Rate Control Amendment ("Constitutional Amendment") to the Constitution of the State of Arkansas was adopted, which provides, in summary, that "consumer loans and credit sales" have a maximum percentage limitation of 17% per annum and that all "general loans" have a maximum limitation of 5% over the Federal Reserve Discount Rate in effect at the time the loan was made. In 1983, the Arkansas Supreme Court determining that "consumer loans and credit sales" are "general loans" and are subject to the limitation of 5% over the Federal Reserve Discount Rate, as well as a maximum limitation of 17% per annum. The Constitutional Amendment also provided penalties for usurious "general loans" and "consumer loans and credit sales," including forfeiture of all principal and interest on consumer loans and credit sales made at a greater rate of interest than 17% per annum, and, on "general loans" made at usurious rates, forfeiture of uncollected interest and refund to the borrower of twice the interest collected. The relative importance of the Arkansas usury laws and federal pre-emption thereof to the financial operations of WBC varies from time to time, depending on a number of factors, including general economic conditions and prevailing interest rates. Limitations on the interest earnings of WBC subsidiary banks occur during periods of high interest rates. The effect of such limitations cannot be accurately predicted because of the factors mentioned above. The Texas usury law establishes different usury limits for various types of loans. These interest rate limits may vary from time to time. The interest rate limitations currently in effect are more than sufficient when compared to prevailing interest rates. STATE REGULATION The Arkansas Bank Holding Company Act of 1983 permits Arkansas bank holding companies to own and control multiple banks and subjects Arkansas bank holding companies to regulation by the Arkansas State Bank Department. Under Arkansas law, bank holding companies are limited to owning or controlling banks having in the aggregate no more than 25% of the total deposits held by all state and national banks in Arkansas. For purposes of this limitation, deposits include all individual, partnership, and corporate deposits, but not correspondent accounts of banks or the fluids of national, state, or local government authorities. The Arkansas State Bank Department ("ASBD") is authorized to administer the provisions of the Arkansas Bank Holding Company Act and to determine those activities of bank holding companies that it deems to be "directly related to banking activities." Under current interpretations and regulations of the ASBD, permissible non-banking activities under the Bank Holding Company Act of 1956, as amended, are given due consideration as being "directly related to banking activities" under the Arkansas Act. During 1988, the Arkansas General Assembly passed Act 539 which authorized county-wide and eventually statewide branching and regional interstate banking effective January 1, 1989. Unlimited branching in contiguous counties will be allowed beginning alter 1993 while unlimited statewide branching will become effective after 1998. The Texas Banking Code permits an "out-of state" bank holding company to acquire control of a bank located in the state of Texas, if such bank received a charter and was continually operated for at least five years prior to the acquisition, and subjects the "out-of state" bank holding company to the supervision and regulation by the Banking Department of Texas. On January 29, 1993, the Company entered into an agreement with the Banking Department of Texas as required by the Texas Banking Code. Pursuant to the agreement, the Company represented that Worthen National Bank of Texas ("Worthen-Texas") would comply with applicable capital adequacy guidelines and that the consolidated equity capital of Worthen-Texas during the first three years after the acquisition will at all times equal or exceed the dollar level existing immediately prior to the acquisition. The Company further agreed that a majority of the board of directors of Worthen-Texas will reside in the state of Texas, that it would not acquire an institution located in the state of Texas, the deposits of which are insured by the Federal Deposit Insurance Corporation, unless the institution is a bank as defined by the Bank Holding Company Act of 1956, as amended, and that additional information or reports would be filed with the Banking Department of Texas upon request. Under the Texas Banking Code an "out-of state" bank holding company is limited in that it can not control more than 25% of the total deposits of all state and national banks domiciled in the state of Texas. For purpose of this limitation, the term "deposit" is given the meaning assigned to that term in Section 23 of the Federal Deposit Insurance Act, as amended. ARKANSAS CORPORATE CODE In 1987, the Arkansas General Assembly passed the Arkansas Business Corporation Act of 1987 (the "1987 Act"), which was signed into law on April 14, 1987, and which became effective January 1, 1988. As a compromise to the passage of the 1987 Act, the General Assembly included a provision allowing existing Arkansas corporations to continue to be governed by the present corporate code (the "1965 Act"), unless a corporation affirmatively elected to be governed under the 1987 Act The 1987 Act provides that existing Arkansas corporations, such as WBC, may elect to be governed by its provisions upon receiving requisite stockholder approval and further that such an election, once made, is irrevocable. On February 23, 1988, WBC's stockholders adopted and approved various proposals, including a proposal to amend and restate the Articles of Incorporation adopting the 1987 Act as the corporate law which shall govern the affairs of WBC. WBC's Amended and Restated Articles of Incorporation were subsequently filed with the Arkansas Secretary of State and became effective February 24, 1988. Upon the filing of the Amended and Restated Articles of Incorporation, the 1987 Act became the applicable state corporate code governing the affairs of WBC. The 1987 Act was based primarily upon the American Bar Association's Model Business Corporation Act as substantially revised in 1984 and was legislated in partly the need to update and modernize the law affectIng Arkansas corporations. In general as compared to the 1965 Act, the 1987 Act is thought to be more flexible, easier to understand, and to permit corporations to avail themselves of many modern financIng techniques and management procedures not available under the 1965 Act. The 1987 Act should result in more predictable judicial interpretations by Arkansas courts. BANK HOLDING COMPANY ACT OF 1956, AS AMENDED WBC is a bank holding company within the meaning of the Bank Holding Company Act of 1956, as amended ("BHC Act"), and is registered as such with the Board of Governors of the Federal Reserve System("FRB"). As a bank holding company, WBC is required to file with the FRB an annual report and such additional information as the FRB may require pursuant to the BHC Act The FRB also periodically examines WBC and each of its subsidiaries. Under the terms of the BHC Act, WBC, as a bank holding company, is generally required to obtain regulatory approval from the FRB before it may acquire or dispose of a substantial interest in any bank or bank holding company. With certain exceptions, the BHC Act further restricts nonbanking acquisitions by registered bank holding companies to shares of companies whose activities the FRB deems to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. In making such determinations, the FRB is required to consider whether the performance of such activities by an affiliate can reasonably be expected to produce benefits to the public, such as increased competition or gains in efficiency, against the risks of possible adverse effects, such as undue concentration of resources, decreased or unfair competition, conflicts of interest or unsound banking practices. The FRB has determined by regulation that certain activities, including among others making and servicing loans, operating an industrial loan institution, performing certain fiduciary functions, leasing real and personal property, providing certain investment and financing advice and brokerage services, performing certain data processing operations, acting as an insurance agent for certain types of insurance, and underwriting credit life and disability insurance related to credit transactions within the particular holding company system, among others, are permissible activities for bank holding companies and their affiliates. Further the BHC Act and regulations of the FRB prohibit bank holding companies, such as WBC, from engaging in certain tie-in arrangements in connection with extensions of credit, lease or sale transactions or the furnishing of services. RISK-BASED CAPITAL GUIDELINES On January 19, 1989, the FRB issued final guidelines to implement risk-based capital requirements for bank holding companies. The guidelines establish a systematic analytical framework that makes regulatory capital requirements more sensitive to differences in risk profiles among banking organizations, takes off-balance sheet exposures into account in assessing capital adequacy, and minimizes disincentives to holding liquid, low-risk assets. The Company's year end 1993 total risk based capital ratio of 14.11% exceeds the current minimum regulatory requirement of 8.00%. FEDERAL RESERVE ACT The FRB has cease-and-desist powers over parent holding companies and nonbanking subsidiaries where actions of such holding companies and nonbanking subsidiaries would constitute a serious threat to the safety, soundness or stability of a subsidiary bank. The FRB also has authority to regulate debt obligations, other thin commercial paper, issued by bank holding companies. The Company is an "affiliate" of its subsidiary banking institutions and will be an "affiliate" of any other acquired banks within the meaning of the Federal Reserve Act The Federal Reserve Act imposes restrictions on loans by the subsidiary banks to WBC or to any other affiliated companies, on investments by the subsidiary banks in the securities of WBC, and on the use of such securities as collateral security for loans by subsidiary banks to any borrower. WBC is also subject to certain restrictions with respect to engaging in the business of issuing, underwriting, public sale and distribution of securities. In the event that WBC's subsidiary banks experience significant loan losses or rapid growth of loans or deposits, WBC may, as the sole or majority shareholder, be required by regulatory authorities to invest additional capital in order to maintain the capital of each subsidiary bank at or above applicable regulatory minima. GENERAL The national bank subsidiaries of WBC are subject to supervision and regular examination by the Office of the Comptroller of the Currency ("OCC"). All of WBC's subsidiary banks are members of the Federal Deposit Insurance Corporation ("FDIC") which currently insures the deposits of each member bank to a maximum of $100,000 per deposit relationship. For this protection, each bank pays a semi-annual statutory assessment to the FDIC and is subject to the rules and regulations of the FDIC and to examinations by the FDIC. WBC and its subsidiaries (including bank-related subsidiaries) are also subject to examinations and regulation by the FRB under provisions of the Bank Holding Company Act of 1956, as amended, and WBC is required to file annual reports with the FRB and the ASBD, annual and other periodic reports with the United States Securities and Exchange Commission, and to file such additional reports as the FRB may require pursuant to that Act. The bank subsidiaries and their affiliates are subject to various state and federal statutes and regulations governing capital, reserves, deposits, investments, loans, mergers, issuance of securities, dividends, establishment of branches, brokerage and investment advisory services and other aspects of their operations. The approval of the OCC is required if the total of all dividends declared by the Board of Directors of any national bank subsidiary in any calendar year exceeds the total of the respective bank's net income for that year combined with retained net profit for the preceding two years, less any transfers to surplus. Various bills and regulations including the Financial Institutions Regulatory and Interest Rate Control Act of 1978, the Depository Institutions Deregulation and Monetary Control Act of 1980, the Garn-St. Germain Depository Institutions Act of 1982, the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 and the Federal Deposit Insurance Corporation Improvement Act of 1991 have been enacted or adopted, and other legislation is being considered in the United States Congress and various other governmental regulatory and legislative bodies which could result in additional regulation affecting WBC and its subsidiaries and otherwise affect the powers of banks, bank holding companies, and bank-related companies. MONETARY POLICY The monetary policy of the FRB has a significant effect on the operating results of bank holding companies and their subsidiary banks as a result of its controlling influence upon the national supply and cost of bank credit. The FRB implements monetary policy principally through open market operations in U.S. Government securities, changes in the discount rate on member bank borrowings, and change in reserve requirements against member bank deposits. These means are used in varying combinations to influence overall growth and distribution of bank loans, investments and deposits, and their use affects interest rates charged on loans or paid for deposits. The policies of the FRB have a direct effect on the amount of bank loans and deposits and the interest rates charged and paid thereon. FRB monetary policies have materially affected the operating results of commercial banks in the past and are expected to continue to do so in the future. WBC's financial statements reflect the various effects of monetary policies. The nature of future monetary policies and the effect of such policies on the future business and earnings of WBC cannot be accurately predicted; however, such economic policies can materially affect the revenues and net income of commercial banks. PATENTS, SEASONALITY OF BUSINESS AND CUSTOMERS Patents or trademarks are not material to the conduct of the Company's business. Historically, the business of the Company has not been seasonal in nature nor does management of WBC anticipate any differences or seasonal trends in the future. Although certain depositors and loan customers are important to the Company's banking subsidiaries, the Company is not dependent upon any single customer or a few customers, the loss of any one or more of which would have a material adverse effect on the financial condition or results of operations of the Company on a consolidated basis. COMPETITION The activities engaged in by WBC and its subsidiaries are highly competitive. With each activity engaged in, the Company encounters intense competition from other banks, lending institutions, credit unions, savings and loan associations, brokerage firms, mortgage companies, industrial loan associations, finance companies, and several other financial and financial service institutions. The amount of competition has increased significantly over the past few years since the deregulation of the banking industry. The Company's subsidiary banks actively compete with other banks and financial institutions in their efforts to obtain deposits and make loans, in the scope and type of services offered, in interest rates paid on time deposits and charged on loans and in other aspects of commercial banking. They are also in competition with major international retail establishments, brokerage firms and other financial institutions within and outside Arkansas. Competition with these financial institutions is expected to increase, especially with the passage of legislation authorizing interstate banking. According to information obtained from the Arkansas Association of Bank Holding Companies, during 1993 there were approximately 34 multi-bank holding companies in Arkansas and an approximate 104 additional single bank holding companies. As of December 31, 1993, the Company was the second largest multi-bank holding company in Arkansas in terms of total assets and total deposits. EMPLOYEES As of December 31, 1993, the Company and its subsidiaries employed 2,252 persons. None of the employees are represented by any union or similar groups and the Company has not experienced any labor disputes or strikes arising from any such organized labor groups. The Company considers its relationship with its employees to be good. EXECUTIVE OFFICERS OF THE REGISTRANT As of March 16, 1994, the executive officers of the Registrant are as follows: SERVED AS AN CURRENT TITLE EXECUTIVE NAME AND POSITION AGE OFFICER SINCE - ---- ------------ --- ------------- Curtis F. Bradbury, Jr. Chairman, President 44 1985 and Chief Executive Officer of WBC and Chairman and Chief Executive Officer of WNBA Andrew T. Melton Executive Vice 47 1986 President, Chief Financial Officer and Treasurer James C. Patridge Executive Vice 43 1987 President SERVED AS AN CURRENT TITLE EXECUTIVE NAME AND POSITION AGE OFFICER SINCE - ---- ------------ --- ------------- Michael F. Heald Senior Vice President 34 1988 and Director of Audit William G. Hobbs Senior Vice President 44 1986 Asset/Liability and Funds Management Alan C. King Senior Vice President, 42 1987 Controller and Chief Accounting Officer Gary A. Rickenbach Senior Vice President 36 1988 Director of Loan Review and Mergers and Acquisitions Gary L. Smith Senior Vice President and 40 1985 Assistant to the Chairman The Executive Officers are elected and employed by WBC's Board of Directors to serve for terms set from time to time by the Board in its discretion until re-elected or replaced. Each executive officer has held the same position or another executive position with the Company or one of its subsidiaries during the past five years. In addition to the foregoing persons, executive officers of the Company's banking subsidiaries are members of a committee that exercises certain policy making functions. Therefore, although not employed by or occupying officer positions with the Company, they may for certain purposes be deemed as "executive officers." As of March 16, 1994, the persons occupying such positions include: Dale E. Cole, Worthen National Bank, Batesville and Worthen National Bank of Newark; Edwin M Horton, Worthen National Bank of South Arkansas; Marlin D. Jackson and Frank Oldham, Worthen National Bank of Conway; Brooks H. Morris, Worthen National Bank of Harrison; David Bartlett, Worthen National Bank of Hot Springs; Thomas Spillyards, Worthen National Bank of Pine Bluff; Robert Y. Taylor, Worthen Bank National Bank of Russellville; James F. Stobaugh and Rick L. Parsons, Worthen National Bank of Northwest Arkansas; and John I. Fleischauer, Jr., Worthen National Bank of Arkansas. With the guidance of the Board of Directors and executive management of the Company, each of these persons is employed by the Boards of Directors of the respective banking subsidiaries to serve for terms set from time to time by such Boards until re-elected or replaced. SELECTED STATISTICAL INFORMATION The information required in response to this portion of Item 1 is incorporated by reference from the disclosures contained in the Registrant's 1993 Annual Report to Stockholders, portions of which are included herein as Exhibit 13. ITEM 2. ITEM 2. PROPERTIES. The principal offices of the Company and its largest subsidiary, WNBA, are located in the Worthen National Bank of Arkansas building at 200 West Capitol Avenue in downtown Little Rock, Arkansas. The building is owned by WNBA. The Company and its banking subsidiaries maintain 119 locations throughout the State of Arkansas and the Austin, Texas area. The majority of these offices are owned by the respective subsidiary banks. In the opinion of management of the Company, the physical properties of the Company and its subsidiaries are adequate and fully utilized. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. In the ordinary course of business, there are various legal proceedings pending against the Company, its subsidiaries and affiliates, most of which are considered litigation incidental to the conduct of business, including, among other matters, defense of routine corporate, employment, banking, lender liability and securities related litigation. Management, after consultation with legal counsel and based upon available facts and proceedings to date which are preliminary in certain instances, is of the opinion that the ultimate resolution of these proceedings will have no material adverse effect on the consolidated financial position of the Company. However, certain matters disclosed in this Annual Report on Form 10-K for the fiscal year ended December 31, 1993, may be considered to be material in amount or nature. In January of 1993, the Company, its directors, and certain of its officers and shareholders were sued in the United States District Court for the Southern District of New York, in WINICKI V. WORTHEN BANKING CORPORATION, ET AL.. 93-CIV-0135. The complaint alleged that the defendants violated Section 14(a) of the Securities Exchange Act of 1934 ("Exchange Act"), Rule 14a-9 of the Securities and Exchange Commission ("SEC" or "Commission"), and certain state law provisions relating to fiduciary duties in connection with the matters disclosed in the Company's proxy statement distributed in December of 1992. The complaint was filed as a class action and sought an injunction to prevent the Company from holding a special meeting or from consummating certain transactions which were the subject of the proxy statement, and unspecified monetary damages. The Company has denied all material allegations in the complaint and in January 1993, the parties entered into a Memorandum of Understanding ("MOU") under which the Company agreed to distribute revised disclosure material to its shareholders and not to oppose an application by plaintiff's counsel for fees in an agreed amount. On January 21, 1994, the Court provisionally certified a class for purposes of settlement. The settlement remains subject to Court approval following a fairness hearing at which class members may raise any objections to the settlement. Notice of the settlement was sent to class members beginning on February 9, 1994, and a fairness hearing is scheduled for April 5, 1994. On March 31, 1993, the Board of Governors of the Federal Reserve System ("FED") advised WBC that the Company's application to merge The Union of Arkansas Corporation with a subsidiary of WBC had been approved. The FED approved the merger, in part, in reliance upon representations and commitments made to the FED by the Company, by Stephens Group, Inc. and by certain Stephens family members. These included a representation that Stephens Group, Inc. does not and will not exert control over the management and policies of WBC and that Stephens Group, Inc. and its subsidiaries will comply with the restrictions imposed by Sections 23A and 23B of the Federal Reserve Act. Management believes that such representations and commitments will not materially affect the Company's general business policies, financial condition, or results of operations. The Company has also been advised that the FED has made a determination that Stephens Group, Inc. and its affiliates, are affiliates of the Company, as that term is defined in Sections 23A and 23B of the Federal Reserve Act. The Board of Governors also notified the Company on March 31, 1993 that the Board of Governors had ordered an investigation to review the ownership and control of the Company for compliance with the Bank Holding Company Act and the Change in Bank Control Act, including the nature and extent of the relationships between the Company and Stephens Group, Inc. and its subsidiaries. The Company is not aware of any assertion by the Board of Governors that the Company is not in compliance with the Bank Holding Company Act or the Change in Bank Control Act. In the event the Board of Governors determines that there has been a violation of the Bank Holding Company Act, it is authorized to initiate certain administrative enforcement actions against the Company and its institution-affiliated parties. These actions could include, among other things, the issuance of an order to cease and desist or the assessment of monetary penalties against the Company or its institution-affiliated parties. The amount of such monetary penalties, if any, would be determined by the Board of Governors on the basis of the facts and circumstances surrounding the alleged violations and might or might not have a material adverse effect upon the Company's financial condition or results of operations. In addition, under regulations promulgated by the Board of Governors, in the event it determines that an impermissible control relationship exists, it would have discretion to order either termination of the impermissible control relationship, or the filing of an application seeking the approval of such control relationship, or to pursue other remedial actions. However, the Company cannot now predict the results or the final outcome of the investigation. The Company intends to continue to cooperate with the Board of Governors in this investigation. WILKINS V. UNION NATIONAL BANK Case No. 90 CH 9203, in the Circuit Court of Cook County, Illinois, County Department, Chancery Division. In September of 1990, plaintiffs Herbert L. Wilkins and Mary Wilkins sued Union National Bank ("Union") in a purported class action complaint which sought remedies against both Union and WNBA as successor of Union, including: (1) a declaration that Union's method of calculating escrow deposit requirements was unlawful, (2) refunds of excess escrow balances existing in mortgage escrow accounts (through application of such balances as prepayments of mortgage principal or through direct refunds), (3) payment of interest on excess escrow balances carried in such escrow accounts, (4) punitive damages in an unspecified amount, (5) an injunction prohibiting defendant from imposing excessive escrow requirements in the future, and (6) attorney's fees. Union and WNBA have denied all material allegations of the complaint. Management of WNBA believes that WNBA has valid and meritorious defenses to the allegations set forth in the complaint and intends to defend this matter vigorously unless a settlement satisfactory to WNBA can be reached. WNBA has reached a settlement agreement on a basis favorable to WNBA with counsel for plaintiffs. The settlement is subject to court approval, which has not yet been obtained. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. No vote of holders of securities issued by WBC was taken on any matter during the fourth quarter of 1993. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The information required in response to this Item is incorporated by reference from the disclosure contained under the caption "Earnings, Dividends and Price Range Per Share" on Page 21 of the Registrant's 1993 Annual Report to Stockholders. The last trade price for the Company's common stock on March 16, 1994 was $21.50. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The information required in response to this Item is incorporated by reference from the disclosure contained under the caption "Selected Financial Data" on page 7 of the Registrant's 1993 Annual Report to Stockholders. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information required in response to this Item is incorporated by reference from the disclosure contained under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 8 through 22 of the Registrant's 1993 Annual Report to Stockholders. ITEM 8 ITEM 8 FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information required in response to this Item, including the opinion of KPMG Peat Marwick, is incorporated by reference from the disclosures contained under the captions "Consolidated Financial Statements" and "Selected Quarterly Financial Data" on pages 23 through 45 and page 22, respectively, of the Registrant's 1993 Annual Report to Stockholders. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF ThE REGISTRANT. The information required in response to this Item is incorporated by reference from the Registrant's Definitive Proxy Statement which will be filed with the Securities and Exchange Commission no later than 120 days after the end of the 1993 fiscal year covered by this Annual Report on Form 10-K See also the caption "Executive Officers of the Registrant" under Item 1 of this Annual Report on Form lo-K ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. The information required in response to this Item is incorporated by reference from the Registrant's Definitive Proxy Statement which will be filed with the Securities and Exchange Commission no later than 120 days after the end of the 1993 fiscal year covered by this Annual Report on Form 10-K. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The information required in response to this Item is incorporated by reference from the Registrant's Definitive Proxy Statement which wall be filed with the Securities and Exchange Commission no later than 120 days after the end of the 1993 fiscal year covered by this Annual Report on Form 10-K. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The information required in response to this Item is incorporated by reference from the Registrant's Definitive Proxy Statement which will be filed with the Securities and Exchange Commission no later than 120 days after the end of the 1993 fiscal year covered by this Annual Report on Form 10-K. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. ITEM 14(a)(1) AND (2) WORTHEN BANKING CORPORATION AND SUBSIDIARIES LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULE The following consolidated financial statements and the report of independent auditors of Worthen Banking Corporation and subsidiaries for the year ended December 31, 1993 as required by Item 8, are: The report of independent auditors of The Union of Arkansas Corporation and subsidiaries for the years ended December 31, 1992 and 1991 is included as Exhibit 99 of the Exhibits in Item 14(a)(3). The following consolidated financial statement schedule of Worthen Banking Corporation and subsidiaries, including the independent auditors' report thereon, is included in Item 14(d): Schedule II - Guarantees of Securities of Other Issuers at December 31, 1993. Schedules other than those listed above (or columns omitted from the Schedule filed herein) required by Article 9 of Regulation S-X are not required under the related instructions or are inapplicable, and, therefore, have been omitted. ITEM 14(a)(3) - EXHIBITS The exhibits required by Item 601 of Regulation S-K which are required to be filed in response to this Item 14(a)(3) are submitted as a separate section of this Annual Report on Form 10-K under the caption "Exhibit Index." ITEM 14(b) - REPORTS ON FORM 8-K No current reports on Form 8-K were filed by the Company during the three months ended December 31, 1993. ITEM 14(c) - EXHIBITS The exhibits required by Item 601 of Regulation S-K which are required to be filed in response to this Item 14(c) are submitted as a separate section of this Annual Report on Form 10-K under the caption "Exhibit Index." ITEM 14(d) - FINANCIAL STATEMENT SCHEDULES The response to this portion of Item 14 is submitted as a separate section of this Annual Report on Form 10-K immediately following the signature pages of this Annual Report on Form 10-K. 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, there unto duly authorized, on the 30th day of March, 1993. WORTHEN BANKING CORPORATION By: \s\ Curtis F. Bradbury. Jr. --------------------------- Curtis F. Bradbury, Jr. Chairman, President and Chief Executive Officer POWER OF ATTORNEY Each person whose signature appears below hereby authorizes Curtis F. Bradbury, Jr., or Andrew T. Melton, to file one or more amendments to this Annual Report on Form 10-K, which amendments may make such changes, additions, deletions or modifications to the Annual Report on Form 10-K as they deem appropriate, and each such person hereby appoints Curtis F. Bradbury, Jr. or Andrew T. Melton as his lawful attorney-in-fact to execute in the name and on behalf of each such person individually, and in each capacity stated below, any such amendments to the Annual Report on Form 10-K. 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 dates indicated. SIGNATURE TITLE DATE /s/ Curtis F. Bradbury, Jr. Chief Executive Officer March 30, 1994 - -------------------------- and Director Curtis F. Bradbury, Jr. /s/ Andrew T. Melton Chief Financial Officer March 30, 1994 - --------------------------- Andrew T. Melton /s/ Alan C. King Controller and Chief March 30, 1994 - --------------------------- Accounting Officer Alan C. King /s/ James H. Atkins Director March 30, 1994 - --------------------------- James H. Atkins /s/ Gus M. Blass, II Director March 30, 1994 - --------------------------- Gus M. Blass, II /s/ Fred I. Brown, Jr. Director March 30, 1994 - --------------------------- Fred I. Brown, Jr. /s/Alex Dillard Director March 30, 1994 - --------------------------- Alex Dillard /s/ Michael T. Flynn Director March 30, 1994 - --------------------------- Michael T. Flynn /s/ Kaneaster Hodges, Jr. Director March 30, 1994 - --------------------------- Kaneaster Hodges, Jr. /s/T. Milton Honea Director March 30, 1994 - --------------------------- T.Milton Honea /s/George C. Kell Director March 30, 1994 - --------------------------- George C. Kell /s/Herbert H. McAdams. II Director March 30, 1994 - --------------------------- Herbert H. McAdams, II /s/Raymond P. Miller, M.D. Director March 30, 1994 - --------------------------- Raymond P. Miller, M.D. /s/A. Dan Phillips Director March 30, 1994 - --------------------------- A.Dan Phillips /s/Winthrop Paul Rockefeller Director March 30, 1994 - --------------------------- Winthrop Paul Rockefeller /s/David Solomon Director March 30, 1994 - --------------------------- David Solomon /s/Leland E. Tollett Director March 30, 1994 - --------------------------- Leland E. Tollett REPORT OF INDEPENDENT AUDITORS The Board of Directors and Stockholders Worthen Banking Corporation Under date of February 25, 1994, we reported on the consolidated balance sheet of Worthen Banking Corporation and Subsidiaries as of December 31, 1993 and the related consolidated statements of earnings, stockholders' equity and cash flows for the year then ended as contained in the 1993 Annual Report to Stockholders. These consolidated financial statements and our report thereon are incorporated by reference in the annual report on Form 10-K for the year 1993. In connection with our audit of the aforementioned consolidated financial statements, we have audited the financial statement schedule listed in the accompanying index. This financial statement schedule is the responsibility of the Company's management. Our responsibility is to express an opinion on the financial statement schedule based on our audit In our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein. /s/ KPMG Peat Marwick ----------------------------- KPMG PEAT MARWICK Little Rock, Arkansas February 25, 1994 SCHEDULE II GUARANTEES OF SECURITIES OF OTHER ISSUERS WORTHEN BANKING CORPORATION DECEMBER 31, 1993 EXHIBIT INDEX EXHIBIT NUMBER DESCRIPTION PAGE - -------------- ----------- ----- 3(a) Amended and Restated Articles of N/A Incorporation of Registrant (filed as Exhibit 3(a) to Registrant's Annual Report on Form 10-K for the year ended December 31, 1987 and incorporated by reference herein). 3(b) Amended and Restated Bylaws of Registrant N/A (filed as Exhibit 3 to Registrant's Quarterly Report on Form 10-Q for the period ended June 30, 1988 and incorporated by reference herein). 3(c) Amended and Restated Articles of Incorporation N/A (filed as Exhibit 3(i) to Registrant's Quarterly Report on Form 10-Q for the period ended June 30, 1993) incorporated by reference herein. 11 Statement of computation of per share N/A earnings (see Consolidated Financial Statements of the Registrant contained in the Registrant's 1993 Annual Report) which is included herein as Exhibit 13. 13 Pages 7 - 45 of the Registrant's 1993 Annual Report. --- 21 Subsidiaries of the Registrant. --- 23(a) Consent of KPMG Peat Marwick. --- 23(b) Consent of Frost and Company. 24 Power of Attorney (see Signature Page). 17 99 Report of independent auditors of The Union of --- Arkansas Corporation and subsidiaries for the years ended December 31, 1992 and 1991.

1993 ITEM 1. BUSINESS General. Weingarten Realty Investors (the "Company"), an unincorporated trust organized under the Texas Real Estate Investment Trust Act and its predecessor entity began the ownership and development of shopping centers and other commercial real estate in 1948. The Company, as of December 31, 1993, owned or had interests in 150 developed income-producing real estate projects, 134 of which were shopping centers, located in the Houston metropolitan area and in other parts of Texas and in Louisiana, Arkansas, Oklahoma, New Mexico, Arizona, Maine and Tennessee. The Company's other commercial real estate projects included twelve industrial projects, three multi-family housing properties and one office building, which serves as the Company's headquarters. The Company's interests in these projects aggregated approximately 15.0 million square feet of building area and 57.3 million square feet of land area. The Company also owned interests in 24 parcels of unimproved land held for future development which aggregated approximately 8.5 million square feet. The Company currently employs 153 persons, its principal executive offices are located at 2600 Citadel Plaza Drive, Houston, Texas 77008, and its phone number is (713) 866-6000. Reorganizations. In December 1984, the Company engaged in a series of transactions primarily designed to enable it to qualify as a real estate investment trust ("REIT") for federal income tax purposes for the 1985 calendar year and subsequent years. The Company contributed certain assets considered unsuitable for ownership by the Company as a REIT and $3.5 million in cash to WRI Holdings, Inc. ("Holdings"), a Texas corporation and a newly-formed subsidiary of the Company, in exchange for voting and non-voting common stock of Holdings (which was subsequently distributed to the Company's shareholders) and $26.8 million of mortgage bonds. For additional information concerning Holdings, refer to Note 8 of the Notes to Consolidated Financial Statements at page 25. On March 22, 1988, the Company's shareholders approved the conversion of the Company's form of organization from a Texas corporation to an unincorporated trust organized under the Texas Real Estate Investment Trust Act. The conversion was effected by the Company's predecessor entity, Weingarten Realty, Inc., transferring substantially all of its assets and liabilities to the newly-formed Company in exchange for common shares of beneficial interest, $.03 par value ("Common Shares"), in the Company. The shareholders of the corporation received Common Shares for their shares of Common Stock of the corporation (on a share- for-share basis), and the trust continues the business that was previously conducted by the corporation. The change did not affect the registrant's assets, liabilities, management or federal income tax status as a REIT. Management Services. Through December 31, 1992, the Company contracted with Weingarten Realty Management Company (the "Management Company"), whereby the Management Company performed certain services for the Company as an independent contractor. The Management Company provided leasing and management services with respect to the operation of substantially all of the Company's properties including collecting rent, making repairs, cleaning and providing maintenance. In addition, the Management Company performed acquisition and development services for the Company such as conducting feasibility studies on properties subject to purchase, constructing additional improvements on its existing properties, developing new properties or renovating existing improvements. The Management Company paid all operating expenses of the properties out of the rents collected from such properties and was required to maintain books and records and to furnish the Company monthly and annual financial reports and annual budgets for each property. The Management Company was paid a fee under the management agreement for managing the Company's properties based on gross revenues from the Company's income producing properties and was paid additional fees for leasing services and for certain additional services specifically requested by the Company, including market research, advertising and promotion, development, acquisition and management information services. The Management Company was also reimbursed for certain of its costs and expenses. The Company continues to be "self-advised" and is now self-managed. Effective January 1, 1993, the Management Company was acquired by the Company, thereby allowing direct management of its properties. This transaction was completed based on a favorable private letter ruling by the Internal Revenue Service. It formally integrated the management personnel of the Company with management personnel previously employed by the Management Company. The combination had no material effect on the Company's operations or financial position. Location of Properties. Historically, the Company has emphasized investments in properties located primarily in the Houston area. Since 1987, the Company has actively acquired properties outside of Houston. Of the Company's 174 properties which were owned as of December 31, 1993, 77 of its 150 developed properties and 16 of its 24 parcels of unimproved land were located in the Houston metropolitan area. In addition to these properties, the Company owned 46 developed properties and 5 parcels of unimproved land located in other parts of Texas. Because of the Company's investments in the Houston area, as well as in other parts of Texas, the Houston and Texas economies affect, to some degree, the business and operations of the Company. Houston's 1993 economic performance was generally flat compared to 1992 and performed at a lower level than the strengthening national economy. This stagnant economic performance was due in large part to weak oil and gas prices, energy industry consolidations, and national policy uncertainty in the health care and aerospace industries. A deterioration in the Houston or Texas economies could adversely affect the Company. However, the Company's centers are generally anchored by grocery and drug stores under long-term leases, and such types of stores tend to be less affected by economic change. Competition. There are other developers and operators engaged in the development, acquisition, and operation of shopping centers and commercial property who compete with the Company in its trade areas. This results in competition for both acquisitions of existing income-producing properties and also for prime development sites. There is also competition for tenants to occupy the space that the Company and its competitors develop, acquire and manage. The Company believes that the principal competitive factors in attracting tenants in its market areas are location, price, anchor tenants and maintenance of properties and that the Company's competitive advantages include the favorable locations of its properties, its ability to provide a retailer with multiple locations in the Houston area with anchor tenants and its practice of continuous maintenance and renovation of its properties. Financial Information. Certain additional financial information concerning the Company is included in the Company's Consolidated Financial Statements located on pages 16 through 30 herein. ITEM 2. ITEM 2. PROPERTIES At the end of 1993 the Company's real estate properties consisted of 174 locations in eight states. A complete listing of these properties, including the name, location, building area and land area, as applicable, is as follows: SHOPPING CENTERS (Table continued on following page) (Table continued on following page) (Table continued on following page) (Table continued on following page) - --------------- Note: Total square footage includes 4,700,000 square feet of land leased and 170,000 square feet of building leased from others. The square feet figures represent the Company's proportionate ownership of the entire property. * Denotes partial ownership. The Company's interest is 50% except where noted. General. In 1993, no single property accounted for more than 3.7% of the Company's total assets or 5.6% gross revenues. Three properties, in the aggregate, represented approximately 12.6% of the Company's gross revenues for the year ended December 31, 1993; otherwise, none of the remaining properties accounted for more than 2.6% of the Company's gross revenues during the same period. The occupancy rate for all of the Company's improved properties as of December 31, 1993 was 92.1%. Substantially all of the Company's properties are owned directly by the Company (subject in certain cases to mortgages), although the Company's interests in certain of its properties are held indirectly through its interests in joint ventures or under long-term leases. In the opinion of management of the Company, its properties are well maintained and in good repair, suitable for their intended uses, and adequately covered by insurance. Shopping Centers. As of December 31, 1993, the Company owned, either directly or through its interests in joint ventures, 134 shopping centers with approximately 12.4 million square feet of building area. The shopping centers were located predominantly in Texas with other locations in Louisiana, Arkansas, Oklahoma, New Mexico, Arizona, Maine and Tennessee. The Company's shopping centers are primarily neighborhood and community shopping centers which range in size from 100,000 to 400,000 square feet, as distinguished from small strip centers which generally contain 5,000 to 25,000 square feet and from large regional enclosed malls which generally contain over 500,000 square feet. Most of the centers do not have climatized common areas but are designed to allow retail customers to park their automobiles in close proximity to any retailer in the center. The Company's centers are customarily constructed of masonry, steel and glass and all have lighted, paved parking areas which are typically landscaped with berms, trees and shrubs. They are generally located at major intersections in close proximity to neighborhoods which have existing populations sufficient to support retail activities of the types conducted in the Company's centers. The Company has approximately 2,600 separate leases with approximately 1,900 different tenants in its portfolio, including national and regional supermarket chains, other nationally or regionally known stores (including drug stores, discount department stores, junior department stores and catalog stores) and a great variety of other regional and local retailers. The large number of locations offered by the Company and the types of traditional anchor tenants help attract prospective new tenants. National and regional supermarket chains which are tenants in the Company's centers include Albertsons, Fiesta, Fleming Foods, HEB, Kroger Supermarkets, Market Basket, Price-Lo, Randalls Food Markets, Rice Food Markets and Super Value Supermarkets. In addition to these supermarket chains, the Company's nationally and regionally known retail store tenants include Eckerd and Walgreen drugstores; K-Mart and Wal-Mart discount stores; Beall's, Palais Royal and Weiner's junior department stores; MacFrugals, Marshall's, Office Depot, Solo Serve, 50-Off and T.J. Maxx off-price specialty stores; Luby's, Piccadilly and Wyatt cafeterias; Academy, Oshman's and SportsTown sporting goods; Service Merchandise catalog stores; and the following restaurant chains: Arby's, Boston Chicken, Burger King, Champ's, Church's Fried Chicken, Dairy Queen, Domino's, Jack-in-the-Box, Kentucky Fried Chicken, Long John Silver's, McDonald's, Olive Garden, Outback Steakhouse, Pizza Hut, Shoney's, Steak & Ale, Taco Bell and What-a-burger. The Company also leases space in 3,000 to 10,000 square foot areas to national chains such as Clothestime, The Gap, One Price Stores, Payless Shoes (a division of the May Company) and Radio Shack (McDuff's). The Company's shopping center leases have lease terms generally ranging from three to five years for tenant space under 5,000 square feet and from 10 to 35 years for tenant space over 10,000 square feet. Leases with primary lease terms in excess of 10 years, generally for anchor and out-parcels, frequently contain renewal options which allow the tenant to extend the term of the lease for one or more additional periods, each such period generally being of a shorter duration than the primary lease term. The rental rates paid during a renewal period are generally based upon the rental rate for the primary term, sometimes adjusted for inflation or for the amount of the tenant's sales during the primary term. Most of the Company's leases provide for the monthly payment in advance of fixed minimum rentals, the tenants' pro rata share of ad valorem taxes, insurance (including fire and extended coverage, rent insurance and liability insurance) and common area maintenance for the center (based on estimates of the costs for such items) and for the payment of additional rentals based on a percentage of the tenants' sales ("percentage rentals"). Utilities are generally paid directly by tenants except where common metering exists with respect to a center, in which case the Company makes the payments for the utilities and is reimbursed by the tenants on a monthly basis. Generally, the Company's leases prohibit the tenant from assigning or subletting its space and require the tenant to use its space for the purpose designated in its lease agreement and to operate its business on a continuous basis. Certain of the lease agreements with major tenants contain modifications of these basic provisions in view of the financial condition, stability or desirability of such tenants. Where a tenant is granted the right to assign or sublet its space, the lease agreement generally provides that the original lessee will remain liable for the payment of the lease obligations under such lease agreement. During 1993, the Company added approximately 1.2 million square feet to its portfolio of shopping center properties through the acquisition of properties and another 148,000 square feet of space through development. The acquisitions were primarily focused in the Houston area. However, during the year, the Company entered two new markets -- El Paso, which complements its West Texas and Albuquerque holdings, and Phoenix, Arizona, which represents an opportunity to gain a significant presence in a growing metropolitan area. Industrial Properties. The Company currently owns a total of twelve industrial projects, all located in the greater Houston area. These projects include 40 buildings having a total of 2.3 million square feet of building area situated on 5.6 million square feet of land. These figures include the Company's interests in a joint venture. Major tenants of the Company's industrial properties include Advo (a leading direct mail advertising company), Pepsico's PFS division, Stone Container Corporation, Iron Mountain Records Storage and Paul Arpin Van Lines. Four of such buildings, containing approximately 642,000 square feet of building space, are located in the Railwood Industrial Park, a master-planned industrial park in northeast Houston, which offers full utilities, loading docks and rail service in an architecturally controlled environment. During 1993, the Company acquired one project representing 68,000 square feet of office/service space. This center is located in Houston and had an average occupancy of 26% at the time of the acquisition. Office Building. The Company owns a seven-story, 121,000 square foot masonry office building with a detached, covered, three-level parking garage situated on 171,000 square feet of land fronting on North Loop 610 West in Houston. The building serves as the Company's corporate headquarters. Other than the Company, the major tenant of the building is Charter Bank, which occupies 22%. Multi-family Residential Properties. The Company owns, through joint venture interests, three apartment projects located in Houston and San Antonio, Texas and Shreveport, Louisiana. The Company's percentage ownership represents approximately 283 units of the projects' aggregate 833 units. All are garden- type projects complemented by landscaping, recreational areas and adequate parking. These projects are managed by our joint venture partners, all of whom are experienced apartment operators. Unimproved Land. The Company owns, directly or through its interest in joint ventures, 24 parcels of unimproved land aggregating approximately 8.5 million square feet of land area located in Texas and Louisiana. These properties include approximately 5.6 million square feet of land adjacent to certain of the Company's existing developed properties, which may be used for expansion of these developments, as well as approximately 2.9 million square feet of land which may be used for new development. Almost all of these unimproved properties are served by roads and utilities and are ready for development. Most of these parcels are suitable for development as shopping centers, and the Company intends to emphasize the development of these parcels for such purpose. ITEM 3. ITEM 3. LEGAL PROCEEDINGS There are no material pending legal proceedings, other than ordinary routine litigation incidental to its business, to which the Company is a party or to which any of its properties is subject. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. EXECUTIVE OFFICERS OF THE REGISTRANT The following table sets forth certain information with respect to the twelve executive officers of the Company as of March 4, 1994. Mr. S. Alexander is the Company's Chairman and its Chief Executive Officer. He has been employed by the Company since 1955 and has served in his present capacity since January 1, 1993. Prior to becoming Chairman, Mr. Alexander served as President and Chief Executive Officer of the Company since 1962. Mr. Alexander is President, Chief Executive Officer and a Trust Manager of Weingarten Properties Trust and a member of the Houston Regional Advisory Board of Texas Commerce Bank National Association, Houston, Texas ("TCB"). Mr. Debrovner became President and Chief Operating Officer of the Company on January 1, 1993. Prior to assuming such position, Mr. Debrovner served as President of Weingarten Realty Management Company (the "Management Company") since the Company's reorganization in December 1984. Prior to such time, Mr. Debrovner was an employee of the Company for 17 years, holding the positions of Senior Vice President from 1980 until March 1984, and Executive Vice President until December 1984. As Executive Vice President, Mr. Debrovner was generally responsible for the Company's operations. Mr. Debrovner is also a Trust Manager Weingarten Properties Trust. Mr. Robertson is Executive Vice President of the Company and its Chief Financial Officer. Prior to becoming Executive Vice President, Mr. Robertson served as Senior Vice President and Chief Financial Officer since 1980. He has been with the Company since 1971. Mr. Robertson is also a Trust Manager of Weingarten Properties Trust, and a director of PaineWebber Retail Properties Investments, Inc. Mr. A. Alexander became Executive Vice President/Asset Management of the Company on January 1, 1993. Prior to his present position, Mr. Alexander was Senior Vice President/Asset Management of the Management Company. Prior to such time, Mr. Alexander was Vice President of the Management Company and, prior to the Company's reorganization in December 1984, was Vice President and an employee of the Company since 1978. Mr. Alexander has been primarily involved with leasing operations at both the Company and the Management Company. Mr. Alexander is also a Trust Manager of Weingarten Properties Trust and a director of Charter Bank Houston, N.A. Ms. DuFour became Vice President/Acquisitions and Secretary of the Company on January 1, 1993. From January 1986 until March 1989, she was Secretary/Treasurer and from March 1989 until December 1992 she was Vice President, Secretary and Treasurer of the Company. Mr. Karp became Vice President/Operating Properties of the Company on January 1, 1993. For the five years prior to that time, he served as Vice President/Operating Properties of the Management Company. Mr. Marcisz became Vice President/Construction of the Company on January 1, 1993. For the five years prior to that time, he served as Vice President/Construction of the Management Company. Mr. Richter became Vice President/Financial Administration and Treasurer of the Company on January 1, 1993. For the five years prior to that time, he served as Vice President/Financial Administration and Treasurer of the Management Company. Mr. Tucker became Vice President/General Counsel of the Company on January 1, 1993. For the five years prior to that time, he served as Vice President, Secretary and General Counsel of the Management Company. Mr. Cunningham became Vice President/New Development and Acquisitions on January 1, 1993. For the five years prior to that time, he served as Vice President/New Development and Acquisitions of the Management Company. Mr. Hendrix became Vice President/Leasing of the Company during January 1994. From January 1, 1993 until that time, he served as Associate Director/Leasing of the Company, and for the four years prior to that time, he served the Management Company as a leasing executive. Mr. Weingarten became Vice President/Leasing of the Company during January 1994. From January 1, 1993 until that time, he served as Associate Director/Leasing of the Company, and for the four years prior to that time, he served the Management Company as a leasing executive. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON SHARES OF BENEFICIAL INTEREST AND RELATED SHAREHOLDER MATTERS The number of holders of record of the Company's Common Shares, as of March 4, 1994 was 2,443. The high and low sale prices per share of the Company's Common Shares, as reported on the New York Stock Exchange composite tape, and dividends per Common Share paid for the periods indicated were as follows: ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The following table sets forth selected consolidated financial data with respect to the Company and should be read in conjunction with the Consolidated Financial Statements. - --------------- (1) Relates to prepayment penalties paid in connection with the early retirement of permanent debt. (2) Funds from operations does not consider the effects of changes in operating assets and liabilities such as receivables and payables; consequently, it may not be the same as cash flows from operating activities. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion should read in conjunction with the Consolidated Financial Statements and the Notes thereto and the Comparative Summary of Selected Financial Data appearing elsewhere in this report. Historical results and percentage relationships on the Statements of Consolidated Income, including trends which might appear, should not be taken as indicative of future operations. FINANCING AND CAPITAL STRUCTURE The Company's total debt decreased $95.9 million to $147.7 million at December 31, 1993, compared to $243.6 million at the end of 1992. This significant reduction in debt between years was primarily the result of the Company's decision to call all $123.0 million of outstanding convertible note and debenture issues during 1993. The issues were converted into 3.9 million common shares, all of which had a beneficial anti-dilutive effect on earnings per share. During March 1993, the Company raised $113.0 million of new capital through an equity offering of 2.8 million common shares. Although a large portion of these proceeds was initially used to reduce short-term revolving credit debt, the proceeds were ultimately the primary source of the Company's capital needs for the year. During 1993, approximately $96.0 million was invested in new assets, consisting of acquisitions totaling 1.3 million square feet, the development of new shopping centers and capital improvements to existing properties. The Company had an average cost of debt for 1993 of 8.1% and its current debt structure provides protection against future interest rate fluctuations. The $92.2 million of floating-rate debt currently in place is covered by virtue of $40.0 million of interest rate swap contracts (extending out 8-11 years) and the existing option of liquidating the $51.4 million of government securities and reducing a like amount of debt. As a result of the conversion of all outstanding convertible notes and debentures into equity and the common share offering, the Company's financial position and capital structure is the strongest in its history. LIQUIDITY The Company anticipates that cash flow from operating activities will continue to provide adequate capital for all principal payments as well as dividend payments in accordance with REIT requirements, and that cash on hand, borrowings under its existing credit facilities, and the use of project financing as well as other debt and equity alternatives will provide the necessary capital to achieve growth. Cash flow from operating activities as reported in the Statements of Consolidated Cash Flows increased to $57.6 million for 1993 from $38.3 million for 1992. The Company satisfied its REIT requirement of distributing at least 95% of ordinary taxable income with dividend distributions of $52.3 million in 1993. Accordingly, federal income taxes were not provided. The Company's dividend payout ratio for the year approximated 90% of the 1993 funds from operations (defined as net income plus depreciation, amortization and extraordinary charge, less gains on sales of property and securities). Recently, the Company's Board of Trust Managers approved an increase in the quarterly dividend per common share from $.54 to $.57. As of December 31, 1993, the Company had approximately $59.7 million available under its $100 million revolving credit facilities. The Company also has a substantial number of operating properties which are currently free of debt or other restrictions, thereby providing a collateral base for future borrowings. More importantly, the Company's extremely low debt-to-equity ratio subsequent to the capital restructuring discussed above affords it a wide range of alternatives in the financial markets to fund future capital needs. RESULTS OF OPERATIONS The Company considers funds from operations to be the most appropriate measure of the performance of an equity REIT since such measure does not recognize depreciation and amortization expenses as operating expenses. Management believes that reduction for these charges are not meaningful in evaluating income-producing real estate, which historically has not depreciated. COMPARISON OF 1993 TO 1992 Net income increased $16.2 million, or 80.5%, to $36.2 million ($1.50 per share) in 1993 from $20.1 million ($1.15 per share) in 1992. Funds from operations increased $17.3 million, or 42.4%, to $58.0 million in 1993 from $40.7 million in 1992. These significant increases realized between comparative years relate to the Company's shopping center acquisitions during the past two years, as well as a substantial decrease in interest expense achieved through the conversion into equity of all the convertible issues outstanding at the start of 1993. Rental revenues were $94.2 million for 1993 as compared to $83.2 million for 1992. The $11.0 million difference represents a 13.2% increase. New properties added through the Company's acquisition and new development programs contributed a significant part of this increase. Interest income increased $1.9 million in 1993 as compared with 1992, primarily because the Company had significantly more funds invested in government securities in 1993 than it did in 1992. The funds invested during 1993 represented a portion of the proceeds derived from a public offering during March of 1993. The increase in interest income was also due to $.4 million more interest received from WRI Holdings, Inc. on the Hospitality mortgage bonds, due to its improved cash flow from its hotel operations. The Company did not recognize interest income from various other debt with WRI Holdings, Inc. of approximately $5.2 million and $4.9 million in 1993 and 1992, respectively. The $.8 million increase in other income between years is due, in part, to additional income recorded with respect to the Company's unconsolidated equity investment in real estate properties. Since the fourth quarter of 1992, the Company has increased its investment in joint ventures accounted for using the equity method, resulting in this increase. The increase in other income is also due to certain management fee income relating primarily to the non-owned portion of the Company's joint venture investments, as the Company became self-managed at the beginning of 1993 (more fully explained below). Interest expense decreased $8.6 million in 1993 to $10.0 million, as compared to $18.7 million in 1992, primarily because average debt outstanding during the year decreased $129.2 million, from $267.7 million in 1992 to $138.5 million in 1993. This significant reduction in average debt outstanding was achieved by the use of proceeds from the Company's last two public offerings and the conversion of all of the Company's outstanding convertible debt issues into equity. The conversion of the convertible notes and debentures during 1993 is expected to further decrease interest expense by $3.1 million and increase net income by a like amount for 1994. The reduction in interest expense for the year was partially offset by the Company's $40 million in interest rate swap contracts. Although these instruments provide rate protection for the long-term (8.1% for 8-11 years), they penalized the 1993 results of operations with $1.0 million of additional interest expense. During the year, the Company had an average of only $18.5 million of floating rate debt outstanding, thus leaving approximately $21.5 million of unmatched interest rate swaps. The reduction in interest expense was also partially offset by a $.9 million decrease in the amount of interest which was capitalized during the year (thus serving to increase interest expense). The significant portion of this change in capitalized interest ($.7 million) relates to certain tracts of land under development, which, as of the end of 1992, had reached their net realizable value. Depreciation and amortization was $23.4 million for 1993 and $21.3 million for 1992 and operating expenses were $17.3 million for 1993 and $14.6 million for 1992. This aggregate $4.8 million increase was primarily due to property additions made by the Company during the past two years. Ad valorem taxes charged to operations increased $1.5 million to $12.9 million in 1993 from $11.4 million in 1992, also as the result of the property additions mentioned above. Gains on sales of property and securities for 1993 relate to gains realized as the results of fires at two of the Company's properties. The fires had no material impact on the Company's current earnings. Effective January 1, 1993, Weingarten Realty Management Company (the "Management Company"), a separate but related company, was acquired by the Company, thus allowing direct management of the Company's properties. The Company also performs property management services for joint ventures in which it participates. The acquisition had no material financial effect on the Company because the additional salaries paid as a result of the merger were offset by the various management fees no longer being paid to the Management Company. Beginning in the first quarter of 1994, the Company will adopt Statement of Financial Accounting Standards No. 115, which requires that marketable securities be carried at the lower of aggregate cost or market. The adoption of this standard will not have a material effect on the Company's consolidated financial statements. COMPARISON OF 1992 TO 1991 Net income increased $2.1 million, or 11.8%, to $20.1 million ($1.15 per share) in 1992 from $18.0 million ($1.08 per share) in 1991. Funds from operations increased $4.4 million, or 12.0% to $40.7 million in 1992 from $36.4 million in 1991, primarily due to increased rental revenues. Rental revenues were $83.2 million for 1992 as compared to $74.5 million for 1991. The $8.7 million difference represents an 11.8% increase. New properties added through the Company's acquisition and development programs contributed $6.7 million of the increase. The remainder stems from existing properties and relates to increases in minimum rentals on renewals and increases in reimbursements of ad valorem taxes and other operating expenses. Interest income decreased approximately $1.9 million in 1992 as compared with 1991, primarily because of less interest income from the government securities. The Company's remaining investment of $17.3 million in these securities was sold at the end of the second quarter of 1992, after having been held during all of 1991. These securities were sold because management had concluded that the gain associated with this investment had been maximized. The Company did not recognize interest income from various debt with an affiliate of approximately $4.9 million and $4.7 million in 1992 and 1991, respectively. The $.5 million increase in other income between years related primarily to lease cancellation income, most of which was received during the second quarter of 1992 as the result of a settlement with a prior tenant. The remainder of the positive change in this line item was due to increased income recorded with respect to the Company's unconsolidated equity investments in real estate properties. Interest expense decreased $1.5 million in 1992 to $18.7 million, as compared to $20.2 million in 1991. Of this decrease, $1.0 million related to a decrease in average rate from 8.2% in 1991 to 7.8% in 1992. The remainder is due to an increase in capitalized interest associated with the increased development activity experienced by the Company. Average debt outstanding was relatively stable between years in spite of the capital expenditures previously mentioned, due to the $82.1 million of new proceeds associated with the 2 million common share offering and the sale of the Company's remaining investment in government securities. Depreciation and amortization was $21.3 million for 1992 and $19.0 million for 1991 and operating expenses were $14.6 million for 1992 and $12.6 million for 1991. This aggregate $4.3 million increase was primarily due to property additions made by the Company during the past two years. Ad valorem taxes charged to operations increased to $11.4 million in 1992 from $9.5 million in 1991. The $1.9 million increase was due to property additions as well as tax rate increases. The increase between years of $.5 million in general and administrative expenses was due to increases in executive compensation, professional fees and state income taxes. The $1.8 million gains on sales property and securities is the result of a $1.3 million gain realized upon the sale of the Company's remaining $17.3 million investment in government securities coupled with gains associated with the sale of two small tracts of unimproved land. The extraordinary charge of $1.2 million consisted of prepayment penalties incurred as a result of the Company's election to pay off a number of its permanent loans. EFFECTS OF INFLATION The rate of inflation remained modest during 1993 and, as such, was inconsequential to the Company's operations. The Company has structured its leases, however, in such a way as to remain largely unaffected should significant inflation occur. Most of the leases contain percentage rent provisions with the Company to receive rentals based on the tenants' gross sales. Many leases provide for increasing minimum rentals during the terms of the leases through escalation provisions. In addition, many of the Company's leases are for terms of less than ten years, which allows the Company to adjust rental to changing market conditions when the leases expire. Most of the Company's leases require the tenant to pay a large portion of operating expenses. As a result of these lease provisions, increases due to inflation, as well as tax rate increases which are usually anticipated to occur, generally do not have a significant adverse effect upon the Company's operating results. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEPENDENT AUDITORS' REPORT Weingarten Realty Investors: We have audited the accompanying consolidated balance sheets of Weingarten Realty Investors as of December 31, 1993 and 1992, and the related statements of consolidated income, cash flows and shareholders' equity for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on the financial statements and financial statement schedules 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, such consolidated financial statements present fairly, in all material respects, the financial position of Weingarten Realty Investors at December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. DELOITTE & TOUCHE Houston, Texas February 24, 1994 STATEMENTS OF CONSOLIDATED INCOME (AMOUNTS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) See Notes to Consolidated Financial Statements. CONSOLIDATED BALANCE SHEETS (AMOUNTS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) See Notes to Consolidated Financial Statements. STATEMENTS OF CONSOLIDATED CASH FLOWS (AMOUNTS IN THOUSANDS) See Notes to Consolidated Financial Statements. STATEMENTS OF CONSOLIDATED SHAREHOLDERS' EQUITY (AMOUNTS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 See Notes to Consolidated Financial Statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Operations of Weingarten Realty Investors, a Texas business trust, consist of one business segment -- acquiring, developing and leasing of real estate, primarily anchored shopping centers, in Texas and throughout the southwestern part of the United States. The Company currently operates and intends to operate in the future as a real estate investment trust ("REIT"). Consolidated financial statements include the accounts of the Company, its subsidiaries and its interest in 50% or more-owned joint ventures and partnerships. All significant intercompany balances and transactions have been eliminated. Joint ventures which are less than 50% owned are accounted for using the equity method. Carrying charges, principally interest and ad valorem taxes, of land under development and buildings under construction are capitalized as part of projects under development and buildings and improvements to the extent that such charges do not cause the carrying value of the asset to exceed its net realizable value. Property is carried at cost plus capitalized carrying charges. Depreciation is computed using the straight-line method, generally over estimated useful lives of 18-50 years for buildings and 10-20 years for parking lot surfacing and equipment. Maintenance and repairs are expensed. Major replacements are capitalized and the replaced asset and corresponding accumulated depreciation is removed from the accounts. Marketable debt securities, consisting of U.S. government agency guaranteed pass-through certificates and U.S. Treasury Notes, are carried at amortized cost. Premiums and discounts are amortized (accreted) to operations over the estimated remaining lives of the securities using the constant yield method. Federal income taxes are not provided because the Company believes it qualifies as a REIT under the provisions of the Internal Revenue Code and, therefore, applicable taxable income is included in the taxable income to its shareholders. As a REIT, the Company must distribute at least 95% of its ordinary taxable income to its shareholders and meet certain other requirements. Taxable income differs from net income for financial reporting purposes principally because of differences in the timing of recognition of interest, ad valorem taxes, depreciation, rental revenue and installment gains on sales of property. Unamortized debt and lease costs are amortized primarily on a straight-line basis over the terms of the debt and over the lives of leases, respectively. Rental revenue is generally recognized on a straight-line basis over the life of the lease for operating leases and over the lease terms using the interest method for direct financing leases. Contingent rentals (payments for taxes, insurance and maintenance by the lessees and for an amount based on a percentage of the tenants' sales) are estimated and accrued over the lease year. Income per common share is computed using the weighted average number of common shares outstanding during the period and excludes the negligible dilutive effect of shares issuable in connection with share options and awards. Cash flows are computed using the indirect method. For cash flow purposes, the Company considers all highly liquid debt instruments with a maturity of less than three months as cash equivalents. Dollar amounts presented in the tabulations in the notes to consolidated financial statements are stated in thousands of dollars, except per share amounts. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 2. DEBT AND CONVERTIBLE DEBENTURES The Company's total debt consisted of the following: Principal due in the next five years (excluding amounts due under interim debt), in millions, is $.8 in 1994, $.5 in 1995, 1996 and 1997, and $.6 in 1998. The Company made cash payments for interest on debt, net of amounts capitalized, in millions, of $9.4 in 1993, $18.3 in 1992 and $19.8 in 1991. At December 31, 1993, property under direct financing leases and other property with carrying values aggregating $328 million and current and future rentals from these properties and leases were used as collateral for the Company's debt. Various debt agreements contain restrictive covenants, the most restrictive of which requires the Company to produce annual consolidated distributable cash flow, as defined in the applicable debt agreements, of not less than 170% of interest payments, to limit the payment of dividends to no more than 95% of such annual consolidated distributable cash flow and to limit short term debt (as defined) to the greater of 33% of total debt or $75 million. Management believes that the Company is in compliance with all restrictive covenants. Permanent and Interim Debt The Company generally classifies debt as permanent if the debt is payable over an initial period of more than ten years and as interim if the debt is payable over five years or less. Interim debt is typically used to provide funds for the acquisition or development of properties, and is replaced by permanent debt, subject to availability and relative costs. The Company has a revolving credit agreement with a bank for $80 million, available through June 2004. Under the agreement, the lender has the option to call and convert the outstanding debt to a term loan that would be payable over approximately four years. During 1993, the balance outstanding under the agreement NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) averaged about $14.3 million with a weighted average interest rate of 3.8%; and the maximum balance outstanding under the agreement was $62.5 million. The Company also has an additional $20 million revolving credit agreement with another bank, available through May 1994. Funds advanced under the agreement generally bear interest at the federal funds rate plus one percent, without any obligation to maintain collected balances. Upon termination of the agreement, the outstanding amount may be converted to a term loan payable over a two-year period. During 1993, the balance outstanding under the agreement averaged $4.2 million with a weighted average interest rate of 4.1%. The maximum balance outstanding under the agreement was $20 million. These revolving credit facilities are subject to normal banking terms and conditions and do not materially restrict the Company's activities. In 1992, the Company purchased $40 million of interest rate swap contracts which fix the average effective interest rate of an equal amount under the Company's revolving credit agreements at an estimated 8.1% for periods maturing in 2001 and 2004. Amounts outstanding under the revolving credit agreement up to the $40 million notional amount of the interest rate swaps are not callable by the lender as long as the swaps are owned by the Company. The Company is currently paying a higher rate of interest than it is receiving under the swap agreements, and thus currently has no financial exposure in the unlikely event of default by the counterparty. Convertible Notes and Debentures In 1993, the Company converted all of its convertible notes and debentures into common shares of beneficial interest. A total of 3.9 million shares were issued during the year related to these conversions. Had all of the debt been converted as of January 1, 1993, net income per common share would have been $1.55 per share for the year ended December 31, 1993. NOTE 3. CARRYING CHARGES CAPITALIZED The following carrying charges were capitalized: NOTE 4. LEASING OPERATIONS Leasing Arrangements The Company's lease terms range from less than one year for smaller tenant spaces to thirty-five years for larger tenant spaces. In addition to minimum lease payments, most of the leases provide for contingent rentals. Rentals under Operating Leases Future minimum rental income from non-cancelable operating leases at December 31, 1993, in millions, is: $75.5 in 1994; $67.2 in 1995; $58.1 in 1996; $49.1 in 1997; $42.4 in 1998 and $277.9 thereafter. The future minimum rental amounts do not include estimates for contingent rentals. Such contingent rentals, in millions, aggregated $21.4 in 1993, $19.5 in 1992 and $16.5 in 1991. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Property under Direct Financing Leases Leases that are, in substance, the financing of an asset purchase by the party leasing the property are recorded as property under direct financing leases. The Company, in its capacity as lessor, has removed the leased property from the books and recorded the future lease payments receivable using the following components: At December 31, 1993, minimum lease payments to be received in each of the five succeeding years, in millions, are: $1.9 in 1994 and 1995; $1.8 in 1996 and 1997 and $1.7 in 1998. The future minimum lease payments do not include amounts for contingent rentals; contingent rental income on properties leased under direct financing leases, in millions, was $.6 in 1993, $.8 in 1992 and $.6 in 1991. NOTE 5. LEASE COMMITMENTS Operating Leases The Company leases land and a shopping center from the owners, and then subleases these properties to other parties. Future minimum rentals under these operating leases, in millions, are: $1.2 in 1994; $1.3 in 1995; $1.2 in 1996; $1.1 in 1997; $1.0 in 1998 and $15.4 thereafter. Future minimum rental payments on these leases have not been reduced by future minimum sublease rentals aggregating $15.8 million through 2017 that are due under various noncancelable subleases. The following summarizes total rental expenses and sublease rental revenue (excluding amounts for improvements constructed by the Company on the leased land): Capital Leases Leases which transfer substantially all of the risks and benefits of ownership associated with the underlying property to the Company are considered capital leases, and the present value of the required lease payments are recorded as property and the related debt is recorded as obligations under capital leases. The debt is amortized as each lease payment is made. Property under capital leases, consisting of a shopping center aggregating $6.5 million, is included in buildings and improvements at December 31, 1993 and 1992. Future minimum lease payments under these capital leases total $12.7 million, with annual payments due of $.6 million in 1994 through 1998, and $9.7 million thereafter. The amount of these total payments representing interest is $6.4 million. Accordingly, the present value of the net minimum lease payments is $6.1 million at December 31, 1993. The Company subleases this property to other parties. The minimum lease payments discussed above have not been reduced by minimum sublease rentals aggregating $3.4 million due under non-cancelable NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) subleases. Minimum sublease rentals do not include estimates for contingent rentals that aggregated $.2 million in 1993 and 1992 and $.1 million in 1991. NOTE 6. RELATED PARTY TRANSACTIONS The Company and Weingarten Realty Management Company (the "Management Company") were related parties during 1991 and 1992 because, prior to January 1, 1993, the Management Company was owned by directors and shareholders of the Company. As the Company had only a few employees, its operations were primarily performed by employees of the Management Company through a contract to lease, manage and develop the Company's properties. The Company and WRI Holdings, Inc. ("Holdings") are related parties because they share certain directors and are under common management. See Note 8 for related party information about Holdings. Effective January 1, 1993, the assets of the Management Company, which were not material in relation to the Company's consolidated balance sheet, were acquired by the Company through the assumption of less than $.1 million of net liabilities from the shareholders of the Management Company. This event did not have a significant effect on 1993 earnings because the additional salaries paid as the result of this merger were offset by the various fees no longer being paid to the Management Company. The Management Company charged the Company fees aggregating $8.3 million and $8.0 million for 1992 and 1991, respectively, in connection with services rendered under the management contract. Fees paid under the management contract were generally based upon a specified percent of revenues, minimum lease rentals of space leased and costs incurred for acquisition, construction and development of the Company's properties. The Management Company owed the Company $1.3 million at December 31, 1992. The Company owns an interest in several joint ventures and partnerships. Notes receivable from these entities totalled $10.1 million and $14.0 million at December 31, 1993 and 1992, respectively, and bear interest at 2.7% to 9.3% at December 31, 1993 and are due at various dates through 2020. The Company's $80 million revolving credit agreement is with Texas Commerce Bank National Association ("TCB"). NOTE 7. COMMITMENTS AND CONTINGENCIES The Company was contingently liable at December 31, 1993 for $1.2 million of notes payable executed by various joint ventures and partnerships. The Company is committed to lend Holdings an additional $3.3 million. The Company remains contingently liable for $1.5 million of notes payable by Hospitality Venture which were transferred to Holdings in 1988. The Company is involved in various matters of litigation arising in the normal course of business. While the Company is unable to predict with certainty the amounts involved, the Company's management and counsel are of the opinion that, when such litigation is resolved, the Company's resulting liability, if any, will not have a significant effect on the Company's consolidated financial position. NOTE 8. INVESTMENT IN MORTGAGE BONDS AND NOTES RECEIVABLE FROM AN AFFILIATE Concurrent with the Company being organized as a REIT in 1984, certain property and investments in joint ventures, which were considered to be incompatible with a REIT's operation, and $3.5 million were transferred to Holdings in exchange for $26.8 million of mortgage bonds. The transfer price for the assets was based upon independent appraisals. The appraised values exceeded the Company's carrying value of the assets; however, because Holdings is a related party, the gain of $17.3 million was deferred by the Company. Holdings currently owns three investments: a 50% interest in Hospitality Venture, which owns and operates eight motor hotels in Florida and Alabama ("Hospitality"); unimproved land in a multi-use land development NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) north of Houston ("River Pointe"); and unimproved land in a major industrial park in Houston ("Railwood"). The mortgage bonds and notes receivable from Holdings, and related deferred gain, were as follows: Before 1988, Holdings was current on the payments of all interest; accordingly, the Company had recognized interest income on all of Holdings' debt at the stated interest pay rates. During the fourth quarter of 1988, Holdings' cash flow and capital resources became insufficient to meet the full interest requirements on the mortgage bonds. The accrual of interest income on the River Pointe and Railwood mortgage bonds has been suspended and interest income on the Hospitality mortgage bonds has been limited to Holdings' pro rata share of cash flow from Hospitality Venture. Interest income from the mortgage bonds and notes receivable recognized by the Company for financial reporting purposes, in millions, aggregated $2.1 for 1993, and $1.6 for 1992 and 1991. At December 31, 1993 and 1992, accrued interest receivable from Holdings was $.4 million and $.3 million, respectively. The Company had an unrecorded receivable for interest of $22.3 million and $17.1 million at December 31, 1993 and 1992, respectively. Of these amounts, $5.4 million and $4.8 million represent the difference between the accrual rate and the pay rate on the Railwood and River Pointe mortgage bonds at December 31, 1993 and 1992, respectively. Interest income not recognized by the Company for financial reporting purposes aggregated, in millions, $5.2, $4.9 and $4.7 for 1993, 1992 and 1991, respectively. Management of the Company believes that the fair value of the security collateralizing the debt from Holdings is greater than the net investment in such debt (cost less related deferred gain) and that there would not be a charge to operations if the Company were to foreclose on the debt. If foreclosure were required, however, the net investment in such debt would become the Company's basis of the repossessed assets. However, the Company does not currently anticipate foreclosure on Holdings' properties due to certain restrictions imposed on such assets in connection with the Company's REIT status. Accordingly, the NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Company's management presently does not believe that the net investment in the mortgage bonds and notes receivable from Holdings has been impaired nor that a reserve for any such impairment is currently required. NOTE 9. SHARE OPTIONS AND AWARDS The Company has an incentive Share Option Plan (the "Plan") which expires in December 1997. During 1991, the Company amended the Plan to add awards of common shares of beneficial interest, at nominal cost to the recipient, in addition to options. The Plan provides options and awards for a maximum of 500,000 common shares. The Company has an additional share option plan which grants 100 share options to every employee of the Company, excluding officers, upon completion of each five year interval of service. This plan, which expires in 2002, provides options for a maximum of 100,000 common shares. For both of the share option plans, options are granted to employees of the Company at an exercise price equal to the quoted fair market value of the common shares on the date the options are granted. All options and awards that are granted expire upon termination of employment or ten years from the date of grant. Following is a summary of the option activity for the three years ended December 31, 1993: During 1991, 56,000 common shares were granted as awards to certain key officers of the Company and the Management Company. Through December 31, 1993, 42,000 of these common shares had vested and were issued; the remaining 14,000 common shares will vest in 1994. Compensation expense of $.6 million, $.4 million and $.5 million was recognized in 1993, 1992 and 1991, respectively, relating to the share awards. At December 31, 1993, 238,884 common shares were available for the future grant of options or awards and options for 123,267 shares were exercisable. On January 3, 1994, the Company issued 62,900 restricted shares and granted 434,400 share options under a compensatory Incentive Share Plan for key officers of the Company. This plan, which expires in 2003, provides for a total of 500,000 shares, either in the form of restricted shares or options. The restricted shares generally vest over a ten year period, with potential acceleration of vesting due to appreciation in the market value of the Company's shares. The share options vest over a five year period beginning two years after the date of grant. Share options are granted at the market price at the date of grant. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 10. DIVIDEND DISTRIBUTIONS For federal income tax purposes, the cash dividends distributed to shareholders are characterized as follows: NOTE 11. CHANGES IN OPERATING ACCOUNTS The effect of changes in the operating accounts on cash flows from operating activities is as follows: During 1993, $123.0 million in convertible debentures and notes were converted into 3.9 million common shares of beneficial interest. During 1992, the Company converted $4.1 million of convertible debentures into .1 million common shares and issued .4 million common shares valued at $14.6 million to a partner for the purchase of the partner's interest in a joint venture. During 1991, the Company converted $3.6 million of convertible debentures into .1 million common shares and assumed $10.4 million of permanent debt in connection with the acquisition of certain properties. NOTE 12. FAIR VALUE DISCLOSURE OF FINANCIAL INSTRUMENTS The following disclosure of estimated fair value was determined by the Company, using available market information and appropriate valuation methodologies. However, considerable judgment is necessary to interpret market data and develop the related estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amounts that the Company could realize upon disposition of the financial instrument. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts. Cash and cash equivalents, accrued rent and accounts receivable, marketable debt securities, notes receivable from joint ventures, partnerships and tenants, interim debt and accounts payable and accrued expenses are carried at amounts which reasonably approximate their fair value. Mortgage bonds and notes receivable from an affiliate were not fair valued because it is not practicable to reasonably assess the credit adjustment that would be applied in the marketplace for such bonds and notes receivable. However, management of the Company believes that the fair value of the security collateralizing such bonds and notes receivable is greater than the net investment in such instruments (cost less related deferred gain). NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Permanent debt with carrying values of $89.0 million has fair values of $93.8 million, which were estimated based on interest rates currently available to the Company for issuance of debt with similar terms and remaining maturities. Interest rate swap agreements are valued at an estimated unrealized net loss of $5.6 million, which represents amounts at which they could be settled, based upon estimates obtained from dealers. The fair value estimates presented herein are based on pertinent information available to management as of December 31, 1993. Although management is not aware of any factors that would significantly affect the estimated fair value amounts, such amounts have not been comprehensively revalued for purposes of these financial statements since that date, and current estimates of fair value may differ significantly from the amounts presented herein. NOTE 13. PENSION PLAN Effective January 1, 1993, the Company acquired the assets of the Management Company, including a defined benefit pension plan covering substantially all of its employees. This plan was merged with the plan of the Company, effective January 1, 1993. The benefit formula for both pre-existing plans is identical to the formula for the surviving merged plan. The benefits are based on years of service and the employee's compensation during the last five years of service. The Company's funding policy is to make annual contributions as required by applicable regulations. The following table sets forth the plan's funded status and amounts recognized in the Company's balance sheet at December 31, 1993. The components of net periodic pension cost are as follows: Assumptions used to develop periodic pension expense and the actuarial present value of projected benefit obligations: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Disclosure for the Company's pension plan for 1992 is not included since such plan was not significant prior to the merger of the Management Company. NOTE 14. QUARTERLY FINANCIAL DATA (UNAUDITED) Summarized quarterly financial data for the years ended December 31, 1993 and 1992 is as follows: NOTE 15. PRICE RANGE OF COMMON SHARES (UNAUDITED) The high and low sale prices per share of the Company's common shares, as reported on the New York Stock Exchange composite tape, and dividends per share paid for the periods indicated were as follows: ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT (a) Information with respect to the Company's trust managers and compliance with Section 16(a) of the Securities Exchange Act of 1934, as amended, is incorporated by reference from the Company's Proxy Statement in connection with the Annual Meeting of Shareholders to be held April 28, 1994, which Proxy Statement will be filed with the Securities and Exchange Commission not later than 120 days after the end of the fiscal year covered by this Form 10-K. Except for those portions of such Proxy Statement specifically incorporated by reference herein, such Proxy Statement is deemed not to be filed as part of this Report. (b) See "Executive Officers of the Registrant" above. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Information with respect to executive compensation is incorporated by reference from pages 11 through 14 of the Company's Proxy Statement in connection with the Annual Meeting of Shareholders to be held April 28, 1994, which Proxy Statement will be filed with the Securities and Exchange Commission not later than 120 days after the end of the fiscal year covered by this Form 10-K. Except for those portions of such Proxy Statement specifically incorporated by reference herein, such Proxy Statement is deemed not to be filed as part of this Report. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information with respect to security ownership of certain beneficial owners and management is incorporated by reference from pages 2 through 4 of the Company's Proxy Statement in connection with the Annual Meeting of Shareholders to be held April 28, 1994, which Proxy Statement will be filed with the Securities and Exchange Commission not later than 120 days after the end of the fiscal year covered by this Form 10-K. Except for those portions of such Proxy Statement specifically incorporated by reference herein, such Proxy Statement is deemed not to be filed as part of this Report. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information with respect to certain relationships and related transactions is incorporated by reference from pages 14 through 16 of the Company's Proxy Statement in connection with the Annual Meeting of Shareholders to be held April 28, 1994, which Proxy Statement will be filed with the Securities and Exchange Commission not later than 120 days after the end of the fiscal year covered by this Form 10-K. Except for those portions of such Proxy Statement specifically incorporated by reference herein, such Proxy Statement is deemed not to be filed as part of this Report. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) Financial Statements and Financial Statement Schedules: (2) Financial Statement Schedules: All other schedules are omitted since the required information is not present or is not present in amounts sufficient to require submission of the schedule or because the information required is included in the consolidated financial statements and notes hereto. (b) No reports on Form 8-K were filed during the last quarter of the period covered by this annual report. (c) Exhibits: - --------------- * Filed with this report. + Management contract or compensatory plan or arrangement. SIGNATURE PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES AND EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED. WEINGARTEN REALTY INVESTORS By: STANFORD ALEXANDER ---------------------------------- Stanford Alexander, President Date: March 21, 1994 PURSUANT TO THE REQUIREMENT OF THE SECURITIES AND 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 DATES INDICATED. SCHEDULE II WEINGARTEN REALTY INVESTORS AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES (OTHER THAN RELATED PARTIES) FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (AMOUNTS IN THOUSANDS) - ------------ SCHEDULE VIII WEINGARTEN REALTY INVESTORS VALUATION AND QUALIFYING ACCOUNTS DECEMBER 31, 1993, 1992 AND 1991 (AMOUNTS IN THOUSANDS) - --------------- (1) Write-offs of accounts receivable previously reserved. SCHEDULE X WEINGARTEN REALTY INVESTORS SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (AMOUNTS IN THOUSANDS) SCHEDULE XI WEINGARTEN REALTY INVESTORS REAL ESTATE AND ACCUMULATED DEPRECIATION DECEMBER 31, 1993 (AMOUNTS IN THOUSANDS) - --------------- Note A -- Encumbrances do not include $40,350,000 outstanding under the revolving credit agreements and $35,000,000 outstanding under the 14-year term loan payable to a group of insurance companies secured by property collateral pools including all or part of 42 shopping centers, one industrial project and five parcels of unimproved land. SCHEDULE XI (CONTINUED) The changes in total cost of the properties for the years ended December 31, 1993, 1992 and 1991 were as follows: The changes in accumulated depreciation for the years ended December 31, 1993, 1992 and 1991 were as follows: - --------------- Note B -- Transferred from net investment in direct financing leases. SCHEDULE XII WEINGARTEN REALTY INVESTORS MORTGAGE LOANS ON REAL ESTATE DECEMBER 31, 1993 (AMOUNTS IN THOUSANDS) (See notes on following page) SCHEDULE XII (CONTINUED) - ------------ Note A -- Changes in mortgage loans for the years ended December 31, 1993, 1992 and 1991 are summarized below: - ------------ Note B -- The aggregate cost at December 31, 1993 for federal income tax purposes is $24,104. Note C -- Principal payments are due monthly to the extent of cash flow generated by the underlying property.

1993 Item 1.BUSINESS - -------------------------------------------------------------------------------- GENERAL AEP was incorporated under the laws of the State of New York in 1906 and reorganized in 1925. It is a public utility holding company which owns, directly or indirectly, all of the outstanding common stock of its operating electric utility subsidiaries. Substantially all of the operating revenues of AEP and its subsidiaries are derived from the furnishing of electric service. The service area of AEP's electric utility subsidiaries covers portions of the states of Indiana, Kentucky, Michigan, Ohio, Tennessee, Virginia and West Virginia. The generating and transmission facilities of AEP's subsidiaries are physically interconnected, and their operations are coordinated, as a single integrated electric utility system. Transmission networks are interconnected with extensive distribution facilities in the territories served. At December 31, 1993, the subsidiaries of AEP had a total of 20,007 employees. AEP, as such, has no employees. The principal operating subsidiaries of AEP are: APCo (organized in Virginia in 1926), which is engaged in the generation, purchase, transmission and distribution of electric power to approximately 838,000 customers in the southwestern portion of Virginia and southern West Virginia, and in supplying electric power at wholesale to other electric utility companies and municipalities in those states and in Tennessee. At December 31, 1993, APCo and its wholly owned subsidiaries had 4,587 employees. A generating subsidiary of APCo, Kanawha Valley Power Company, which owns and operates under Federal license three hydroelectric generating stations located on Government lands adjacent to Government- owned navigation dams on the Kanawha River in West Virginia, sells its net output to APCo. Among the principal industries served by APCo are coal mining, primary metals, chemicals, textiles, paper, stone, clay, glass and concrete products and furniture. In addition to its AEP System interconnection, APCo also is interconnected with the following unaffiliated utility companies: Carolina Power & Light Company, Duke Power Company and VEPCo. A comparatively small part of the properties and business of APCo is located in the northeastern end of the Tennessee Valley. APCo has several points of interconnection with TVA and has entered into agreements with TVA under which APCo and TVA interchange and transfer electric power over portions of their respective systems. CSPCo (organized in Ohio in 1937, the earliest direct predecessor company having been organized in 1883), which is engaged in the generation, purchase, transmission and distribution of electric power to approximately 578,000 customers in Ohio, and in supplying electric power at wholesale to other electric utilities and to municipally owned distribution systems within its service area. At December 31, 1993, CSPCo had 2,143 employees. CSPCo's service area is comprised of two areas in Ohio, which include portions of twenty-five counties. One area includes the City of Columbus and the other is a predominantly rural area in south central Ohio. Approximately 80% of CSPCo's retail revenues are derived from the Columbus area. Among the principal industries served are food processing, chemicals, primary metals, electronic machinery and paper products. In addition to its AEP System interconnection, CSPCo also is interconnected with the following unaffiliated utility companies: CG&E, DP&L and Ohio Edison Company. I&M (organized in Indiana in 1925), which is engaged in the generation, purchase, transmission and distribution of electric power to approximately 525,000 customers in northern and eastern Indiana and southwestern Michigan, and in supplying electric power at wholesale to other electric utility companies, rural electric cooperatives and municipalities. At December 31, 1993, I&M had 3,944 employees. Among the principal industries served are transportation equipment, primary metals, fabricated metal products, electrical and electronic machinery, rubber and miscellaneous plastic products and chemicals and allied products. Since 1975, I&M has leased and operated the assets of the municipal system of the City of Fort Wayne, Indiana. In addition to its AEP System interconnection, I&M also is interconnected with the following unaffiliated utility companies: Central Illinois Public Service Company, CG&E, Commonwealth Edison Company, Consumers Power Company, Illinois Power Company, Indianapolis Power & Light Company, Louisville Gas and Electric Company, Northern Indiana Public Service Company, PSI Energy Inc. and Richmond Power & Light Company. KEPCo (organized in Kentucky in 1919), which is engaged in the generation, purchase, transmission and distribution of electric power to approximately 161,000 customers in an area in eastern Kentucky, and in supplying electric power at wholesale to other utilities and municipalities in Kentucky. At December 31, 1993, KEPCo had 842 employees. In addition to its AEP System interconnection, KEPCo also is interconnected with the following unaffiliated utility companies: Kentucky Utilities Company and East Kentucky Power Cooperative Inc. KEPCo is also interconnected with TVA. Kingsport Power Company (organized in Virginia in 1917), which provides electric service to approximately 41,000 customers in Kingsport and eight neighboring communities in northeastern Tennessee. Kingsport Power Company has no generating facilities of its own. It purchases electric power distributed to its customers from APCo. At December 31, 1993, Kingsport Power Company had 102 employees. OPCo (organized in Ohio in 1907 and reincorporated in 1924), which is engaged in the generation, purchase, transmission and distribution of electric power to approximately 657,000 customers in the northwestern, east central, eastern and southern sections of Ohio, and in supplying electric power at wholesale to other electric utility companies and municipalities. At December 31, 1993, OPCo and its wholly owned subsidiaries had 5,749 employees. Among the principal industries served by OPCo are primary metals, stone, clay, glass and concrete products, rubber and plastic products, petroleum refining, chemicals and metal and wire products. In addition to its AEP System interconnection, OPCo also is interconnected with the following unaffiliated utility companies: CG&E, The Cleveland Electric Illuminating Company, DP&L, Duquesne Light Company, Kentucky Utilities Company, Monongahela Power Company, Ohio Edison Company, The Toledo Edison Company and West Penn Power Company. Wheeling Power Company (organized in West Virginia in 1883 and reincorporated in 1911), which provides electric service to approximately 41,000 customers in northern West Virginia. Wheeling Power Company has no generating facilities of its own. It purchases electric power distributed to its customers from OPCo. At December 31, 1993, Wheeling Power Company had 143 employees. Another principal electric utility subsidiary of AEP is AEGCo, which was organized in Ohio in 1982 as an electric generating company. AEGCo sells power at wholesale to I&M, KEPCo and VEPCo. AEGCo has no employees. See Item 2 Item 2.PROPERTIES - -------------------------------------------------------------------------------- At December 31, 1993, subsidiaries of AEP owned (or leased where indicated) generating plants with the net power capabilities (winter rating) shown in the following table: - -------- (a) Unit 1 of the Rockport Plant is owned one-half by AEGCo and one-half by I&M. Unit 2 of the Rockport Plant is leased one-half by AEGCo and one-half by I&M. The leases terminate in 2022 unless extended. (b) Unit 3 of the John E. Amos Plant is owned one-third by APCo and two-thirds by OPCo. (c) Represents CSPCo's ownership interest in generating units owned in common with CG&E and DP&L. (d) I&M plans to close the Breed Plant on March 31, 1994. (e) Leased from the City of Fort Wayne. Indiana. Since 1975, I&M has leased and operated the assets of the municipal system of the City of Fort Wayne, Indiana under a 35-year lease with a provision for an additional 15-year extension at the election of I&M. See Item 1 under Fuel Supply, for information concerning coal reserves owned or controlled by subsidiaries of AEP. The following table sets forth the total circuit miles of transmission and distribution lines of the AEP System, APCo, CSPCo, I&M, KEPCo and OPCo and that portion of the total representing 765,000-volt lines: - -------- (a)Includes jointly owned lines. (b)Includes lines of other AEP System companies not shown. TITLES The AEP System's electric generating stations are generally located on lands owned in fee simple. The greater portion of the transmission and distribution lines of the System has been constructed over lands of private owners pursuant to easements or along public highways and streets pursuant to appropriate statutory authority. The rights of the System in the realty on which its facilities are located are considered by it to be adequate for its use in the conduct of its business. Minor defects and irregularities customarily found in title to properties of like size and character may exist, but such defects and irregularities do not materially impair the use of the properties affected thereby. System companies generally have the right of eminent domain whereby they may, if necessary, acquire, perfect or secure titles to or easements on privately-held lands used or to be used in their utility operations. Substantially all the physical properties of APCo, CSPCo, I&M, KEPCo and OPCo are subject to the lien of the mortgage and deed of trust securing the first mortgage bonds of each such company. SYSTEM TRANSMISSION LINES AND FACILITY SITING Legislation in the states of Indiana, Kentucky, Michigan, Ohio, Virginia, and West Virginia requires prior approval of sites of generating facilities and/or routes of high-voltage transmission lines. Delays and additional costs in constructing facilities have been experienced as a result of proceedings conducted pursuant to such statutes, as well as in proceedings in which operating companies have sought to acquire rights-of-way through condemnation, and such proceedings may result in additional delays and costs in future years. PEAK DEMAND The AEP System is interconnected through 119 high-voltage transmission interconnections with 29 neighboring electric utility systems. The all-time and 1993 one-hour peak demands were 25,174,000 and 22,142,000 kilowatts, respectively, (including 6,459,000 and 4,043,000 kilowatts, respectively, of scheduled deliveries to unaffiliated systems which the System might, on appropriate notice, have elected not to schedule for delivery) and occurred on January 18, 1994 and July 26, 1993, respectively. The net dependable capacity to serve the System load on such dates, including power available under contractual obligations, was 24,202,000 and 23,896,000 kilowatts, respectively. The all-time and 1993 one-hour internal peak demands were 19,236,000 and 18,085,000 kilowatts, respectively, and occurred on January 19, 1994 and July 28, 1993, respectively. The net dependable capacity to serve the System load on such dates, including power available under contractual arrangements, was 24,202,000 and 23,896,000 kilowatts, respectively. The all-time one-hour integrated and internal net system peak demands and 1993 peak demands for AEP's generating subsidiaries are shown in the following tabulation: HYDROELECTRIC PLANTS Licenses for hydroelectric plants, issued under the Federal Power Act, reserve to the United States the right to take over the project at the expiration of the license term, to issue a new license to another entity, or to relicense the project to the existing licensee. In the event that a project is taken over by the United States or licensed to a new licensee, the Federal Power Act provides for payment to the existing licensee of its "net investment" plus severance damages. Licenses for six System hydroelectric plants expired in 1993 and applications for new licenses for these plants were filed in 1991. The existing licenses for these plants were extended on an annual basis and will be renewed automatically until new licenses are issued. No competing license applications were filed. One new license was issued in March 1994. COOK NUCLEAR PLANT Unit 1 of the Cook Plant, which was placed in commercial operation in 1975, has a nominal net electric rating of 1,020,000 kilowatts. Unit 1's availability factor was 100% during 1993 and 64.8% during 1992. Unit 2, of slightly different design, has a nominal net electrical rating of 1,090,000 kilowatts and was placed in commercial operation in 1978. Unit 2's availability factor was 96.6% during 1993 and 19.5% during 1992. The availability of Units 1 and 2 was affected in 1992 by outages to refuel and Unit 2 main turbine/generator vibrational problems. Units 1 and 2 are licensed by the NRC to operate at 100% of rated thermal power to October 25, 2014 and December 23, 2017, respectively. NUCLEAR INSURANCE The Price-Anderson Act limits public liability for a nuclear incident at any nuclear plant in the United States to $9.4 billion. I&M has insurance coverage for liability from a nuclear incident at its Cook Plant. Such coverage is provided through a combination of private liability insurance, with the maximum amount available of $200,000,000, and mandatory participation for the remainder of the $9.4 billion liability, in an industry retrospective deferred premium plan which would, in case of a nuclear incident, assess all licensees of nuclear plants in the U.S. Under the deferred premium plan, I&M could be assessed up to $158,600,000 payable in annual installments of $20,000,000 in the event of a nuclear incident at Cook or any other nuclear plant in the U.S. There is no limit on the number of incidents for which I&M could be assessed these sums. I&M also has property damage, decontamination and decommissioning insurance for loss resulting from damage to the Cook Plant facilities in the amount of $2.75 billion. Nuclear insurance pools provide $1.265 billion of coverage and Nuclear Electric Insurance Limited (NEIL) and Energy Insurance Bermuda (EIB) provide the remainder. If NEIL's and EIB's losses exceed their available resources, I&M would be subject to a total retrospective premium assessment of up to $15,327,023. NRC regulations require that, in the event of an accident, whenever the estimated costs of reactor stabilization and site decontamination exceed $100,000,000, the insurance proceeds must be used, first, to return the reactor to, and maintain it in, a safe and stable condition and, second, to decontaminate the reactor and reactor station site in accordance with a plan approved by the NRC. The insurers then would indemnify I&M for property damage up to $2.5 billion less any amounts used for stabilization and decontamination. The remaining $250,000,000, as provided by NEIL (reduced by any stabilization and decontamination expenditures over $2.5 billion), would cover decommissioning costs in excess of funds already collected for decommissioning. See Fuel Supply--Nuclear Waste. NEIL's extra-expense program provides insurance to cover extra costs resulting from a prolonged accidental outage of a nuclear unit. I&M's policy insures against such increased costs up to approximately $3,500,000 per week (starting 21 weeks after the outage) for one year, $2,350,000 per week for the second and third years, or 80% of those amounts per unit if both units are down for the same reason. If NEIL's losses exceed its available resources, I&M would be subject to a total retrospective premium assessment of up to $8,929,456. POTENTIAL UNINSURED LOSSES Some potential losses or liabilities may not be insurable or the amount of insurance carried may not be sufficient to meet potential losses and liabilities, including liabilities relating to damage to the Cook Plant and costs of replacement power in the event of a nuclear incident at the Cook Plant. Future losses or liabilities which are not completely insured, unless allowed to be recovered through rates, could have a material adverse effect on results of operation and the financial condition of AEP, I&M and other AEP System companies. Item 3. Item 3.LEGAL PROCEEDINGS - -------------------------------------------------------------------------------- In February 1990 the Supreme Court of Indiana overturned an order of the IURC, affirmed by the Indiana Court of Appeals, which had awarded I&M the right to serve a General Motors Corporation light truck manufacturing facility located in Fort Wayne. In August 1990 the IURC issued an order transferring the right to serve the GM facility to an unaffiliated local distribution utility. In October 1990 the local distribution utility sued I&M in Indiana under a provision of Indiana law that allows the local distribution utility to seek damages equal to the gross revenues received by a utility that renders retail service in the designated service territory of another utility. On November 30, 1992, the DeKalb Circuit Court granted I&M's motion for summary judgment to dismiss the local distribution utility's complaint. The local distribution utility has begun an appeal to the Indiana Court of Appeals. I&M received revenues of approximately $29,000,000 from serving the GM facility. It is not clear whether the plaintiffs claim will be upheld on appeal because the service was rendered in accordance with an IURC order I&M believed in good faith to be valid. On April 4, 1991, then Secretary of Labor Lynn Martin announced that the U.S. Department of Labor ("DOL") had issued a total of 4,710 citations to operators of 847 coal mines who allegedly submitted respirable dust sampling cassettes that had been altered so as to remove a portion of the dust. The cassettes were submitted in compliance with DOL regulations which require systematic sampling of airborne dust in coal mines and submission of the entire cassettes (which include filters for collecting dust particulates) to the Mine Safety and Health Administration ("MSHA") for analysis. The amount of dust contained on the cassette's filter determines an operator's compliance with respirable dust standards under the law. OPCo's Meigs No. 2, Meigs No. 31, Martinka, and Windsor Coal mines received 16, 3, 15 and 2 citations, respectively. MSHA has assessed civil penalties totalling $56,900 for all these citations. OPCo's samples in question involve about 1 percent of the 2,500 air samples that OPCo submitted over a 20-month period from 1989 through 1991 to the DOL. OPCo is contesting the citations before the Federal Mine Safety and Health Review Commission. An administrative hearing was held before an administrative law judge with respect to all affected coal operators. On July 20, 1993, the administrative law judge rendered a decision in this case holding that the Secretary of Labor failed to establish that the presence of a "white center" on the dust sampling filter indicated intentional alteration. The administrative law judge has set for trial the case of an unaffiliated mine to determine if there was an intentional alteration of the dust sampling filter. All remaining cases, including the citations involving OPCo's mines, have been stayed. On September 21, 1993, CSPCo was served with a complaint issued by Region V, Federal EPA which alleged violations by Conesville Plant of the Toxic Substances Control Act and proposed a penalty of $41,000. On October 4, 1993, I&M was served with a complaint issued by Region V, Federal EPA which alleged violations by Breed Plant of the Clean Water Act and proposed a penalty of $70,000. On October 4, 1993, OPCo was served with a complaint issued by Region V, Federal EPA which alleged violations by OPCo's General Service Center (Canton, Ohio) of the Toxic Substances Control Act and proposed a penalty of $24,000. Settlement discussions have been held in each of these cases and it is expected that these matters will be resolved shortly. On June 18, 1993, OPCo was served with a complaint issued by Region V, Federal EPA which alleged violations by Muskingum River Plant of the Toxic Substances Control Act and proposed a penalty of $87,000. In February 1994, OPCo paid a penalty of $12,185 and agreed to undertake supplemental environmental projects in 1994 valued at $61,547. On February 28, 1994, Ormet Corporation filed a complaint in the U.S. District Court, Northern District of West Virginia, against AEP, OPCo, the Service Corporation and two of its employees, Federal EPA and the Administrator of Federal EPA. Ormet is the operator of a major aluminum reduction plant in Ohio and is a customer of OPCo. See Certain Industrial Contracts. Pursuant to the Clean Air Act Amendments of 1990, OPCo received sulfur dioxide emission allowances for its Kammer Plant. See Environmental and Other Matters. Ormet's complaint seeks a declaration that it is the owner of approximately 89% of the Phase I and Phase II allowances issued for use by the Kammer Plant. OPCo believes that since it is the owner and operator of Kammer Plant and Ormet is a contract power customer, Ormet is not entitled to any of the allowances attributable to the Kammer Plant. See Item 1 for a discussion of certain environmental and rate matters. Meigs Mine--On July 11, 1993, water from an adjoining sealed and abandoned mine owned by Southern Ohio Coal Company ("SOCCo"), a mining subsidiary of OPCo, entered Meigs 31 mine, one of two mines currently being operated by SOCCo. Ohio EPA approved a plan to pump water from the mine to certain Ohio River tributaries under stringent conditions for biological and water quality monitoring and restoring the streams after pumping. On July 30, pumping commenced in accordance with the Ohio EPA approved plan. Since September 16, 1993, SOCCo has processed all water removed from the mine through its expanded treatment system and is in compliance with the effluent limitations in its water discharge permit. Pumping has removed most of the water that entered the mine on July 11 and the mine was returned to service in February 1994. On July 26, 1993, the Ohio Department of Natural Resources Division of Reclamation issued an administrative order directing SOCCo to cease pumping due to that agency's concern over possible environmental harm. On July 26, 1993, following SOCCo's appeal of the cessation order, the chairman of the Reclamation Board of Review issued a temporary stay pending a hearing by the full Reclamation Board. On January 14, 1994, the administrative proceeding was settled on the basis of agreements by the Division of Reclamation to dismiss the administrative order and by SOCCo to treat all water removed from the mine in accordance with its discharge permit and to pay certain expenses of the Division of Reclamation. On August 19, 1993, the U.S. District Court for the Southern District of Ohio granted SOCCo's motion for a preliminary injunction against the Federal Office of Surface Mining Reclamation and Enforcement ("OSM") and Federal EPA preventing them from exercising jurisdiction to issue orders to cease pumping. On August 30, 1993, the U.S. Court of Appeals for the Sixth Circuit denied OSM's motion for a stay of the District Court's preliminary injunction but granted Federal EPA's motion for a stay in part which allowed Federal EPA to investigate and make findings with respect to alleged violations of the Clean Water Act and thereafter to exercise its enforcement authority under the Clean Water Act if a violation was identified. On September 2, 1993, Federal EPA issued an administrative order requiring a partial cessation of pumping, the effect of which was delayed by Federal EPA until September 8, 1993. On September 8, 1993, the District Court granted SOCCo's motion requesting that enforcement of the Federal EPA order be stayed. On September 23, 1993, the Court of Appeals ruled that the District Court could not review the Federal EPA order in the absence of a civil enforcement action and lifted the stay. A further decision of the Court of Appeals with respect to the appeal of the preliminary injunction is pending. On January 3, 1994, the District Court held that the complaint filed by SOCCo should not be dismissed and concluded that sufficient legal and factual grounds existed for the court to consider SOCCo's claim that Federal EPA could not override Ohio EPA's authorization for SOCCo to bypass its water treatment system on an emergency basis during pumping activities. In a separate opinion, the District Court denied Federal EPA's request that the District Court defer consideration of SOCCo's motion involving a request for a Declaration of Rights with respect to the mine water releases into area streams. The West Virginia Division of Environmental Protection ("West Virginia DEP") has proposed fining SOCCo $1,800,000 for violations of West Virginia Water Quality Standards and permitting requirements alleged to have resulted from the release of mine water into the Ohio River. SOCCo is meeting with the West Virginia DEP in an attempt to resolve this matter. Although management is unable to predict what enforcement action Federal EPA or OSM may take, the resolution of the aforementioned litigation, environmental mitigation costs and mine restoration costs are not expected to have a material adverse impact on results of operations or financial condition. Item 4. Item 4.SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - -------------------------------------------------------------------------------- AEP, APCO, I&M AND OPCO. None. AEGCO, CSPCO AND KEPCO. Omitted pursuant to Instruction J(2)(c). ---------------- EXECUTIVE OFFICERS OF THE REGISTRANTS AEP The following persons are, or may be deemed, executive officers of AEP. Their ages are given as of March 15, 1994. - -------- (a) All of the executive officers listed above have been employed by the Service Corporation or System companies in various capacities (AEP, as such, has no employees) during the past five years, except E. Linn Draper, Jr. who was Chairman of the Board, President and Chief Executive Officer of Gulf States Utilities Company from 1987 until 1992 when he joined AEP and the Service Corporation. All of the above officers are appointed annually for a one-year term by the board of directors of AEP, the board of directors of the Service Corporation, or both, as the case may be. APCO The names of the executive officers of APCo, the positions they hold with APCo, their ages as of March 15, 1994, and a brief account of their business experience during the past five years appears below. The directors and executive officers of APCo are elected annually to serve a one-year term. - -------- (a)Positions are with APCo unless otherwise indicated. OPCO The names of the executive officers of OPCo, the positions they hold with OPCo, their ages as of March 15, 1994, and a brief account of their business experience during the past five years appear below. The directors and executive officers of OPCo are elected annually to serve a one-year term. - -------- (a)Positions are with OPCo unless otherwise indicated. PART II --------------------------------------------------------------------- Item 5. Item 5.MARKET FOR REGISTRANTS' COMMON EQUITY AND RELATED STOCKHOLDER MATTERS - -------------------------------------------------------------------------------- AEP. AEP Common Stock is traded principally on the New York Stock Exchange. The following table sets forth for the calendar periods indicated the high and low sales prices for the Common Stock as reported on the New York Stock Exchange Composite Tape and the amount of cash dividends paid per share of Common Stock. - -------- (1) See Note 5 of the Notes to the Consolidated Financial Statements of AEP for information regarding restrictions on payment of dividends. At December 31, 1993, AEP had approximately 194,000 shareholders of record. AEGCO, APCO, CSPCO, I&M, KEPCO AND OPCO. The information required by this item is not applicable as the common stock of all these companies is held solely by AEP. Item 6. Item 6.SELECTED FINANCIAL DATA - -------------------------------------------------------------------------------- AEGCO. Omitted pursuant to Instruction J(2)(a). AEP. The information required by this item is incorporated herein by reference to the material under Selected Consolidated Financial Data in the AEP 1993 Annual Report (for the fiscal year ended December 31, 1993). APCO. The information required by this item is incorporated herein by reference to the material under Selected Consolidated Financial Data in the APCo 1993 Annual Report (for the fiscal year ended December 31, 1993). CSPCO. Omitted pursuant to Instruction J(2)(a). I&M. The information required by this item is incorporated herein by reference to the material under Selected Consolidated Financial Data in the I&M 1993 Annual Report (for the fiscal year ended December 31, 1993). KEPCO. Omitted pursuant to Instruction J(2)(a). OPCO. The information required by this item is incorporated herein by reference to the material under Selected Consolidated Financial Data in the OPCo 1993 Annual Report (for the fiscal year ended December 31, 1993). Item 7. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION - -------------------------------------------------------------------------------- AEGCO. Omitted pursuant to Instruction J(2)(a). Management's narrative analysis of the results of operations and other information required by Instruction J(2)(a) is incorporated herein by reference to the material under Management's Narrative Analysis of Results of Operations in the AEGCo 1993 Annual Report (for the fiscal year ended December 31, 1993). AEP. The information required by this item is incorporated herein by reference to the material under Management's Discussion and Analysis of Results of Operations and Financial Condition in the AEP 1993 Annual Report (for the fiscal year ended December 31, 1993). APCO. The information required by this item is incorporated herein by reference to the material under Management's Discussion and Analysis of Results of Operations and Financial Condition in the APCo 1993 Annual Report (for the fiscal year ended December 31, 1993). CSPCO. Omitted pursuant to Instruction J(2)(a). Management's narrative analysis of the results of operations and other information required by Instruction J(2)(a) is incorporated herein by reference to the material under Management's Narrative Analysis of Results of Operations in the CSPCo 1993 Annual Report (for the fiscal year ended December 31, 1993). I&M. The information required by this item is incorporated herein by reference to the material under Management's Discussion and Analysis of Results of Operations and Financial Condition in the I&M 1993 Annual Report (for the fiscal year ended December 31, 1993). KEPCO. Omitted pursuant to Instruction J(2)(a). Management's narrative analysis of the results of operations and other information required by Instruction J(2)(a) is incorporated herein by reference to the material under Management's Narrative Analysis of Results of Operations in the KEPCo 1993 Annual Report (for the fiscal year ended December 31, 1993). OPCO. The information required by this item is incorporated herein by reference to the material under Management's Discussion and Analysis of Results of Operations and Financial Condition in the OPCo 1993 Annual Report (for the fiscal year ended December 31, 1993). Item 8. Item 8.FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - -------------------------------------------------------------------------------- AEGCO. The information required by this item is incorporated herein by reference to the financial statements and supplementary data described under Item 14 herein. AEP. The information required by this item is incorporated herein by reference to the financial statements and supplementary data described under Item 14 herein. APCO. The information required by this item is incorporated herein by reference to the financial statements and supplementary data described under Item 14 herein. CSPCO. The information required by this item is incorporated herein by reference to the financial statements and supplementary data described under Item 14 herein. I&M. The information required by this item is incorporated herein by reference to the financial statements and supplementary data described under Item 14 herein. KEPCO. The information required by this item is incorporated herein by reference to the financial statements and supplementary data described under Item 14 herein. OPCO. The information required by this item is incorporated herein by reference to the financial statements and supplementary data described under Item 14 herein. Item 9. Item 9.CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE - -------------------------------------------------------------------------------- AEGCO, AEP, APCO, CSPCO, I&M, KEPCO AND OPCO. None. PART III -------------------------------------------------------------------- Item 10. Item 10.DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANTS - -------------------------------------------------------------------------------- AEGCO. Omitted pursuant to Instruction J(2)(c). AEP. The information required by this item is incorporated herein by reference to the material under Nominees for Director and Share Ownership of Directors and Executive Officers of the definitive proxy statement of AEP, dated March 10, 1994, for the 1994 annual meeting of shareholders. Reference also is made to the information under the caption Executive Officers of the Registrants in Part I of this report. APCO. The information required by this item is incorporated herein by reference to the material under Election of Directors of the definitive information statement of APCo for the 1994 annual meeting of stockholders, to be filed within 120 days after December 31, 1993. Reference also is made to the information under the caption Executive Officers of the Registrants in Part I of this report. CSPCO. Omitted pursuant to Instruction J(2)(c). I&M. The names of the directors and executive officers of I&M, the positions they hold with I&M, their ages as of March 15, 1994, and a brief account of their business experience during the past five years appear below. The directors and executive officers of I&M are elected annually to serve a one- year term. - -------- (a)Positions are with I&M unless otherwise indicated. (b)Dr. Draper is a director of Pacific Nuclear Systems, Inc. and Mr. Lhota is a director of Huntington Bancshares Incorporated. (c)Messrs. DeMaria, Dowd, Draper, Lhota and Maloney are directors of AEGCo, APCo, CSPCo, KEPCo and OPCo. Messrs. DeMaria, Dowd, Draper and Maloney are also directors of AEP. KEPCO. Omitted pursuant to Instruction J(2)(c). OPCO. The information required by this item is incorporated herein by reference to the material under the heading Election of Directors of the definitive information statement of OPCo for the 1994 annual meeting of shareholders, to be filed within 120 days after December 31, 1993. Reference also is made to the information under the caption Executive Officers of the Registrants in Part I of this report. Item 11. Item 11.EXECUTIVE COMPENSATION - ------------------------------------------------------------------------------- AEGCO. Omitted pursuant to Instruction J(2)(c). AEP. The information required by this item is incorporated herein by reference to the material under Compensation of Directors, Executive Compensation and the performance graph of the definitive proxy statement of AEP, dated March 10, 1994, for the 1994 annual meeting of shareholders. APCO. The information required by this item is incorporated herein by reference to the material under Executive Compensation of the definitive information statement of APCo for the 1994 annual meeting of stockholders, to be filed within 120 days after December 31, 1993. CSPCO. Omitted pursuant to Instruction J(2)(c). KEPCO. Omitted pursuant to Instruction J(2)(c). OPCO. The information required by this item is incorporated herein by reference to the material under Executive Compensation of the definitive information statement of OPCo for the 1994 annual meeting of shareholders, to be filed within 120 days after December 31, 1993. I&M Certain executive officers of I&M are employees of the Service Corporation. The salaries of these executive officers are paid by the Service Corporation and a portion of their salaries has been allocated and charged to I&M. The following table shows for 1993, 1992 and 1991 the compensation earned from all AEP System companies by (i) the chief executive officer and four other most highly compensated executive officers (as defined by regulations of the SEC) of I&M at December 31, 1993 and (ii) a chief executive officer and executive officer, both of whom retired in 1993. Summary Compensation Table - -------- (1) Reflects payments under the AEP Management Incentive Compensation Plan ("MICP") in which individuals in key management positions with AEP System companies participate. Amounts for 1993 are estimates but should not change significantly. For 1991 and 1993, these amounts included both cash paid and a portion deferred in the form of restricted stock units. These units are paid out in cash after three years based on the price of AEP Common Stock at that time. Dividend equivalents are paid during the three- year period. At December 31, 1993, Dr. Draper and Messrs. DeMaria, Maloney, Dowd and Lhota held 813, 746, 715, 593 and 639 units having a value of $30,177, $27,701, $26,526, $22,020 and $23,730, respectively, based upon a $37 1/8 per share closing price of AEP's Common Stock as reported on the New York Stock Exchange. For 1992, MICP payments were made entirely in cash. (2) Includes amounts contributed by AEP System companies under the American Electric Power System Employees Savings Plan on behalf of their employee participants. For 1993 this amount was $7,075 for Dr. Draper and Messrs. Katlic, Maloney, Dowd and Lhota and $6,000 for Mr. Disbrow and $7,006 for Mr. DeMaria. The AEP System Savings Plan is available to all employees of AEP System companies (except for employees covered by certain collective bargaining agreements) who have met minimum service requirements. Includes director's fees for AEP System companies. For 1993 these fees were: Dr. Draper, $11,105; Mr. Disbrow, $3,580; Mr. DeMaria, $10,805; Mr. Katlic, $2,300; Mr. Maloney, $10,925; Mr. Dowd, $8,685; and Mr. Lhota, $10,085. Includes payments of $93,173 and $36,077 for unused accrued vacation which Messrs. Disbrow and Katlic, respectively, received upon their retirement. (3) Dr. Draper was elected chairman of the board and chief executive officer of I&M and other AEP System companies and chairman of the board, president and chief executive officer of AEP and the Service Corporation, succeeding Mr. Disbrow, who retired, effective April 28, 1993. Retirement Benefits The American Electric Power System Retirement Plan provides pensions for all employees of AEP System companies (except for employees covered by certain collective bargaining agreements), including the executive officers of I&M. The Retirement Plan is a noncontributory defined benefit plan. The following table shows the approximate annual annuities under the Retirement Plan that would be payable to employees in certain higher salary classifications, assuming retirement at age 65 after various periods of service. The amounts shown in the table are the straight life annuities payable under the Plan without reduction for the joint and survivor annuity. Retirement benefits listed in the table are not subject to any deduction for Social Security or other offset amounts. The retirement annuity is reduced 3% per year in the case of retirement between ages 60 and 62 and further reduced 6% per year in the case of retirement between ages 55 and 60. If an employee retires after age 62, there is no reduction in the retirement annuity. PENSION PLAN TABLE Compensation upon which retirement benefits are based consists of the average of the 36 consecutive months of the employee's highest salary, as listed in the Summary Compensation Table, out of the employee's most recent 10 years of service. With respect to Messrs. Disbrow and Katlic, since they retired in 1993, the amounts of $600,000 and $316,944, respectively, are the actual salaries upon which their retirement benefits are based. Mr. Disbrow's retirement benefit was enhanced by computing his benefit based on his 1992 base salary. As of December 31, 1993, the number of full years of service credited under the Retirement Plan to each of the executive officers of I&M named in the Summary Compensation Table were as follows: Dr. Draper, 1 year; Mr. Disbrow, 39 years; Mr. DeMaria, 34 years; Mr. Katlic, 10 years; Mr. Maloney, 38 years; Mr. Dowd, 31 years; and Mr. Lhota, 29 years. Dr. Draper's employment agreement described below provides him with a supplemental retirement annuity that credits him with 24 years of service in addition to his years of service credited under the Retirement Plan less his actual pension entitlement under the Retirement Plan and any pension entitlements from prior employers. Mr. Katlic has a contract with the Service Corporation under which the Service Corporation agrees to provide him with a supplemental retirement annuity equal to the annual pension that Mr. Katlic would have received with service of 30 years under the AEP System Retirement Plan as then in effect, less his actual annual pension entitlement under the Retirement Plan. Mr. Katlic commenced receiving his supplemental annuity upon his retirement effective October 31, 1993. AEP has determined to pay supplemental retirement benefits to 23 AEP System employees (including Messrs. Disbrow, DeMaria, Maloney and Lhota) whose pensions may be adversely affected by amendments to the Retirement Plan made as a result of the Tax Reform Act of 1986. Such payments, if any, will be equal to any reduction occurring because of such amendments. Upon his retirement on April 28, 1993, Mr. Disbrow began receiving an annual supplemental benefit of $2,642. Assuming retirement of the remaining eligible employees in 1994, none would be eligible to receive supplemental benefits. AEP made available a voluntary deferred-compensation program in 1982 and 1986, which permitted certain executive employees of AEP System companies to defer receipt of a portion of their salaries. Under this program, an executive was able to defer up to 10% or 15% annually (depending on the terms of the program offered), over a four-year period, of his or her salary, and receive supplemental retirement or survivor benefit payments over a 15-year period. The amount of supplemental retirement payments received is dependent upon the amount deferred, age at the time the deferral election was made, and number of years until the executive retires. The following table sets forth, for the executive officers named in the Summary Compensation Table, the amounts of annual deferrals and, assuming retirement at age 65, annual supplemental retirement payments under the 1982 and 1986 programs. Employment Agreement Dr. Draper has a contract with AEP and the Service Corporation which provides for his employment for an initial term from no later than March 15, 1992 until March 15, 1997. Dr. Draper commenced his employment with AEP and the Service Corporation on March 1, 1992. AEP or the Service Corporation may terminate the contract at any time and, if this is done for reasons other than cause and other than as a result of Dr. Draper's death or permanent disability, the Service Corporation must pay Dr. Draper's then base salary through March 15, 1997, less any amounts received by Dr. Draper from other employment. -------------- Directors of I&M receive a fee of $100 for each meeting of the Board of Directors attended in addition to their salaries. -------------- The AEP System is an integrated electric utility system and, as a result, the member companies of the AEP System have contractual, financial and other business relationships with the other member companies, such as participation in the AEP System savings and retirement plans and tax returns, sales of electricity, transportation and handling of fuel, sales or rentals of property and interest or dividend payments on the securities held by the companies' respective parents. Item 12. Item 12.SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT - ------------------------------------------------------------------------------- AEGCO. Omitted pursuant to Instruction J(2)(c). AEP. The information required by this item is incorporated herein by reference to the material under Share Ownership of Directors and Executive Officers of the definitive proxy statement of AEP, dated March 10, 1994, for the 1994 annual meeting of shareholders. APCO. The information required by this item is incorporated herein by reference to the material under Share Ownership of Directors and Executive Officers in the definitive information statement of APCo for the 1994 annual meeting of stockholders, to be filed within 120 days after December 31, 1993. CSPCO. Omitted pursuant to Instruction J(2)(c). I&M. All 1,400,000 outstanding shares of Common Stock, no par value, of I&M are directly and beneficially held by AEP. Holders of the Cumulative Preferred Stock of I&M generally have no voting rights, except with respect to certain corporate actions and in the event of certain defaults in the payment of dividends on such shares. The table below shows the number of shares of AEP Common Stock that were beneficially owned, directly or indirectly, as of December 31, 1993, by each director and nominee of I&M and each of the executive officers of I&M named in the summary compensation table, and by all directors and executive officers of I&M as a group. It is based on information provided to I&M by such persons. No such person owns any shares of any series of the Cumulative Preferred Stock of I&M. Unless otherwise noted, each person has sole voting power and investment power over the number of shares of AEP Common Stock set forth opposite his name. Fractions of shares have been rounded to the nearest whole share. - -------- (a) The amounts include shares held by the trustee of the AEP Employees Savings Plan, over which directors, nominees and executive officers have voting power, but the investment/disposition power is subject to the terms of such Plan, as follows: Mr. Bailey, 550 shares; Mr. DeMaria, 2,081 shares; Mr. Disbrow, 4,027 shares; Mr. D'Onofrio, 2,889 shares; Mr. Katlic, 2,230 shares; Mr. Lhota, 5,245 shares; Mr. Maloney, 2,142 shares; Mr. Menge, 2,566 shares; Mr. Prater, 1,561 shares; Mr. Synowiec, 1,754 shares; Mr. Walters, 3,685 shares; and all directors and executive officers as a group, 33,806 shares. Messrs. Disbrow's, Dowd's and Maloney's holdings include 85 shares each; Messrs. Bailey's, DeMaria's, D'Onofrio's, Katlic's, Lhota's, Menge's, Prater's, Synowiec's, and Walter's holdings include 44, 83, 59, 60, 60, 62, 48, 53 and 45 shares, respectively; and the holdings of all directors and executive officers as a group include 738 shares, each held by the trustee of the AEP Employee Stock Ownership Plan, over which shares such persons have sole voting power, but the investment/disposition power is subject to the terms of such Plan. (b) Includes shares with respect to which such directors, nominees and executive officers share voting and investment power as follows: Mr. DeMaria, 3,624 shares; Mr. Disbrow, 283 shares; Mr. Draper, 115 shares; Mr. Lhota, 1,368 shares; Mr. Maloney, 2,000 shares; Mr. Menge, 24 shares; and all directors and executive officers as a group, 7,883 shares. Mr. DeMaria disclaims beneficial ownership of 807 shares. (c) 85,231 shares in the American Electric Power System Educational Trust Fund, over which Messrs. DeMaria, Lhota and Maloney share voting and investment power as trustees (they disclaim beneficial ownership of such shares), are not included in their individual totals, but are included in the group total. (d) Represents less than 1 percent of the total number of shares outstanding on December 31, 1993. KEPCO. Omitted pursuant to Instruction J(2)(c). OPCO. The information required by this item is incorporated herein by reference to the material under Share Ownership of Directors and Executive Officers in the definitive information statement of OPCo for the 1994 annual meeting of shareholders, to be filed within 120 days after December 31, 1993. Item 13. Item 13.CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS - ------------------------------------------------------------------------------- AEP. The information required by this item is incorporated herein by reference to the material under Transactions With Management of the definitive proxy statement of AEP, dated March 10, 1994, for the 1994 annual meeting of shareholders. APCO, I&M AND OPCO. None. AEGCO, CSPCO, AND KEPCO. Omitted pursuant to Instruction J(2)(c). PART IV ------------------------------------------------------------------- Item 14. Item 14.EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K - -------------------------------------------------------------------------------- (a) The following documents are filed as a part of this report: (b) No Reports on Form 8-K were filed during the quarter ended December 31, 1993. 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. THE SIGNATURE OF THE UNDERSIGNED COMPANY SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO SUCH COMPANY AND ANY SUBSIDIARIES THEREOF. AEP Generating Company By: /s/ G. P. Maloney --------------------------------- (G. P. MALONEY, VICE PRESIDENT) Date: March 23, 1994 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 DATES INDICATED. THE SIGNATURE OF EACH OF THE UNDERSIGNED SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO THE ABOVE-NAMED COMPANY AND ANY SUBSIDIARIES THEREOF. SIGNATURE TITLE DATE --------- ----- ---- (I) PRINCIPAL EXECUTIVE OFFICER: *E. Linn Draper, Jr. President, Chief Executive Officer and Director (II) PRINCIPAL FINANCIAL OFFICER: /s/ G. P. Maloney Vice President and March 23, 1994 - ------------------------------------- Director (G. P. MALONEY) (III) PRINCIPAL ACCOUNTING OFFICER: /s/ P. J. DeMaria Vice President, March 23, 1994 - ------------------------------------- Treasurer and (P. J. DEMARIA) Director (IV) A MAJORITY OF THE DIRECTORS: *A. Joseph Dowd *Henry Fayne *John R. Jones, III *Wm. J. Lhota *James J. Markowsky /s/ G. P. Maloney *By: ---------------------------------- March 23, 1994 (G. P. MALONEY, ATTORNEY-IN-FACT) 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. American Electric Power Company, Inc. By: /s/ G. P. Maloney --------------------------------- (G. P. MALONEY, VICE PRESIDENT) Date: March 23, 1994 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 DATES INDICATED. SIGNATURE TITLE DATE --------- ----- ---- (I) PRINCIPAL EXECUTIVE OFFICER: *E. Linn Draper, Jr. Chairman of the Board, President, Chief Executive Officer and Director (II) PRINCIPAL FINANCIAL OFFICER: /s/ G. P. Maloney Vice President and March 23, 1994 - ------------------------------------- Director (G. P. MALONEY) (III) PRINCIPAL ACCOUNTING OFFICER: /s/ P. J. DeMaria Treasurer and March 23, 1994 - ------------------------------------- Director (P. J. DEMARIA) (IV) A MAJORITY OF THE DIRECTORS: *A. Joseph Dowd *Robert M. Duncan *Arthur G. Hansen *Lester A. Hudson, Jr. *Angus E. Peyton *Toy F. Reid *W. Ann Reynolds *Linda Gillespie Stuntz *Morris Tanenbaum *Ann Haymond Zwinger *By: /s/ G. P. Maloney ---------------------------------- March 23, 1994 (G. P. MALONEY, ATTORNEY-IN-FACT) 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. THE SIGNATURE OF THE UNDERSIGNED COMPANY SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO SUCH COMPANY AND ANY SUBSIDIARIES THEREOF. Appalachian Power Company By: /s/ G. P. Maloney --------------------------------- (G. P. MALONEY, VICE PRESIDENT) Date: March 23, 1994 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 DATES INDICATED. THE SIGNATURE OF EACH OF THE UNDERSIGNED SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO THE ABOVE-NAMED COMPANY AND ANY SUBSIDIARIES THEREOF. SIGNATURE TITLE DATE --------- ----- ---- (I) PRINCIPAL EXECUTIVE OFFICER: *E. Linn Draper, Jr. Chairman of the Board, Chief Executive Officer and Director (II) PRINCIPAL FINANCIAL OFFICER: /s/ G. P. Maloney Vice President and March 23, 1994 - ------------------------------------- Director (G. P. MALONEY) (III) PRINCIPAL ACCOUNTING OFFICER: /s/ P. J. DeMaria Vice President, March 23, 1994 - ------------------------------------- Treasurer and (P. J. DEMARIA) Director (IV) A MAJORITY OF THE DIRECTORS: *A. Joseph Dowd *Luke M. Feck *Wm. J. Lhota *James J. Markowsky *J. H. Vipperman *By: /s/ G. P. Maloney ---------------------------------- March 23, 1994 (G. P. MALONEY, ATTORNEY-IN-FACT) 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. THE SIGNATURE OF THE UNDERSIGNED COMPANY SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO SUCH COMPANY AND ANY SUBSIDIARIES THEREOF. Columbus Southern Power Company By: /s/ G. P. Maloney --------------------------------- (G. P. MALONEY, VICE PRESIDENT) Date: March 23, 1994 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 DATES INDICATED. THE SIGNATURE OF EACH OF THE UNDERSIGNED SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO THE ABOVE-NAMED COMPANY AND ANY SUBSIDIARIES THEREOF. SIGNATURE TITLE DATE --------- ----- ---- (I) PRINCIPAL EXECUTIVE OFFICER: *E. Linn Draper, Jr. Chairman of the Board, Chief Executive Officer and Director (II) PRINCIPAL FINANCIAL OFFICER: /s/ G. P. Maloney Vice President and March 23, 1994 - ------------------------------------- Director (G. P. MALONEY) (III) PRINCIPAL ACCOUNTING OFFICER: Vice President, March 23, 1994 /s/ P. J. DeMaria Treasurer and - ------------------------------------- Director (P. J. DEMARIA) (IV) A MAJORITY OF THE DIRECTORS: *A. Joseph Dowd *C. A. Erikson *Henry Fayne *Wm. J. Lhota *James J. Markowsky *By: /s/ G. P. Maloney ---------------------------------- March 23, 1994 (G. P. MALONEY, ATTORNEY-IN-FACT) 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. THE SIGNATURE OF THE UNDERSIGNED COMPANY SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO SUCH COMPANY AND ANY SUBSIDIARIES THEREOF. Indiana Michigan Power Company By: /s/ G. P. Maloney --------------------------------- (G. P. MALONEY, VICE PRESIDENT) Date: March 23, 1994 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 DATES INDICATED. THE SIGNATURE OF EACH OF THE UNDERSIGNED SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO THE ABOVE-NAMED COMPANY AND ANY SUBSIDIARIES THEREOF. SIGNATURE TITLE DATE --------- ----- ---- (I) PRINCIPAL EXECUTIVE OFFICER: *E. Linn Draper, Jr. Chairman of the Board, Chief Executive Officer and Director (II) PRINCIPAL FINANCIAL OFFICER: /s/ G. P. Maloney Vice President and March 23, 1994 - ------------------------------------- Director (G. P. MALONEY) (III) PRINCIPAL ACCOUNTING OFFICER: /s/ P. J. DeMaria Vice President, March 23, 1994 - ------------------------------------- Treasurer and (P. J. DEMARIA) Director (IV) A MAJORITY OF THE DIRECTORS: *Mark A. Bailey *W. N. D'Onofrio *A. Joseph Dowd *Wm. J. Lhota *Richard C. Menge *R. E. Prater *D. B. Synowiec *W. E. Walters *By: /s/ G. P. Maloney March 23, 1994 ---------------------------------- (G. P. MALONEY, ATTORNEY-IN-FACT) 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. THE SIGNATURE OF THE UNDERSIGNED COMPANY SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO SUCH COMPANY AND ANY SUBSIDIARIES THEREOF. Kentucky Power Company By: /s/ G. P. Maloney --------------------------------- (G. P. MALONEY, VICE PRESIDENT) Date: March 23, 1994 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 DATES INDICATED. THE SIGNATURE OF EACH OF THE UNDERSIGNED SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO THE ABOVE-NAMED COMPANY AND ANY SUBSIDIARIES THEREOF. SIGNATURE TITLE DATE --------- ----- ---- (I) PRINCIPAL EXECUTIVE OFFICER: *E. Linn Draper, Jr. Chairman of the Board, Chief Executive Officer and Director (II) PRINCIPAL FINANCIAL OFFICER: /s/ G. P. Maloney Vice President and March 23, 1994 - ------------------------------------- Director (G. P. MALONEY) (III) PRINCIPAL ACCOUNTING OFFICER: /s/ P. J. DeMaria Vice President, March 23, 1994 - ------------------------------------- Treasurer and (P. J. DEMARIA) Director (IV) A MAJORITY OF THE DIRECTORS: *C. R. Boyle, III *A. Joseph Dowd *Wm. J. Lhota *Ronald A. Petti *By: /s/ G. P. Maloney --------------------------------- March 23, 1994 (G. P. MALONEY, ATTORNEY-IN-FACT) 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. THE SIGNATURE OF THE UNDERSIGNED COMPANY SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO SUCH COMPANY AND ANY SUBSIDIARIES THEREOF. Ohio Power Company By: /s/ G. P. Maloney --------------------------------- (G. P. MALONEY, VICE PRESIDENT) Date: March 23, 1994 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 DATES INDICATED. THE SIGNATURE OF EACH OF THE UNDERSIGNED SHALL BE DEEMED TO RELATE ONLY TO MATTERS HAVING REFERENCE TO THE ABOVE-NAMED COMPANY AND ANY SUBSIDIARIES THEREOF. SIGNATURES TITLE DATE ---------- ----- ---- (I) PRINCIPAL EXECUTIVE OFFICER: *E. Linn Draper, Jr. Chairman of the Board, Chief Executive Officer and Director (II) PRINCIPAL FINANCIAL OFFICER: /s/ G. P. Maloney Vice President and March 23, 1994 - ------------------------------------- Director (G. P. MALONEY) (III) PRINCIPAL ACCOUNTING OFFICER: /s/ P. J. DeMaria Vice President, March 23, 1994 - ------------------------------------- Treasurer and (P. J. DEMARIA) Director (IV) A MAJORITY OF THE DIRECTORS: *A. Joseph Dowd *C. A. Erikson *Henry Fayne *Wm. J. Lhota *James J. Markowsky *By: /s/ G. P. Maloney March 23, 1994 ---------------------------------- (G. P. MALONEY, ATTORNEY-IN-FACT) INDEX TO FINANCIAL STATEMENT SCHEDULES S-1 INDEPENDENT AUDITORS' REPORT American Electric Power Company, Inc. and Subsidiaries: We have audited the consolidated financial statements of American Electric Power Company, Inc. and its subsidiaries and the financial statements of certain of its subsidiaries, listed in Item 14 herein, as of December 31, 1993 and 1992, and for each of the three years in the period ended December 31, 1993, and have issued our reports thereon dated February 22, 1994; such financial statements and reports are included in your respective 1993 Annual Report to Shareowners and are incorporated herein by reference. Our audits also included the financial statement schedules of American Electric Power Company, Inc. and its subsidiaries and of certain of its subsidiaries, listed in Item 14. These financial statement schedules are the responsibility of the respective Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, such financial statement schedules, when considered in relation to the corresponding basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. Deloitte & Touche Columbus, Ohio February 22, 1994 S-2 AMERICAN ELECTRIC POWER COMPANY, INC. AND SUBSIDIARY COMPANIES SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Total additions of $676,404,000 in 1993, $718,154,000 in 1992 and $733,909,000 in 1991 were less than 10% of the total as of the respective year- ends. Retirements or sales of $278,435,000 in 1993, $297,460,000 in 1992 and $198,352,000 in 1991 were less than 10% of the total as of the respective year- ends. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. Amortization of nuclear fuel of $41,325,000 in 1993, $19,343,000 in 1992 and $50,124,000 in 1991 was credited directly to the property account and charged to fuel expense. In 1993 other charges include a reduction of $157,535,000 to reflect the PUCO disallowance of a portion of the Zimmer Plant investment as discussed in Note 3 of the Notes to Consolidated Financial Statements. The methods used to compute the annual provisions for depreciation are described in Note 1 of the Notes to Consolidated Financial Statements. The current provisions were determined using the following composite rates for functional classes of property: S-3 AMERICAN ELECTRIC POWER COMPANY, INC. AND SUBSIDIARY COMPANIES SCHEDULE VI -- ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- S-4 AMERICAN ELECTRIC POWER COMPANY, INC. AND SUBSIDIARY COMPANIES SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS AND RESERVES - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a)Recoveries on accounts previously written off. (b)Uncollectible accounts written off. (c)Billings to others. (d)Payments and accrual adjustments. (e)Includes interest on trust funds. (f)Adjust royalty provision. S-5 AMERICAN ELECTRIC POWER COMPANY, INC. AND SUBSIDIARY COMPANIES SCHEDULE IX -- SHORT-TERM BORROWINGS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a)Sum of month-end short-term borrowings divided by number of months outstanding. (b)Interest for the period divided by average amount outstanding. S-6 AEP GENERATING COMPANY SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Total additions of $4,089,000 in 1993, $4,512,000 in 1992 and $3,796,000 in 1991 were less than 10% of the total as of the respective year-ends. Retirements or sales of $1,038,000 in 1993, $1,830,000 in 1992 and $1,450,000 in 1991 were less than 10% of the total as of the respective year-ends. There were no additions to individual accounts in excess of two percent of total assets. The methods used to compute the annual provisions for depreciation are described in Note 1 of the Notes to Financial Statements. The current provisions were determined using the following composite rates for functional classes of property: S-7 AEP GENERATING COMPANY SCHEDULE VI -- ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- S-8 AEP GENERATING COMPANY SCHEDULE IX -- SHORT-TERM BORROWINGS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a)Sum of month-end short-term borrowings divided by number of months outstanding. (b)Interest for the period divided by average amount outstanding. S-9 APPALACHIAN POWER COMPANY AND SUBSIDIARIES SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Total additions of $201,169,000 in 1993, $198,116,000 in 1992 and $196,937,000 in 1991 were less than 10% of the total as of the respective year- ends. Retirements or sales of $47,254,000 in 1993, $42,926,000 in 1992 and $32,428,000 in 1991 were less than 10% of the total as of the respective year- ends. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. The methods used to compute the annual provisions for depreciation are described in Note 1 of the Notes to Consolidated Financial Statements. The current provisions were determined using the following composite rates for functional classes of property: S-10 APPALACHIAN POWER COMPANY AND SUBSIDIARIES SCHEDULE VI -- ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- S-11 APPALACHIAN POWER COMPANY AND SUBSIDIARIES SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS AND RESERVES - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a) Recoveries on accounts previously written off. (b) Uncollectible accounts written off. (c) Payments and transfers. S-12 APPALACHIAN POWER COMPANY AND SUBSIDIARIES SCHEDULE IX -- SHORT-TERM BORROWINGS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a) Sum of month-end short-term borrowings divided by number of months outstanding. (b) Interest for the period divided by average amount outstanding. S-13 COLUMBUS SOUTHERN POWER COMPANY AND SUBSIDIARIES SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Total additions of $97,455,000 in 1993, $80,279,000 in 1992 and $111,856,000 in 1991 were less than 10% of the total as of the respective year-ends. Retirements or sales of $18,161,000 in 1993, $21,999,000 in 1992 and $19,773,000 in 1991 were less than 10% of the total as of the respective year- ends. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. In 1993 other charges include a reduction of $157,535,000 to reflect the PUCO disallowance of a portion of the Zimmer Plant investment as discussed in Note 2 of the Notes to Consolidated Financial Statements. The methods used to compute the annual provisions for depreciation are described in Note 1 of the Notes to Consolidated Financial Statements. The current provisions were determined using the following composite rates for functional classes of property: S-14 COLUMBUS SOUTHERN POWER COMPANY AND SUBSIDIARIES SCHEDULE VI -- ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a) Reflects the write-off of accumulated depreciation related to a portion of the Zimmer Plant investment that was disallowed by the PUCO as discussed in Note 2 of the Notes to Consolidated Financial Statements. S-15 COLUMBUS SOUTHERN POWER COMPANY AND SUBSIDIARIES SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS AND RESERVES - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a) Recoveries on accounts previously written off. (b) Uncollectible accounts written off. (c) Payments. S-16 COLUMBUS SOUTHERN POWER COMPANY AND SUBSIDIARIES SCHEDULE IX -- SHORT-TERM BORROWINGS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a) Sum of month-end short-term borrowings divided by number of months outstanding. (b) Interest for the period divided by average amount outstanding. S-17 INDIANA MICHIGAN POWER COMPANY AND SUBSIDIARIES SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Total additions of $125,247,000 in 1993, $175,728,000 in 1992 and $149,187,000 in 1991 were less than 10% of the total as of the respective year- ends. Retirements or sales of $61,586,000 in 1993, $25,301,000 in 1992 and $40,396,000 in 1991 were less than 10% of the total as of the respective year- ends. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. Amortization of nuclear fuel of $41,325,000 in 1993, $19,343,000 in 1992 and $50,124,000 in 1991 was credited directly to the property account and charged to fuel expense. The methods used to compute the annual provisions for depreciation are described in Note 1 of the Notes to Consolidated Financial Statements. The current provisions were determined using the following composite rates for functional classes of property: S-18 INDIANA MICHIGAN POWER COMPANY AND SUBSIDIARIES SCHEDULE VI -- ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- S-19 INDIANA MICHIGAN POWER COMPANY AND SUBSIDIARIES SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS AND RESERVES - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a) Recoveries on accounts previously written off. (b) Uncollectible accounts written off. (c) Billings to others. (d) Payments and accrual adjustments. (e) Includes interest on trust funds. (f) Adjust Royalty Provision. S-20 INDIANA MICHIGAN POWER COMPANY AND SUBSIDIARIES SCHEDULE IX -- SHORT-TERM BORROWINGS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a) Sum of month-end short-term borrowings divided by number of months outstanding. (b) Interest for the period divided by average amount outstanding. S-21 KENTUCKY POWER COMPANY SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Total additions of $37,808,000 in 1993, $35,203,000 in 1992 and $31,369,000 in 1991 were less than 10% of the total as of the respective year-ends. Retirements or sales of $12,000,000 in 1993, $11,352,000 in 1992 and $8,092,000 in 1991 were less than 10% of the total as of the respective year-ends. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. The methods used to compute the annual provisions for depreciation are described in Note 1 of the Notes to Financial Statements. The current provisions were determined using the following composite rates for functional classes of property: S-22 KENTUCKY POWER COMPANY SCHEDULE VI -- ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- S-23 KENTUCKY POWER COMPANY SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS AND RESERVES - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a) Recoveries on accounts previously written off. (b) Uncollectible accounts written off. (c) Payments. S-24 KENTUCKY POWER COMPANY SCHEDULE IX -- SHORT-TERM BORROWINGS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a) Sum of month-end short-term borrowings divided by number of months outstanding. (b) Interest for the period divided by average amount outstanding. S-25 OHIO POWER COMPANY AND SUBSIDIARIES SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- Total additions of $197,089,000 in 1993, $201,737,000 in 1992 and $228,500,000 in 1991 were less than 10% of the total as of the respective year- ends. Retirements or sales of $128,775,000 in 1993, $191,662,000 in 1992 and $90,472,000 in 1991 were less than 10% of the total as of the respective year- ends. There were no additions to individual accounts in excess of two percent of total assets other than transfers from Construction Work in Progress. The methods used to compute the annual provisions for depreciation are described in Note 1 of the Notes to Consolidated Financial Statements. The current provisions for other than mining assets were determined using the following composite rates for functional classes of property: The current provisions for mining assets were calculated by use of the following methods: S-26 OHIO POWER COMPANY AND SUBSIDIARIES SCHEDULE VI -- ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- S-27 OHIO POWER COMPANY AND SUBSIDIARIES SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS AND RESERVES - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a) Recoveries on accounts previously written off. (b) Uncollectible accounts written off. (c) Billings to others. (d) Payments. S-28 OHIO POWER COMPANY AND SUBSIDIARIES SCHEDULE IX -- SHORT-TERM BORROWINGS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- - -------- (a) Sum of month-end short-term borrowings divided by number of months outstanding. (b) Interest for the period divided by average amount outstanding. S-29 EXHIBIT INDEX Certain of the following exhibits, designated with an asterisk(*), are filed herewith. The exhibits not so designated have heretofore been filed with the Commission and, pursuant to 17 C.F.R. (S)201.24 and (S)240.12b-32, are incorporated herein by reference to the documents indicated in brackets following the descriptions of such exhibits. Exhibits, designated with a dagger (+), are management contracts or compensatory plans or arrangements required to be filed as an exhibit to this form pursuant to Item 14(c) of this report. AEGCO E-1 AEGCO (continued) E-2 AEP++ (continued) E-3 AEP++ (continued) E-4 APCO++ (continued) E-5 APCO++ (continued) E-6 CSPCO++ (continued) E-7 I&M++ (continued) E-8 I&M++ (continued) E-9 KEPCO (continued) E-10 OPCO++ (continued) E-11 OPCO++ (continued) -------------- ++Certain instruments defining the rights of holders of long-term debt of the registrants included in the financial statements of registrants filed herewith have been omitted because the total amount of securities authorized thereunder does not exceed 10% of the total assets of registrants. The registrants hereby agree to furnish a copy of any such omitted instrument to the SEC upon request. E-12

1993 ITEM 1 BUSINESS GENERAL Formica Corporation and its subsidiaries (the "Company" or "Formica") designs, manufactures and distributes decorative laminates and other surfacing products worldwide and is the world's largest producer of high pressure decorative laminates. The Company's products compete against a wide range of surfacing materials which include decorative laminates produced by other manufacturers, as well as wood, veneers, marble, tile, plastics and foils. The Company distributes its products under the FORMICA(R), COLORCORE(R) and SURELL(R) brand names and the ANVIL F(R) Logo, among others. The Company's ten manufacturing facilities are located in the United States, the United Kingdom, Canada, France, Spain, Germany and Taiwan, and its products are principally distributed throughout North America, Europe and the Far East. For information by geographic area, including net sales, operating income, capital expenditures and identifiable assets, see Note 9 to the Company's Consolidated Financial Statements as well as "Item 7 - Management's Discussion and Analysis of Results of Operations and Financial Condition." PRODUCTS Decorative laminates are used in a wide range of surfacing applications where durability, design, construction versatility and ease of maintenance are factors. The Company's principal products are high pressure decorative laminates. In a few geographic areas, the Company also offers a complementary line of low pressure laminates in designs that match or complement the Company's high pressure laminate products. In addition, the Company acquired Wildon Industries, Inc. ("Wildon") in 1986 for the purpose of developing a high quality solid surfacing material, which is marketed under the SURELL brand name. The Company also manufactures and sells resins and licenses its FORMICA brand name and proprietary technology and know-how to third parties. Commercial applications for the Company's decorative laminates include countertops, furniture, flooring, doors, window sills, walls and other interior surfacing uses. Residential applications for the Company's decorative laminates include cabinetry and countertops for kitchens and bathrooms; surfacing for living room, dining room, family room, kitchen and bathroom furniture; and other interior architectural uses throughout the house. The Company's products are used in homes, retail stores, offices, office lobbies, hotels, hospitals, restaurants, airports, banks, computer centers, ships, buses and railroad cars, as well as numerous other uses. High Pressure Decorative Laminates. High pressure decorative laminates include standard line decorative products and premium decorative products which accounted for approximately 77% and 17%, respectively, of the Company's total net sales for the year ended December 31, 1993. The Company's standard decorative line consists of decorative laminates such as solid colors, abstract patterns, woodgrain patterns and other simulations of natural materials. These products are sold in sheet form in a multitude of sizes and in over 1,000 colors, patterns and textures. Premium decorative laminates have characteristics that make them particularly suitable for various specialized applications and generate higher profit margins than the standard line products. Premium decorative laminates include the Company's DESIGN CONCEPTS(R) and FORMATIONS(R) collections and COLORCORE(R) surfacing material, a solid "color-through" laminate, which are marketed for special end-use applications such as office furniture, store fixtures, restaurant interiors, airports and custom-built kitchens. Premium decorative products also include laminates for uses requiring fire-rated materials such as shipbuilding and office interiors; textured laminates, which are designed to look and feel like leather or slate; metallic laminates which are manufactured with a metallic surface for "high style" effects; and laminates applied to static-free flooring used in computer centers. Solid Surfacing Products. The Company's solid surfacing products are manufactured by combining resin with filler and curing the mixture in molds under heat. These products, distributed under the brand name SURELL, are available in a selection of colors and granite-like patterns, which run throughout the entire thickness of the product. The products can be shaped and molded for use in a variety of residential and commercial applications such as vanities with dripless edges and integral backsplashes, or produced in sheet form for work surfaces, countertops and other surface applications. The Company has devoted substantial resources to the development of its solid surfacing products as a high quality surfacing material and to the development of efficient manufacturing methods for the production of these products in commercial quantities. The current United States market for solid surfacing material is dominated by E.I. DuPont de Nemours & Co. which sells its product through a distribution network which includes a limited number of distributors of other FORMICA brand products. The Company believes that there are significant opportunities for new entrants in the expanding market for solid surfacing material and intends to use its brand name and established channels of distribution to take advantage of these opportunities. The Company is marketing its solid surfacing products as premium products on a broad scale through its domestic and international distribution network. New Product and Design Development. A major portion of the Company's research efforts is devoted to the development of new applications for high pressure decorative laminates and solid surfacing products, new products and process improvements. Design is an important factor in the choice of the product line manufactured by the Company and in the surfacing industry as a whole. New laminate designs are introduced periodically by the Company and its competitors. The Company considers itself the industry leader worldwide in decorative laminate design and new product development and carries out design development in North America and Europe. The Company has won numerous design and product awards. The Company's efforts to refine the designs of its products have resulted in such products as the DESIGN CONCEPTS and FORMATIONS collections, COLORCORE, a solid "color-through" laminate, and the STRIPES and GEOMETRICA(R) collections featuring silk screenprinted pinstripes and bands in a variety of colors. During the last several years, the Company introduced solid opaque laminates, granite-like solid surfacing materials, high wear laminates and a number of other premium products. In addition, the Company has introduced a number of other product lines including ALULAM(R), a metallic exterior surfacing laminate, and ALACORE(R), a translucent laminate collection with three-dimensional design effects. In addition to new products designed and developed internally, the Company has acquired worldwide distribution rights to several new products. The Company recently introduced to the market a new surfacing material called NUVEL, which was developed by General Electric Company ("GE"). In late 1992, Formica entered into a worldwide exclusive distribution agreement with GE, which manufactures this product using its proprietary technology. The product has the features of traditional solid surfacing materials but can be installed at a lower cost. In addition to traditional solid surfacing applications such as countertops, the product has numerous additional applications including cabinetry, doors, furniture and store fixtures. The product is being marketed with the GE logo as well as the NUVEL and FORMICA trademarks. Another new product which the Company has begun marketing through its worldwide distribution network is called GRANULON, which is a spray-on surfacing material. The GRANULON product is a densified liquid composite available in an array of granite and solid colors that can be used for a variety of traditional and unique surfacing applications including furniture, cabinetry and molded shapes. Formica has also recently signed an agreement with a European manufacturer of specialty wood veneer laminates and will be distributing these products under the FORMICA LIGNA brand name. In addition to the new products mentioned above, the Company has entered into a cooperative enterprise agreement for the distribution of locally produced laminate products throughout the People's Republic of China. The products are manufactured using Formica technology. MARKETING, DISTRIBUTION AND CUSTOMERS The Company believes its global distribution and dealer network with its extensive sales force and the FORMICA brand name and ANVIL F Logo are major marketing strengths and key elements to the Company's success. The Company believes that none of the Company's competitors has as extensive a worldwide distribution and dealer network or the brand recognition of the FORMICA brand name. The Company's products are sold through distributors of wholesale building materials and distributors of products for the cabinet industry and directly to original equipment manufacturers for both residential and commercial uses. For the year ended December 31, 1993, approximately 60% of the Company's net sales were made through independent distributors, and the remaining 40% were made directly to users of the Company's products. The Company's distribution network includes approximately 700 independent distributor locations worldwide. Many distributors have sub-distributorships and dealer networks. As a result, the Company's products are represented in thousands of locations worldwide. The effort of the Company's domestic and international sales and architectural specification representatives, when combined with the sales force of its distributor network, provides the Company with sales and marketing coverage in over 100 countries throughout the world. The Company's sales representatives market the Company's products directly to end-users and work with distributors by monitoring distributors' inventories, calling on customers, architects and designers with the distributors' sales representatives and assisting distributors in the development of advertising and promotional campaigns and materials and the introduction of products. Generally, the Company's distributorship sales are made by distributors that exclusively carry the Company's brand of high pressure decorative laminates. The typical distributor of the Company's products also sells some or all of the following: other surfacing materials, adhesives, cabinetry, flooring material, particle board, hardware and other related architectural and building materials. The Company considers its distribution network to be an important vehicle for the introduction of new products the Company may develop or distribute in the future. The Company estimates that of its net sales for the year ended December 31, 1993, approximately one-half were derived from products used in commercial applications and one-half from products used in residential applications. In addition, the Company estimates that approximately two-thirds of its net sales for such period were derived from products used in remodeling or renovation projects, while approximately one-third of its net sales for such periods were derived from product used in new construction. Sales in the commercial market are heavily influenced by the specifications of architects and designers. In addition to the Company's regular sales force, a specialized sales force calls exclusively on architects and designers in North America, Europe and the Far East. The Company's backlog is not significant due to the ability of the Company to respond adequately to customer requests for product shipments. Generally, the Company's products are manufactured from raw materials in stock and are delivered to the Company's customers within one to thirty days from receipt of the order, depending on customer delivery specifications. Substantially all orders are shipped by the Company by the customer's due date. The Company has no significant long-term contracts for the distribution of its products. For the year ended December 31, 1993, no customer or affiliated group of customers accounted for as much as 5% of the Company's consolidated net sales. MANUFACTURING AND RAW MATERIALS High pressure decorative laminates are produced from a few basic raw materials which include kraft paper, fine decorative papers and melamine and phenolic resins. The papers are impregnated with resins and placed between stainless steel plates in a multi-opening press and cured under pressure and elevated temperature. The number of paper laminations per sheet of laminate varies with the specific type of product being produced, but all have melamine resin on the surface to create a hard, durable surface. Surface textures can range from very high gloss smooth surfaces to deeply textured surfaces and surfaces with other special design and performance features. In addition to patents, the Company has proprietary technology and know-how in the design and manufacture of its products. Kraft papers are available globally from several major sources and many smaller producers. Fine papers are supplied by many producers in North America, Europe and Asia. Melamine, phenol and formaldehyde, the primary raw materials for resins, are global commodity chemicals available from many suppliers. The Company currently purchases these raw materials on a global basis from various suppliers at market prices. The Company believes that it is the largest purchaser of these raw materials on a worldwide basis in the high pressure laminate industry. The Company may, from time to time, enter into one-year or longer-term contracts with suppliers when advantageous to it. The Company also acquires certain chemicals under exclusive arrangements from producers in connection with licensing technology from those producers. The Company has experienced no supply problems of any raw materials in the last 10 years. The Company manufactures and distributes products on a global basis with ten manufacturing facilities located in the United States, Canada, the United Kingdom, France, Spain, Taiwan and a 50% interest in a joint venture manufacturing plant in Germany which produces specialized metallic surfaced laminate products. These multiple manufacturing locations around the world enable the Company to reduce delivery times, freight costs and duties that it would otherwise encounter. Generally, each facility is shut down from one to four weeks annually for maintenance, refurbishment and traditional vacation periods. In general, each manufacturing facility produces a standard product line for its geographic market and produces one or more specialty products which may be sold in its market or exported to other markets. This allocation of production responsibility is designed to insure prompt delivery to customers of the Company's standard product lines and economies of scale in the production of the Company's premium products. In addition, certain of the Company's specialty products have been developed in response to regional design preferences. The Company's manufacturing facilities normally operate 24 hours a day on a five or seven day week schedule. Periodically, the Company operates on an overtime basis to satisfy customer requirements during periods of peak demand. Management believes that its existing manufacturing facilities are satisfactory for the Company's projected requirements. The Company has devoted substantial resources to the development of its plate manufacturing technology and produces its own plates in its manufacturing facility in LaPlaine, France. As of December 31, 1989, the Company had substantially completed the installation of such plate technology in all of its laminate manufacturing facilities. COMPETITION The Company's products compete around the world with decorative laminates manufactured by other producers, as well as with wood, veneers, marble, tile, plastics, foils and other surfacing materials. Competition is based principally on breadth of product line, product quality, marketing, technology, price and service. The Company competes in a number of geographic markets and its success in each of these markets is influenced by the factors mentioned above. The Company believes it is the single largest producer of decorative laminates on a worldwide basis. The Company also believes it is the largest or second largest producer of decorative laminates in various national markets (including the United States, Canada, the United Kingdom, France, Spain, and Taiwan) in which it competes on a local basis with many other producers, some of which are owned by larger enterprises which may have greater assets or resources than the Company. In many of the other national markets in which the Company competes, it enjoys a smaller but nonetheless significant market position. In the North American laminate market, the Company's principal competitors include Ralph Wilson Plastics Company, Nevamar Corporation and Arborite Corporation. In Europe, principal competitors include Perstorp and Polyrey. INTERNATIONAL OPERATIONS The Company's net sales from international operations to third parties accounted for approximately 47% of total net sales of the Company's products for the year ended December 31, 1993. The Company has manufacturing subsidiaries located in the United Kingdom, France, Spain, Canada and Taiwan and has a 50% interest in a German joint venture. The Company's principal international markets are located in Europe, Canada, Mexico and the Far East. The Company's international operations are subject to foreign currency fluctuations, local laws concerning repatriation of profits and other factors normally associated with multinational operations. See "Item 7 - Management's Discussion and Analysis of Results of Operations and Financial Condition" and Note 9 to the Company's Consolidated Financial Statements for information about the business of the Company by geographic area. PATENTS, TRADEMARKS AND LICENSES The Company owns patents and possesses proprietary information which relate to its products and processes. The Company believes that the loss of any of its patents would not have a material adverse effect upon its business. Trademarks are important to the Company's business and licensing activities. The Company has a vigorous program of trademark enforcement to prevent the unauthorized use of its trademarks, to strengthen the value of its trademarks and to improve its image and customer goodwill. The Company believes that the FORMICA trademark and the ANVIL F Logo are its most significant trademarks. In addition to registration in the United States, the FORMICA trademark and the ANVIL F Logo are registered in over 100 countries. The COLORCORE trademark is registered in the United States and over 20 other countries. The SURELL trademark is also registered in the United States and in several other countries. Formica has used the FORMICA brand name continuously since 1913. Additionally, the Company has numerous other registered trademarks, trade names and logos, both in the United States and abroad. The Company believes that numerous opportunities exist to license the Company's internationally recognized FORMICA trademark and ANVIL F Logo and the Company's proprietary technology and know-how. The Company has existing licensing arrangements for its trademarks and, in certain cases, its proprietary technology with CSR Limited in Australia and New Zealand and with manufacturers of adhesives and certain other complementary products. In addition to the above, the Company has non-royalty licenses with a company in India and with American Cyanamid Company which permits the exclusive use of the FORMICA trademark primarily in South America. RESEARCH AND DEVELOPMENT Technical support to the Company's business is organized on a worldwide basis. The major part of the Company's research program, which involves the development of new applications for existing products, new products and process improvements, is carried out by the Research and Development departments located in the United States and the United Kingdom. Technical groups located at each plant also participate in the overall program and work on smaller projects under the direction of the Company's research director. Research and development costs charged to operations during the years ended December 31, 1993, 1992 and 1991 amounted to $3.3 million, $3.5 million, and $3.6 million, respectively. See Note 2 to the Company's Consolidated Financial Statements for information concerning research and development costs. ENVIRONMENTAL MATTERS The Company (and the industry in which it competes) is subject to extensive regulation under federal, state, local and foreign environmental laws and regulations regarding emissions to air, discharges to water and the generation, handling, storage, transportation, treatment and disposal of waste and other materials as well as laws and regulations relating to occupational health and safety. The Company believes that its manufacturing facilities are being operated in compliance in all material respects with the applicable environmental, health and safety laws and regulations but cannot predict whether more burdensome requirements will be imposed by governmental authorities in the future. Pursuant to the requirements of applicable federal, state and local statutes and regulations, the Company has received or applied for all of the environmental permits and approvals material to the operation of its manufacturing facilities. In November 1987, the United States Environmental Protection Agency (the "EPA") identified the Company as a Potentially Responsible Party ("PRP") pursuant to its authority under the Comprehensive Environmental Response, Compensation and Liability Act, as amended ("CERCLA"), in connection with the Pristine, Inc. Superfund Site in Reading, Ohio. The Company's share of waste contribution to this site is approximately 11.5%. The EPA has completed a Remedial Investigation/Feasibility Study and has issued a Record of Decision calling for remedial action at the site which is estimated to cost approximately $21.7 million. The Company and other generators at the site signed a Consent Decree with the U.S. Government (EPA) in which a remedial clean-up plan has been agreed upon. The Consent Decree was approved by the United States District Court for the Southern District of Ohio and became effective on November 23, 1990. On October 16, 1989, the State of Ohio, in connection with its involvement at the site, instituted a lawsuit, entitled State of Ohio v. Pristine, Inc., et al., in the United States District Court for the Southern District of Ohio which demanded payment of approximately $104,000 in past costs and sought a declaratory judgment holding the Company and 29 other named defendants jointly and severally liable for the reimbursement of the State's future oversight costs. The Company and other named defendants jointly responded to this action and entered into settlement discussions that culminated in the negotiation of a Consent Decree in which the State substantially reduced its damage demands. The Consent Decree was approved by the Court and became effective on August 16, 1991, resulting in a dismissal of the State's law suit. In October, 1991, the City of Reading asserted a claim alleging that its municipal water well field has been contaminated by groundwater emanating from the Pristine, Inc. Superfund Site as well as a claim seeking natural resource damages. The City of Reading's claim was asserted against the owner/operator of the site as well as approximately 115 alleged generators of hazardous waste at the site, including the Company. The City of Reading and approximately 87 generators of waste at the site, including the Company, entered into a settlement agreement, dated as of September 1, 1993, whereby the City of Reading's claim was settled for $1.3 million, which claim has been paid on a pro rata basis by such generators of waste. The Company believes that it has adequate reserves for its anticipated share of the current estimate of the costs associated with the clean-up of this site. In August 1987, the Company received an Information Request Notice from the EPA advising that, pursuant to its authority under CERCLA, it was investigating the Bridgeport Rental and Oil Services waste disposal site in Logan Township, New Jersey. Although the EPA indicated that the Company may have contributed a small quantity of waste to the site in 1974, the Company has no records available to verify the EPA's claim and has so responded in its answers to the Information Request Notice. In late August 1989 the Company received a letter from the EPA naming it as a PRP at the site and demanding payment of at least $17.8 million for past cleanup costs. The notice, which was addressed to 57 other PRPs, also indicated that the EPA was prepared to use public funds to conduct further remedial action at the site. The Company and other PRPs are vigorously contesting the amount and nature of the EPA's claim and are actively pursuing other generators who may have contributed waste to the site. In connection with the waste storage site in Logan Township, New Jersey, the Company, on April 3, 1989, received from the New Jersey Department of Environmental Protection ("DEP") a Directive issued pursuant to the DEP's alleged authority under the New Jersey Spill Compensation and Control Act. The Directive demanded that the Company and 112 other alleged dischargers of hazardous substances pay the State of New Jersey approximately $9.2 million. That amount represents monies which New Jersey has paid to the EPA as a portion of its share of the remedial costs to be incurred in connection with the cleanup of the site. In response to the Directive, the Company, without admitting liability, contributed a nominal sum toward a good faith settlement offer which was forwarded to the DEP by a group of approximately 40 Directive recipients. That group and other recipients have also submitted statements to the DEP raising numerous defenses to the Directive. To date, communications with the EPA and DEP have continued, and no proceedings have been instituted in connection with the Directive. However, in a continuing effort to pursue all potentially responsible site generators, the Company and the other PRPs discovered evidence which linked numerous governmental departments to a significant amount of waste which had been deposited at the site. Thus, a group of PRPs, which did not include the Company, instituted a contribution action entitled Rollins Environmental Services (NJ), Inc., et al. vs. The United States of America, et al., Civil Action No. 92-1253 in the United States District Court for the District of New Jersey. Thereafter, the EPA instituted a cost recovery action, naming only certain site PRPs, in the same Court. That case, which is entitled United States of America vs. Allied Signal Inc., et al., Civil Action No. 92-2726, was then consolidated with the Rollins contribution suit. Although the Company is not a party to either case, it has agreed to take part in an informal discovery/settlement process pursuant to a Case Management Order. The Company believes it has adequate reserves to cover its anticipated liability in this site. In March 1990, the Company received an Information Request Notice from the EPA advising that, pursuant to its authority under CERCLA, it was continuing its investigation of the New Lyme Landfill Superfund Site in Ashtabula County, Ohio. Although the EPA indicated that the Company may have contributed waste to this residential/industrial site prior to the site shutdown in 1978, the Company, after investigation, was unable to locate records to determine if it had contributed waste to this site and so advised the EPA in its response to the Information Request Notice. To date the Company has received no further communications from the EPA or any other entity concerning this site. On or about October 5, 1990, a third party complaint entitled United States of America v. Norrell F. Dearing et al. v. Formica Corporation et al., United States District Court for the Northern District of Ohio, Eastern Division was served upon the Company. The third party complaint seeks contribution, in an unspecified amount, from the Company and other third party defendants for response costs incurred and to be incurred by the government of the United States in connection with the Old Mill Superfund Site in Rock Creek, Ohio. The original complaint, as amended, entitled United States of America v. Dearing et al., alleges that the EPA had incurred to date more than $7.7 million in response costs at the Old Mill Superfund Site which included the essentially complete implementation of the selected remedial action at the site. The Company has investigated whether or not it or a predecessor company contributed hazardous waste to this site during the 1977-1979 time period alleged in the complaint and has been unable to locate records to verify the allegations. The Company has filed an answer to the third party complaint, denying liability and raising numerous affirmative defenses and continues to vigorously defend this action. On February 9, 1993, the Company was served with a second third party complaint entitled State of Ohio v. Norrell E. Dearing et al. v. Formica Corporation et al. This third party complaint seeks contribution, in an unspecified amount, from the Company and other third party defendants for response costs incurred and to be incurred by the State of Ohio in connection with this site. The Company has filed an answer to this complaint denying liability and raising numerous affirmative defenses, and intends to vigorously defend this action. The Company, as of December 17, 1993, entered into an Indemnification Agreement with American Cyanamid Company ("ACCO") and Cytec Industries Inc. ("Cytec") wherein ACCO and Cytec agreed to indemnify and hold harmless the Company from and against any liability, including the two above-referenced third party complaints, resulting from the disposal by the Company of hazardous waste, originating from a Painesville, Ohio manufacturing facility operated by a predecessor company, at the Old Mill Superfund Site. In May 1991, the Company received an Information Request Notice from the EPA advising that, pursuant to its authority under CERCLA, the EPA was investigating the Skinner Landfill Superfund Site in West Chester, Ohio. Although the EPA indicated that the Company might have contributed waste to this site, the Company has no records available which verify the claim. However, in August 1991, the EPA issued a General Notice of Liability naming the Company and various other parties as PRPs at the site. At that time, the Company also received information which indicated that another site PRP had allegedly deposited relatively small quantities of the Company's waste at the site on three occasions in the 1960's and 1970's. In early 1992, a group of nine companies, including the Company, joined together to vigorously contest the matter when the EPA announced that it preferred a site incineration remedy estimated to cost approximately $29 million. Following concerted PRP efforts and local community negative reaction to the proposed incineration remedy, the EPA withdrew its preferred remedy and issued a unilateral abatement remedy Order calling for the expenditure of approximately $200,000 to secure the site and to provide public water hookups for some site neighbors. That Order was issued in December 1992 and was directed at 20 recipients, including the Company. Without admitting liability, the Company and nine other recipients have worked together to comply with the Order, while the remaining recipients are contesting the matter. In the meantime, the EPA has issued a Record of Decision calling for a site remedy estimated to cost $15.5 million. The Company and the other PRPs are pursuing the matter with the EPA as it prepares to issue a unilateral order calling for the formulation of a Remedial Design for the site. Concurrently, the Company and other PRPs are pursuing all other potentially responsible site generators. On or about October 20, 1993 the Company was served with a Summons and Complaint entitled California Sport Fishing Protection Alliance v. Formica Corp., in the United States District Court, Eastern District of California. This Complaint, brought as a citizens' suit under the Clean Water Act, alleges that the Company's Rocklin, California manufacturing plant has violated its National Pollutant Discharge Elimination System permits ("NPDES") and is polluting the Sacramento River. The Complaint alleges that the Company is discharging into a creek waste water which contains a pH level outside of the range imposed in its NPDES permits. The Complaint seeks: (a) to enjoin the Company from violating its NPDES permits and the Clean Water Act; (b) an order directing the Company to adequately test receiving waters for violations of applicable water quality standards; (c) an order directing the Company to comply with all reporting requirements contained in its NPDES permits; (d) an order directing the Company, for a period of one year, to provide the Plaintiff with copies of all reports and documents submitted to government agencies relating to its NPDES permits; (e) an order requiring the Company to pay civil penalties of up to $25,000 per day for each violation of its NPDES permits; (f) an order directing the Company to make payments to an environmental remediation project approved by the Court; and (g) an award of Plaintiff's costs of litigation, including reasonable attorney and expert witness fees. The Company has filed an Answer to the Complaint denying liability and raising several affirmative defenses and intends to vigorously defend this action. EMPLOYEES AND EMPLOYEE RELATIONS As of December 31, 1993, the Company had approximately 3,300 employees, of whom 1,100 were salaried and 2,200 were hourly workers. In the United States, approximately 800 of the Company's employees are covered by two collective bargaining agreements that expire in September 1994 and April 1995. Of the approximately 1,800 employees of the Company's international operations, 1,200 are represented by a variety of local unions. The Company considers its employee relations to be generally satisfactory. Item 2 Item 2 PROPERTIES The location and general description of the principal properties owned or leased by the Company (or by the Company's German joint venture) are set forth in the table below: The Company believes that all of its properties are suitable and adequate for its present needs. The Company also believes that it has sufficient manufacturing and distribution capacity for its present and foreseeable needs. Pursuant to the CIBC Credit Documents, all of the principal properties owned by the Company are subject to liens in favor of the lenders thereunder as security for the obligations of the Company thereunder, except that the Mt. Bethel, Pennsylvania facility is subject to a lien related to an installment sale arrangement for the facility with a local development authority and the Company's Hsinfeng, Taiwan facility is subject to a lien pursuant to the Taiwan Credit Agreement. ITEM 3 ITEM 3 LEGAL PROCEEDINGS The Company is a party to various legal proceedings, in addition to those described under "Item 1 - Environmental Matters", arising in the ordinary course of business, none of which is expected to have a material adverse effect on the Company's business or financial condition. ITEM 4 ITEM 4 SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There were no matters submitted for a vote of security holders during the fourth quarter of the fiscal year covered by this report. PART II ITEM 5 ITEM 5 MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS The Preferred Stock and Common Stock of the Company is not publicly traded, and therefore, there is no public market for the stock of the Company. ITEM 6 ITEM 6 SELECTED FINANCIAL DATA (a) (in thousands) (a) Selected financial information (other than net sales) on a post-acquisition basis of accounting is not comparable to the information for the Company on a pre-acquisition basis of accounting, because of changes in the organizational structure, recorded asset values, cost structure and capitalization of the Company resulting from the leveraged buy out transaction in May 1989. (b) Operating income in 1991 included $3.2 million representing the settlement of a claim by Formica against a third party. This settlement primarily represented a reimbursement of costs incurred by Formica and was recorded as a reduction of cost of sales of $2.8 million and selling, general and administrative expenses of $0.4 million, and as an increase to other income, net of $0.2 million. (c) Other income (expense), net in 1993 included $1.9 million relating to the reversal of other long-term liabilities associated with reserves which management believed were no longer needed. Other income (expense), net in 1992 included $9.1 million relating to a reduction of other long-term liabilities attributable to changes in certain of the Company's postretirement medical benefit plans (See Notes 2, 6 and 10 of the Consolidated Financial Statements) and $2.0 million relating to the reversal of other long-term liabilities as a result of the release of certain warranties and representations made by Formica in connection with the prior sale of a subsidiary. (d) The Company adopted the accounting and disclosure rules prescribed by Statement of Financial Accounting Standards No. 109 ("SFAS 109") on accounting for income taxes as of January 1, 1993. The adjustments to the January 1, 1993 balance sheet to adopt SFAS 109 netted to $2,850,000, which has been reflected in the 1993 net loss as the cumulative effect of a change in accounting principle. ITEM 7 ITEM 7 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS 1993 compared to 1992 Net sales for the year ended December 31, 1993 increased $0.9 million, or 0.2%, as compared with the same period in 1992. When adjusted to exclude $24.4 million of foreign exchange effects, net sales increased $25.3 million, or 5.7%. Domestic net sales rose $26.2 million, or 12.3%, above the comparable 1992 period primarily due to an increase in unit volumes. Net sales in the international segment decreased by $25.3 million, or 10.9%. Excluding the impact of foreign exchange, international net sales decreased $0.9 million, or 0.4%, primarily due to decreased unit volumes. Cost of sales for 1993 increased $5.4 million, or 1.7%, above the comparable 1992 period. When adjusted to exclude $17.7 million of foreign exchange effects, cost of sales increased $23.1 million, or 7.4%. Domestic cost of sales increased $18.8 million, or 12.2%, primarily as a result of increased unit volumes. International cost of sales decreased $13.4 million, or 8.3%, for the period. When adjusted for the impact of foreign exchange, international cost of sales increased by $4.3 million or 2.7%, primarily due to the mix of subsidiaries sales. Selling, general and administrative expenses for 1993 increased $4.6 million, or 4.8%, compared to 1992. When adjusted to exclude $4.8 million of foreign exchange effects, selling, general and administrative expenses increased $9.4 million, or 10.0%. The increase in domestic selling, general and administrative expenses of $6.1 million, or 12.2%, was primarily attributable to increased advertising, selling, distribution and administrative expenses associated with higher unit volumes and the introduction of new products. International selling, general and administrative expenses decreased $1.5 million, or 3.5%, compared to 1992. When adjusted for foreign exchange effects, international selling, general and administrative expenses rose $3.3 million, or 7.5%, primarily due to general inflationary cost increases and increased selling, distribution, advertising and administrative expenses related to the introduction of new products. Operating income for 1993 declined $9.1 million, or 24.3%, compared to 1992. When adjusted to exclude $1.9 million of foreign exchange effects, operating income decreased $7.2 million, or 19.2%. Domestic operating income increased $1.3 million, or 14.5%, primarily due to higher sales volume, partially offset by the aforementioned higher selling, general and administrative expenses. International operating income decreased $10.4 million, or 36.8%. When adjusted for the effects of foreign exchange, international operating income declined $8.5 million, or 30.1%, primarily attributable to increases in cost of sales and selling, general and administrative expenses. Earnings before interest expense and income taxes ("EBIT") for 1993 decreased $16.8 million, or 32.2%, below 1992. EBIT decreased $15.1 million, or 28.9%, when adjusted to exclude $1.7 million of foreign exchange effects. Domestic EBIT decreased $8.4 million, or 28.3%, primarily as a result of other income recorded in 1992 of $9.1 million attributable to a revision of certain of the Company's postretirement medical benefit plans (see Notes 2, 6 and 10 to the Consolidated Financial Statements), $2.0 million of other income relating to the reversal of other long-term liabilities associated with the release of certain warranties and representations (see Notes 2 and 10 to the Consolidated Financial Statements) and $1.4 million of interest income associated with a Federal income tax refund, partially offset in 1993 by higher sales and approximately $1.9 million of other income resulting from the reversal of reserves (see Notes 2 and 10 to the Consolidated Financial Statements). International EBIT for the period was $8.4 million, or 37.2%, below the comparable 1992 period. When adjusted for the impact of foreign exchange, international EBIT decreased $6.7 million, or 29.6%, primarily due to decreased sales levels and higher cost of sales resulting from the European economic downturn and higher selling, general and administrative expenses. The decrease of approximately $5.5 million in interest expense for 1993 as compared to 1992 was principally attributable to lower interest rates and foreign exchange effects, which more than compensated for the one-time acceleration of deferred financing costs amortization of $2.0 million associated with the paydown of revolving credit debt (see Note 4 to the Consolidated Financial Statements) and increased accretion of the Company's Discount Debentures. The income tax benefit for 1993 changed by approximately $9.6 million as compared to the income tax provision for 1992, primarily due to a change in the mix of subsidiary pre-tax earnings and the reduction of income tax reserves due to the favorable settlement of certain tax examinations. 1992 compared to 1991 Net sales for the twelve months ended December 31, 1992 increased $25.0 million, or 5.9%, from the comparable 1991 period. When adjusted to exclude $4.5 million of foreign exchange effects, net sales increased $20.5 million, or 4.9%. The Company's domestic net sales increased by $22.7 million, or 11.9%, primarily due to an increase in unit volume. International net sales increased $2.3 million, or 1.0%. When adjusted to exclude foreign exchange effects, international net sales decreased $2.2 million, or 0.9%. This decrease in international net sales resulted primarily from general adverse economic conditions in certain European markets and a shift in the geographic mix of countries the Company serviced causing a decrease in average net selling prices, partially offset by an increase in unit volume. Cost of sales for 1992, compared to 1991, increased $21.2 million, or 7.2%, primarily due to increased unit volume. When adjusted to exclude $2.6 million of foreign exchange effects, cost of sales increased $18.6 million, or 6.3%. Domestic cost of sales increased $20.1 million, or 15.1%, primarily due to the effects of increased unit volume and the one-time favorable impact of $2.8 million on third quarter 1991 cost of sales (See Note 10 to the Company's Consolidated Financial Statements) resulting from the settlement of a third party claim. International cost of sales increased $1.1 million, or 0.7%, but when adjusted to exclude foreign exchange effects, international cost of sales decreased $1.5 million, or 1.0%. The decrease in international cost of sales was attributable to the lower sales levels and reduced manufacturing costs. Selling, general and administrative expenses for 1992 increased $5.9 million, or 6.7%, compared to 1991. When adjusted to exclude $0.9 million of foreign exchange effects, selling, general and administrative expenses increased $5.0 million, or 5.7%. Domestic selling, general and administrative expenses increased $1.6 million, or 3.4%, primarily due to increased distribution expenses as a result of higher unit volume, partially offset by lower administrative expenses. International selling, general and administrative expenses increased $4.3 million, or 10.7%, compared to 1991. When adjusted for the impact of foreign exchange, international selling, general and administrative expenses rose $3.4 million, or 8.5%, primarily due to higher advertising and selling expenses. Operating income for 1992 declined $2.1 million compared to 1991, primarily due to the one-time favorable impact of $3.2 million on third quarter 1991 operating income resulting from the settlement of a third party claim (See Note 10 to the Company's Consolidated Financial Statements). When adjusted to reflect $1.0 million of foreign exchange effects, operating income decreased $3.1 million, or 7.7%. Domestic operating income increased $0.9 million, or 11.6%, primarily due to higher sales volume and the aforementioned one-time favorable impact of $3.2 million on third quarter 1991 operating income. International operating income declined $3.0 million, or 9.7%. When adjusted for the effects of foreign exchange, international operating income declined $4.0 million, or 12.8%, attributable to decreased sales levels and increased selling, general and administrative expenses, partially offset by reduced manufacturing costs. EBIT for 1992 increased $8.7 million, or 20.1%. When adjusted to exclude $0.5 million of foreign exchange effects, EBIT increased $8.2 million, or 18.8%. Domestic EBIT increased $12.2 million, or 71.0%, primarily due to other income of $9.1 million attributable to a reduction of other long-term liabilities resulting from changes in certain of the Company's postretirement medical benefit plans (See Notes 2, 6 and 10 to the Company's Consolidated Financial Statements), higher sales, $2.0 million of other income relating to the reversal of other long-term liabilities as a result of the release of certain warranties and representations made by the Company in connection with the prior sale of a subsidiary and the receipt of approximately $1.4 million of interest income associated with a federal income tax refund. These increases were partially offset by the one-time favorable impact of $3.4 million on third quarter 1991 EBIT resulting from the settlement of a third party claim as discussed above. International EBIT decreased $3.5 million or 13.4%. When adjusted for the effects of foreign exchange, international EBIT decreased $4.0 million, or 15.5%, primarily due to lower sales and higher selling, general and administrative expenses. Interest expense decreased in 1992 by $0.3 million, or 0.6%, compared to 1991, primarily as a result of lower interest rates and lower debt levels which more than offset the increase in accretion of Formica's Subordinated Discount Debentures. The income tax provision for 1992 changed $3.6 million compared to the income tax benefit for 1991 due to the effect of the previously mentioned nonrecurring items and a change in the mix of subsidiary pre-tax earnings. LIQUIDITY AND CAPITAL RESOURCES At December 31, 1993, the Company's working capital was $77.1 million, representing a decrease of $13.2 million, or 14.7%, from the amount at December 31, 1992. Exclusive of the impact of foreign currency exchange effects, the Company's working capital decreased $8.4 million, or 9.3%, from the amount at December 31, 1992. The decrease in working capital was primarily due to lower inventory levels and higher accounts payable, partially offset by an increase in accounts receivable levels. The decrease in inventory resulted from management's efforts to reduce quantities on hand in order to conserve working capital. The higher accounts payable balances were primarily a result of increased purchases in the fourth quarter of 1993. The increase in accounts receivable was due primarily to an increase in net sales for the fourth quarter of 1993 as compared to 1992. In September 1989, Formica and certain of its foreign subsidiaries entered into revolving credit agreements with CIBC or its affiliates, as agent, and other banks for borrowings in the United States, France and the United Kingdom (the "CIBC Credit Agreement"). Additionally, Formica's subsidiaries in Canada and Spain entered into the Foreign Credit Documents and its subsidiary in Taiwan entered into the Taiwan Credit Agreement (as herein defined) to repay existing debt and provide for working capital requirements. The Taiwan credit facility was renewed for an additional one-year period commencing November 30, 1993. The Company expects to renew this facility on an annual basis as of November 30 of each succeeding year. With the funding on September 11, 1989 under the CIBC Credit Agreement and the Foreign Credit Documents, which provided $224.0 million of bank commitments to support principal, interest and international local borrowing arrangements, Formica received $177.1 million to be applied towards the permanent financing of the Acquisition. On October 4, 1989, the commitments were reduced by $18.0 million with the proceeds received from the issuance of Senior Subordinated Notes and Subordinated Discount Debentures. On September 11, 1993, 1992 and 1991, in accordance with the terms of the CIBC Credit Agreement and the Foreign Credit Documents, the commitments were further reduced by approximately $31.4 million, $12.5 million and $11.0 million, respectively, (expressed in U.S. Dollars using December 31, 1993 exchange rates). On September 27, 1993, FM Holdings Inc. ("Holdings"), the parent of the Company, consummated a private placement of $50.0 million of 13 1/8% Accrual Debentures due September 15, 2005. Interest on the Accrual Debentures will accrue and compound on a semi-annual basis and will be payable in cash on September 15, 1998 in an aggregate amount of approximately $44.0 million. Thereafter, interest will be payable on March 15 and September 15 of each year. Using funds received from the closing of the private placement, Holdings made a capital contribution of $47.5 million to Formica in 1993. The $47.5 million capital contribution was then used by Formica to pay down debt outstanding under its bank credit agreements. After the private placement was completed, Holdings filed a registration statement with the SEC, and upon the registration statement being declared effective, Holdings exchanged the privately placed Accrual Debentures for identical publicly registered Debentures. As of December 31, 1993, utilizing foreign currency exchange rates in effect at that time, the Company had approximately $69.6 million of available and unused principal borrowing commitments for both revolving credit and working capital purposes over and above the $75.0 million of outstanding borrowings under the CIBC Credit Agreement and the Foreign Credit Documents. Commitment fees of 1/2% are paid on the unused lines of credit under the CIBC Credit Agreement and the Foreign Credit Documents. Considering Formica's right to repay the loans under the Credit Documents without penalty and the floating interest rate, the Company believes the carrying amounts approximate fair value at December 31, 1993. Under the terms of the CIBC Credit Agreement and the Foreign Credit Documents, the commitments will be further reduced on each anniversary of September 11, 1989 (the merger date) in the following amounts (expressed in U.S. Dollars using December 31, 1993 exchange rates): 1994 -- $18.3 million; 1995 -- $13.4 million; 1996 -- $19.4 million; and 1997 -- remainder. Additionally, the Working Capital Facility of $15.0 million, which is part of the CIBC Credit Agreement, matures in September 1994. The CIBC Credit Agreement and the Foreign Credit Documents contain covenants, the most restrictive of which significantly limit Formica's ability to borrow additional funds, acquire or dispose of certain operating assets, redeem its stock and repay its Senior Subordinated Notes and Subordinated Discount Debentures prior to maturity. Formica is also prohibited from making loans, paying dividends and otherwise making distributions to Holdings, except under certain limited circumstances. Additionally, Formica must maintain minimum levels of working capital and earnings before interest expense, income taxes, depreciation expense and amortization expense. Also Formica must maintain minimum interest coverage ratios and cannot exceed certain maximum leverage ratios. Certain of the minimum levels and ratios become more restrictive in each succeeding year of the agreements. Payments of principal and interest under the various debt instruments will be the Company's largest use of funds for the foreseeable future. Funds generated from operations and borrowings are expected to be adequate to fund the Company's debt service obligations, capital expenditures and working capital requirements. Borrowings under the Credit Documents bear interest at floating rates which averaged approximately 11.8% for the year ended December 31, 1993. Formica has interest rate swap agreements outstanding at December 31, 1993 on approximately $18.6 million of these borrowings at an average interest rate of approximately 11.9%. The average interest rate of borrowings under the Credit Documents for 1993, after taking into consideration the adverse impact of the interest rate swap agreements, approximated 12.7%. The Company's percentage of long-term debt to total capital (long-term debt and stockholders' equity) changed from 88.5% at December 31, 1992 to 76.1% at December 31, 1993. The Company believes that it has adequate resources from operations and unused credit facilities to fund its operations and expected future capital expenditures through the expiration of the CIBC Credit Agreement and the Foreign Credit Documents. Indebtedness of the Company under the CIBC Credit Agreement and the Foreign Credit Documents is due in full in September 1997, the 14% Senior Subordinated Notes are due in 1999 and require a sinking fund payment on October 1, 1998 to redeem $40.0 million of the aggregate principal amount of such notes and the 15 3/4% Subordinated Discount Debentures are due in 2001 and require a sinking fund payment on October 1, 2000 to redeem $38.4 million of the aggregate principal amount of such debentures. See Note 4 to the Company's Consolidated Financial Statements for additional information with respect to bank revolving credit facilities and other long-term debt. For a discussion of the risks associated with the Company's environmental matters, see "Business -- Environmental Matters." ITEM 8 ITEM 8 FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Formica Corporation: We have audited the accompanying consolidated balance sheets of Formica Corporation (a Delaware corporation) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, stockholder's equity and cash flows for each of the three years in the period ended December 31, 1993. 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 financial statements referred to above present fairly, in all material respects, the financial position of Formica Corporation and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. As discussed in Notes 2, 6 and 8 of the consolidated financial statements referred to above, effective January 1, 1993, the Company changed its method of accounting for income taxes and postretirement benefits other than pensions. ARTHUR ANDERSEN & CO. Roseland, New Jersey March 1, 1994 FORMICA CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (DOLLAR AMOUNTS IN THOUSANDS, EXCEPT PAR VALUE OF STOCK) ASSETS The accompanying notes to consolidated financial statements are an integral part of these statements. FORMICA CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS) The accompanying notes to consolidated financial statements are an integral part of these statements. FORMICA CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENT OF STOCKHOLDER'S EQUITY FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (DOLLAR AMOUNTS IN THOUSANDS) The accompanying notes to consolidated financial statements are an integral part of these statements. FORMICA CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) The accompanying notes to consolidated financial statements are an integral part of these statements. FORMICA CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (1) ACQUISITION BY FM ACQUISITION CORPORATION In connection with a tender offer which commenced February 10, 1989 (the "tender offer"), FM Acquisition Corporation (FM Acquisition), a wholly-owned subsidiary of FM Holdings Inc. (Holdings), acquired approximately 87.3% of the common stock of Formica Corporation and subsidiaries (the "Company") on May 3, 1989 for $19 per share (the "acquisition"). On September 7, 1989, a merger was approved by the Company's stockholders and on September 11, 1989 (the "merger date"), FM Acquisition was merged with and into the Company. The remaining 12.7% of the Company's common stock was converted into rights to receive $19.00 per share in cash. The investment in the Company represents substantially all of the assets of Holdings. The acquisition was accounted for by the Company using the purchase method of accounting. The purchase cost with respect to the shares of the Company attributed to investors who have a continuing interest in Holdings following the acquisition consists of such investor's basis in their shares(i.e., the original cost of their investment in the Company plus their proportionate share of the earnings and losses of the Company since the date such investment was acquired). The purchase cost was finalized during the second quarter of 1990. The total purchase cost of approximately $354 million was allocated first to the assets and liabilities of the Company based on their estimated fair values as determined by valuations and other studies, with the remainder, approximately $43.3 million, allocated to excess of purchase price over net assets acquired (goodwill). The funds required for the merger and related transactions were obtained pursuant to several credit agreements, from the issuance of subordinated bridge notes totalling $125 million and from equity financing of approximately $87 million from Holdings. Subsequent to the merger date, certain of the funds received from the issuance of Senior Subordinated Notes ($100 million) and Subordinated Discount Debentures ($45 million) were used to repay the subordinated bridge notes. See Note 4 - Long-term debt for a further discussion of these obligations. (2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of presentation The accompanying consolidated financial statements include the accounts of the Company and its majority-owned subsidiaries. All significant intercompany balances and transactions have been eliminated. Earnings per share data are not presented because the Company's common stock is not publicly traded and since the Company is a wholly-owned subsidiary of Holdings. (2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Cumulative effect of change in accounting principles During the first quarter of 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS 109). SFAS 109 is an asset and liability approach that requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in the Company's financial statements or tax returns. In estimating future tax consequences, SFAS 109 generally considers all expected future events other than enactments of changes in the tax law or rates. Previously, the Company used the SFAS 96 asset and liability approach that gave no recognition to future events other than the recovery of assets and settlement of liabilities at their carrying amounts. Under SFAS 109, the Company recognizes to a greater degree the future tax benefits of expenses which have been recognized in the financial statements. International operations Assets and liabilities of international operations are translated at the rate of exchange in effect at the balance sheet date. Revenues and expenses are translated at the weighted average exchange rate for the period. The resulting translation adjustments are reflected as a separate component of stockholders' equity. Substantially all foreign subsidiaries are consolidated on the basis of fiscal years ending on November 30 to facilitate year end closing. Net assets of foreign subsidiaries totalled $13,540,000 and $14,257,000 at December 31, 1993 and 1992, respectively. Inventories Inventories are stated at the lower of cost or market. Cost is determined using the last-in, first-out (LIFO) method for substantially all inventories in the United States ($33,431,000 at December 31, 1993 and $38,269,000 at December 31, 1992) and the first-in, first-out (FIFO) method for all other inventories. Had the FIFO method of determining cost been utilized for all inventories, inventory values would have been approximately $1,634,000 and $682,000 higher at December 31, 1993 and 1992, respectively. The tax basis of the LIFO inventories at December 31, 1993 was approximately $16,006,000. (2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Property, plant and equipment Property, plant and equipment at December 31, 1993 and 1992 was as follows: Depreciation is computed on a straight-line basis over the estimated useful lives of the related assets; generally 25 years for buildings and 12 years for major machinery and equipment. Expenditures for maintenance and repairs are charged to operations as incurred. Improvements that significantly extend the useful economic lives of assets are capitalized as well as interest costs incurred in connection with major capital expenditures. Capitalized interest is amortized over the lives of the related assets. Gains or losses on dispositions are included in the consolidated statements of operations. Depreciation expense for the years ended December 31, 1993, 1992 and 1991 was $18,573,000, $19,729,000, and $19,172,000, respectively. Net interest costs of $561,000, $763,000, and $542,000 were capitalized during 1993, 1992 and 1991, respectively. Goodwill Goodwill (the excess of the purchase price over net assets acquired) is being amortized on a straight-line basis over 40 years. The Company continually evaluates whether events and circumstances have occurred that indicate the remaining estimated useful life of the goodwill may warrant revision or that the remaining balance of goodwill may not be recoverable. The Company uses estimates of the results of operations of Formica over the remaining life of the goodwill in measuring whether the goodwill is recoverable. Trademarks and patents As a result of the transaction described in Note 1, trademarks and patents were adjusted to their fair values as of May 4, 1989. Trademarks ($90,000,000) are being amortized on a straight-line basis over 40 years. Patents ($20,400,000) are being amortized on a straight-line basis over periods ranging between 9 and 15 years. The Company continually evaluates the remaining useful lives and the recoverability of trademarks and patents as described above for goodwill. (2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Deferred charges and other assets Deferred charges and other assets consist principally of deferred financing costs incurred in connection with the merger. These assets are being amortized using the interest method over periods ranging from 8 to 12 years. Accumulated amortization of deferred financing costs was $12,800,000 and $8,900,000 at December 31, 1993 and 1992, respectively. Research and development Research and development costs are charged to operations as they are incurred. Such costs amounted to $3,291,000, $3,488,000 and $3,604,000, for the years ended December 31, 1993, 1992 and 1991, respectively. Other income, net Other income, net generally consists primarily of royalty income, interest income and gains and losses on foreign currency transactions. In 1993, other income, net includes $1.9 million relating to the reversal of other long-term liabilities associated with reserves which management believe are no longer needed. In 1992, other income, net consists primarily of $9.1 million relating to a reduction of other long-term liabilities attributable to changes in certain of the Company's postretirement medical benefit plans (See Notes 6 and 10) and $2.0 million relating to the reversal of other long-term liabilities as a result of the release of certain warranties and representations made by the Company in connection with the prior sale of a subsidiary. Statements of cash flows For purposes of the statements of cash flows, the Company generally considers all highly liquid instruments purchased with a maturity of three months or less to be cash equivalents. During the years ended December 31, 1993, 1992 and 1991, the Company paid interest of $32,880,000, $41,726,000 and $43,290,000, and income taxes of $1,026,000, $602,000, and $1,111,000, respectively. (3) SHORT-TERM BORROWINGS Short-term borrowings of Formica consisted of various bank borrowings, overdraft facilities, international discounted receivables and commercial loans. The following information relates to short-term borrowings: (a) Based on month-end balances. (b) Calculated by relating appropriate interest expense to monthly average borrowings. (4) LONG-TERM DEBT Long-term debt of Formica at December 31, 1993 and 1992 consisted of the following: (4) LONG-TERM DEBT (CONTINUED) Bank Credit Agreements In September 1989, Formica executed revolving credit agreements with Canadian Imperial Bank of Commerce (CIBC), as agent, and certain other banks for borrowings in the U.S. and by Formica's Canadian, French, Spanish and U.K. subsidiaries, which agreements have since been amended from time to time (the "CIBC Bank Credit Agreement"). Additionally, Formica's Taiwan subsidiary entered into a revolving credit facility with a local bank to repay existing debt and provide for working capital requirements. The U.S. borrowings were made under a credit agreement (the "U.S. Credit Agreement") with CIBC, as agent, and certain other banks. The U.S. Credit Agreement comprises a revolving credit facility of $26.6 million, a working capital facility of $15.0 million to be used for domestic and international working capital purposes and a letter of credit facility for a U.S. dollar equivalent of approximately $34.8 million. The letter of credit facility covers letters of credit denominated in Spanish pesetas (up to Pts 2,893,792,500) and Canadian dollars (up to C$18,670,322) to support, respectively, the Spanish and Canadian subsidiaries' principal borrowings and a portion of the interest imputed thereon. The obligations of Formica under the U.S. Credit Agreement are guaranteed by Holdings and certain of the subsidiaries of Formica and are secured by first priority mortgages on real property, liens on other significant assets (including inventory, receivables, machinery and equipment, contract rights and intangibles) and pledges of the capital stock of Formica and a portion of the capital stock of certain of its subsidiaries. Formica's assets are available first and foremost to satisfy the claims of its own creditors. The U.S. Credit Agreement expires September 1997 with mandatory commitment reductions under the revolving credit facility which began in 1991. The working capital facility matures in September 1994. The letters of credit issued under the letter of credit facility have stated expiration dates of no more than one year, and are renewable (as long as no default exists) for additional one-year periods with a final expiration in September 1997. The U.K. and French borrowings are made under credit facilities with local affiliates of CIBC, as agents, and certain other banks. These credit facilities provide for aggregate borrowings of Pounds Sterling 26,030,000 (approximately $38.8 million) and French Francs 154,500,000 (approximately $26.2 million), respectively, subject to currency exchange provisions. The final maturity of such borrowings is September 1997 with mandatory commitment reductions which began in 1991. The obligations under the U.K. and French credit facilities are guaranteed by Formica and certain of its subsidiaries. In addition, such obligations are secured by certain security agreements covering significant assets of the U.K. and French subsidiaries (including real property, machinery and equipment, inventory, receivables and intangibles) and, with respect to the U.K. subsidiary, by the pledge of the capital stock of its subsidiaries. (4) LONG-TERM DEBT (CONTINUED) The Canadian and Spanish borrowings are made under revolving credit arrangements with local banks. Such borrowings are supported by the letter of credit facility referred to above covering up to C$17,500,000 (approximately $13.2 million) and Pts 2,700,000,000 (approximately $19.3 million) in principal, respectively. The final maturity of such borrowings is September 1997 with mandatory commitment reductions which began in 1991. The U.S. Credit Agreement contains covenants, the most restrictive of which significantly limit Formica's ability to borrow additional funds, acquire or dispose of certain operating assets, redeem its stock and repay its senior subordinated notes and subordinated discount debentures prior to maturity. Formica is also prohibited from making loans, paying dividends and otherwise making distributions to Holdings, except under certain limited circumstances. Additionally, Formica must maintain minimum levels of working capital and earnings before interest expense, income taxes, depreciation expense and amortization expense. Also Formica must maintain minimum interest coverage ratios and cannot exceed certain maximum leverage ratios. Certain of the minimum levels and ratios become more restrictive in each succeeding year of the agreement. Agreements covering the U.K., French, Spanish and Canadian loan facilities provide for events of default consistent with the events of default as defined in the U.S. Credit Agreement. The CIBC Bank Credit Agreement carry cross default language should an event of default occur under any of the CIBC Bank Credit Agreement. Under the terms of the CIBC Bank Credit Agreement, the commitments have been reduced commencing with the second anniversary of the merger date. Further reductions are as follows (expressed in U.S. dollars using December 31, 1993 exchange rates): 1994-- $18.3 million; 1995--$13.4 million; 1996--$19.4 million; 1997--remainder. Additionally, the Working Capital Facility of $15.0 million, which is part of the CIBC Credit Agreement, matures in September 1994. Borrowings under the CIBC Bank Credit Agreement would have to be repaid only to the extent that outstanding local borrowings exceed the commitment level in effect after the aforementioned reductions. In November 1989, Formica's Taiwan subsidiary entered into a loan agreement with a local bank which permits local currency borrowings of up to NT$150,000,000 (approximately $5.6 million) at variable interest rates quoted by the bank. This loan agreement was renewed as of November 30, 1993 and now includes a separate short-term line of credit facility. At December 31, 1993, such borrowings bore interest at 6.7%. The loan agreement has a maturity of one year and may be extended for successive twelve-month periods at the option of the bank. Formica expects to renew this facility on an annual basis as of November 30, of each succeeding year. The loan is collateralized by a first priority mortgage on all of the borrower's real property. The borrower also undertakes not to encumber any of its other assets unless the benefit of such security is also extended to the bank. If Formica fails to maintain beneficial ownership in its Taiwan subsidiary, the bank will be entitled to terminate the commitment and accelerate (4) LONG-TERM DEBT (CONTINUED) the maturity of any outstanding borrowings. This loan agreement is unrelated to the CIBC Bank Credit Agreement. The CIBC Bank Credit Agreement bear interest, at the option of Formica, at one of several variable rates. Borrowings under the CIBC Bank Credit Agreement and the Taiwan revolving credit facility bear interest at floating rates which in 1993 averaged approximately 11.8%. Formica has interest rate swap agreements outstanding at December 31, 1993 on approximately $18.6 million of these borrowings at an average interest rate of approximately 11.9%. The average interest rate of borrowings under the CIBC Bank Credit Agreement and the Taiwan revolving credit facility for 1993, after taking into consideration the adverse impact of the interest rate swap agreements, approximated 12.7%. The estimated cost to cancel the interest rate swap agreements at December 31, 1993 was $1.2 million, taking into account current interest rates. As of December 31, 1993, utilizing foreign currency exchange rates in effect at that time, Formica had approximately $69.6 million of available and unused principal borrowing commitments for both revolving credit and working capital purposes over and above the $75.0 million of outstanding borrowings under both the CIBC Bank Credit Agreement and the Taiwan revolving credit facility. Commitment fees of 1/2% are paid on the unused lines of credit under the CIBC Bank Credit Agreement. Considering Formica's right to repay the loans under the CIBC Bank Credit Agreement and the Taiwan revolving credit facility without penalty and the floating interest rates, Formica believes the carrying amounts approximate fair value at December 31, 1993. Senior Subordinated Notes In October 1989, Formica sold $100 million principal amount of Senior Subordinated Notes pursuant to an Indenture dated September 15, 1989 (the "Notes"). Such Notes bear interest at 14% per annum, payable semi-annually, and mature on October 1, 1999. A sinking fund payment of $40 million is required to be made on October 1, 1998. The Notes are not redeemable prior to October 1, 1994, except under limited circumstances. However, in the event of a change of control, as defined in the Indenture, holders of the Notes will have the right to require Formica to repurchase the Notes at 101% of their principal amount. The estimated fair value of the Notes at December 31, 1993 was $107.0 million based on quoted market prices. This estimated fair value does not represent Formica's actual obligation to the holders of the Notes as of December 31, 1993. Subordinated Discount Debentures In October 1989, Formica issued $95.9 million principal amount of Subordinated Discount Debentures pursuant to an Indenture dated September 15, 1989 (the "Discount Debentures"). The Discount Debentures were issued at 46.918% ($45 million) of their principal amount and bear interest at 15 3/4% per annum. No interest is payable until October 1, 1994 and thereafter interest is payable semi-annually. The Discount Debentures mature on October 1, 2001, however, a sinking fund payment of $38.4 million is required to be made on October 1, 2000. (4) LONG-TERM DEBT (CONTINUED) The Discount Debentures may be redeemed under certain circumstances, but only after the Notes have been redeemed in full. In the event of a change of control, as defined in the Indenture, holders of the Discount Debentures will have the right to require Formica to repurchase the Discount Debentures at 101% of their accreted value. The accreted value of the Discount Debentures at December 31, 1993 was $85.7 million. The estimated fair value of the Discount Debentures was $94.0 million at December 31, 1993 based on quoted market prices. The estimated fair value does not represent Formica's actual obligation to the holders of the Discount Debentures as of December 31, 1993. The Notes and Discount Debentures are subordinated in right of payment to all debt outstanding under the CIBC Bank Credit Agreement, (including, in the case of the Discount Debentures, the Notes) as defined in the respective Indentures. The Indentures for the Notes and Discount Debentures contain covenants which, among other things, limit the incurrence of additional indebtedness, restrict the payment of dividends and the making of other distributions and of certain loans and investments by Formica and its subsidiaries, limit asset sales, limit the ability of Formica and its subsidiaries to create liens, limit the ability of Formica to enter into certain transactions with affiliates and limit the ability of Formica to merge or consolidate or to transfer substantially all of its assets. Other long-term debt Other long-term debt consists principally of certain international subsidiaries' direct borrowings. Interest on these borrowings is calculated at adjusted local market rates ranging from 7.0% to 11.0%. Other long-term debt matures in the next five years as follows (in thousands): 1995--$954; 1996--$771; 1997--$636; 1998--$583; and thereafter--$1,013. (5) STOCKHOLDERS' EQUITY On September 27, 1993, Holdings consummated a private placement of $50 million of 13 1/8% Accrual Debentures due September 15, 2005. Interest on the Accrual Debentures will accrue and compound on a semi-annual basis and will be payable in cash on September 15, 1998 in an aggregate amount of approximately $44 million. Thereafter, interest will be payable on March 15 and September 15 of each year. Using funds received from the closing of the private placement, Holdings made a capital contribution of $47.5 million to Formica in 1993. The $47.5 million capital contribution was then used by Formica to pay down debt outstanding under its bank credit agreements. After the private placement was completed, Holdings filed a registration statement with the SEC, and upon the registration statement being declared effective, Holdings exchanged the privately placed Accrual Debentures for identical publicly registered Debentures. (6) BENEFIT PLANS Formica has established pension plans covering substantially all United States and Canadian employees and certain employees in other countries. Benefits payable under the plans are reduced by any amounts received by the participants from Formica's former parent corporation. The aggregate amount of net periodic pension cost for the principal defined benefit retirement plans is presented below: (6) BENEFIT PLANS (CONTINUED) The following table sets forth the funded status and amounts reflected in the accompanying balance sheets for the benefit plans: The pension asset is included in deferred charges and other assets and the pension liability is included in other long-term liabilities and accrued salaries and benefits in the consolidated balance sheets. The projected benefit obligations at December 31, 1993 and 1992 were determined using an average assumed discount rate of approximately 7.8% and 9.4%, respectively, and an assumed average rate of increase in future compensation levels of approximately 4.8% and 5.8%, respectively. The average expected long-term rate of return on assets for 1993 and 1992 was approximately 9.6% and 10.1%, respectively. In addition to pension benefits, Formica provides certain health care benefits to its domestic retirees on a shared-cost basis. Eligible employees receive postretirement benefits comparable to those received while working for Formica. Formica may terminate, amend or change the plan periodically. Substantially all of the current domestic retirees receive coverage from Formica's former parent corporation's health care benefit plan. (6) BENEFIT PLANS (CONTINUED) As a result of changes to certain of Formica's postretirement medical benefit plans, Formica's estimated accumulated postretirement benefit obligation decreased by $9.1 million at December 31, 1992. This adjustment of Formica's estimated obligation was recorded as other income in the Company's Consolidated Statement of Operations for the year ended December 31, 1992. The income tax provision associated with the increase in other income was $3.5 million and the resulting decrease in the net loss was $5.6 million. In the first quarter of 1993, Formica adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" (SFAS 106). This statement requires the accrual of the cost of providing postretirement benefits, including medical and life insurance coverage, during the active service of the employee. There was no effect on the 1993 financial statements as a result of adopting SFAS 106. In accordance with the provisions of this statement, postretirement benefit information for prior years has not been restated. Such expense was immaterial in each year. The Net Periodic Postretirement Benefit Cost (NPPBC) is the amount to be expensed for any given year. The NPPBC for 1993 was approximately $269,000. The pro-forma effect of this change on years prior to 1993 was not determinable. Prior to 1993, Formica recognized expense in the year the benefits were paid. Included in other long-term liabilities in the December 31, 1993 and 1992 consolidated balance sheet are approximately $2.2 million and $1.9 million, respectively, representing the accumulated postretirement benefit obligation ("APBO") related to these other postretirement health care benefits. The NPPBC for the year ended December 31, 1993 includes the following components (in thousands): The discount rate used in determining the APBO and the assumed average rate of increase in future compensation levels was 7.0% and 5.0%, respectively, at December 31, 1993. The assumed trend rate used in projecting health care costs was 15% in 1993, declining by 1% per year to an ultimate level of 6% per year in 2002. However, the impact of these projected health care costs on the APBO was limited by the current plans' provisions. Accordingly, a 1% increase in the health care cost trend rate assumptions would have no impact on the APBO at December 31, 1993 or the service cost and interest cost components of the NPPBC for 1993. (7) COMMITMENTS AND CONTINGENCIES Formica rents office and warehouse space, transportation equipment and certain other items under noncancellable operating leases. Certain of these leases include additional charges based on inflation and increases in real estate taxes. Rent expense for the years ended December 31, 1993, 1992 and 1991 was $8,568,000, $7,617,000 and $8,819,000, respectively. Minimum commitments under these leases are $6,296,000 in 1994; $4,314,000 in 1995; $2,805,000 in 1996; $2,125,000 in 1997; $1,085,000 in 1998 and $548,000 thereafter. The Company also leases certain plant and equipment pursuant to agreements accounted for as capital leases. Minimum rental commitments and amounts capitalized under these agreements are not significant. In the ordinary course of business, Formica is the subject of or party to various pending or threatened litigation and claims. Formica is also involved in various environmental matters in which the Environmental Protection Agency or other third parties have claimed that Formica may be partially responsible for certain costs related to the clean up of waste disposal sites. While it is not possible to predict with certainty the outcome of any of these matters, management believes that the ultimate result of such actions or claims individually or in the aggregate, will not have a material adverse effect on the consolidated financial statements of the Company. (8) INCOME TAXES The (benefit) provision for income taxes consists of the following components: (8) INCOME TAXES (CONTINUED) United States and foreign operations contributed to loss before income taxes as follows: Deferred tax liabilities (assets) are comprised of the following at December 31, 1993: (8) INCOME TAXES (CONTINUED) The principal items giving rise to deferred taxes in 1992 and 1991 are as follows: The difference between the U.S. statutory tax rate and the Company's effective tax rate was due to the following: The net change in the valuation allowance for deferred tax assets was an increase of $2,839,000 which is exclusive of foreign exchange effects. The Company increased its U.S. Federal deferred income tax liability in 1993 by approximately $1,566,000 as a result of legislation enacted during 1993, increasing the corporate income tax rate from 34% to 35% commencing January 1, 1993. (8) INCOME TAXES (CONTINUED) The Company has provided foreign withholding and U.S. Federal income taxes on the cumulative unremitted earnings of certain consolidated international subsidiaries and joint ventures. The Company has not provided for certain income taxes on the undistributed earnings of one of its international subsidiaries, as it is the Company's intention to permanently reinvest such earnings, which amount to $22,303,000 at December 31, 1993. At December 31, 1993, the Company had foreign tax credit carryforwards available of $6,377,360 which expire in 1994 ($4,192,646); 1997 ($1,184,714); and 1998 ($1,000,000). At December 31, 1993, the Company had for Federal income tax purposes net operating loss carryforwards available of $12,008,956 expiring as follows: 2006-- $10,809,725 and 2008--$1,199,231. In February 1992, the Financial Accounting Standards Board issued a Statement of Financial Accounting Standards No. 109 ("SFAS 109") on accounting for income taxes. This statement supersedes SFAS 96, Accounting for Income Taxes. The Company adopted the accounting and disclosure rules prescribed by SFAS 109 as of January 1, 1993. The adjustments to the January 1, 1993 balance sheet to adopt SFAS 109 netted to $2,850,000. This amount is reflected in the 1993 net loss as the cumulative effect of a change in accounting principle. (9) SEGMENT AND GEOGRAPHIC DATA Formica is engaged in one line of business--the design, manufacture and distribution of decorative laminates and other surfacing products. Information about the business of Formica by geographic area is presented in the table below: (a) Includes additional depreciation and amortization expense of $8,248,000, $8,665,000 and $8,667,000 for the years ended December 31, 1993, 1992 and 1991, respectively, relating to the revaluation of certain assets in connection with the acquisition. (b) Includes unallocated corporate and research expenses of $6,693,000, in 1993, $6,101,000 in 1992, and $6,503,000 in 1991. (9) SEGMENT AND GEOGRAPHIC DATA (CONTINUED) Geographic data concerning international operations are as follows: Export sales are not a significant part of the Company's domestic operations. Transfers between areas are valued at cost plus markup, which approximates fair market value. (10) QUARTERLY FINANCIAL INFORMATION (UNAUDITED) (IN THOUSANDS) (a) The results of operations for the three months ended March 31, 1993 included $2.85 million reflected as the cumulative effect of a change in accounting principle, relating to the adoption of SFAS 109. (b) The results of operations for the three months ended September 30, 1993 included $1.9 million relating to the reversal of other long-term liabilities associated with reserves which management believed were no longer needed. (10) QUARTERLY FINANCIAL INFORMATION (CONTINUED) (c) The results of operations for the three months ended December 31, 1993 included $2.9 million income tax benefit related to the reversal of certain deferred taxes which the Company believes are no longer needed. (d) The results of operations for the three months ended March 31, 1992 included $2.8 million relating to a reduction of other long-term liabilities attributable to changes in certain of the Company's postretirement medical benefit plans. (e) The results of operations for the three-month period ended June 30, 1992 included $6.3 million relating to a reduction of other long-term liabilities attributable to changes in certain of the Company's postretirement medical benefit plans and $2.0 million relating to the reversal of other long-term liabilities as a result of the release of certain warranties and representations made by Formica in connection with the prior sale of a subsidiary. ITEM 9 ITEM 9 CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES There were no reports on Form 8-K reporting a change of accountants or disagreement on any matter of financial statement disclosure filed within the twenty-four months prior to the date of the most recent financial statements. PART III ITEM 10 ITEM 10 DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT DIRECTORS AND EXECUTIVE OFFICERS The following table provides certain information about each of the current directors and executive officers of Formica. All directors hold office until the next annual meeting of stockholders of Formica, and until their successors are duly elected and qualified. All executive officers are elected by and serve at the discretion of the Boards of Directors of Formica. None of the executive officers of Formica is related by blood, marriage or adoption to any other executive officer or director of Formica. ITEM 11 ITEM 11 EXECUTIVE COMPENSATION The following table discloses compensation received by the Chief Executive Officer and the four remaining most highly paid executive officers of Formica for the three fiscal years ended December 31, 1993. SUMMARY COMPENSATION TABLE (1) Bonus amounts were accrued for the year indicated and paid in the subsequent year. (2) The amounts shown in this column reflect payments of $6,771 and $8,045 covering the personal use of a Company vehicle for fiscal years 1993 and 1992, respectively, and $4,150 and $5,685 for certain legal and tax preparation fees for fiscal years 1993 and 1992, respectively, for Mr. Langone. The amounts shown in this column reflect payment of $15,017 covering the personal use of a Company vehicle for the fiscal year 1993, and $2,200 for fiscal years 1993 and 1992 for tax preparation fees for Mr. Marshall. (3) The amounts shown in this column include the following: (a) Payment by the Company of a premium of $1,576 for fiscal year 1993 and $1,368 for fiscal year 1992 for term life insurance; Company paid split dollar life insurance consisting of $1,378 for fiscal year 1993 and $1,325 for fiscal year 1992 for term life and an estimated benefit to the executive of $5,160 for fiscal year 1993 and $5,339 for fiscal year 1992; $3,214 for fiscal year 1993 and $3,544 for fiscal year 1992 as the Company's matching contribution to the Employee Savings Plan; and $3,538 for fiscal year 1993 and $3,433 for fiscal year 1992 as the Company's contribution to the Profit Sharing account for Mr. Langone. (b) Company paid split dollar life insurance consisting of $135 for fiscal year 1993 and $176 for fiscal year 1992 for term life and an estimated benefit to the executive of $509 for fiscal year 1993 and $596 for fiscal year 1992; $2,565 for fiscal year 1993 and $2,400 for fiscal year 1992 as the Company's matching contribution to the Employee Savings Plan; and $2,625 for fiscal year 1993 and $2,400 for fiscal year 1992 as the Company's contribution to the Profit Sharing account for Mr. Schneider. (c) Company paid split dollar life insurance consisting of $431 for fiscal year 1993 and $445 for fiscal year 1992 for term life and an estimated benefit to the executive of $1,142 for fiscal year 1993 and $1,173 for fiscal year 1992; and $326,074 of compensation for fiscal year 1992 realized by the exercise of stock options in Holdings for Mr. Marshall. Mr. Marshall realized compensation as disclosed for 1992 by the exercise of his stock options when Holdings elected to repurchase his stock under the terms of the Holdings Subscription and Stockholders Agreement. (d) Company paid split dollar life insurance consisting of $280 for fiscal year 1993 for term life and an estimated benefit to the executive of $1,881 for fiscal year 1993; $2,100 for fiscal year 1993 as the Company's matching contribution to the Employee Savings Plan; and $2,100 for fiscal year 1993 as the Company's contribution to the Profit Sharing account for Mr. Mahony. (e) Company paid split dollar life insurance consisting of $99 for fiscal year 1993 and $141 for fiscal year 1992 for term life and an estimated benefit to the executive of $746 for fiscal year 1993 and $677 for fiscal year 1992; $1,974 for fiscal year 1993 and $1,897 for fiscal year 1992 as the Company's matching contribution to the Employee Savings Plan; and $1,974 for fiscal year 1993 and $1,897 for fiscal year 1992 as the Company's contribution to the Profit Sharing account for Mr. Brooks. (4) Amounts shown in this column include payments made under the Formica Employee Savings Plan and Profit Sharing Plan in which all U.S. salaried employees participate. (5) Mr. Mahony was not part of the highly compensated executive officer group for years 1992 and 1991, and accordingly, no disclosure is required for these years. * Under the Securities and Exchange Commission's transition rules, no disclosure is required. The following table provides information concerning options granted to the named executive officers pursuant to the 1990 Holdings Stock Option Plan. OPTION GRANTS IN FISCAL YEAR 1993(1) (1) The options reflected in this table represent shares of Series A Common Stock of Holdings. All of the outstanding shares of the capital stock of Formica are owned by Holdings. (2) The capital stock of Holdings is not publicly traded, and accordingly, the fair market value of Holdings' Series A Common Stock cannot be readily determined. Under the terms of the 1990 Holdings Stock Option Plan and the Subscription and Stockholders Agreement entered into by each of the named executives, if the named executive's employment with the Company is terminated for any reason, Holdings, at its sole option, may purchase the stock issuable upon the exercise of the option at an agreed upon formula. Assuming each of the named executive's employment with the Company was terminated at 1993 year end and further assuming Holdings elected to purchase the Series A Common Stock issuable upon the exercise of such executive's stock options in accordance with the provisions of the Subscription and Stockholders Agreement, the present value of each executive's stock options would have been equal to his exercise price as follows: Mr. Langone, $3,135; Mr. Schneider, $294; Mr. Marshall, $42; Mr. Mahony, $400; and Mr. Brooks, $130. The following table provides information on option exercises in fiscal year 1993 by the named executive officers and the value of such officers' unexercised options at December 31, 1993. _______________ (1) The options reflected in this table represent shares in Holdings. All of the outstanding shares of the capital stock of Formica are owned by Holdings. (2) The capital stock of Holdings is not publicly traded, and accordingly, the fair market value of Holdings' stock cannot be readily determined. Each of the named executives who held options to purchase Holdings stock at year end have entered into a Subscription and Stockholders Agreement, which among other things, contains a formula for the purchase by Holdings of the stock, at the sole option of Holdings, in the event the executive's employment with the Company is terminated for any reason. Assuming each of the named executive's employment with the Company was terminated at 1993 year end and further assuming Holdings elected to purchase the stock issuable upon the exercise of such executive's stock options in accordance with the provisions of the Subscription and Stockholders Agreement, the value of each executive's stock options would have been as follows: Mr. Langone, $3,135; Mr. Schneider, $305,318; Mr. Marshall, $73,842; Mr. Mahony, $138,554; and Mr. Brooks, $230,314. (3) The capital stock of Holdings is not publicly traded, and accordingly, the present value of Holdings' Series A Common Stock cannot be readily determined. Under the terms of the 1990 Holdings Stock Option Plan and the Subscription and Stockholders Agreement entered into by each of the named executives, if Mr. Schneider's employment with the Company is terminated for any reason, Holdings, at its sole option, may purchase the stock issuable upon the exercise of the options at an agreed upon formula. Assuming Mr. Schneider's employment with the Company was terminated at 1993 year end and further assuming Holdings elected to purchase the Series A Common Stock issued upon the exercise of such executive's stock options in accordance with the provisions of the Subscription and Stockholders Agreement, the present value of the 15,610 shares of Series A Common Stock acquired by Mr. Schneider would have been $1,561. PENSION PLAN The Company maintains the Formica Corporation Employee Retirement Plan (the "Retirement Plan"), a non-contributory defined benefit plan for United States employees. The Retirement Plan was amended and restated as of January 1, 1990, to bring it into compliance with legislation which took effect on January 1, 1989 and amended again in May 1990 and June 1992. Pension benefits are determined based upon a career average pay formula. The annual pension benefit to which a salaried employee is entitled, under the Retirement Plan, at the normal retirement date (age 65 and five years of service) is an amount equal to the sum of: (A) (i) 1.5 percent of earnings for each year of service, plus (ii) 1.5 percent of earnings to date of termination (if termination is effective other than at year end); plus (B) the accrued benefit as of June 30, 1992 determined as being the greater of (i) the benefit accrued under the Retirement Plan then in effect or (ii) 1.5 percent of the five year average annual earnings multiplied by years of service as of June 30, 1992. The Retirement Plan formula calculates annual pension amounts on a single life annuity basis. The Internal Revenue Code of 1986, as amended (the "Code"), limits the annual amount payable to an individual under a tax qualified pension plan to $90,000 (as adjusted for cost of living increases) and places limitations upon amounts payable to certain individuals. The $90,000 limit on the annual amount payable to an individual imposed by the Code was adjusted in 1993 to $115,641 and in 1994 to $118,800 to account for cost of living increases. The Code also limits the amount of annual compensation that may be taken into account by a plan to $200,000 (as adjusted for cost of living increases). The $200,000 compensation limit was adjusted in 1993 to $235,840 and adjusted downward, effective January 1, 1994, to $150,000. Estimated annual benefits payable upon retirement under the Company's Retirement Plan to Messrs. Langone, Schneider, Marshall, Mahony and Brooks are $118,800, $72,018, $0, $76,937 and $64,869, respectively, assuming current Code limitations, no change in present salary and continued service to normal retirement at age 65. Mr. Langone and Mr. Mahony were previously employed by American Cyanamid (Formica's former parent) and, therefore, their benefits would be reduced by any amounts payable under the American Cyanamid retirement plan. Mr. Marshall was previously employed by the Company's United Kingdom subsidiary and is entitled to retirement benefits under that company's retirement plan. EMPLOYMENT MATTERS Messrs. Langone, Schneider, Marshall and Brooks entered into employment agreements with Formica (the "Employment Agreements") in May 1989 and in September 1989 which took effect on September 11, 1989. The Employment Agreements contain customary employment terms, have a duration of five years from their effectiveness, subject to annual automatic renewal unless earlier terminated, and provide for initial annual base salaries, subject to adjustments, of $290,000, $130,000, $150,000 and $115,000, respectively, for Messrs. Langone, Schneider, Marshall and Brooks plus additional compensation or incentive plans adopted by Formica to the extent such participation is determined by the Board of Directors of Formica. The Employment Agreements provide that certain benefits are to be continued for a stated period following termination of employment. The amount of payments to be made to each individual would vary depending upon such individual's level of compensation and benefits at the time of termination and whether such employment was terminated prior to the end of their term by Formica for "Cause" or by the employee for "Good Reason" (except in the latter case for Mr. Marshall) (as such terms are defined in the Employment Agreements) or otherwise during the term of the agreements. In addition, the Employment Agreements include noncompetition and confidentiality provisions. On February 5, 1989, the Board of Directors of Formica approved termination agreements with Messrs. Langone, Schneider, Marshall and Brooks that, in general, would provide that immediately upon the occurrence of a "change of control event", as defined, involving Formica, an executive whose employment terminates for any reason other than death, permanent disability, retirement, for cause, or without good reason, all terms as defined, at any time after a change of control event (except in the case of Mr. Langone) will be entitled to (a) 299 percent of his latest salary and bonus earned and (b) continued coverage under certain employee welfare and pension benefit plans for certain specified periods after termination and certain other benefits. Mr. John Boanas resigned as a member of the Board of Directors and as an executive officer of Holdings and Formica effective January 31, 1993. Mr. Boanas will be entitled to an annual pension payment from Formica of $37,072 upon attaining the age of 65. In connection with his resignation, Mr. Boanas entered into noncompetition agreements with the Company which restrict Mr. Boanas for a period of four years from becoming associated with any company which competes with the Company in consideration of the Company paying $125,000 per year to Mr. Boanas during the four-year term of the agreements. In addition, the Company agreed to repurchase from a trust established by Mr. Boanas the stock he owned in Holdings at a purchase price of $620,750 payable in installments with interest at 6 percent per annum between January 31, 1993 and January 31, 1995. COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION Non-employee Directors Ilan Kaufthal, Charles P. Durkin, Jr. and Wayne B. Lyon serve on the Compensation Committee of Formica's Board of Directors. Mr. Durkin is a Managing Director of Dillon Read who manages the investments of the Saratoga Investors (as herein defined), an owner of more than 5 percent of the stock of Holdings (see "Item 12 ITEM 12 SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS, DIRECTORS AND EXECUTIVE OFFICERS The authorized capital stock of Holdings is divided into 10,020,000 shares of Preferred Stock, par value $.01 per share (the "Preferred Stock"), of which 9,000,000 shares are Series A Preferred Stock (the "Series A Preferred Stock") and 1,020,000 shares are Convertible Preferred Stock (the "Convertible Preferred Stock"), and 2,680,000 shares of Common Stock, par value $.01 per share (the "Common Stock"), of which 1,200,000 shares are Series A Common Stock (the "Series A Common Stock") and 1,480,000 shares are Series B Common Stock (the "Series B Common Stock"). As of December 31, 1993, there were issued and outstanding 8,513,585 shares of Series A Preferred Stock, 394,135 shares of Series A Common Stock, 1,002,717 shares of Series B Common Stock and no shares of Convertible Preferred Stock. An additional 127,045 shares of Series A Preferred Stock, 116,368 shares of Series A Common Stock and 445,409 shares of Series B Common Stock are subject to options granted by Holdings. The holders of Series A Preferred Stock, Series A Common Stock and Series B Common Stock are entitled to one vote per share on all matters to be voted on by stockholders of Holdings and will vote together as a single class. The Convertible Preferred Stock does not possess the right to vote on any matters to be voted upon by stockholders of Holdings, except as required by law. In February 1990, the Board of Directors of Holdings adopted the 1990 Holdings Stock Option Plan (the "Holdings Plan"). The Holdings Plan authorizes the grant of stock options to acquire Series A Common Stock to employees of Holdings' subsidiaries. A total of 34,116 shares (subsequently adjusted in 1993 to 95,300) of Series A Common Stock were reserved for grants of options under the Holdings Plan. In addition, as of March 1, 1994, options to acquire 80,524 shares have been granted under the Holdings Plan and remain outstanding. Additionally, options to acquire 4,190 shares were granted and have been exercised under the Holdings Plan and remain outstanding. The table below sets forth the beneficial ownership of the outstanding shares of Holdings' capital stock, as of March 1, 1994, by (i) each person who owns beneficially more than 5% of any class of capital stock of Holdings, (ii) each director of Formica, (iii) the Chief Executive Officer and certain other of the highly compensated executive officers of the Company and (iv) all directors and executive officers of Formica as a group. _______________ (1) The amount of any series of stock is calculated in accordance with Rule 13d-3(d)(1) of the Exchange Act which provides that a person shall be deemed to be a beneficial owner of a security if that person has the right to acquire beneficial ownership of such security within sixty days. In addition, Rule 13d-3(d)(1) provides that any securities not outstanding which are subject to such right shall be deemed to be outstanding for the purpose of computing beneficial ownership of the outstanding securities of the class owned by such person and percentage of voting interest but shall not be deemed to be outstanding for the purpose of computing the percentage of the class owned by any other person. (2) The "Saratoga Investors" are Saratoga, Saratoga Partners II, C.V., Lexington Partners II, L.P., Concord Partners II, L.P., Concord Partners, Concord Partners Japan, Limited, Cord Capital, N.V., and Dillon, Read Inc. ("DRI") and Dillon Read, as nominees. All of the Saratoga Investors, other than DRI and Dillon Read, are corporations or limited partnerships formed to invest in transactions originated by Dillon Read and are managed by Dillon Read. DRI and Dillon Read, as nominees for certain managing directors and officers of Dillon Read, together have sole voting and investment power pursuant to powers of attorney with respect to the shares of Holdings capital stock beneficially owned by them. Accordingly, Dillon Read, alone or with DRI, has the sole power to vote or dispose of the shares of Holdings capital stock owned by the Saratoga Investors. DRI is Dillon Read's parent company and may also be deemed to beneficially own the 9,680 shares of Series A Common Stock (or 0.1% of the voting interest) owned by DR Interfunding, which shares are excluded from the table. With the exception of Saratoga, none of the Saratoga Investors owns more than 5% of the outstanding shares of Holdings capital stock. Dillon Read is the Initial Purchaser of the Debentures and was the underwriter for the public offering of the Senior Subordinated Notes and acted as placement agent in connection with the private placement of the Subordinated Discount Debentures. See Notes 6 and 7 above. (3) Includes 420,000 shares of Series B Common Stock beneficially owned by Masco, which are subject to a presently exercisable option granted by Holdings. (4) Includes 31,352 shares of Series A Common Stock subject to presently exercisable options. (5) Includes 20,140 shares of Series A Preferred Stock and 4,028 shares of Series B Common Stock, all of which are subject to presently exercisable options. (6) Bret E. Russell is an employee of Dillon Read and he has invested funds through DRI and Dillon Read, as nominees, and Lexington Partners II, L.P., which in aggregate constitute less than 1% of the funds invested by the Saratoga Investors. (7) Charles P. Durkin, Jr., is an employee of Dillon Read and he has invested funds through DRI and Dillon Read, as nominees, and Lexington Partners II, L.P., which in aggregate constitute less than 1% of the funds invested by the Saratoga Investors. (8) Wayne B. Lyon is an employee of Masco. (9) Peter J. Pirsch is an employee of Masco. (10) All shares are subject to presently exercisable options. (11) Includes 59,455 shares of Series A Preferred Stock, 54,854 shares of Series A Common Stock and 11,891 shares of Series B Common Stock, all of which are subject to presently exercisable options. ITEM 13 ITEM 13 CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The Company may from time to time enter into financial advisory or other investment banking relationships with Dillon Read or one of its affiliates pursuant to which Dillon Read or its affiliate will receive customary fees and will be entitled to reimbursement for all reasonable disbursements and out-of-pocket expenses incurred in connection therewith. The Company expects that any such arrangement will include provisions for the indemnification of Dillon Read against certain liabilities, including liabilities under the Federal securities laws. During 1993, Dillon Read received a fee of $100,000 from the Company for financial advisory services. In addition, in September, 1993, Dillon Read, acting as the initial purchaser in connection with the private placement of $50 million of Accrual Debentures by Holdings received a discount on its purchase of the Accrual Debentures in the amount of $1.75 million. The Company and Masco Corporation may from time to time purchase products from each other in regular commercial transactions. PART IV ITEM 14 ITEM 14 EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) 2. Financial Statement Schedules The following financial statement schedules are included in this report: Report of Independent Public Accountants on Schedules Schedule V - Property, Plant and Equipment Schedule VI - Accumulated Depreciation of Property, Plant and Equipment Schedule VIII - Valuation and Qualifying Accounts Schedule X - Supplementary Income Statement Information All other schedules are omitted because they are not applicable, not required, or the required information is included in the consolidated financial statements or notes thereto. (a) 3. Exhibits Exhibit No. Description 1(m) Purchase Agreement dated September 17, 1993 between FM Holdings Inc. and Dillon, Read & Co. Inc. 2.1(a) Merger Agreement dated February 6, 1989, as amended, by and among FM Holdings Inc., FM Acquisition Corporation and Formica Corporation 3.1(m) Articles of Incorporation of the Registrant 3.2(m) By-laws of the Registrant 4.1(a) Form of Senior Subordinated Note due 1999 (included in Exhibit 4.3) 4.2(b) Form of Subordinated Discount Debenture due 2001 (included in Exhibit 4.4) 4.3(a) Form of Indenture of Formica Corporation for Senior Subordinated Notes due 1999 4.4(b) Form of Indenture of Formica Corporation for Subordinated Discount Debentures due 2001 4.5(a) Form of Credit Agreement dated as of September 7, 1989 by and among Formica Corporation (certain subsidiaries of Formica Corporation), the financial institutions then or thereafter parties thereto and Canadian Imperial Bank of Commerce, New York Agency, as agent 4.6(a) Form of Credit Agreement dated as of September 7, 1989 by and among Formica Limited, the financial institutions then or thereafter parties thereto and Canadian Imperial Bank of Commerce, London Branch, as agent 4.7(a) Form of Loan Agreement dated as of September 7, 1989 by and among Formica France S.A., the financial parties then or thereafter parties thereto and Canadian Imperial Bank of Commerce (International), S.A., as agent 4.8(a) Form of Credit Agreement dated as of September 7, 1989 between Canadian Imperial Bank of Commerce and Formica Canada Inc. 4.9(a) Form of Loan Agreement dated as of September 7, 1989 between Formica Espanola, S.A. and Banco Bilbao Vizcaya, S.A. 4.10(d) Loan Agreement dated November 30, 1990 between Credit Lyonnais, Taipei Branch and Formica Taiwan Corporation 4.11.A(d) Schedules I, II and III to the Loan Agreement dated November 30, 1990 between Credit Lyonnais, Taipei Branch and Formica Taiwan Corporation 4.11(e) Amendment No. 1 dated as of January 15, 1990 to Loan Agreement dated as of September 7, 1989 by and among Formica Limited, the financial institutions then or thereafter parties thereto and Canadian Imperial Bank of Commerce, London Branch, as agent 4.12(g) Amendment No. 1 dated as of September 20, 1990 to the Credit Agreement dated as of September 7, 1989 by and among Formica Corporation, certain subsidiaries of Formica Corporation, the financial institutions then and thereafter parties thereto and Canadian Imperial Bank of Commerce, New York Agency, as agent, and Consent and Waiver, dated as of September 20, 1990, and Initial Participant Consent related thereto 4.13(f) Amendment No. 2 dated as of August 8, 1991 to the Credit Agreement dated as of September 7, 1989 by and among Formica Corporation, the financial institutions then and thereafter parties thereto and Canadian Imperial Bank of Commerce, New York Agency, as agent 4.14(c) Recognition and Assumption Agreement dated as of December 20, 1991 among Formica Corporation, Formica Technology Inc., Texas, Formica Technology Inc., Delaware and Canadian Imperial Bank of Commerce, New York Agency and Pledge Agreement Supplement dated as of December 20, 1991 between Formica Corporation and Canadian Imperial Bank of Commerce, New York Agency related thereto 4.15(i) Amendment No. 1 dated as of February 17, 1992 to the Loan Agreement dated November 30, 1990 between Credit Lyonnais, Taipei Branch and Formica Taiwan Corporation 4.16(k) Consent to Release of Pledged Shares dated as of July 6, 1992 to the Credit Agreement dated as of September 7, 1989, as amended, by and among Formica Corporation, certain subsidiaries of Formica Corporation, the financial institutions then and thereafter parties thereto and Canadian Imperial Bank of Commerce, New York Agency, as agent 4.17(l) Amendment No. 3 dated as of March 9, 1993 to the Credit Agreement dated as of September 7, 1989 by and among Formica Corporation, certain subsidiaries of Formica Corporation, the financial institutions then and thereafter parties thereto and Canadian Imperial Bank of Commerce, New York Agency, as agent, and Consent related thereto 4.18(j) Amendment dated as of July 20, 1993 to the Loan Agreement dated November 30, 1990 between Credit Lyonnais, Taipei Branch and Formica Taiwan Corporation 4.19(j) Short-Term Line of Credit Facility dated as of July 20, 1993 between Credit Lyonnais, Taipei Branch and Formica Taiwan Corporation 4.20(m) Amendment No. 4 dated as of August 20, 1993 to the Credit Agreement dated as of September 7, 1989 by and among Formica Corporation, certain subsidiaries of Formica Corporation, the financial institutions then and thereafter parties thereto and Canadian Imperial Bank of Commerce, New York Agency, as agent, and Consent related thereto 4.21(m) Form of 13 1/8% Accrual Debenture due 2005, Series A (included in Exhibit 4.23) 4.22(m) Form of 13 1/8% Accrual Debenture due 2005, Series B (included in Exhibit 4.23) 4.23(m) Indenture between FM Holdings Inc. and United Jersey Bank, as trustee, relating to the Accrual Debentures due 2005, Series A and the Accrual Debentures due 2005, Series B 4.24(m) Registration Rights Agreement dated September 27, 1993 between FM Holdings Inc. and Dillon, Read & Co. Inc. 4.25(m) Debenture Pledge Agreement dated September 27, 1993 between FM Holdings Inc. and United Jersey Bank, as trustee 4.26(m) Collateral Subordination and Intercreditor Agreement dated September 27, 1993 between Canadian Imperial Bank of Commerce, as collateral agent, and United Jersey Bank, as trustee 4.27(m) Amended and Restated Pledge Agreement dated as of September 27, 1993 made by FM Holdings Inc. in favor of Canadian Imperial Bank of Commerce, as collateral agent 4.28(m) Amendment No. 1 to U.S. Pledge Agreement dated as of September 27, 1993 made by Formica Corporation and the other pledgors named therein in favor of Canadian Imperial Bank of Commerce, as collateral agent 5(m) Opinion of Simpson Thacher & Bartlett regarding the legality of the New Debentures being registered 8(m) Opinion of Simpson Thacher & Bartlett regarding tax matters 10.1(a) Employment Agreement between Vincent P. Langone and Formica Corporation 10.2(a) Employment Agreements between John Boanas and Formica Corporation 10.3(a) Employment Agreement between David Schneider and Formica Corporation 10.4(a) Formica Corporation Employee Savings Plan for employees not covered by a collective bargaining agreement 10.5(a) Formica Corporation Employee Savings Plan for employees covered by a collective bargaining agreement 10.6(e) Formica Corporation Employee Retirement Plan, as Amended and Restated as of January 1, 1990 10.7(a) Form of Indemnity Agreement dated as of June 27, 1987 between Formica Corporation and its directors and officers 10.8(a) Form of Executive Officer Termination Agreement dated February 5, 1989 between Formica Corporation and each of Messrs. Brook, Kraus, Schneider and Marshall 10.9(a) Form of Executive Officer Termination Agreement between Formica Corporation and Vincent P. Langone 10.10(a) Form of Executive Officer Termination Agreement between Formica Corporation and John Boanas 10.11(a) Form of Employment Agreement between Peter Marshall and Formica Corporation 10.12(a) Form of Employment Agreement between Charles Brooks and Formica Corporation 10.13(a) Form of Employment Agreement between Robert Kraus and Formica Corporation 12(m) Historical deficiency of earnings available to cover fixed charges and ratio of earnings to fixed charges 21 List of subsidiaries of the Registrant 23.1(m) Consent of Arthur Andersen & Co. 23.2 Consent of Simpson Thacher & Bartlett with respect to the Accrual Debentures due 2005, Series B (included in their opinion filed as Exhibit 5) 24(m) Powers of Attorney 25(m) Statement of eligibility of the Trustee on Form T-1 (separately bound) 29.1(m) Form of Letter of Transmittal 29.2(m) Form of Notice of Guaranteed Delivery 29.3(m) Form of Exchange Agent Agreement to be entered into between FM Holdings Inc. and United Jersey Bank, as exchange agent _______________ (a) Previously filed as an Exhibit to Registration Statement No. 33-30012, filed by Formica Corporation, as the Exhibit No. indicated and hereby incorporated by reference. (b) Previously filed as an Exhibit to Registration Statement No. 33-31900, filed by Formica Corporation, as the Exhibit No. indicated and hereby incorporated by reference. (c) Previously filed as an Exhibit to Formica Corporation's Form 10-K for the year ended December 31, 1991 as the Exhibit No. indicated and hereby incorporated by reference. (d) Previously filed as an Exhibit to Formica Corporation's Form 10-K for the year ended December 31, 1990 as the Exhibit No. indicated and hereby incorporated herein by reference. (e) Previously filed as an Exhibit to Formica Corporation's Form 10-K for the year ended December 31, 1989 as the Exhibit No. indicated and hereby incorporated herein by reference. (f) Previously filed as an Exhibit to Formica Corporation's Form 10-Q for the quarter ended June 30, 1991 as the Exhibit No. indicated and hereby incorporated by reference. (g) Previously filed as an Exhibit to Formica Corporation's Form 10-Q for the quarter ended September 30, 1990 as the Exhibit No. indicated and hereby incorporated herein by reference. (h) Previously filed as an Exhibit to Post-Effective Amendment No. 5 to Registration Statement No. 33-30012 and Post-Effective Amendment No. 4 to Registration Statement No. 33-31900, each filed by Formica Corporation, as the Exhibit No. indicated and hereby incorporated by reference. (i) Previously filed as an Exhibit to Formica Corporation's Form 10-Q for the quarter ended March 31, 1992 as the Exhibit No. indicated and hereby incorporated by reference. (j) Previously filed as an Exhibit to Formica Corporation's Form 10-Q for the quarter ended June 30, 1993 as the Exhibit No. indicated and hereby incorporated by reference. (k) Previously filed as an Exhibit to Formica Corporation's Form 10-Q for the quarter ended September 30, 1992 as the Exhibit No. indicated and hereby incorporated by reference. (l) Previously filed as an Exhibit to Formica Corporation's Form 10-K for the year ended December 31, 1992 as the Exhibit No. indicated and hereby incorporated by reference. (m) Previously filed as an Exhibit to FM Holdings Inc.'s S-4 Registration Statement No. 33-70196 as the Exhibit No. indicated and hereby incorporated by reference. ___________________ (b) Reports Filed on Form 8-K No reports were required to be filed on Form 8-K during the last quarter for the period for which this report is filed. SIGNATURES Pursuant to the requirements of Section l3 or l5(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. FORMICA CORPORATION /S/ Vincent P. Langone Dated as of March 29, 1994 Vincent P. Langone Chairman of the Board, President and Chief Executive Officer /S/ David Schneider David Schneider Vice President and Chief Financial Officer and Chief Accounting 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 dates indicated. Signature Title Date /S/ Charles P. Durkin, Jr. Director March 29, 1994 Charles P. Durkin, Jr. /S/ Ilan Kaufthal Director March 29, 1994 Ilan Kaufthal /S/ Wayne B. Lyon Director March 29, 1994 Wayne B. Lyon /S/ Peter J. Pirsch Director March 29, 1994 Peter J. Pirsch /S/ Bret E. Russell Director March 29, 1994 Bret E. Russell SCHEDULE INDEX REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON SCHEDULES To Formica Corporation: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements of Formica Corporation and subsidiaries included in Item 8 of this Form 10-K and have issued our report thereon dated March 1, 1994. Our audits were made for the purpose of forming an opinion on the basic consolidated financial statements taken as a whole. The schedules listed in Item 14(a)2 of this Form 10-K are the responsibility of the Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic consolidated financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic consolidated financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic consolidated financial statements taken as a whole. ARTHUR ANDERSEN & CO. Roseland, New Jersey March 1, 1994 (1) Other changes include reclassifications and activity relating to nonrecurring items. (1) Other changes include reclassifications and activity relating to nonrecurring items. SCHEDULE X FORMICA CORPORATION AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION (IN THOUSANDS) EXHIBIT INDEX

1993 Item 1. Business. Alcoa is the world's largest integrated aluminum company, engaged in the production and sale of primary aluminum and semi-fabricated and finished aluminum products. It was formed in 1888 under the laws of the Commonwealth of Pennsylvania. Alcoa produces and sells alumina and alumina-based chemicals, a variety of other finished products, and components and systems for a multitude of applications. These products are used primarily by packaging, transportation (including aerospace, automotive, rail and shipping), building and industrial customers worldwide. Alcoa has operating and sales locations in over 20 countries. Discussion of Alcoa's operations and properties by its three business segments follows. The Alumina and Chemicals segment includes the production and sale of bauxite, alumina and alumina-based chemicals, and related transportation services. The Aluminum Processing segment includes the production and sale of molten metal, ingot, and aluminum products that are flat-rolled, engineered or finished. Also included are power, transportation and other services. The Non-Aluminum Products segment includes the production and sale of electrical, ceramic, plastic, vinyl, and composite materials products, manufacturing equipment, gold, magnesium and steel and titanium forgings. Most aluminum facilities located in the United States (U.S.) are owned by the parent company. Alcoa of Australia Limited (AofA) and Alcoa Aluminio S.A. (Aluminio) in Brazil are the two largest operating subsidiaries. Alcoa serves a variety of customers in a number of markets. Consolidated revenues from these markets are: Segment and geographic area financial information are presented in Note K to the Financial Statements. Competition The markets for most aluminum products are highly competitive. Price, quality and service are the principal competitive factors in most of these markets. Where aluminum products compete with other materials, the diverse characteristics of aluminum are also a significant factor, particularly its light weight and recyclability. The competitive conditions are discussed later for each of the Company's major product classes. The Company is examining all aspects of its operations and activities and is redesigning them where necessary to enhance effectiveness and achieve cost reductions. Alcoa believes that its competitive position is enhanced by its improved processes, extensive facilities and willingness and ability to commit capital where necessary to meet growth in important markets, and by the capability of its employees. Research and development, and an increased emphasis on internal technology transfer, has led to improved product quality, enhanced production techniques, new product development and cost control. The dissolution of the Soviet Union and the lack of a mechanism to successfully integrate its economy with market economies significantly contributed to a global oversupply of aluminum in recent years. Prior to 1991 former Soviet aluminum producers primarily served internal markets. The internal market weakened substantially after the collapse of the Soviet Union. To earn hard currency, former Soviet aluminum producers began exporting significant quantities of aluminum. These exports caused an imbalance in demand and supply and resulted in severe downward pressure on aluminum prices. In late 1993, discussions among the governments of six major primary aluminum producing nations were initiated to address the global aluminum supply situation. A multi-government accord was reached among Australia, Canada, the European Union (EU), Norway, Russia and the U.S. in late January 1994 under which the Russian industry will reduce its annual aluminum exports by 500,000 metric tons per year for up to two years, the EU will refrain from renewing import quotas on Russian ingot when the quotas expire at the end of February 1994, and certain of the participating governments will create a fund to assist in the modernization of the Russian industry. The accord recognizes that there is currently an excess of supply of between 1.5 and 2.0 million metric tons of annual production. In February 1994, Alcoa announced that it would reduce primary aluminum production in its U.S. operations by an additional 100,000 metric tons per year. AofA separately announced a reduction of 25,000 metric tons at its Point Henry smelter in Geelong, Australia. Also, the joint venture smelter in Portland, State of Victoria in which AofA owns a 45% interest announced a reduction of 26,000 metric tons. Suriname Aluminum Company (Suralco), a wholly-owned subsidiary, announced a reduction of 3,000 metric tons that will continue until world aluminum supply is in better balance with demand. These reductions are in addition to Alcoa's indefinite curtailments during 1993 of 310,000 metric tons of U.S. smelting production. Other Risk Factors In addition to the risks inherent in the Company's business and operations as described in this Form 10-K, the Company is exposed generally to financial, market, political, business and economic risks in connection with its worldwide operations. Major Interests Outside the United States Alcoa International Holdings Company (AIHC), a subsidiary, holds most of the Company's investments in Australia, Hungary, India, Japan, Mexico, the Netherlands and Norway, and several wholly owned subsidiaries that act as sales representatives and distributors outside the U.S. for products produced by various Alcoa operations. In 1988 AIHC issued $250 million of voting preferred stock which represents 25% of its total voting stock. The preferred stock is held by unaffiliated third parties. AofA, owned 51% by AIHC, operates integrated aluminum facilities in Australia, including mining, refining, smelting and fabricating facilities. More than half of AofA's 1993 revenues were derived from alumina, and the balance was derived principally from primary aluminum, rigid container sheet (RCS) and gold. Alcoa Brazil Holdings Company (ABHC), owned 79% by the Company, holds Alcoa's interest in Aluminio, an integrated aluminum producer in Brazil. Aluminio operates mining, refining, smelting and fabricating facilities at various locations in Brazil. More than 20% of Aluminio's 1993 revenues were derived from primary aluminum, and exports accounted for approximately one-third of its revenues. Aluminio is owned 75% by ABHC; Alcoa's effective ownership in Aluminio is 59%. Alumina and Chemicals Segment Bauxite, aluminum's principal raw material, is refined into alumina through a chemical process and is then smelted into primary aluminum. Approximately half of the Company's alumina production in 1993 was sold to third parties. The Company sells alumina-based chemicals to customers in a broad spectrum of industries for use in refractories, ceramics, abrasives, chemicals processing and other specialty applications. Bauxite Most of the bauxite mined and alumina produced by the Company, except by AofA, is further processed into aluminum. The Company has long-term contracts to purchase bauxite mined by a partially-owned entity in the Republic of Guinea. The current contracts expire in 1995. Alcoa is negotiating new agreements that are expected to be completed in 1994. This bauxite services most of the requirements of Alcoa's Point Comfort, Texas alumina refinery. Suralco mines bauxite in Suriname under rights which expire after the year 2000. Suralco also holds a minority interest in a bauxite mining joint venture managed by the majority owner, Billiton, an affiliate of the Royal Dutch/Shell Group (Shell). Bauxite from both mining operations serves Suralco's share of the refinery in Suriname referred to below. AofA's bauxite mineral leases expire in 2003. Renewal options allow AofA to extend the leases until 2045. The natural gas requirements of the refineries are supplied primarily under a contract with the State Energy Commission of Western Australia. The contract expires in 2005 and imposes minimum purchase requirements. Bauxite mining rights in Jamaica expire after the year 2020. These rights are owned by the joint venture with the government of Jamaica referred to in the next section. Alumina Alumina, a commodity, is sold by Alcoa principally from its operations in Australia, Jamaica and Suriname. Most of the alumina supply contracts are negotiated on the basis of agreed volumes over a multi-year time period to assure a continuous supply of alumina to the smelters which receive the alumina. Most alumina is sold under contracts where prices are negotiated periodically or are based on formulas related to aluminum ingot market prices or to production costs. An imbalance of alumina demand and supply has resulted in declining alumina prices. AofA is the world's largest and one of the lowest cost producers of alumina. Its three alumina plants, located in Kwinana, Pinjarra and Wagerup in Western Australia, have in the aggregate an annual rated capacity of approximately 6.1 million metric tons. Most of AofA's alumina is sold under supply contracts to a number of customers worldwide. An Alcoa subsidiary owns 55% of the 1.6 million metric ton per year alumina refinery in Paranam, Suriname and operates the plant. Billiton holds the remaining 45%. An Alcoa subsidiary and a corporation owned by the government of Jamaica are equal participants in a joint venture, managed by the subsidiary, that owns an alumina refinery in Clarendon Parish, Jamaica. Annual alumina capacity at the Clarendon refinery will be increased from 800,000 to approximately 1,000,000 metric tons in the next several years. Aluminio is the operator of the Alumar Consortium (Alumar), a cost- sharing and production-sharing venture which owns a large refining and smelting project near the northern coastal city of Sao Luis, Maranhao, Brazil. The alumina refinery has an annual capacity of 1,000,000 metric tons, and is owned 54% by Aluminio, 36% by a Billiton affiliate of Shell and 10% by an affiliate of Alcan Aluminium Limited (Alcan). A majority of the alumina production is consumed at the smelter. The sale of Shell's Billiton affiliates in Brazil and Suriname to Gencor of South Africa is pending. Aluminio holds a 13.2% interest in Mineracao Rio Do Norte S.A. (MRN), a mining company which is jointly owned by affiliates of Alcan, Billiton, Companhia Brasileira de Aluminio, Companhia Vale do Rio Doce, Norsk Hydro and Reynolds Metals Company. Aluminio purchases bauxite from MRN under a long-term supply contract. At Pocos de Caldas, Minas Gerais, Brazil, Aluminio mines bauxite and operates a refinery which produces alumina, primarily for its Pocos de Caldas smelter. Industrial Chemicals Alcoa sells industrial chemicals to customers in a broad spectrum of markets for use in refractories, ceramics, abrasive chemicals processing and other specialty applications. A variety of industrial chemicals, principally alumina-based chemicals, are produced or processed at plants in Bauxite, Arkansas; Ft. Meade, Florida; Dalton, Georgia; Lake Charles and Vidalia, Louisiana; Nashville, Tennessee; Point Comfort, Texas; Kwinana, Australia; Pocos de Caldas, Brazil; Ludwigshafen, Germany; Iwakuni and Naoetsu, Japan; and Moerdijk and Rotterdam, in The Netherlands. Aluminum fluoride, used in aluminum smelting, is produced from fluorspar or fluosilicic acid at Point Comfort and Ft. Meade. An expansion of facilities for drying alumina trihydrate at Point Comfort was completed in 1993. Alumina trihydrate is used extensively in petrochemical processing, water treatment and a variety of other applications. The Company and AofA are cooperating to market alumina-based and other chemicals in Asia and other regional chemical markets. The Company purchased a minority equity interest in Australian Fused Materials, Ltd. (AFM) in 1993. AFM manufactures and markets fused alumina as well as other chemicals for Australian, Asian and other regional markets. Fused alumina is used in the manufacture of refractories. In 1993 the Company and The Associated Cement Companies Ltd. of Bombay, India formed a joint venture to import, process and market tabular alumina and alumina-based chemicals for the refractory and ceramic industries in India. The venture plans to build a processing plant in Falta, West Bengal which is scheduled for completion in 1994. Aluminum Processing Segment Revenues and shipments for the principal classes of products in the aluminum processing segment are as follows: Aluminum Ingot Primary aluminum ingot is a traded commodity and prices are established by market forces of demand and supply, including available levels of inventories. The Company's sales of primary aluminum to third parties are generally made at prices determined by reference to published trading prices adjusted for availability of the product. Alcoa has a metal trading operation responsible for hedging programs that are designed to minimize the effects of price volatility on the Company and its customers for primary aluminum in the international commodity markets as well as price exposure to aluminum scrap, including used beverage cans. The Company smelts primary aluminum from alumina obtained principally from the alumina refineries discussed earlier. Smelters are located at Warrick, Indiana; Massena, New York; Badin, North Carolina; Alcoa, Tennessee; Rockdale, Texas; Wenatchee, Washington; Point Henry and Portland, Australia; Pocos de Caldas and Sao Luis, Brazil; and Paranam, Suriname. Alcoa's consolidated annual rated primary aluminum capacity at these smelters is approximately 1.9 million metric tons. When operating at capacity, the Company's smelters more than satisfy the primary aluminum requirements of the Company's fabricating operations. Purchases of aluminum scrap (principally used beverage cans), supplemented by purchases of ingot when necessary, satisfy any additional aluminum requirements. Most of the Company's primary aluminum production in 1993 was delivered to other Alcoa operations for alloying and/or further fabricating. The joint venture smelter at Portland, Victoria, with an annual rated capacity of 320,000 metric tons, is owned 45% by AofA, 25% by the State of Victoria, 10% by the First National Resource Trust, 10% by the China International Trust and Investment Corporation, and 10% by Marubeni Aluminium Australia Pty., Ltd. (Portland Smelter Participants). A subsidiary of AofA operates the smelter. Each participant is required to contribute to the cost of operations and construction in proportion to its interests in the venture and is entitled to its proportionate share of the output. Alumina is supplied by AofA. The Portland site can accommodate additional smelting capacity. The Alumar Consortium aluminum smelter at Sao Luis, Brazil has an annual rated capacity of 328,000 metric tons. Aluminio receives about 54% of the primary aluminum production. During 1993 and early 1994, Alcoa indefinitely idled approximately 410,000 metric tons of annual rated primary aluminum capacity in the U.S. Smelters located in Indiana, North Carolina, Tennessee, Texas and Washington were affected. AofA separately announced a 25,000 metric tons capacity reduction at its Point Henry smelter. The joint venture smelter at Portland, in which AofA owns a 45% interest, announced a 26,000 metric tons production reduction. Suralco reduced annual primary aluminum production by 3,000 metric tons. See "Competition" above. The Company utilizes electric power, natural gas and other forms of energy in its refining, smelting and processing operations. Aluminum is produced from alumina by an electrolytic process requiring large amounts of electric power. Electric power accounts over time for approximately 30% of the Company's primary aluminum costs. The Company generates approximately 40% of the power used at its smelters worldwide. Most firm power purchase contracts tie prices to aluminum prices or to prices based on various indices. Over 40% of the power for the Point Henry smelter is generated by AofA using its extensive brown coal deposits. The balance of the power, and power for the Portland, Victoria smelter, is available under contracts with the State Electricity Commission of Victoria. Power prices are tied by formula to aluminum prices. The State Government of Victoria has announced its desire to renegotiate the power contract for the Portland smelter. AofA and the Portland Smelter Participants have informed the State that they are willing to discuss ways to improve the operational aspects of the power contract. Electric power for Alumar's Sao Luis smelter is purchased from the government-controlled power grid in Brazil at a small discount from the applicable industrial tariff price and is protected by a cap based on the London Metal Exchange price of aluminum. Aluminio's Pocos de Caldas smelter purchases firm and interruptible power from the government-controlled electric utility. Aluminio has prepaid all of the Pocos de Caldas facility's electricity requirements through January 1, 1996. Over 50% of the power requirements for Alcoa's U.S. smelters is generated by the Company and the remainder is purchased from others under long-term contracts. More than 10% of the self-generated power results from the Company's entitlement to a fixed percentage of the output from a hydroelectric power facility located in the northwestern United States. The Company generates substantially all of the power used at its Warrick smelter using coal reserves near the smelter that should satisfy requirements through the late 1990s. Lignite is used to generate power for the Rockdale, Texas smelter. Company-owned generating units supply about half of the total requirements and the balance is purchased from a dedicated power plant under a contract which expires not earlier than 2011. See "Environmental" below. In connection with the electric power generated for the aluminum smelters at Alcoa, Tennessee and Badin, North Carolina, two subsidiaries of the Company own and operate hydroelectric facilities subject to Federal Energy Regulatory Commission licenses effective until 2005 and 2008, respectively. For the Tennessee plant, the Company also purchases firm and interruptible power from the Tennessee Valley Authority under a contract which expires in 2000. For the Badin plant, the Company purchases additional power under an evergreen contract providing for specified periods of notice before termination by either party. The purchased power contract for the Massena smelter expires not earlier than 2003 but may be terminated by the Company with one year's notice. Alcoa has two principal power contracts for its Wenatchee smelter. The contract from the power output entitlement referred to above expires in 2011. The contract with Bonneville Power Administration (BPA) expires in 2001 and includes 25% interruptible power. Power restrictions may occur when precipitation is below normal. A BPA power restriction resulted in the indefinite closure of one potline at Wenatchee in early 1993. Alcoa chose not to restart the potline after the restriction was lifted due to low ingot prices. Beginning in 1995, a portion of the power supplied under the entitlement contract will be replaced by power purchased from the local public utility district. Additional power also may be purchased from the district. Although not included in the revenues by market or revenues and shipments tables above or in the rated primary aluminum capacity figure above, the Company reports equity earnings from its interest in two primary aluminum smelters in Norway. Elkem Aluminium ANS, 50% owned by Norsk Alcoa A/S, a subsidiary, is a partnership that owns and operates the smelters. Flat-Rolled Products The Company's flat-rolled products serve three principal markets: light gauge sheet products serve principally the packaging market, and sheet and plate products serve principally the transportation and building and construction markets. Alcoa employs its own sales force for most products sold in the packaging market. Most of the packaging revenues in 1993 were derived from rigid container sheet (RCS) sold to can companies to make beverage and food cans, and can ends. The number of RCS customers in the U.S. is relatively small, in part because the number of can companies has been shrinking. Use of aluminum beverage cans continues to increase, particularly in Asia, Europe and South America where per capita consumption remains relatively low. Aluminum foil and non-RCS packaging sheet are sold principally in the packaging markets. Aluminum's diverse characteristics, particularly its light weight and recyclability, are significant factors in packaging markets where alternatives such as steel, plastic and glass are competitive materials. Leadership in the packaging markets is maintained by improving processes and facilities, as well as by providing research and technical support to customers. Light gauge aluminum sheet and foil products are manufactured at several locations. RCS is produced at Warrick, Indiana; Alcoa, Tennessee; Point Henry, Australia; Moka, Japan (a joint venture facility); and Swansea, Wales. Light gauge sheet and foil are produced at Lebanon, Pennsylvania and foil also is produced at Davenport, Iowa. Light gauge sheet and foil products are manufactured by Aluminio at Recife, Brazil. Can recycling or remelt facilities are located at or near the Indiana, Tennessee and Wales plants. In 1993 the Company recycled approximately 268,000 metric tons of used aluminum beverage cans, which are an important source of metal for RCS. The cost of used beverage cans declined in 1992 and 1993 as primary aluminum prices dropped. Recycling aluminum conserves raw materials, reduces litter and saves energy - about 95% of the energy needed to produce aluminum from bauxite. Also, recycling capacity costs much less than new primary aluminum capacity. The Company has a joint venture with Kobe Steel, Ltd. (Kobe) in Japan. The venture, KSL Alcoa Aluminum Company, Ltd. (KAAL), completed construction of a cold rolling mill at Moka, Japan and began commercial operations in 1993. It manufactures and sells RCS in Japan and other Asian countries. AIHC holds a 50% interest in KAAL. Alcoa supplies aluminum to the joint venture. Sheet and plate products principally serve aerospace, automotive, lithographic, railroad, ship building, building and construction, defense and other industrial and consumer markets. The Company maintains its own sales forces for most of these products. Differentiation of material properties, price and service are significant competitive factors. Aluminum's diverse characteristics are important in these markets, where competitive materials include steel and plastics for automotive and building applications; magnesium, titanium, composites and plastics for aerospace and defense applications; and wood and vinyl in building and construction applications. The Company's largest sheet and plate plant is located at Davenport, Iowa. It produces products requiring special alloying, heat treating and other processing, some of which are unique or proprietary. A distribution center was opened in Paal, Belgium during late 1993 to serve European sheet and plate markets. Alcoa continues to develop alloys and products for aerospace applications, such as new aluminum alloys for application in the Boeing 777 aircraft. A research and development effort also has resulted in the commercial development of a series of aluminum and aluminum-lithium alloys which offer significant weight savings over traditional materials for aerospace and defense applications. The Company participates in a joint venture with an affiliate of Akzo N.V., a chemical company based in The Netherlands, to perform research and development and to produce fiber-metal laminates made of aluminum and resins reinforced with advanced fibers for the aircraft industry. The Company and Kobe also have established two additional joint venture companies, one in the United States and one in Japan, to serve the transportation industry. The initial emphasis of the new companies is on expanding the use of aluminum sheet products in passenger cars and light trucks. In late 1992 AIHC acquired a 50.1% interest in Kofem Kft., a subsidiary of the government-owned Hungarian Aluminium Industrial Corporation (Hungalu). The new venture, Alcoa-Kofem Kft. (A-K), produces common alloy flat and coiled sheet, soft alloy extrusions and end products for the building, construction, food and agricultural markets in central and western Europe. A-K will invest up to $146 million, including part of AIHC's initial investment, over the next five years for product quality and environmental and safety upgrades at the A-K facility. Alcoa is providing technological and operational expertise to A-K. Engineered Products Engineered products principally include extrusion and tube, wire, rod and bar, forgings, aluminum building products, aluminum memory disk blanks and other products which are sold in a wide range of markets, but principally in the transportation market. Aluminum extrusions and tube are produced principally at six U.S. locations. The Chandler, Arizona plant produces hard alloy extrusions and tube; the Vernon, California plant produces hard alloy extrusions and tube; the Lafayette, Indiana plant produces a broad range of common and hard alloy extrusions and tube; the Baltimore, Maryland plant produces large press extrusions; and plants at Tifton, Georgia and Delhi, Louisiana produce common alloy extrusions. In late 1993 Alcoa and VAW Aluminium AG (VAW) formed a joint venture to produce and market high strength aluminum extrusions, tube and rod to principally serve European transportation and defense markets. An Alcoa subsidiary owns 60% and VAW owns 40% of the venture which is called Alcoa VAW Hannover Presswerk GmbH & Co. KG and is located in Hannover, Germany. Alcoa's Delhi facility will supply Toyota Motor Company (Toyota) with extruded aluminum front and rear bumpers for the 1995 Toyota Avalon to be assembled at Georgetown, Kentucky. The bumpers were jointly designed by Alcoa and Toyota. A 50-50 limited partnership formed with Kobe in 1991 to manufacture and market aluminum tube for photoreceptors for North American markets will cease manufacturing operations in early 1994 and is expected to be dissolved later in the year. Alcoa Construction Products produces and markets residential aluminum siding and other aluminum building products. These products are sold principally to distributors and jobbers. Aluminum forgings are produced at Cleveland, Ohio; Vernon, California; and Bologne, France. Forgings are sold principally in the aerospace, defense and transportation markets. Forged aluminum wheels for truck, bus and automotive markets are produced at Cleveland, Ohio. Mechanical-grade redraw rod, wire and cold-finished rod and bar are produced at Massena and are sold to distributors and customers for a variety of applications in the building and transportation markets. Aluminum extruded products are manufactured by a subsidiary of Aluminio in Argentina and at several Aluminio locations in Brazil. Other Aluminum Products Alcoa Automotive Structures GmbH was formed in 1991 to produce aluminum components and sub-assemblies for aluminum automotive spaceframes. Aluminum spaceframes represent a significant departure from the traditional method and material used to manufacture primary auto body structures. In 1993 Alcoa completed construction and began operating a unique multi-million dollar plant in Soest, Germany to supply aluminum spaceframe products to its first customer, Audi AG. In 1994 Audi will market its new A8 luxury sedan, the first automobile to utilize a complete aluminum spaceframe body structure. The A8 is a result of a 10 year development effort between Alcoa and Audi and is constructed with spaceframes, components and sub-assemblies produced by Alcoa. Alcoa continues to cooperate with several automobile manufacturers in Europe, North America and Japan to develop new aluminum products for automotive market applications. Alcoa produces aluminum closures for bottles at Richmond, Indiana; Worms, Germany; Tokyo, Japan; and near Barcelona, Spain. The Company sells aluminum scrap and produces and markets aluminum paste, particles, flakes and atomized powder. Subsidiaries of Alcoa Nederland Holding B.V. (ANH) produce extrusions, common alloy sheet products and certain finished products such as automated greenhouse systems, as well as fabricated products such as aluminum windows and aluminum ceiling systems. In early 1993 ANH acquired a 100% interest in Compri-Aluminium B.V. (Compri). Compri manufactures, sells and installs aluminum and steel building products in Belgium and The Netherlands. Alutodo, S.A. de C.V., a subsidiary, buys and sells aluminum and aluminum products through distribution centers at several locations in Mexico. Non-Aluminum Products Segment Alcoa produces plastic closures for bottles at Crawfordsville, Indiana; Olive Branch, Mississippi; Buenos Aires, Argentina; Sao Paulo, Brazil; Santiago, Chile; Bogota, Colombia; Tellig, Germany; Tokyo, Japan; Saltillo, Mexico; and near Barcelona, Spain. Alcoa participates in a joint venture with Al Zayani Investments W.L.L. of Bahrain, known as Gulf Closures W.L.L., to manufacture plastic beverage container closures for markets in the Middle East. Production at Manama, Bahrain began in 1993. Alcoa's worldwide closure businesses are coordinated from Indianapolis, Indiana. The use of plastic closures has surpassed that of aluminum closures for beverage containers in the U.S. and is gaining momentum in other countries. The Company manufactures packaging equipment and machinery, principally for producing and decorating metal cans and can ends. In addition, the Company manufactures a line of equipment for applying plastic or aluminum closures to beverage containers. Alcoa also owns a minority interest in a company which sells food packaging machinery that fills and seals metal and multi-layered polymer and paper containers. Alcoa Fujikura Ltd. (AFL), owned 51% by Alcoa and 49% by Fujikura Ltd. of Japan, produces and markets automotive electrical distribution systems, as well as fiber optic products and systems for selected electric utilities and telecommunications markets. AFL continues to be a Q-1 supplier to Ford Motor Company and is now supplying electrical distribution systems to Subaru (in the U.S.), Auto Alliance, Inc. (Mazda-Ford joint venture) and PACCAR Inc. In 1993 AFL acquired the remaining interest in the Stribel group of companies, which are European manufacturers of electromechanical and electronic components for the European automotive market. Alcoa Construction Product's principal product for building and construction markets is vinyl siding. Other non-aluminum building products include vinyl windows, window lineal systems, shutters and building accessories and wood windows and patio doors. Norcold and Stolle Products Division manufactures recreational vehicle refrigerators, and auto parts and appliance control panels. A subsidiary, Alcoa Electronic Packaging, Inc. (AEP), produces ceramic packages used to hold integrated circuits for electronic equipment. During 1993 AEP increased shipments of several parts to a key customer. AEP currently is working with several potential customers to broaden its market base in 1994. Production capacity is being increased to respond to these opportunities. Alcoa Composites, Inc., a subsidiary, principally designs and manufactures composite parts and structures for aerospace and transportation applications. Facilities to recover gold from AofA's mining leases in Western Australia were constructed, and mined gold was first poured, in 1988. Production has been declining since 1990, and the gold deposit is expected to be depleted by 1997. Magnesium is produced by the Company in Addy, Washington, from minerals in the area owned by the Company. Alcoa uses magnesium for certain aluminum alloys. Recycling is also a source of aluminum- magnesium alloys. Due to world magnesium market conditions the Company reduced magnesium production during 1993. Third party sales of magnesium are continuing. Titanium and steel forgings are produced at Cleveland, Ohio and Bologne, France and are sold principally in aerospace markets. Aluminio owns and operates a chain of retail construction materials outlets in Brazil. Alcoa's wholly owned subsidiaries own and develop luxury residential/resort communities in South Carolina and Florida; the remaining properties are being actively marketed. Research and Development The Company, a technological leader in the aluminum industry, engages in research and development (R&D) programs which include basic and applied research and process and product development. The research activities are principally conducted at Alcoa Technical Center (ATC), near Pittsburgh, Pennsylvania. Several subsidiaries and divisions conduct their own R&D programs as do many plants. Expenditures for such activities were $130 million in 1993, $212 million in 1992 and $252 million in 1991. Most of the 1993 decrease was related to Alcoa Electronic Packaging which moved to production status in 1993, and to program reductions at ATC. Substantially all R&D activities are funded by the Company and its various units. The Company's strategy has been to focus its R&D expenditures on specific programs related to existing businesses, and this will lead to lower R&D expenditures in 1994. Environmental Alcoa's Environmental Policy confirms its commitment to operate worldwide in a manner which protects the environment and the health of employees and of the citizens of the communities where the Company has an impact. The Company engages in a continuing effort to develop and implement modern technology and policies to meet environmental objectives. Approximately $76 million was spent during 1993 for new or expanded facilities for environmental control. Capital expenditures for such facilities will approximate $56 million in 1994. The costs of operating these facilities are not included in these figures. Remediation expenses being incurred by the Company at many of its facilities and at certain sites involved in proceedings under the Comprehensive Environmental Response, Compensation and Liability Act of 1980 (CERCLA or Superfund) and other sites are increasing. See Environmental Matters on page 17 in the Annual Report to Shareholders, and Item 3 - "Legal Proceedings" below. Alcoa's operations, like those of others in manufacturing industries, have in recent years become subject to increasingly stringent legislation and regulations to protect human health and the environment. This trend is expected to continue. Compliance with new laws, regulations or policies could require substantial expenditures by the Company in addition to those referenced above. Environmental requirements also may affect the marketing of certain products manufactured by the Company. For example, legislation imposing deposits on beverage containers including aluminum cans has been passed in a number of states and is being considered elsewhere. Federal and state regulations, such as U.S. Food and Drug Administration regulations and California Proposition 65 affect the manufacture of materials to be used in food and beverage containers. The Coalition of Northeastern Governors (CONEG) model law (as enacted by several states) governing the use or presence of certain materials may impact the manufacture of certain packages or packaging components for foods and beverages. A proposed directive similar to the CONEG legislation is under consideration by the Commission of the European Union. Environmental laws and regulations are important both to the Company and to the communities where it operates. The Company supports the use of sound scientific research and realistic risk criteria to analyze environmental and human health effects and to develop effective laws and regulations in all countries where it operates. Alcoa recognizes that recycling and waste reduction offer real solutions to the solid waste problem and it continues vigorously to pursue efforts in these areas. Employees During 1993 the Company employed an average of approximately 63,400 people worldwide. New three-year labor agreements covering the majority of the Company's U.S. production workers were ratified in mid- 1993. Major provisions included: an increase in base wages effective in 1993 and an additional base wage increase in 1995; a managed health care program; a pay for performance plan that aligns the variable pay component with the location's goals and overall corporate financial performance; and changes in the factor used to calculate pension benefits. Also, agreement was reached on principles to guide joint labor-management development of a location-specific, business-based outsourcing process. Wages for employees in Australia are covered by agreements which are negotiated under guidelines established by a national industrial relations authority. Wages for both hourly and salaried employees in Brazil are negotiated annually in compliance with government guidelines. Each Aluminio location, however, has established a separate compensation package for its employees which includes real wage increases and certain employee welfare plans. Item 2. Item 2. Properties. See "Item 1 - Business." Alcoa believes that its facilities, substantially all of which are owned, are suitable and adequate for its operations. Item 3. Item 3. Legal Proceedings. In the ordinary course of its business, Alcoa is involved in a number of lawsuits and claims, both actual and potential, including some which it has asserted against others. While the amounts claimed may be substantial, the ultimate liability cannot now be determined because of the considerable uncertainties that exist. It is possible that results of operations or liquidity in a particular period could be materially affected by certain contingencies. Management believes, however, that the disposition of matters that are pending or asserted will not have a materially adverse effect on the financial position of the Company Environmental Matters Alcoa is involved in proceedings under the Superfund or analogous state provisions regarding the usage, disposal, storage or treatment of hazardous substances at a number of sites in the U.S. The Company has committed to participate, or is engaged in negotiations with Federal or state authorities relative to its alleged liability for participation, in clean-up efforts at several such sites. In response to a unilateral order issued under Section 106 of CERCLA by the U.S. Environmental Protection Agency (EPA) Region II regarding releases of hazardous substances, including polychlorinated biphenyls (PCBs) into the Grasse River near its Massena, New York facility, Alcoa proposed during 1993 to EPA that it engage in certain remedial activities in the Grasse River for the removal and appropriate disposal of certain river sediments. EPA has accepted the proposal in principle; however, it is deciding certain critical details, such as how removed sediments will be managed. Representatives of various Federal and state agencies and a Native American tribe, acting in their capacities as trustees for natural resources, have asserted that Alcoa may be liable for loss or damage to such resources under Federal and state law based on Alcoa's operations at its Massena, New York facility. While formal proceedings have not been instituted, the Company is actively investigating these claims. In June 1993 EPA published notice of its intent to include portions of Lavaca Bay and Alcoa's Point Comfort Operations on the Superfund National Priorities List (NPL). Alcoa provided comments to that proposal in August 1993 as part of the administrative record. In December 1993, Alcoa and EPA Region VI agreed to commence negotiations for an administrative consent order under which Alcoa would implement a comprehensive remedial investigation and feasibility study for the proposed NPL site. These negotiations, which include Alcoa, EPA, the State of Texas and certain Federal and state natural resources trustees, are now ongoing. These Federal and state natural resources trustees have served Alcoa with notice of their intent to file suit to recover damages for alleged loss, injury or destruction of natural resources in Lavaca Bay, adjacent to the Point Comfort Operations, and to recover the costs for performing the assessment of such alleged damages. Alcoa and representatives of the trustees have entered into a series of agreements that provide for implementation of various studies of Lavaca Bay and its resources. These same parties have entered into several tolling agreements that suspend any applicable statute of limitations period. The Stolle Corporation (Stolle), a subsidiary, disclosed to the Ohio Environmental Protection Agency that it had previously managed hazardous waste at its Sidney, Ohio diversified products plant in a manner which may not meet regulatory requirements then applicable. In December 1993, the Ohio Attorney General contacted Stolle to discuss potential resolution of alleged violations. Discussions are expected to begin in late March or early April 1994. In September 1993 EPA Region V issued an administrative complaint to Alcoa's Cleveland, Ohio Works alleging improper use and disposal of PCBs and failure to obtain an EPA identification number for PCB disposal activities. The complaint cites the applicable maximum statutory penalties for these alleged violations and assesses a fine of $197,000. Settlement negotiations are ongoing. Other Matters Alcoa was named as one of several defendants in a number of lawsuits filed as a result of the Sioux City, Iowa DC-10 plane crash in 1989. The plaintiffs claim that Alcoa fabricated the titanium fan disk involved in the alleged engine failure of the plane from a titanium forging supplied by a third party. Twenty-two of the 117 cases are still pending; the other 95 have been settled without participation by Alcoa. While Alcoa is covered by the releases given by the plaintiffs in the settled cases, Alcoa remains subject to claims for contribution from the defendants who have actually paid the settlements. In some of the cases, punitive damages of $5 million are sought from each defendant. Alcoa and a subsidiary were notified in September 1991 by the Department of Justice (DOJ) of its investigation regarding criminal violations of antitrust laws in the small press, hard alloy extrusion industry. On March 5, 1993, Alcoa and the subsidiary received an antitrust grand jury Investigation subpoena requiring production of documents relating to pricing of small press, hard alloy extrusions. Alcoa and its subsidiary have provided the documentation requested. Employees of Alcoa and the subsidiary have been called to testify before the grand jury. In February 1992 Alcoa received a Civil Investigative Demand (CID) from the DOJ to determine whether there might be a violation of the Sherman Act or the Clayton Act as a result of Alcoa's acquisition from Halethorpe Extrusions, Inc. of assets relating to the production of extruded aluminum products. The DOJ also advised Alcoa that it intended to issue a CID to Pimalco, Inc., a wholly owned subsidiary, in connection with the same acquisition. The investigation was concluded in early 1993, and no charges were brought against the Company. Aura Systems, Inc. has filed suit against Alcoa and Alcoa Packaging Machinery, Inc. and various other defendants alleging violations of the federal antitrust laws. The suit, which seeks an unspecified amount of damages, was transferred to the U.S. District Court for the District of Colorado in the third quarter. The suit was dismissed in December 1993. In October 1992 Alcoa Composites, Inc. was served with a subpoena requiring the production of certain documentary material to the U.S. government in connection with an investigation to determine whether criminal violations of federal defense procurement laws or regulations occurred with respect to the subsidiary's subcontract to manufacture helicopter blades for the U.S. Army. The subsidiary is responding to the subpoena. The Company does not have sufficient information at this time to ascertain whether any violations may have taken place or whether any grounds exist for naming the subsidiary in any proceeding which may be initiated as a result of the investigation. The Company continues to provide information to the U.S. government. In December 1992 Alcoa initiated a lawsuit against nearly one- hundred different insurance carriers that provided Alcoa with insurance coverage for various periods between the years 1956 and 1985. The suit asks the court to declare that these insurance companies are required, under the terms of the policies issued, to reimburse monies spent by Alcoa in the past or future for environmental liabilities that have arisen in recent years. On December 21, 1992, Alcoa was named as a defendant in KML Leasing v. Rockwell Standard Corporation filed in the U.S. District Court for the District of Oklahoma on behalf of 7,317 Aero Commander, Rockwell Commander and Gulfstream Commander aircraft owners. The complaint alleges defects in certain wingspars manufactured by Alcoa. Alcoa's aircraft builders products liability insurance carrier has assumed defense of the matter. In May 1993, Alcoa received a reservation of rights letter from its insurance carrier which purports to reserve its rights with respect to a majority of the types of damages claimed. Alcoa is challenging the reservation. In December 1993 Alcoa was served with a subpoena from the Antitrust Division of the DOJ to produce documents to a Federal grand jury sitting in Philadelphia. The grand jury is investigating pricing practices in the used beverage container and aluminum scrap markets. The Company is cooperating with the DOJ. Alcoa and Alcoa Specialty Chemicals, Inc., a subsidiary, are defendants in a case filed by Aluminum Chemicals, Inc., et al. in the District Court of Harris County, Texas. In an Eighth Amended Petition filed in December 1993, the plaintiffs allege claims for breach of fiduciary duty, fraud, interference with contractual and business relations, breach of contract, conversion, misappropriation of trade secrets, deceptive trade practices and civil conspiracy in connection with a former partnership, Alcoa-Coastal Chemicals. The plaintiffs are seeking lost profits and other compensatory damages in excess of $100 million, and punitive damages. The court already has granted several motions, including motions for partial summary judgment in favor of defendants. Additional motions are pending or contemplated. Alcoa and its subsidiary intend to file a counterclaim seeking damages. The case is currently scheduled for trial in July 1994. In late 1993, Alcoa Fujikura, Ltd. (AFL), a subsidiary, was notified by the U.S. Customs Service (USCS) that it is the subject of an investigation regarding the proper marking of country of origin on wire harnesses produced in Mexico from 1986 to 1989. The USCS investigation focuses on AFL's administration of an approved waiver process pertaining to parts for production as well as importation of wire harnesses for sale as repair parts through 1993. AFL is cooperating with USCS. In December 1993, the European Union Competition Office and German Cartel Office began an investigation of the competitive practices of Alcoa Chemie, GmbH., a subsidiary, in the tabular alumina business in Germany. The subsidiary is cooperating with the investigation. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. No matters were submitted to a vote of the Company's security holders during the fourth quarter of 1993. Item 4A. Executive Officers of the Registrant. The names, ages, positions and areas of responsibility of the executive officers of the Registrant as of March 1, 1994 are listed below. Paul H. O'Neill, 58, Chairman of the Board and Chief Executive Officer. Mr. O'Neill became a director of Alcoa in 1986 and was elected Chairman of the Board and Chief Executive Officer effective in June 1987. Before joining Alcoa, Mr. O'Neill had been an officer since 1977 and President and a director since 1985 of International Paper Company. Alain J. P. Belda, 50, Executive Vice President (effective March 15, 1994). Mr. Belda was President of Alcoa Aluminio S.A. in Brazil from 1979 to March 1994. He was elected Vice President of Alcoa in 1982 and, in 1989, was given responsibility for all of Latin America (other than Suriname). In August 1991 he was named President - Latin America for the Company. In his new assignment Mr. Belda will work with 10 Alcoa business unit presidents. George E. Bergeron, 52, Vice President and President - Rigid Packaging Division. Mr. Bergeron was named President - Alcoa Closure Systems International in 1982 and was elected Vice President and General Manager - Rigid Packaging Division in July 1990. He assumed his current responsibilities in August 1991. Peter R. Bridenbaugh, 53, Executive Vice President - Science, Technology, Engineering, Environment, Safety and Health. Dr. Bridenbaugh became Director, Alcoa Laboratories in 1983. He was elected Vice President Research and Development in 1984. He assumed his current responsibilities in 1991. John L. Diederich, 57, Executive Vice President - Chairman's Counsel. Mr. Diederich was elected Managing Director of Alcoa of Australia Limited and Vice President of Alcoa in 1982. He was named Vice President - Metals and Chemicals in July 1986 and was elected a Group Vice President in October 1986. He assumed his current responsibilities in 1991. Richard L. Fischer, 57, Executive Vice President - Chairman's Counsel. Mr. Fischer was elected Vice President and General Counsel in 1983 and became a Senior Vice President in 1984. From 1985 through 1989 he also had responsibility for Government and Public Affairs. He was given additional responsibilities in 1986 for Corporate Development and in 1989 for the Company's expansion activities in Europe and Asia. He assumed his current responsibilities in 1991. Ronald R. Hoffman, 59, Executive Vice President - Human Resources, Quality, and Communications. Mr. Hoffman, an officer since 1975, was named Vice President - Flat Rolled Products in 1979. He was elected a Group Vice President in 1984 and was given responsibility for the Company's Packaging Systems group in 1986. He assumed his current responsibilities in 1991. R. Lee Holz, 58, Vice President and General Counsel. Mr. Holz, an attorney with the Company since 1960, was named Assistant General Counsel in 1974 and Senior Assistant General Counsel in 1983. He was elected to his current position in 1991. Jan H. M. Hommen, 50, Executive Vice President and Chief Financial Officer. Mr. Hommen was Financial Director of Alcoa Nederland until 1979 when he was elected Assistant Treasurer - Corporate Finance of Alcoa. He was elected Treasurer in August 1986 and Vice President and Treasurer in December 1986. He was elected to his current position in 1991. Robert F. Slagle, 53, Vice President and Managing Director - Alcoa of Australia Limited. Mr. Slagle was elected Treasurer in 1982 and Vice President in 1984. In 1986, he was named Vice President - Industrial Chemicals and, in 1987, was named Vice President - Industrial Chemicals and U.S. Alumina Operations. Mr. Slagle was named Vice President - Raw Materials, Alumina and Industrial Chemicals in 1989 and Managing Director - Alcoa of Australia Limited in 1991. G. Keith Turnbull, 58, Executive Vice President - Strategic Analysis/Planning and Information. Dr. Turnbull was appointed Assistant Director of Alcoa Laboratories in 1980. He was named Director - Technology Planning in 1982 and Vice President - Technology Planning in 1986. In 1991 he was elected to his current position. PART II Item 5. Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters. Dividend per share data, high and low prices per share and the principal exchanges on which the Company's common stock is traded are set forth on page 34 of the 1993 Annual Report to Shareholders (the Annual Report) and are incorporated herein by reference. At February 7, 1994 (the record date for the Company's 1994 annual shareholders meeting) there were approximately 55,000 Alcoa shareholders, including both record holders and an estimate of the number of individual participants in security position listings. Item 6. Item 6. Selected Financial Data. The comparative columnar table showing selected financial data for the Company is set forth on page 15 of the Annual Report and is incorporated herein by reference. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. Management's review and comments on the consolidated financial statements are set forth on pages 14 through 17 of the Annual Report and are incorporated herein by reference. Item 8. Item 8. Financial Statements and Supplementary Data. The Company's consolidated financial statements, the notes thereto and the report of the independent public accountants are set forth on pages 18 through 27 of the Annual Report and are incorporated herein by reference. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. None. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant. The information regarding Directors is contained under the caption "Board of Directors" on pages 4 through 6 of the Registrant's definitive Proxy Statement dated March 4, 1994 (the Proxy Statement) and is incorporated herein by reference. The information regarding executive officers is set forth in Part I, Item 4A under "Executive Officers of the Registrant." The information with respect to this item required by Item 405 of Regulation S-K is incorporated by reference from the Company's 1994 Proxy Statement. Item 11. Item 11. Executive Compensation. This information is contained under the caption "Compensation of executive officers" on pages 8 through 12 of the Proxy Statement. The performance graph and Compensation Committee Report shall not be deemed to be "filed". Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. This information is contained under the caption "Security ownership" on page 8 of the Proxy Statement and is incorporated herein by reference. Item 13. Item 13. Certain Relationships and Related Transactions. This information is contained under the caption "Certain relationships and related transactions" on page 7 of the Proxy Statement and is incorporated herein by reference. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) The Company's consolidated financial statements, the notes thereto and the report of the independent public accountants are set forth on pages 18 through 27 of the Annual Report and are incorporated herein by reference. With the exception of the aforementioned information and the information incorporated by reference in Part II hereof, the Annual Report is not to be deemed filed as part of this report. The following report and additional financial data should be read in conjunction with the Company's consolidated financial statements in the Annual Report: Independent Accountant's Report of Coopers & Lybrand dated January 11, 1994, except for Note U for which the date is February 7, 1994, on the Company's consolidated financial statement schedules filed as a part hereof for the fiscal years ended December 31, 1993, 1992 and 1991 and related consent dated March 9, 1994. Schedules V, VI, VIII, IX and X for the fiscal years ended December 31, 1993, 1992 and 1991 and Schedule VII as of December 31, 1993: Schedule No. Schedule Title V Properties, Plants and Equipment VI Accumulated Depreciation, Depletion and Amortization of Properties, Plants and Equipment VII Guarantees of Securities of Other Issuers VIII Valuation and Qualifying Accounts IX Short-Term Borrowings X Supplementary Income Statement Information Schedules other than those referred to above are omitted because they are not required or the information is included in the notes to financial statements. (b) Reports filed on Form 8-K. None was filed in the fourth quarter of 1993. (c) Exhibits. Exhibit Number Description* 3(i). Articles of the Registrant as amended, incorporated by reference to exhibit 3(a) to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993. 3(ii). By-Laws of the Registrant, incorporated by reference to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1991. 10(a). Amended Long Term Stock Incentive Plan, effective January 1, 1992, incorporated by reference to exhibit 10(a) to the Company's Annual Report on Form 10-K for the year ended December 31, 1991. 10(b). Employees' Excess Benefit Plan, Plan A, incorporated by reference to exhibit 10(b) to the Company's Annual Report on Form 10-K for the year ended December 31, 1980. 10(c). Incentive Compensation Plan, as amended effective January 1, 1993, incorporated by reference to exhibit 10(c) to the Company's Annual Report on Form 10-K for the year ended December 31, 1992. 10(d). Employees' Excess Benefit Plan, Plan C, as amended and restated effective January 1, 1989, incorporated by reference to exhibit 10(d) to the Company's Annual Report on Form 10-K for the year ended December 31, 1992. 10(e). Employees' Excess Benefit Plan, Plan D, as amended effective October 30, 1992, incorporated by reference to exhibit 10(e) to the Company's Annual Report on Form 10-K for the year ended December 31, 1992. 10(f). Employment Agreement of Paul H. O'Neill, as amended through February 25, 1993, incorporated by reference to exhibit 10(h) to the Company's Annual Report on Form 10-K for the year ended December 31, 1987 and exhibit 10(g) to the Company's Annual Report on Form 10-K for the year ended December 31, 1990, and exhibit 10(f)(2) to the Company's Annual Report on Form 10-K for the year ended December 31, 1992. 10(g). Deferred Fee Plan for Directors, as amended effective November 1, 1992, incorporated by reference to exhibit 10(h) to the Company's Annual Report on Form 10-K for the year ended December 31, 1992. 10(h). Stock Plan for Non-Employee Directors, as amended effective July 17, 1992, incorporated by reference to exhibit 10(i) to the Company's Annual Report on Form 10-K for the year ended December 31, 1992. 10(i). Fee Continuation Plan for Non-Employee Directors, incorporated by reference to exhibit 10(k) to the Company's Annual Report on Form 10-K for the year ended December 31, 1989. 10(j). Deferred Compensation Plan, as amended effective October 30, 1992, incorporated by reference to exhibit 10(k) to the Company's Annual Report on Form 10-K for the year ended December 31, 1992. 10(k). Summary of the Executive Split Dollar Life Insurance Plan, dated November 1990, incorporated by reference to exhibit 10(m) to the Company's Annual Report on Form 10-K for the year ended December 31, 1990. 10(l). Form of Indemnity Agreement between the Company and individual directors or officers, incorporated by reference to exhibit 10(j) to the Company's Annual Report on Form 10-K for the year ended December 31, 1987. 11. Computation of Earnings per Common Share. 12. Computation of Ratio of Earnings to Fixed Charges. 13. Portions of Alcoa's 1993 Annual Report to Shareholders. 21. Subsidiaries and Equity Entities of the Registrant. 23. Consent of Independent Certified Public Accountants. 24. Power of Attorney for certain directors. *Exhibit Nos. 10(a) through 10(d) are management contracts or compensatory plans required to be filed as Exhibits to this Form 10-K. Amendments and modifications to other Exhibits previously filed have been omitted when in the opinion of the Registrant such Exhibits as amended or modified are no longer material or, in certain instances, are no longer required to be filed as Exhibits. No other instruments defining the rights of holders of long-term debt of the Registrant or its subsidiaries have been filed as exhibits because no such instruments met the threshold materiality requirements under Regulation S-K. The Registrant agrees, however, to furnish a copy of any such instruments to the Commission upon request. (d) Financial Statement Schedules. To the Shareholders and Board of Directors Aluminum Company of America Our report on the consolidated financial statements of Aluminum Company of America has been incorporated by reference in this Form 10-K from page 18 of the 1993 Annual Report to Shareholders of Aluminum Company of America. In connection with our audits of such financial statements, we have also audited the related financial statement schedules listed under Item 14 of this Form 10-K. In our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. /s/Coopers & Lybrand COOPERS & LYBRAND 600 Grant Street Pittsburgh, Pennsylvania January 11, 1994, except for Note U for which the date is February 7, 1994 SCHEDULE V - PROPERTIES, PLANTS AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31 (In millions) SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTIES, PLANTS AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31 (In millions) SCHEDULE VII - GUARANTEES OF SECURITIES OF OTHER ISSUERS DECEMBER 31, 1993 (In millions) SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS FOR THE YEAR ENDED DECEMBER 31 (In millions) SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEAR ENDED DECEMBER 31 (In millions) SCHEDULE IX - SHORT-TERM BORROWINGS FOR THE YEAR ENDED DECEMBER 31 (In millions) SIGNATURE 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. ALUMINUM COMPANY OF AMERICA March 11, 1994 By /s/Earnest J. Edwards Earnest J. Edwards Vice President and Controller (Also signing as Principal Accounting 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 dates indicated. Signature Title Date /s/Paul H. O'Neill Chairman of the Board March 11, 1994 Paul H. O'Neill and Chief Executive Officer (Principal Executive Officer and Director) /s/Jan H. M. Hommen Executive Vice President and March 11,1994 Jan H. M. Hommen Chief Financial Officer (Principal Financial Officer) Kenneth W. Dam, John P. Diesel, Joseph T. Gorman, Judith M. Gueron, John P. Mulroney, Sir Arvi Parbo, Forrest N. Shumway and Franklin A. Thomas, each as a Director, on March 11, 1994, by Barbara S. Jeremiah, their Attorney-in-Fact.* *By /s/Barbara S. Jeremiah Barbara S. Jeremiah Attorney-in-Fact EXHIBIT INDEX Exhibit Number Description 3(i). Articles of the Registrant as amended, incorporated by reference to exhibit 3(a) to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993. 3(ii). By-Laws of the Registrant, incorporated by reference to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1991. 10(a). Amended Long Term Stock Incentive Plan, effective January 1, 1992, incorporated by reference to exhibit 10(a) to the Company's Annual Report on Form 10-K for the year ended December 31, 1991. 10(b). Employees' Excess Benefit Plan, Plan A, incorporated by reference to exhibit 10(b) to the Company's Annual Report on Form 10-K for the year ended December 31, 1980. 10(c). Incentive Compensation Plan, as amended effective January 1, 1993, incorporated by reference to exhibit 10(c) to the Company's Annual Report on Form 10-K for the year ended December 31, 1992. 10(d). Employees' Excess Benefit Plan, Plan C, as amended and restated effective January 1, 1989, incorporated by reference to exhibit 10(d) to the Company's Annual Report on Form 10-K for the year ended December 31, 1992. 10(e). Employees' Excess Benefit Plan, Plan D, as amended effective October 30, 1992, incorporated by reference to exhibit 10(e) to the Company's Annual Report on Form 10-K for the year ended December 31, 1992. 10(f). Employment Agreement of Paul H. O'Neill, as amended through February 25, 1993, incorporated by reference to exhibit 10(h) to the Company's Annual Report on Form 10-K for the year ended December 31, 1987 and exhibit 10(g) to the Company's Annual Report on Form 10-K for the year ended December 31, 1990, and exhibit 10(f)(2) to the Company's Annual Report on Form 10-K for the year ended December 31, 1992. 10(g). Deferred Fee Plan for Directors, as amended effective November 1, 1992, incorporated by reference to exhibit 10(h) to the Company's Annual Report on Form 10-K for the year ended December 31, 1992. 10(h). Stock Plan for Non-Employee Directors, as amended effective July 17, 1992, incorporated by reference to exhibit 10(i) to the Company's Annual Report on Form 10-K for the year ended December 31, 1992. 10(i). Fee Continuation Plan for Non-Employee Directors, incorporated by reference to exhibit 10(k) to the Company's Annual Report on Form 10-K for the year ended December 31, 1989. 10(j). Deferred Compensation Plan, as amended effective October 30, 1992, incorporated by reference to exhibit 10(k) to the Company's Annual Report on Form 10-K for the year ended December 31, 1992. 10(k). Summary of the Executive Split Dollar Life Insurance Plan, dated November 1990, incorporated by reference to exhibit 10(m) to the Company's Annual Report on Form 10-K for the year ended December 31, 1990. 10(l). Form of Indemnity Agreement between the Company and individual directors or officers, incorporated by reference to exhibit 10(j) to the Company's Annual Report on Form 10-K for the year ended December 31, 1987. 11. Computation of Earnings per Common Share. 12. Computation of Ratio of Earnings to Fixed Charges. 13. Portions of Alcoa's 1993 Annual Report to Shareholders. 21. Subsidiaries and Equity Entities of the Registrant. 23. Consent of Independent Certified Public Accountants. 24. Power of Attorney for certain directors.

1993 ITEM 1. BUSINESS (a) General Development of Business PACCAR Inc (the Company), incorporated under the laws of Delaware in 1971, is the successor to Pacific Car and Foundry Company which was incorporated in Washington in 1924. The Company traces its predecessors to Seattle Car Manufacturing Company formed in 1905. In the U.S., the Company's manufacturing operations are conducted through unincorporated manufacturing divisions and a wholly owned subsidiary. Each of the divisions and the subsidiary are responsible for at least one of the Company's products. That responsibility includes new product development, applications engineering, manufacturing and marketing. Outside the U.S., the Company manufactures and sells through wholly owned subsidiary companies in Canada and Australia, through a United Kingdom branch of a wholly owned U.S. subsidiary, and through an affiliate in Mexico. In January 1994, the Company increased its ownership in the Mexican affiliate from 49% to 55%. An export sales division generally is responsible for export sales. Product financing and leasing is offered through U.S. and foreign finance subsidiaries. A U.S. subsidiary is responsible for retail automotive parts sales. (b) Financial Information About Industry Segments and Geographic Areas Information about the Company's industry segments and geographic areas in response to Items 101(b), (c)(1)(i), and (d) of Regulation S-K appears on page 39 of the Annual Report to Stockholders for the year ended December 31, 1993 and is incorporated herein by reference. (c) Narrative Description of Business The Company has three principal industry segments, (1) manufacture of heavy-duty trucks and related parts, (2) automotive parts sales and related services, and (3) finance and leasing services provided to customers and dealers. Manufactured products also include industrial winches and oilfield equipment. The Company competes in the truck parts aftermarket primarily through its dealer network. It sells general automotive parts and accessories through retail outlets. The Company's finance and leasing activities are principally related to Company products and associated equipment. TRUCKS The Company designs and manufactures trucks which are marketed under the Peterbilt, Kenworth, and Foden nameplates in the Class 8 diesel category (having a minimum gross vehicle weight of 33,000 pounds). These vehicles, which are built in five plants in the U.S. and one each in Australia, Canada, the United Kingdom and Mexico, are used worldwide for over-the-road and off-highway heavy-duty hauling of freight, petroleum, wood products, construction and other materials. Heavy-duty trucks and related service parts are the largest segment of the Company's business, accounting for 88% of total 1993 revenues. The Company competes in the North American Class 6/7 markets with its Mid-Ranger cab-over-engine vehicles. These medium-duty trucks are assembled at PACCAR's factory in Quebec, Canada. This line of business represents a small percentage of the Company's sales to date. Trucks are sold to independent dealers for resale. The Company's U.S. independent dealer network consists of 310 outlets. Trucks manufactured in the U.S. for export are marketed by PACCAR International, a U.S. division. Those sales are made through a worldwide network of 34 dealers. Trucks manufactured in the United Kingdom, Australia, Canada, and Mexico are marketed domestically through independent dealers and factory branches; trucks manufactured in these countries for export are also marketed by PACCAR International. The Company's trucks are essentially custom products and have a reputation for high quality. Major components, such as engines, transmissions and axles, as well as a substantial percentage of other components, are purchased from component manufacturers pursuant to customer specifications. Raw materials and other components used in the manufacture of trucks are purchased from a number of suppliers. The Company is not limited to any single source for any major component. No significant shortage of materials or components was experienced in 1993 and none is expected in 1994. Manufacturing inventory levels are based upon production schedules and orders are placed with suppliers accordingly. Replacement truck parts are sold and delivered to the Company's independent dealers through the PACCAR Parts Division. Parts consist of proprietary parts manufactured by PACCAR and finished parts purchased from various suppliers. Replacement parts inventory levels are determined largely by anticipated customer demand and the need for timely delivery. There were six principal competitors in the U.S. Class 8 truck market in 1993. PACCAR's share of that market was approximately 22% of registrations in 1993. The market is highly competitive in price, quality and service, and PACCAR is not dependent on any single customer for its sales. There are no significant seasonal variations. The Kenworth, Peterbilt and Foden trademarks and trade names are recognized internationally and play an important role in the marketing of the Company's truck products. The Company engages in a continuous program of trademark and trade name protection in all marketing areas of the world. Although the Company's truck products are subject to environmental noise and emission controls, competing manufacturers are subject to the same controls. The Company believes the cost of complying with noise and emission controls will not be detrimental to its business. The Company's truck sales backlog at year-end 1993 was estimated at $1,268,000,000. This compares with $776,000,000 at year-end 1992. Production of the year-end 1993 backlog is expected to be completed during 1994. The number of persons employed by the Company in its truck business at December 31, 1993 was approximately 8,000. OTHER MANUFACTURED PRODUCTS Other products manufactured by the Company account for 2% of total 1993 revenues. This group includes industrial winches and oilfield extraction pumps and service equipment. Winches are manufactured in two U.S. plants and are marketed under the Braden, Carco, and Gearmatic nameplates. Oilfield extraction pumps and service equipment are manufactured in three U.S. plants and marketed under the Trico and Kobe nameplates. The markets for all of these products are highly competitive and the Company competes with a number of well established firms. The Braden, Carco, Gearmatic, Trico, and Kobe trademarks and trade names are recognized internationally and play an important role in the marketing of those products. The Company has an ongoing program of trademark and trade name protection in all relevant marketing areas. AUTOMOTIVE PARTS The Company purchases and sells general automotive parts and accessories, which account for 5% of total 1993 revenues, through 120 retail locations under the names of Grand Auto and Al's Auto Supply. These locations are supplied from the Company's distribution warehouses. FINANCE COMPANIES The Company has five wholly owned finance companies which provide financing principally for trucks manufactured by the Company in the U.S., Canada, the United Kingdom, and Australia. These companies provide lease financing for independent dealers selling PACCAR products and retail and inventory financing for new and used Class 6, 7 and 8 trucks regardless of make or model. Installment contracts are secured by the products financed. LEASING COMPANIES PACCAR Leasing Corporation (PLC), a wholly owned subsidiary, franchises selected PACCAR truck dealers to engage in full service truck leasing under the PacLease trade name. PLC also leases equipment to and provides managerial and sales support for its franchisees. Similar leasing operations are conducted in Canada through a division of PACCAR of Canada Ltd. and in the United Kingdom through a wholly owned subsidiary, PacLease Limited. RAILEASE Inc, a wholly owned subsidiary, leases railcars to a railroad. GENERAL INFORMATION PATENTS The Company owns numerous patents which relate to all product lines. Although these patents are considered important to the overall conduct of the Company's business, no patent or group of patents is considered essential to a material part of the Company's business. RESEARCH AND DEVELOPMENT The Company maintains a technical center where product testing and research and development activities are conducted. Additional product development activities are conducted within each separate manufacturing division. Amounts spent on research and development were approximately $22 million in 1993, $21 million in 1992 and $22 million in 1991. REGULATION As a manufacturer of highway trucks, the Company is subject to the National Traffic and Motor Vehicle Safety Act and Federal Motor Vehicle Safety Standards promulgated by the National Highway Traffic Safety Administration. The Company believes it is in compliance with the Act and applicable safety standards. Information regarding the effects that compliance with federal, state and local provisions regulating the environment have on the Company's capital and operating expenditures and the Company's involvement in environmental cleanup activities is included in Management's Discussion and Analysis of Financial Condition and Results of Operations and the Company's Consolidated Financial Statements incorporated by reference in Items 7 and 8, respectively. EMPLOYEES On December 31, 1993, the Company employed a total of 11,800 persons, excluding employees of its Mexican affiliate. ITEM 2. ITEM 2. PROPERTIES The Company and its subsidiaries and affiliate own and operate manufacturing plants in seven U.S. states, Canada, Australia, Mexico and the United Kingdom including a new truck manufacturing facility in Renton, Washington which was completed in 1993. Several parts distribution centers, sales and service facilities and finance and administrative offices are also operated in owned or leased premises in these five countries. A facility for product testing and research and development is located in Skagit County, Washington. Retail auto parts sales locations are primarily in leased premises in five western states. The Company's corporate headquarters is located in owned premises in Bellevue, Washington. The Company considers substantially all of the properties used by its businesses to be suitable for their intended purposes. Due to improved business conditions in 1993 in the markets served by the Company's business segments, many of the Company's manufacturing facilities operated at or near their productive capacities. Geographical locations of manufacturing plants within indicated industry segments are as follows: Properties located in Torrance, Signal Hill and Pomona, California; Bartlesville, Oklahoma; Kansas City, Missouri; and Seattle, Washington are being held for sale. These properties were originally obtained principally as a result of business acquisitions in 1987 and 1988. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company and its subsidiaries are parties to various lawsuits incidental to the ordinary course of business. Management believes that the disposition of such lawsuits will not materially affect the Company's consolidated financial position. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the fourth quarter of 1993. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS Common stock of the Company is traded over the counter on the NASDAQ National Market System under the symbol PCAR. The table below reflects the range of trading prices as reported by NASDAQ and cash dividends declared. The cash dividends declared and stock prices have been restated to give effect to the 15% stock dividend declared December 14, 1993. There were 3,292 record holders of the common stock at December 31, 1993. The Company expects to continue paying regular cash dividends, although there is no assurance as to future dividends because they are dependent upon future earnings, capital requirements and financial conditions. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA Selected Financial Data on page 41 of the Annual Report to Stockholders for the year ended December 31, 1993 are incorporated herein by reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Management's Discussion and Analysis of Financial Condition and Results of Operations on pages 21 through 24 of the Annual Report to Stockholders for the year ended December 31, 1993 is incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The following consolidated financial statements of the registrant and its subsidiaries, included in the Annual Report to Stockholders for the year ended December 31, 1993 are incorporated herein by reference: Consolidated Balance Sheets -- December 31, 1993 and 1992 Consolidated Statements of Income -- Years Ended December 31, 1993, 1992 and 1991 Consolidated Statements of Stockholders' Equity -- Years Ended December 31, 1993, 1992 and 1991 Consolidated Statements of Cash Flows -- Years Ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements -- December 31, 1993, 1992 and 1991 Quarterly Results (Unaudited) on page 41 of the Annual Report to Stockholders for the year ended December 31, 1993 are incorporated herein by reference. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE The registrant has not had any disagreements with its independent auditors on accounting or financial disclosure matters. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Item 401(a), (d), (e) and Item 405 of Regulation S-K: Identification of directors, family relationships, business experience and compliance with Section 16(a) of the Exchange Act on pages 3 and 4 of the proxy statement for the annual stockholders meeting of April 26, 1994 is incorporated herein by reference. Item 401(b) of Regulation S-K: Executive Officers of the registrant as of February 1, 1994: Officers are elected annually but may be appointed or removed on interim dates. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION Compensation of Directors and Executive Officers and Related Matters on pages 5 through 11 of the proxy statement for the annual stockholders meeting of April 26, 1994 is incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Stock ownership information on pages 1 and 2 of the proxy statement for the annual stockholders meeting of April 26, 1994 is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information on page 4 of the proxy statement for the annual stockholders meeting of April 26, 1994 is incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) (1) and (2) - The response to this portion of Item 14 is submitted as a separate section of this report. (3) Listing of Exhibits (in order of assigned index numbers) (3) Articles of incorporation and bylaws (a) PACCAR Inc Certificate of Incorporation, as amended to April 27, 1990 (incorporated by reference to the Quarterly Report on Form 10-Q for the quarter ended March 31, 1990). (b) PACCAR Inc Bylaws, as amended to April 28, 1987 (incorporated by reference to the Quarterly Report on Form 10-Q for the quarter ended March 31, 1987). (4) Instruments defining the rights of security holders, including indentures (a) Rights agreement dated as of December 21, 1989 between PACCAR Inc and First Chicago Trust Company of New York setting forth the terms of the Series A Junior Participating Preferred Stock, no par value per share (incorporated by reference to Exhibit 1 of the Current Report on Form 8-K of PACCAR Inc dated December 27, 1989). (b) Indenture for Senior Debt Securities dated as of December 1, 1983 between PACCAR Financial Corp. and Citibank, N.A., Trustee (incorporated by reference to Exhibit 4.1 of the Annual Report on Form 10-K of PACCAR Financial Corp. for the year ended December 31, 1983). (c) First Supplemental Indenture dated as of June 19, 1989 between PACCAR Financial Corp. and Citibank, N.A., Trustee (incorporated by reference to Exhibit 4.2 to PACCAR Financial Corp.'s registration statement on Form S-3, Registration No. 33-29434). (d) Forms of Medium-Term Note, Series E (incorporated by reference to Exhibits 4.3A, 4.3B and 4.3C to PACCAR Financial Corp.'s Registration Statement on Form S-3 dated June 23, 1989, Registration Number 33-29434, and Forms of Medium-Term Note, Series E, incorporated by reference to Exhibit 4.3B.1 to PACCAR Financial Corp.'s Current Report on Form 8-K, dated December 19, 1991, under Commission File Number 0-12553). Letter of Representation among PACCAR Financial Corp., Citibank, N.A. and the Depository Trust Company, Series E, dated July 6, 1989 (incorporated by reference to Exhibit 4.3 of PACCAR Financial Corp.'s Annual Report on Form 10-K, dated March 29, 1990. File Number 0-12553). (e) Forms of Medium-Term Note, Series F (incorporated by reference to Exhibits 4.3A, 4.3B and 4.3C to PACCAR Financial Corp.'s Registration Statement on Form S-3 dated May 26, 1992, Registration Number 33-48118). Form of Letter of Representation among PACCAR Financial Corp., Citibank, N.A. and the Depository Trust Company, Series F (incorporated by reference to Exhibit 4.4 to PACCAR Financial Corp.'s Registration Statement on Form S-3 dated May 26, 1992, Registration Number 33-48118). (f) Forms of Medium-Term Note, Series G (incorporated by reference to Exhibits 4.3A and 4.3B to PACCAR Financial Corp.'s Registration Statement on Form S-3 dated December 8, 1993, Registration Number 33- 51335). Form of Letter of Representation among PACCAR Financial Corp., Citibank, N.A. and the Depository Trust Company, Series G (incorporated by reference to Exhibit 4.4 to PACCAR Financial Corp.'s Registration Statement on Form S-3 dated December 8, 1993, Registration Number 33-51335). (10) Material contracts (a) PACCAR Inc Incentive Compensation Plan (incorporated by reference to Exhibit (10)(a) of the Annual Report on Form 10-K for the year ended December 31, 1980). (b) PACCAR Inc Deferred Compensation Plan for Directors (incorporated by reference to Exhibit (10)(b) of the Annual Report on Form 10-K for the year ended December 31, 1980). (c) Supplemental Retirement Plan (incorporated by reference to Exhibit (10)(c) of the Annual Report on Form 10-K for the year ended December 31, 1980). (d) 1981 Long Term Incentive Plan (incorporated by reference to Exhibit A of the 1982 Proxy Statement, dated March 25, 1982). (e) Amendment to 1981 Long Term Incentive Plan (incorporated by reference to Exhibit (10)(a) of the Quarterly Report on Form 10-Q for the quarter ended March 31, 1991). (f) PACCAR Inc 1991 Long-Term Incentive Plan (incorporated by reference to Exhibit (10)(h) of the Quarterly Report on Form 10-Q for the quarter ended June 30, 1992). (g) Amended and Restated Deferred Incentive Compensation Plan. (13) Annual report to security holders Portions of the 1993 Annual Report to Shareholders have been incorporated by reference and are filed herewith. (21) Subsidiaries of the registrant (23) Consent of independent auditors (24) Power of attorney Powers of attorney of certain directors (b) No reports on Form 8-K were filed for the three months ended December 31, 1993. (c) Exhibits (d) Financial Statement Schedules -- The response to this portion of Item 14 is submitted as a separate section of this report. 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. PACCAR Inc ----------------------------------- Registrant /s/ C. M. Pigott 3-24-94 ----------------------------------- C. M. Pigott, Director, Chairman and Chief Executive 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 dates indicated. * Pursuant to power of attorney ANNUAL REPORT ON FORM 10-K ITEM 14(a)(1) AND (2), (c) AND (d) LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES CERTAIN EXHIBITS FINANCIAL STATEMENT SCHEDULES YEAR ENDED DECEMBER 31, 1993 PACCAR INC AND SUBSIDIARIES BELLEVUE, WASHINGTON FORM 10-K -- ITEM 14(A)(1) AND (2) PACCAR INC AND SUBSIDIARIES LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES The following consolidated financial statements of PACCAR Inc and subsidiaries, included in the Annual Report to Stockholders for the year ended December 31, 1993 are incorporated by reference in Item 8: Consolidated Balance Sheets -- December 31, 1993 and 1992 Consolidated Statements of Income -- Years Ended December 31, 1993, 1992 and 1991 Consolidated Statements of Stockholders' Equity -- Years Ended December 31, 1993, 1992 and 1991 Consolidated Statements of Cash Flows -- Years Ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements -- December 31, 1993, 1992 and 1991 The following consolidated financial statement schedules of PACCAR Inc and consolidated subsidiaries are included in Item 14(d): Schedule VIII -- Allowances for Losses Schedule IX -- Short-Term Borrowings All other schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and therefore have been omitted. PACCAR INC AND SUBSIDIARIES SCHEDULE VIII - ALLOWANCES FOR LOSSES (MILLIONS OF DOLLARS) (A) Allowance for losses deducted from trade receivables. (B) Allowance for losses deducted from notes, contracts, and other receivables. (1) Uncollectible trade receivables, notes, contracts and other receivables written off, net of recoveries. PACCAR INC AND SUBSIDIARIES SCHEDULE IX -- SHORT-TERM BORROWINGS (MILLIONS OF DOLLARS) (A) Short-term borrowings are comprised primarily of amounts owed by the finance and leasing subsidiaries and represent commercial paper and short-term notes with maturities of less than one year and bank lines of credit which have no termination date but are reviewed annually for renewal. (B) The average amount outstanding during the period was computed by dividing the total average monthly outstanding principal balances by twelve. (C) The weighted average interest rate during the period was computed by dividing the actual interest expense by the average short-term borrowings outstanding.

1993 ITEM 1: BUSINESS (a) General development of business. Motorola, Inc. is a corporation organized under the laws of the State of Delaware as the successor to an Illinois corporation organized in 1928. Motorola's principal executive offices are located at 1303 East Algonquin Road, Schaumburg, Illinois 60196 (telephone number: 708-576-5000). Motorola, Inc., one of the world's leading providers of electronic equipment, systems, components and services for worldwide markets, is engaged in the design, manufacture and sale, principally under the Motorola brand, of a diversified line of such products. These products include two-way land mobile communication systems, paging and wireless data systems and other forms of electronic communication systems; cellular mobile and portable telephones and systems; semiconductors, including integrated circuits, discrete devices and microprocessor units; information systems products such as modems, multiplexers and network processors; electronic equipment for military and aerospace use; electronic engine controls, and other automotive and industrial electronic equipment; and multifunction computer systems for distributed data processing and office automation applications. Motorola also provides services for paging, cellular telephone and shared mobile radio. The term "Motorola" as used hereinafter means Motorola, Inc. or Motorola, Inc. and its subsidiaries, as the context requires. (b) Financial information about industry segments. The response to this section of Item 1 is incorporated by reference to Note 7 of the Notes to Consolidated Financial Statements of Motorola's 1993 Annual Report to Stockholders. (c) Narrative description of business. SEMICONDUCTOR PRODUCTS Semiconductors control and amplify electrical signals and are used in a broad range of electronic products, including television receivers and other consumer electronic products, solid-state ignition systems and other automotive electronic products, major home appliances, industrial controls, robotics, aircraft, missiles, space vehicles, communications equipment, computers, minicomputers, calculators and automatic controls. The semiconductor products manufactured by Motorola's Semiconductor Products Sector include integrated circuit devices (metal-oxide semiconductor and bipolar) such as dynamic and static random access memories, microcontrollers, microprocessors, microcomputers, gate arrays, standard cells, digital signal processors, mixed signal and other logic and analog components. In addition, the Sector manufactures a wide variety of discrete devices including zener and tuning diodes, RF devices, power and small signal transistors, field effect transistors, microwave devices, optoelectronics, rectifiers and thyristors. The Sector sells its products worldwide to original equipment manufacturers through its own sales force. Products also are sold through a network of industrial distributors in the United States. Sales outside the United States are made through the Sector's own sales staff and through independent distributors. Semiconductors manufactured by the Sector are also supplied to other operating units of Motorola. The Sector is affected by the cyclical nature of the semiconductor industry. Available capacity, cyclical customer demands, new product introduction and aggressive pricing can have a significant impact on its business. The Sector's capacity is being increased to meet current strong market demand. In addition to the Sector's factory expansion program, it is actively pursuing additional capacity through the sourcing of products from outside vendors. Because of the strong market demand, the available quantity of some products have been allocated to customers from time to time. The semiconductor industry is subject to rapid changes in technology, requires a high level of capital spending and an extensive research, development and design program to maintain state-of-the-art technology. Accordingly, the Sector maintains an extensive research and development program in advanced semiconductor technology. The Sector's backlog amounted to $2.12 billion at December 31, 1993 and $1.55 billion at December 31, 1992. The 1993 backlog amount is believed to be generally firm, and approximately 100% of that amount is expected to be shipped during 1994. However, in the past, the Sector has experienced abrupt and repeated rescheduling of previously firm and even expedited orders. The estimate of the firmness of such orders is subject to future events which may cause the percentage of the 1993 backlog actually shipped to change. The Semiconductor Products Sector experiences intense competition from numerous competitors, including Japanese companies and several other companies around the world, ranging from large companies offering a full range of products to small companies specializing in certain segments of the market. The competitive environment is also changing as a result of increased alliances between competitors. The Sector competes in many markets, including the telecommunications, computer, industrial, automotive, consumer, federal government and distributor markets. Due to the multitude of competitors, price, service, technology and product quality are important factors in competition. The ability to develop new products to meet customer requirements and to meet customer delivery schedules are also competitive factors. Management believes that Motorola's commitment to research and development of new products combined with utilization of state-of-the-art technology should allow the Sector to remain competitive. The Sector is not currently experiencing, nor does it anticipate, any shortages in obtaining raw materials. However, it is experiencing some extended lead times on certain raw materials due to strong industry demand, but it is not currently expected to have any material impact on the Sector's business. A significant portion of certain materials and parts used by the Sector is supplied from a single country. The Sector is actively seeking new sources of supply to decrease this dependency. With respect to other materials, the Sector is constantly seeking new sources of supply to minimize the risk of obtaining materials from only a few sources. Electricity, oil and natural gas are used extensively in the Sector's operations. All of these energy sources are available in adequate quantities for current and foreseeable future needs. Electricity and oil are the primary energy sources for the Sector's foreign operations, and presently, there are no shortages of these sources although the reliability of electrical power has been a problem from time to time. Reference is made to the material under the heading "General" for information relating to patents and trademarks and seasonality of business with respect to this industry segment. The Semiconductor Products Sector's headquarters is in Phoenix, Arizona, with manufacturing facilities in Phoenix, Mesa, Tempe and Chandler, Arizona; Irvine, California; Austin, Texas; Tianjin, China; Toulouse, France; Kwai Chung and Tai Po, Hong Kong; Aizu and Sendai, Japan; Seoul, Korea; Kuala Lumpur and Seremban, Malaysia; Guadalajara, Mexico; Singapore; East Kilbride, Scotland; Manila, the Philippines; and Chung-Li, Taiwan. COMMUNICATIONS PRODUCTS Communications products are designed, manufactured and sold by Motorola's Land Mobile Products Sector and its Paging and Wireless Data Group. In 1993, both operations comprised the Company's Communications Products segment. In January 1994, Motorola's Information Systems Group (consisting of Codex Corporation and Universal Data Systems, Inc.) was combined with the Paging and Wireless Data Group to form the Messaging, Information and Media Sector. However, this new Sector does not constitute a separate reportable industry segment, and the results of operations of the Information Systems Group will continue to be reported under "Other Products." As a principal supplier of mobile and portable FM two-way radio and radio paging and wireless data systems, the Land Mobile Products Sector and the Paging and Wireless Data Group provide equipment and systems to meet the communications needs of individuals and many different types of business, institutional and governmental organizations. Products of the Land Mobile Products Sector and certain products of the Paging and Wireless Data Group provide voice and data communication between vehicles, persons and base stations. The Paging and Wireless Data Group products provide signaling or signaling and one-way voice communications or wireless data communications to people away from their homes, vehicles or offices. The principal customers for two-way radio and radio paging products include public safety agencies, such as police, fire, highway maintenance departments and forestry services; petroleum companies; gas, electric and water utilities; telephone companies; diverse industrial companies; mining companies; transportation companies, such as railroads, airlines, taxicab operations and trucking firms; institutions, such as schools and hospitals; and companies in the construction, vending machine and service businesses. Also, there is a growing base of paging and wireless data customers using the products for personal and family communication needs. These products are also sold and leased to various federal agencies for many uses. Users of two-way radios are regulated by a variety of governmental and other regulatory agencies throughout the world. In the United States, users of two-way radios are licensed by the Federal Communications Commission ("FCC") which has broad authority to make rules and regulations and prescribe restrictions and conditions to carry out the provisions of the Communications Act of 1934. The FCC's authority includes, among other things, the power to classify radio stations, prescribe the nature of the service to be rendered by each class of station, assign frequencies to the various classes of stations and regulate the kinds of equipment which may be used. Regulatory agencies in other countries have similar types of authority. Consequently, the business of this segment may be affected by the rules and regulations adopted by the FCC or regulatory agencies in other countries from time to time. Motorola has developed products using trunking and data communications technologies to enhance spectral efficiencies. The growth of the two-way radio communications industry may be affected, however, by the regulations of the FCC or other regulatory agencies relating to the allocation of frequencies for land mobile communications users, especially in urban areas where such frequencies are heavily used. The Land Mobile Products Sector also manufactures and sells signaling and control systems and communication control centers used in two-way radio operations. This segment carries on an extensive product development program. Its products make substantial use of solid-state semiconductor components, including large-scale integrated circuits. The products manufactured and marketed by this segment are sold directly through its own distribution force, or through independent authorized distributors and dealers, radio common carriers and independent commission sales representatives. Leasing and conditional sale arrangements are also made available to customers. The direct distribution force also provides systems engineering and technical services to meet the customer's particular needs. The customer may choose to install and maintain the equipment with its own employees, or may obtain installation, service and parts from a network of Motorola authorized service stations (most of whom are also authorized dealers) or from other non-Motorola service stations. The majority of the leases and conditional sale contracts entered into by this segment are sold to several unaffiliated finance companies and banks on terms which, in most instances, provide recourse to Motorola with certain limitations. Some leases and conditional sale contracts are sold to a Motorola subsidiary. This segment's backlog amounted to $1.71 billion at December 31, 1993 and $1.12 billion at December 31, 1992. The 1993 backlog amount is believed to be generally firm, and approximately 91% of that amount is expected to be shipped during 1994. The estimate of the firmness of such orders is subject to future events which may cause the percentage of the 1993 backlog actually shipped to change. This segment experiences widespread, intense competition from numerous competitors ranging from some of the world's largest, diversified companies to many small, specialized firms. The principal manufacturing operations of many competitors are located outside of the United States. Competitive factors include price, product performance, product quality, quality and availability of service, and quality and availability of systems engineering, with no one factor being dominant. Management believes that Motorola's commitment to research and development programs for improving existing products and developing new products and its utilization of state-of-the-art technology should allow this segment to remain competitive. Availability of materials and components required by this segment is relatively dependable and certain, but normal fluctuations in market demand/supply could cause temporary, selective shortages. Direct sourcing of materials and components from foreign suppliers is becoming more extensive. This segment operates certain offshore subassembly plants, the loss of one or more of which could constrain this segment's production capabilities. Natural gas, electricity and, to a lesser extent, oil, are the primary sources of energy. Current supplies of these forms of energy are considered to be adequate for this segment's United States and foreign operations. Reference is made to the material under the heading "General" for information relating to patents and trademarks with respect to this segment. The Land Mobile Products Sector has entered into agreements in principle with Dial Page, Inc., CenCall Communications Corp. and NEXTEL Communications, Inc. to transfer substantially all of its 800 MHz specialized mobile radio businesses, systems and licenses in the United States in exchange for equity interests in these companies. This represents a move forward with the Sector's strategic plans of being primarily a technology supplier and equipment manufacturer, rather than a network systems operator in the United States. Further information on this subject is contained in Note 6 of the Notes to Consolidated Financial Statements and in the material under the caption "Results of Operations" in Motorola's 1993 Annual Report to Stockholders, which information is incorporated herein by reference. This segment's headquarters are located in Schaumburg, Illinois, with manufacturing facilities in Schaumburg, Illinois; Boynton Beach and Plantation, Florida; Mount Pleasant, Iowa; Ft. Worth, Texas; Tianjin, China; Bangalore, India; Dublin, Ireland; Arad, Israel; Penang, Malaysia; Vega Baja, Puerto Rico; Taunusstein, Germany; and Singapore. GENERAL SYSTEMS PRODUCTS General systems products are designed, manufactured and sold by Motorola's General Systems Sector which includes the Cellular Subscriber Group, the Cellular Infrastructure Group, the Network Ventures Division, Personal Communications Systems ("PCS") and the Motorola Computer Group. The Cellular Subscriber and Infrastructure Groups manufacture, sell, install and service cellular infrastructure and radiotelephone equipment. In addition, the Cellular Subscriber Group resells cellular line service in the U.S., New Zealand, Germany, France, and the U.K. markets. The Network Ventures Division is a joint venture partner in cellular and telepoint operating systems in Argentina, Uruguay, Hong Kong, Israel, Chile, Mexico, Thailand, Pakistan, Nicaragua, Dominican Republic and Japan. The Cellular Infrastructure Group products include electronic exchanges (i.e., telephone switches), base site controllers and radio base stations. Radiotelephone products include mobile, portable, personal and transportable radiotelephones with various options, personal communications equipment and cordless telephones. PCS products include subscriber and infrastructure equipment for the personal communications market. Products are marketed worldwide through original equipment manufacturers, carriers, distributors, dealers, retailers and, in certain countries, through a direct sales force. Financing of cellular infrastructure equipment is sometimes offered to qualifying customers. Radio frequencies are required to provide cellular service. The allocation of frequencies is regulated in the United States and other countries throughout the world, and limited spectrum space is allocated for cellular and personal communications services. The growth of the cellular and personal communications industry may be affected if adequate frequencies are not allocated for its use, or alternatively, if new technology is not developed to increase capacity on presently allocated frequencies. The Motorola Computer Group develops, manufactures, sells and services multi-function computer systems and board level products, together with operating systems and system enablers. Board and system level products comprise a line of VME products based on the Motorola 68000 and 88000 series microprocessors. These products are sold worldwide to a variety of customers, some of whom produce computer products which compete with the group. The Computer Group's products are marketed to end-users, original equipment manufacturers, value added resellers and distributors throughout the world. The Motorola Computer Group also markets computer products and peripherals that it does not manufacture. General Systems products are subject to constant changes in technology. Consequently, the Sector has an extensive research and development program. The Sector's backlog amounted to $1.2 billion at December 31, 1993 and $721 million at December 31, 1992. The 1993 backlog is believed to be generally firm, and approximately 100% of that amount is expected to be shipped during 1994. The estimate of the firmness of such orders is subject to future events which may cause the percentage of the 1993 backlog actually shipped to change. The General Systems Sector experiences intense competition from numerous competitors ranging from some of the world's largest companies to small, specialized firms. Competitive factors in the market for the products are price, service, delivery, product quality and product and system performance. An additional factor for the Motorola Computer Group products is the availability of software products to address specific user applications. Management believes that Motorola's commitment to research and development programs for improving existing products and developing new products and its utilization of state-of-the-art technology should allow the General Systems Sector to remain competitive. Materials used in the Sector's operations are generally second-sourced to ensure a continuity of supply. Energy necessary for the Sector's operations consists of electricity and natural gas, all of which are currently adequate in supply. The Sector's factories are highly automated and therefore, dependent upon a steady supply of electrical power. Patent protection is very important to the cellular business. Also, reference is made to the material under the heading "General" for information relating to patents and trademarks with respect to this industry segment. The General Systems Sector's headquarters is located in Arlington Heights, Illinois. It operates manufacturing facilities in Tempe, Arizona; Arlington Heights, Grayslake and Libertyville, Illinois; Swindon, England; Penang, Malaysia; Easter Inch, Scotland; Flensburg, Germany; and Tianjin, China. The Sector also has a joint venture manufacturing operation in Austria. GOVERNMENT AND SYSTEMS TECHNOLOGY PRODUCTS The Government and Systems Technology Group is engaged in the design, development and production of electronic systems and products, and it competes for a variety of United States Government projects and commercial business. The Group is expanding its commercial businesses and is giving increased attention to international business opportunities. The Group produces products related to electronic and communications equipment that has various applications based upon customer requirements of the Group's three business segments: Traditional Government, Commercial, and Satellite Communications. The Traditional Government business segment, previously known as the Government Electronics Group, consists of the Tactical Electronics Division and the Communications Division, and primarily does research, development and production work under contracts with governmental agencies, but also conducts independent research and development programs. The Traditional Government business segment produces products such as diversified - 11 - military and space electronic equipment, including aerospace telecommunications systems, military communications equipment, radar systems, data links, display systems, positioning and navigation systems, instrumentation products, countermeasures systems, missile guidance equipment, electronic ordnance devices and drone electronic systems. The Traditional Government business segment has been predominantly dependent upon the United States Government as its main customer, acting as either a prime contractor or a subcontractor to other prime contractors. The total loss of all of this business could have a material adverse effect on the Group. Contracts are secured from United States Government agencies and their suppliers by negotiation and competitive bidding. The government procurement environment is becoming more competitive and regulated. Competition is expected to increase substantially in all aspects of the Traditional Government business due to a slowdown in procurement resulting from a lower defense budget. Competitors include technically competent firms, including large diversified firms as well as smaller firms specializing in narrow product lines. This segment expects to continue to meet competition on the basis of price and quality of product performance. The Group is diversifying by applying its core technologies to quasi-government and commercial opportunities. During 1993, the Group organized its commercial business thrusts into the Diversified Technologies Division (DTD) which is marketing products in the secure telecommunications and commercial test equipment markets. It is developing products for positioning and navigation systems, and personal alarm and reporting systems markets. These businesses are expected to grow in the future, and substantial development and marketing efforts are being exerted in these areas. DTD is actively pursuing potential markets for its developmental product lines. Growth in the Commercial business segment may offset a decline in U.S. Government business. Distribution agreements for the domestic secure telecommunications market are in place with the sales force of the Land Mobile Products Sector (LMPS). International and government markets are handled directly by the Group's own sales force. During 1993, the world wide sales force of LMPS was also used to market test equipment. In 1994, DTD plans to expand the distribution network to penetrate new market segments. - 12 - The Group's Satellite Communications Division (SATCOM) is developing the IRIDIUM TM/SM satellite-based communication system. The IRIDIUM system is a space-based wireless communications system that is being designed to provide global digital service to hand-held telephones and related equipment. The IRIDIUM system involves four components: (1) a constellation of low earth orbit satellites, (2) a centralized system control center, (3) gateways distributed throughout the world and (4) individual subscriber units including, for example, voice, data, facsimile, pager and geolocation units. SATCOM is the prime contractor under contracts with Iridium, Inc. to provide and launch the satellites and maintain the system. The loss of these contracts could have a material adverse effect on the Group. IRIDIUM is a trademark and service mark of Iridium, Inc. Total sales for the Group include sales made to a number of free world governments and corporations. Products of the Group are marketed outside the United States by a few distributors, by independent representatives and by the Group's own sales force. In 1993, approximately 5% of the Group's business was conducted internationally, primarily through the Traditional Government business sector. As the competition for U.S. defense business increases, however, the Group has been focusing increased attention on the international market in the Commercial business and the Traditional Government business sectors. The Group's backlog amounted to $634 million at December 31, 1993 and $553 million at December 31, 1992. The 1993 backlog is believed to be generally firm and approximately 81% of that amount is expected to be shipped during 1994. All contracts with the United States Government are subject to cancellation at the convenience of the Government, and the contracts with Iridium, Inc. may be terminated by Iridium, Inc. pursuant to their terms. The estimate of the firmness of the 1993 backlog is subject to future events which may cause the percentage actually shipped to change. Materials used by the Group in its operations are generally available. Natural gas and electricity are the principal types of energy used, and availability of both to the Group is currently more than adequate. - 13 - Patents are becoming more important as competition increases in a declining U.S. Government market and as the Group expands into commercial and international markets. Also, reference is made to the material under the heading "General" for information relating to patents and trademarks with respect to this industry segment. The Group has its headquarters in Scottsdale, Arizona, with manufacturing facilities in Scottsdale and Chandler, Arizona. INFORMATION SYSTEMS PRODUCTS Information systems products are designed, manufactured and sold by the Information Systems Group, which consists of Codex Corporation ("Motorola Codex") and Universal Data Systems, Inc. ("UDS"), which are wholly owned subsidiaries of Motorola. In January 1994, the Group was combined with the Paging and Wireless Data Group to form the Messaging, Information and Media Sector. However, this new Sector does not constitute a separate reportable industry segment, and the results of operations of the Information Systems Group will continue to be reported under "Other Products." Motorola Codex manufactures and sells high-speed leased-line and dial modems, digital transmission devices, data/voice, time division and statistical multiplexers, network management and control systems, X.25 networking equipment and local area network interconnection products. These products are offered alone, and increasingly in systems, which have been configured to transmit information among personal computers, terminals, other peripheral devices and host computers. Motorola Codex also markets a few communication products it does not manufacture. UDS manufactures and sells a broad line of analog and digital data communications equipment, including modems and DDS (Digital Dataphone Services) service units for dedicated and switched networks, multiplexers, ISDN (Integrated Digital Services Network) terminal adaptors, network management systems and LAN (Local Area Network) product. UDS markets a few data communication products it does not manufacture. Motorola Codex products are sold through a domestic sales organization which sells through direct and indirect channels, such as distributors and - 14 - value added resellers. Motorola Codex's international unit sells and services products in 90 nations through several subsidiaries and numerous distributors. UDS sells its products in the United States directly through its own sales force and through indirect channels, such as independent distributors and value added resellers. UDS has its own international sales organization which utilizes local distributors where it is deemed necessary. Information systems products are subject to constant changes in technology. Consequently, the Group has an extensive research and development program. The Information Systems Group experiences intense competition from numerous competitors ranging from some of the world's largest companies, including AT&T and IBM, to small, specialized firms. Competitive factors in the market for these products are product quality and performance, customer service and price. Management believes that Motorola's commitment to research and development programs for improving existing products and developing new technologies and its utilization of state-of-the-art technology should allow the Group to remain competitive. Materials used in the Group's business consist primarily of electronic components and assemblies which are generally available from multiple sources. Occasionally, shortages or extended delivery periods occur in various component parts, the effects of which have been industry-wide and short in duration. The Group requires commercially available electrical energy for manufacturing and administrative operations. Facilities are temperature controlled with oil or gas heat and electrical power. These types of energy are currently readily available. Reference is made to the material under the heading "General" for information relating to patents and trademarks with respect to this industry segment. Motorola Codex is headquartered in Mansfield, Massachusetts where it has separate product engineering and marketing facilities. Manufacturing operations are located in Mississauga, Ontario, Canada and Mansfield, - 15 - Massachusetts. Motorola Codex also has numerous sales and service offices throughout the world. UDS's headquarters and manufacturing facilities are located in Huntsville, Alabama. AUTOMOTIVE, ENERGY AND CONTROLS PRODUCTS The Automotive, Energy and Controls Group (formerly, the Automotive and Industrial Electronics Group) manufactures and sells products in three major categories: automotive and industrial electronics; energy storage products and systems; and ceramic and quartz electronic components. The Group also includes operations which manufacture electronic ballasts for fluorescent lighting and radio frequency identification devices. The Group is involved in a number of joint ventures. Manufacturing facilities are located at both domestic and foreign locations. The Group sells its automotive and industrial electronics products to original equipment manufacturers, including foreign and domestic automobile manufacturers, heavy vehicle manufacturers, farm equipment manufacturers and industrial customers. A large part of its business is dependent upon two customers, the loss of either of which could have a material adverse effect on the business of the Group. Demand for products is linked to automobile sales in the United States and other countries where the Group sells its products. The Group experiences competition from numerous global competitors including automobile manufacturers. The energy storage products business and the ceramic and quartz products business sell primarily to other industry segments within Motorola, principally the Communications and General Systems Products segments. All materials used by the Group have good availability at this time. The Group uses electricity and gas in its operations, which are currently adequate in supply. Competitive factors in the sale of all of the Group's products include price, product quality and performance, supply integrity, quality - 16 - reputation, experience, responsiveness and design and manufacturing technology. Reference is made to the material under the heading "General" for information relating to patents and trademarks with respect to this industry segment. The Group's headquarters is located in Northbrook, Illinois. It has manufacturing operations located in Scottsdale, Arizona; San Jose, California; Northbrook, Buffalo Grove, Schaumburg and Vernon Hills, Illinois; Albuquerque, New Mexico; Elma, New York; Carlisle, Pennsylvania; Seguin, Texas; Angers, France; Stotfold, England; Tuas, Singapore; Tianjin, China; Chung-Li, Taiwan; Penang, Malaysia; Vega Baja, Puerto Rico; Dublin, Ireland; and San Jose, Costa Rica. GENERAL CUSTOMERS. Motorola is not dependent for a material part of its business upon a single or a very few customers. Slightly less than 4.5% of Motorola's total sales and revenues in 1993 were received from various branches and agencies, including the armed services, of the United States Government. All contracts with the United States Government are subject to cancellation at the convenience of the Government. Government contractors, including Motorola, are routinely subjected to numerous audits and investigations, which may be either civil or criminal in nature. The consequences of these audits and investigations may include administrative action to suspend business dealings with the contractor and to exclude it from receiving new business. In addition, Motorola, like other contractors, is internally reviewing aspects of its government contracting operations, and, where appropriate, taking corrective actions and making voluntary disclosures to the Government. From time to time, these audits and investigations may adversely affect Motorola. - 17 - BACKLOG. Motorola's aggregate backlog position, including the backlog position of subsidiaries through which some of its business units operate, as of the end of the last two fiscal years, was approximately as follows: December 31, 1993. . . $6.006 billion December 31, 1992. . . $4.321 billion The orders supporting the 1993 backlog amounts shown in the foregoing table are believed to be generally firm, and approximately 94% of orders on hand at December 31, 1993 are expected to be shipped during 1994. However, future events may cause the percentage actually shipped to change. RESEARCH AND DEVELOPMENT. Throughout its history, Motorola has relied, and continues to rely primarily on its research and development programs for the development of new products and its production engineering capabilities for the improvement of existing products. Technical data and product application ideas are exchanged among Motorola's industry segments on a regular basis. Research and development expenditures relating to new product development or product improvement, other than customer-sponsored contracts, were approximately $1,521 million in 1993, $1,306 million in 1992 and $1,133 million in 1991. In addition, research funded under customer-sponsored contracts amounted to approximately $324 million in 1993, $37 million in 1992 and $49 million in 1991. The 1993 increase in customer sponsored research and development was predominantly attributable to new contracts with Iridium, Inc. and regulatory agencies. Motorola presently expects to incur $1.7 billion in research and development expenditures in 1994. This is an estimate, and the actual amount which will be spent may vary. Approximately 14,100 professional employees were engaged in such research activities (including customer-sponsored) during 1993. - 18 - PATENTS AND TRADEMARKS. Motorola owns 5,888 patents in the United States and 4,234 in foreign countries. These foreign patents are counterparts of Motorola's United States patents. Many of the patents owned by Motorola are licensed to others, and Motorola is licensed to use certain patents owned by others. In some instances, certain of the patents licensed by Motorola to others have generated significant amounts of revenue to Motorola. During 1993, Motorola was granted 841 United States patents. Although many of Motorola's patents are used in its operations or licensed for use by others, neither Motorola's business nor that of any of its industry segments is dependent to any material degree on any one patent or group of related patents. Motorola considers its trademark "MOTOROLA" and the "M" symbol to be valuable assets. These are protected through trademark registrations. Other trademarks of Motorola are protected and registered in the relevant markets, but are used only on limited product lines. CORPORATE MISSION. Motorola's corporate mission is to grow rapidly, in each of its chosen arenas of the electronics industry, by providing its worldwide customers what they want, when they want it, with six sigma quality (virtually zero defects, i.e., no more than 3.4 parts per million defective) and best-in-class cycle time, as it strives to achieve its fundamental objective of total customer satisfaction and to achieve its stated goals of increased global market share; best-in-class people, marketing, manufacturing, technology, service and product software, hardware and systems; and superior financial results. To try to fulfill this mission, Motorola has concentrated on five key operational initiatives: first, designing products that will accept reasonable variation in component parts, developing manufacturing processes that will produce minimum variation in final output product and designing systems that will achieve six sigma performance; second, examining the total product system to reduce the time from when an order is placed or a product is conceived until it is delivered; third, emphasizing the need for product development and manufacturing disciplines to work together; fourth, implementing a long-term, customer-driven approach that shows it where to commit its resources to give customers what they want; and - 19 - fifth, empowerment for all, in a participative, cooperative and creative workplace to achieve more synergy, greater efficiency and improved quality within and between organizations. In addition, it has tried to develop the following key attributes or elements of a successful quality program: leadership; communications; training; establishing high goals and high expectations; providing for recognition; and developing a participative, cooperative, creative and receptive culture. ENVIRONMENTAL QUALITY. Motorola operations are from time to time the subjects of investigations, conferences, discussions and negotiations with various federal, state and local environmental agencies with respect to the discharge or cleanup of hazardous waste and compliance by those operations with environmental laws and regulations. The balance of the response to this section of Item 1 is incorporated by reference to Note 6 of the Notes to Consolidated Financial Statements under the caption "Environmental and Legal" and the information contained under the caption "Environmental Matters" in Motorola Management's Discussion and Analysis of Financial Condition and Results of Operations in Motorola's 1993 Annual Report to Stockholders. FIXED ASSET EXPENDITURES. Motorola presently expects to incur approximately $2.9 billion of fixed asset expenditures in 1994. This is an estimate, and the actual amount which will be spent may vary. MISCELLANEOUS. At December 31, 1993, there were approximately 120,000 employees of Motorola and its subsidiaries. The business of Motorola and its industry segments is not seasonal to any significant extent, although the Semiconductor Products Sector has tended to have stronger, seasonally-adjusted sales in the first half of the year. (d) Financial information about foreign and domestic operations and export sales. Local governments and their policies and the societal and economic conditions prevailing in those countries in which Motorola operates (particularly unstable governments and social conditions, rates of inflation, monetary fluctuations and balance of payments problems) may have significant effects on Motorola's business. - 20 - Domestic export sales to third parties were $1.83 billion in 1993, $1.14 billion in 1992 and $871 million in 1991. Domestic export sales to affiliates were $3.16 billion in 1993, $2.32 billion in 1992 and $2.06 billion in 1991. The remainder of the response to this section of Item 1 is incorporated by reference to Note 7 of the Notes to Consolidated Financial Statements and the "Results of Operations" section of Motorola's 1993 Annual Report to Stockholders. Item 2: Item 2: Properties Motorola's principal executive offices are located at 1303 East Algonquin Road, Schaumburg, Illinois 60196. Its other major facilities in the United States are located in Arlington Heights, Buffalo Grove, Grayslake, Libertyville, Northbrook and Schaumburg, Illinois; Elma, New York; Phoenix, Chandler, Scottsdale, Mesa and Tempe, Arizona; Boynton Beach and Plantation, Florida; Austin, Dallas, Ft. Worth and Seguin, Texas; Mount Pleasant, Iowa; Mansfield, Massachusetts; Huntsville, Alabama; Albuquerque, New Mexico; Carlisle, Pennsylvania; and Irvine and San Jose, California. Motorola also operates manufacturing facilities or sales offices in 39 other countries. (See "Narrative Description of Business" for information regarding the location of the principal manufacturing facilities for each industry segment.) The United States facilities (both manufacturing and administrative) owned by Motorola contain approximately 16.6 million square feet. Motorola also leases facilities in the United States containing approximately 4.2 million square feet. Motorola's facilities outside the United States contain approximately 8.0 million square feet of which approximately 2.8 million square feet are leased. Motorola considers the productive capacity of the plants operated by each of its industry segments adequate and suitable for the requirements of each of such segments, except for the Semiconductor Products Sector which is engaged in a factory expansion program to meet the strong market demand for its products. - 21- The extent of utilization of such manufacturing facilities varies from plant to plant and from time to time during the year. Item 3: Item 3: Legal Proceedings Motorola is a named defendant in five cases arising out of alleged groundwater, soil and air pollution in Phoenix and Scottsdale, Arizona. MCINTIRE ET AL. V. MOTOROLA and CAMELHEAD EQUITIES ET AL. V. MOTOROLA ET AL. are pending in the U.S. District Court for the District of Arizona, and BAKER ET AL. V. MOTOROLA ET AL., LOFGREN ET AL. V. MOTOROLA ET AL. and BETANCOURT ET AL. V. MOTOROLA ET AL. are pending in the Arizona Superior Court, Maricopa County. The MCINTIRE lawsuit, filed on December 20, 1991, involves over 900 plaintiffs who allege that the operations of Motorola at several facilities in Phoenix and Scottsdale, Arizona have caused property damage and health problems by contaminating the soil, groundwater and air in the area surrounding those facilities. CAMELHEAD EQUITIES, filed on June 1, 1993, is a suit for business losses by four failed real estate development limited partnerships. The BAKER lawsuit, filed on February 11, 1992, is also a proposed class action, involving seven purportedly representative individual named plaintiffs, alleging that Motorola and other defendants contaminated the soil, air and groundwater in the Phoenix/Scottsdale area, diminishing property values and exposing members of the class to possible adverse health effects. The LOFGREN lawsuit, filed on April 6, 1993, is a proposed class action, involving approximately 130 purportedly representative individual named plaintiffs, alleging that Motorola and other defendants contaminated the soil, air and groundwater in the Phoenix/Scottsdale area, causing health problems to members of the class. The BETANCOURT lawsuit, filed on July 16, 1993, involves claims for personal injury by approximately 25 individuals, alleging that Motorola and other defendants contaminated the soil, air and groundwater in the Phoenix/ Scottsdale area, causing health problems to plaintiffs. All five lawsuits seek compensatory and punitive damages. The MCINTIRE complaint includes personal injury and property damage claims and seeks injunctive relief. The BAKER complaint seeks damages for medical monitoring and alleges claims for property, business and economic loss and seeks declaratory and injunctive relief. - 22- A class action, FELDMAN ET AL. V. MOTOROLA, INC. ET AL., against Motorola and several of its officers for alleged violations of Sections 10(b), 20(a) and 20A of the Securities Exchange Act of 1934 and SEC Rule 10b-5 is pending in the U.S. District Court for the Northern District of Illinois. The pending complaint, a consolidation of four cases, maintains that Motorola and the individual defendants committed fraud on the market by artificially inflating the price of Motorola stock through a series of alleged material misrepresentations and omissions. It also alleges that certain of the individual defendants engaged in unlawful insider trading. Plaintiffs propose a class period of May 4, 1990 through January 16, 1991, and seek an unspecified amount of monetary damages. On February 1, 1993, Motorola was named as a defendant in a purported class action that alleged economic loss to purchasers of portable cellular telephones. VERB ET AL. V. MOTOROLA, INC. ET AL., Circuit Court of Cook County, Illinois, 93 CH 00969. The plaintiffs amended their complaint several times. In its final form, the complaint named seven additional defendants (all of which were manufacturers of cellular phones) and added two new plaintiffs. The two new plaintiffs (Messrs. Crist and Pogue) also claimed personal injury, alleging that use of portable cellular phones had aggravated pre-existing brain cancers. Crist's personal injury claim was against Motorola alone while that of Pogue was against another defendant alone. In September 1993, the court dismissed all claims except those of Crist and Pogue. The plaintiffs have appealed this decision to the Illinois Court of Appeal. Subsequently, the court denied the motion of Crist and Pogue for class status and transferred the case from the equity division to the law division. After the transfer, the court severed the cases. Crist's claim for individual economic injury and for personal injury (for aggravation of a pre-existing cancer) is pending against Motorola alone, and there are no other parties associated with the case. The information contained in Motorola Management's Discussion and Analysis of Financial Condition and Results of Operations under the caption "Environmental Matters" and in Note 6 of the Notes to Consolidated Financial Statements under the caption "Environmental and Legal" in Motorola's 1993 Annual Report to Stockholders is incorporated herein by reference. - 23- Motorola is a defendant in various other suits, claims and investigations which arise in the normal course of business. In the opinion of management, the ultimate disposition of these matters, including those matters described above in this Item 3, will not have a material adverse effect on the business or financial position of Motorola. Item 4: Item 4: Submission of Matters to a Vote of Security Holders Not applicable. Executive Officers of the Registrant Following are the persons who were the executive officers of Motorola as of December 31, 1993, their ages as of December 31, 1993 and their current titles and positions held during the last five years: Gary L. Tooker; age 54; Vice Chairman of the Board and Chief Executive Officer since December 1993; President and Acting Chief Executive Officer from October 1993 to December 1993; President and Chief Operating Officer from January 1990 to October 1993; and Chief Operating Officer and Senior Executive Vice President from January 1988 to January 1990. Christopher B. Galvin; age 43; President and Chief Operating Officer since December 1993; Senior Executive Vice President and Assistant Chief Operating Officer from January 1990 to December 1993; Executive Vice President and Chief Corporate Staff Officer from May 1989 to January 1990; and Senior Vice President and Chief Corporate Staff Officer from January 1988 to May 1989. Robert W. Galvin; age 71; Chairman of the Executive Committee of the Board of Directors since January 1990; and Chairman of the Board of Directors from November 1959 to January 1990. John F. Mitchell; age 65; Vice Chairman of the Board and Officer of the Board since January 1988. - 24 - Keith J. Bane; age 54; Senior Vice President and Motorola Director of Strategy, Technology and External Relations since October 1993; and Senior Vice President and Motorola Director of Strategy from November 1988 to October 1993. Arnold S. Brenner; age 56; Executive Vice President and General Manager, Japan Group since November 1988; and Senior Vice President and General Manager, Japan Operations from January 1988 to November 1988. James Donnelly; age 54; Executive Vice President and Motorola Director of Human Resources (name changed from Personnel to Human Resources in 1993) since December 1987. Thomas D. George; age 53; Executive Vice President, and President and General Manager, Semiconductor Products Sector since April 1993; Executive Vice President and Assistant General Manager, Semiconductor Products Sector from November 1992 to April 1993; and Senior Vice President and Assistant General Manager, Semiconductor Products Sector from July 1986 to November 1992. Robert L. Growney; age 51; Executive Vice President and President and General Manager, Messaging, Information and Media Sector since January 1994; Executive Vice President and General Manager, Paging and Wireless Data Group from September 1992 to January 1994; Senior Vice President and General Manager, Paging and Telepoint Systems Group from January 1991 to September 1992; Senior Vice President and General Manager, Radio Technologies Group, Communications Sector from May 1989 to January 1991; and Corporate Vice President and General Manager, Radio Technologies Group, Communications Sector from September 1987 to May 1989. David W. Hickie; age 60; Mr. Hickie retired as an officer of the Company in December 1993; he was formerly Executive Vice President and Chief Corporate Staff Officer from November 1990 to December 1993; Senior Vice President and Chief Corporate Staff Officer from May 1990 to November 1990; and Senior Vice President and Assistant Chief Financial Officer from November 1985 to May 1990. - 25 - Carl F. Koenemann; age 55; Executive Vice President and Chief Financial Officer since December 1991; Senior Vice President and Assistant Chief Financial Officer from May 1990 to December 1991; Corporate Vice President and Assistant Chief Financial Officer from January 1990 to May 1990; and Corporate Vice President and Director of Finance, General Systems Group, from May 1987 to January 1990. James A. Norling; age 51; Executive Vice President, and President, Motorola Europe, Middle East and Africa since April 1993; Executive Vice President, and President and General Manager, Semiconductor Products Sector from December 1989 to April 1993; and Executive Vice President and General Manager, Semiconductor Products Sector from July 1986 to December 1989. Edward F. Staiano; age 57; Executive Vice President, and President and General Manager, General Systems Sector since December 1989; and Executive Vice President and General Manager, General Systems Group from December 1987 to December 1989. Morton L. Topfer; age 57; Executive Vice President, and President and General Manager, Land Mobile Products Sector since August 1991; Senior Vice President, and President and General Manager, Land Mobile Products Sector from December 1990 to August 1991; and Senior Vice President and Assistant General Manager, Communications Sector from December 1987 to December 1990. Frederick T. Tucker; age 53; Executive Vice President and General Manager, Automotive, Energy and Controls Group (name changed from Automotive and Industrial Electronics Group in 1993) since September 1992; Senior Vice President and General Manager, Automotive and Industrial Electronics Group from April 1988 to September 1992; and Corporate Vice President and Assistant General Manager, Automotive and Industrial Electronics Group from January 1987 to April 1988. Richard H. Weise; age 58; Senior Vice President, General Counsel and Secretary since November 1985. - 26 - David G. Wolfe; age 58; Executive Vice President and General Manager, Government and Systems Technology Group (name changed from Government Electronics Group in 1992) since November 1990; and Senior Vice President and General Manager, Government Electronics Group from January 1988 to November 1990. Richard W. Younts; age 54; Executive Vice President and Corporate Executive Director International-Asia and Americas since December 1993; Senior Vice President and Corporate Executive Director, International-Asia and Americas from July 1991 to December 1993; Senior Vice President and President, Nippon Motorola Ltd., Japanese Group from May 1991 to July 1991; and Corporate Vice President and President, Nippon Motorola Ltd. from August 1987 to May 1991. The above executive officers, with the exception of Mr. Hickie, will serve as officers of Motorola until the regular meeting of the Board of Directors in May 1994 or until their respective successors shall have been elected. Christopher B. Galvin is a son of Robert W. Galvin. There is no family relationship between any of the other executive officers listed above. PART II Item 5: Item 5: Market for Registrant's Common Equity and Related Stockholder Matters Motorola's Common Stock is listed on the New York, Chicago, London and Tokyo Stock Exchanges. The remainder of the response to this Item is incorporated by reference to the information under the caption "Quarterly and Other Financial Data" of Motorola's 1993 Annual Report to Stockholders. Item 6: Item 6: Selected Financial Data The response to this Item is incorporated by reference to the information under the caption "Five Year Financial Summary" of Motorola's 1993 Annual Report to Stockholders. - 27 - Item 7: Item 7: Management's Discussion and Analysis of Financial Condition and Results of Operations The response to this Item is incorporated by reference to the information under the captions "Financial Review", "Financial Results" and "Review of Operations" of Motorola's 1993 Annual Report to Stockholders. Item 8: Item 8: Financial Statements and Supplementary Data The response to this Item is incorporated by reference to the information under the captions "Management's Responsibility For Financial Statements", "Independent Auditors' Report", "Statements of Consolidated Earnings", "Statements of Consolidated Stockholders' Equity", "Consolidated Balance Sheets", "Statements of Consolidated Cash Flows", "Supplemental Cash Flow Information", "Notes to Consolidated Financial Statements", "Quarterly and Other Financial Data" and "Five Year Financial Summary" of Motorola's 1993 Annual Report to Stockholders. Item 9: Item 9: Changes in and Disagreements With Accountants on Accounting and Financial Disclosure None. PART III Item 10: Item 10: Directors and Executive Officers of the Registrant The response to this Item required by Item 401 of Regulation S-K, with respect to directors, is incorporated by reference to the information under the caption "Nominees" on pages 2 through 11 of Motorola's Proxy Statement for the 1994 annual meeting of stockholders and with respect to executive officers, is contained in Part I hereof under the caption "Executive Officers of the Registrant". The response to this Item required by Item 405 of Regulation S-K is incorporated by reference to the information under the caption "Security Ownership of Management of the - 28 - Company" on page 18 of Motorola's Proxy Statement for the 1994 annual meeting of stockholders. Item 11: Item 11: Executive Compensation The response to this Item is incorporated by reference to the information under the captions "Director Compensation" and "Compensation Committee Interlocks and Insider Participation" on pages 14, 15 and 16 of Motorola's Proxy Statement for the 1994 annual meeting of stockholders and "Summary Compensation Table," "Stock Option Grants in 1993," "Aggregated Option Exercises in Last Fiscal Year and FY-End Option Values," "Long-Term Incentive Plans - Awards in Last Fiscal Year," "Pension and Supplementary Retirement Plans," and "Other Policies and Agreements" on pages 19 through 23 of Motorola's Proxy Statement for the 1994 annual meeting of stockholders. Item 12: Item 12: Security Ownership of Certain Beneficial Owners and Management The response to this Item is incorporated by reference to the information under the caption "Security Ownership of Management of the Company" on pages 17 and 18 of Motorola's Proxy Statement for the 1994 annual meeting of stockholders. Item 13: Item 13: Certain Relationships and Related Transactions The response to this Item is incorporated by reference to the information under the captions "Director Compensation" and "Compensation Committee Interlocks and Insider Participation" on pages 14, 15 and 16 of Motorola's Proxy Statement for the 1994 annual meeting of stockholders. - 29 - PART IV Item 14: Item 14: Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) 1. Financial Statements See Part II, Item 8 hereof. 2. Financial Statement Schedules and Auditors' Report TITLE SCHEDULE Property, Plant and Equipment. . . . . . . . .V Accumulated Depreciation of Property, Plant and Equipment. . . . . . . . . . . .VI Valuation and Qualifying Accounts. . . . . . ..VIII Short-term Borrowings. . . . . . . . . . . . . IX All schedules omitted are inapplicable or the information required is shown in the consolidated financial statements or notes thereto. The auditors' report of KPMG Peat Marwick with respect to the Financial Statement Schedules is located at page 31. 3. Exhibits Exhibits required to be attached by Item 601 of Regulation S-K are listed in the Exhibit Index attached hereto, which is incorporated herein by this reference. Following is a list of management contracts and compensatory plans and arrangements required to be filed as exhibits to this form by Item 14(c) hereof: Motorola Executive Incentive Plan ("MEIP") Share Option Plan of 1982 Share Option Plan of 1991 Motorola Long Range Incentive Plan of 1994 Motorola Elected Officers Supplementary Retirement Plan Officers Supplemental Medical Plan Accidental Death and Dismemberment Insurance for MEIP - 30 - Participants Arrangement for Directors' Fees Retirement Plan for Non-employee Directors Deferred Fee Plan for Outside Directors Officers' Group Life Insurance Policy Consultant Agreements with William J. Weisz, John T. Hickey, Gardiner L. Tucker, Donald R. Jones and Erich Bloch Form of Termination Agreement Policy Protecting Salary and Medical Benefits Insurance Policy for Non-employee Directors (b) Reports on Form 8-K. Motorola filed no reports on Form 8-K during the last quarter of 1993. (c) Exhibits See Item 14(a)3 above. - 31 - KPMG Peat Marwick Certified Public Accountants Peat Marwick Plaza 303 East Wacker Drive Chicago, IL 60601-9973 INDEPENDENT AUDITORS' REPORT The Board of Directors and Stockholders of Motorola, Inc.: Under date of January 13, 1994, we reported on the consolidated balance sheets of Motorola, Inc. and consolidated subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of earnings, stockholders' equity, and cash flows for each of the years in the three-year period ended December 31, 1993, as contained in the 1993 annual report to stockholders. These consolidated financial statements and our report thereon are incorporated by reference in the annual report on Form 10-K for the year 1993. In connection with our audits of the aforementioned consolidated financial statements, we also have audited the related financial statement schedules as listed in Part IV, Item 14(a)2. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statement schedules based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. /s/ KPMG Peat Marwick January 13, 1994 - 32 - Motorola, Inc. and Subsidiaries Schedule V Property, Plant and Equipment Three Years Ended December 31, 1993 (In millions) - 33- Motorola, Inc. and Subsidiaries Schedule V Property, Plant and Equipment (continued) Three Years Ended December 31, 1993 (In millions) - 34 - Motorola, Inc. and Subsidiaries Schedule V Property, Plant and Equipment (continued) Three Years Ended December 31, 1993 (In millions) - 35 - Motorola, Inc. and Subsidiaries Schedule VI Accumulated Depreciation of Property, Plant and Equipment Three Years Ended December 31, 1993 (In millions) - 36 - Motorola, Inc. and Subsidiaries Schedule VI Accumulated Depreciation of Property, Plant and Equipment (continued) Three Years Ended December 31, 1993 (In millions) - 37 - Motorola, Inc. and Subsidiaries Schedule VI Accumulated Depreciation of Property, Plant and Equipment (continued) Three Years Ended December 31, 1993 (In millions) - 38 - Motorola, Inc. and Subsidiaries Schedule VIII Valuation and Qualifying Accounts Three Years Ended December 31, 1993 (In millions) - 39 - Motorola, Inc. and Subsidiaries Schedule IX Short-term Borrowings Three Years Ended December 31, 1993 (In millions) - 40 - KPMG Peat Marwick Certified Public Accountants Peat Marwick Plaza 303 East Wacker Drive Chicago, IL 60601-9973 CONSENT OF INDEPENDENT AUDITORS The Board of Directors of Motorola, Inc.: We consent to incorporation by reference in the registration statements on Form S-8 (Nos. 33-40876 and 33-58714) and Form S-3 (Nos. 33-30662, 33-55080, 33-59252 and 33-50207) of Motorola, Inc. and consolidated subsidiaries of our reports dated January 13, 1994, relating to the consolidated balance sheets of Motorola, Inc. and consolidated subsidiaries as of December 31, 1993 and 1992 and the related statements of consolidated earnings, stockholders' equity, and cash flows and related financial statement schedules for each of the years in the three-year period ended December 31, 1993, which reports appear in or are incorporated by reference in the Annual Report on Form 10-K of Motorola, Inc. for the year ended December 31, 1993. /s/ KPMG Peat Marwick March 22, 1994 - 41 - SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Motorola, Inc. has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. March 10, 1994 MOTOROLA, INC. By: /s/ Gary L. Tooker ----------------------------- Gary L. Tooker Vice Chairman of the Board and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of Motorola, Inc. and in the capacities and on the dates indicated. SIGNATURE TITLE DATE --------- ----- ---- /s/ Gary L. Tooker Director and Principal 3/10/94 - ------------------------- Executive Officer Gary L. Tooker /s/ Carl F. Koenemann Principal Financial 3/10/94 - -------------------------- Officer Carl F. Koenemann /s/ Kenneth J. Johnson Principal Accounting 3/11/94 - --------------------------- Officer Kenneth J. Johnson - 42 - SIGNATURE TITLE DATE --------- ----- ---- /s/ Erich Bloch Director 3/12/94 - -------------------------- Erich Bloch /s/ David R. Clare Director 3/10/94 - -------------------------- David R. Clare /s/ Wallace C. Doud Director 3/10/94 - -------------------------- Wallace C. Doud /s/ Christopher B. Galvin Director 3/10/94 - -------------------------- Christopher B. Galvin /s/ Robert W. Galvin Director 3/11/94 - -------------------------- Robert W. Galvin /s/ John T. Hickey Director 3/10/94 - -------------------------- John T. Hickey /s/ Anne P. Jones Director 3/13/94 - -------------------------- Anne P. Jones /s/ Donald R. Jones Director 3/21/94 - -------------------------- Donald R. Jones /s/ Walter E. Massey Director 3/13/94 - -------------------------- Walter E. Massey - 43 - SIGNATURE TITLE DATE --------- ----- ---- /s/ John F. Mitchell - ------------------------ Director 3/22/94 John F. Mitchell /s/ Thomas J. Murrin Director 3/12/94 - -------------------------- Thomas J. Murrin /s/ Samuel C. Scott III Director 3/10/94 - --------------------------- Samuel C. Scott III /s/ Gardiner L. Tucker Director 3/12/94 - -------------------------- Gardiner L. Tucker /s/ William J. Weisz Director 3/16/94 - -------------------------- William J. Weisz Director 3/ /94 - -------------------------- B. Kenneth West - 44 - EXHIBIT INDEX EXHIBIT NO. EXHIBIT - ----------- ------- 3(i) Restated Certificate of Incorporation of Motorola, Inc.,including Certificate of Designations for Junior Participating Preferred Stock, Series A (incorporated by reference to Exhibit 3(i)(b) to Motorola's Quarterly Report on Form 10-Q for the fiscal quarter ended July 3, 1993). 3(ii) By-Laws of Motorola, Inc., revised as of February 1, 1994. 4.1 Rights Agreement dated November 9, 1988 (incorporated by reference to Exhibit 4.1 to Motorola's Annual Report on Form 10-K for the fiscal year ended December 31, 1988). 4.2 Amendment to Rights Agreement dated August 7, 1990 (incorporated by reference to Exhibit 2 to Motorola's Form 8 dated August 9, 1990 amending Motorola's Registration Statement on Form 8-A dated November 15, 1988). 4.3 Amendment No. 2 on Form 8 dated December 2, 1992 amending Motorola's Registration Statement on Form 8-A dated November 15, 1988 (incorporated by reference to Motorola's Form 8 dated December 2, 1992). 4.3(a)Amendment No. 3 on Form 8-A/A dated February 28, 1994 amending Motorola's Registration Statement on Form 8-A dated November 15, 1988 (incorporated by reference to Motorola's Amendment No. 3 Form 8-A/A dated February 28, l994). 4.4 LYONs Indenture dated September 1, 1989 (incorporated by reference to Exhibit 4.1 to Motorola's Quarterly Report on Form 10-Q for the quarter ended September 30, 1989). - 45 - EXHIBIT NO. EXHIBIT - ---------- ------- 4.5 Indenture dated as of March 15, 1985 between Motorola, Inc. and Harris Trust and Savings Bank, as Trustee, and specimen of 8.40% Debentures due August 5, 2031 under the Indenture (incorporated by reference to Exhibits 4(C) and 4(B), respectively, to Motorola's Current Report on Form 8-K dated August 12, 1991). 4.6 Indenture dated as of October 1, 1991 between Motorola, Inc. and Harris Trust and Savings Bank, as Trustee (incorporated by reference to Exhibit 4.5 to Motorola's Annual Report on Form 10-K for the fiscal year ended December 31, 1991). 4.7 Specimen of 7.60% Notes due January 1, 2007 (incorporated by reference to Exhibit 4.6 to Motorola's Annual Report on Form 10-K for the fiscal year ended December 31, 1991). 4.8 Specimen of 6 1/2% Notes due March 1, 2008 (incorporated by reference to Exhibit 4(B) to Motorola's Current Report on Form 8-K dated March 1, 1993). 4.9 LYONs Indenture dated September 1, 1993 (incorporated by reference to Exhibit 4(v) to Motorola's Quarterly Report on Form 10-Q for the quarter ended October 2, 1993. 10.1 Motorola Executive Incentive Plan, as amended through November 23, 1993. 10.2 Motorola Long Range Incentive Plan of 1994. 10.3 Share Option Plan of 1982, as amended through March 24, 1992 (incorporated by reference to Exhibit 10.3 to Motorola's Annual Report on Form 10-K for the fiscal year ended December 31, 1990, Exhibit 10.2(a) to Motorola's Annual Report on Form 10-K for the - 46 - EXHIBIT NO. EXHIBIT - ----------- ------- fiscal year ended December 31, 1991 and Exhibit 10.3 to Motorola's Annual Report on Form 10-K for the fiscal year ended December 31, 1992). 10.4 Share Option Plan of 1991, as amended through December 16, 1993. 10.5 Motorola Elected Officers Supplementary Retirement Plan, as amended through June 21, 1993. 10.6 Officers supplemental medical plan (incorporated by reference to Exhibit 10.6 to Motorola's Annual Report on Form 10-K for the fiscal year ended December 31, 1990). 10.7 Accidental death and dismemberment insurance for MEIP participants (incorporated by reference to Exhibit 10.7 to Motorola's Annual Report on Form 10-K for the fiscal year ended December 31, 1990). 10.8 Arrangement for directors' fees and retirement plan for non-employee directors (description incorporated by reference from page 14 of Motorola's Proxy Statement for the 1994 annual meeting of stockholders). 10.9 Deferred Fee Plan for Outside Directors (incorporated by reference to Exhibit 10.10 to Motorola's Annual Report on Form 10-K for the fiscal year ended December 31, 1986). 10.10 Officers' Group Life Insurance Policy (incorporated by reference to Exhibit 10.10 to Motorola's Annual Report on Form 10-K for the fiscal year ended December 31, 1990). 10.11 Consultant Agreement dated February 15, 1994 between Motorola, Inc. and William J. Weisz. - 47 - EXHIBIT NO. EXHIBIT - ----------- -------- 10.12 Consultant Agreement dated January 27, 1994 between Motorola, Inc. and John T. Hickey. 10.13 Consultant Agreement dated January 27, 1994 between Motorola, Inc. and Dr. Gardiner L. Tucker. 10.14 Consultant Agreement dated January 27, 1994 between Motorola, Inc. and Donald R. Jones. 10.15 Consultant Agreement dated January 27, 1994 between Motorola, Inc. and Erich Bloch. 10.16 Form of Termination Agreement in respect of a change in control (incorporated by reference to Exhibit 10.15 to Motorola's Annual Report on Form 10-K for the fiscal year ended December 31, 1989). 10.17 Policy protecting salary and medical benefits of employees in the event of an unsolicited change in control (incorporated by reference to Exhibit 10.16 to Motorola's Annual Report on Form 10-K for the fiscal year ended December 31, 1990). 10.18 Insurance policy covering non-employee Directors (incorporated by reference to Exhibit 10.16 to Motorola's Annual Report on Form 10-K for the fiscal year ended December 31, 1989). 10.19 Iridium Space System Contract between Motorola, Inc. and Iridium, Inc., as amended to date, and Iridium Communications Systems Operations and Maintenance Contract between Motorola, Inc. and Iridium, Inc., as amended to date (incorporated by reference to Exhibits 99.2 and 99.3, respectively, to Motorola's Current Report on Form 8-K dated August 2, 1993. 11 Primary and Fully Diluted Earnings Per Common and Common Equivalent Share. 11.1 Pro Forma Primary and Fully Diluted Earnings Per Common and Common Equivalent Share Giving Retroactive Effect to the March 15, 1994 Two-for-One Stock Split. 13 Portions of Motorola's 1993 Annual Report to Stockholders. - 48 - EXHIBIT NO. EXHIBIT - ----------- ------- 21 Subsidiaries of Motorola. 23 Consent of KPMG Peat Marwick. See page 40 of the Annual Report on Form 10-K of which this Exhibit Index is a part.

1993 ITEM 3. LEGAL PROCEEDINGS. Bass Public Limited Company, Bass International Holdings N.V., Bass (U.S.A.) Incorporated, Holiday Corporation and Holiday Inns, Inc. (collectively "Bass") v. The Promus Companies Incorporated ("Promus"). A complaint was filed in the United States District Court for the Southern District of New York against Promus on February 6, 1992, under Civil Action No. 92 Civ. 0969(SWK). The complaint alleges violation of Rule 10b-5 of the federal securities laws, intentional and negligent misrepresentation, breach of express warranties, breach of contract, and express and equitable indemnification. The complaint generally alleges breaches of representations and warranties under the Merger Agreement with respect to the 1990 spin-off of Promus and acquisition of the Holiday Inn hotel business by Bass, violation of the federal securities laws due to such alleged breaches, and breaches of the Tax Sharing Agreement between Bass and Promus entered into at the closing of the Merger Agreement. The complaint seeks an unspecified amount of damages, unspecified punitive or exemplary damages, and declaratory relief. The Company believes that it has complied with all applicable laws and agreements with Bass in connection with the Merger and is defending its position vigorously. Promus has filed (a) an answer denying, and asserting affirmative defenses to, the substantive allegations of the complaint and (b) counterclaims alleging that Bass has breached the Tax Sharing Agreement and agreements ancillary to the Merger Agreement. The counterclaims request unspecified compensatory damages, injunctive and declaratory relief and Promus' costs, including reasonable attorneys fees and expenses. On April 17, 1992, Bass filed a motion seeking to disqualify the Company's outside counsel in the litigation, Latham & Watkins, on various grounds. That motion was denied by the trial court on January 7, 1994. Discovery has begun, but no trial date has been set. Certain tax matters. In connection with the Spin-off, Promus is liable, with certain exceptions, for taxes of Holiday and its subsidiaries for all pre-merger tax periods. Bass is obligated under the terms of the Tax Sharing Agreement to pay Promus the amount of any tax benefits realized from pre-merger tax periods of Holiday and its subsidiaries. All federal income taxes and interest assessed by the Internal Revenue Service ("IRS") for the 1978 through 1984 tax years were paid during 1992. The federal income taxes and interest thereon associated with the agreed issues from the IRS audit of the 1985 and 1986 tax years were paid in 1991. Negotiations with the IRS to resolve disputed issues for the 1985 and 1986 tax years were concluded and settlement reached during fourth quarter 1993. Final payment of the federal income taxes and related interest due under the settlement is expected to be made during second quarter 1994. The IRS has completed its examination of Holiday's federal income tax returns for 1987 through the Spin-off date and has issued its proposed adjustments to those returns. Federal income taxes and related interest assessed on agreed issues were paid subsequent to year-end. The total liability of approximately $23.7 million for the federal income tax and interest payments to be made, as discussed above, was included in current liabilities on December 31, 1993. A protest of all unagreed issues for the 1987 through Spin-off periods was filed with the IRS during the third quarter of 1993 and negotiations to resolve disputed issues are currently expected to begin during the second quarter of 1994. Final resolution of the disputed issues is not expected to have a materially adverse effect on Promus' consolidated financial position or its results of operations. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Not Applicable. EXECUTIVE OFFICERS OF THE REGISTRANT POSITIONS AND OFFICES HELD AND PRINCIPAL OCCUPATIONS OR EMPLOYMENT DURING PAST 5 NAME AND AGE YEARS - ----------------------------------- ------------------------------------------ Michael D. Rose (52)............... Chairman of the Board and Chief Executive Officer of Promus since November 1989. President of Promus (1989-1991). Chief Executive Officer (1981-1990), Chairman of the Board (1984-1990) and President (1988-1990) of Holiday. Effective April 29, 1994, Mr. Philip G. Satre will become Chief Executive Officer of Promus. Mr. Rose will continue as Chairman of the Board. Mr. Rose also is a director of Ashland Oil, Inc., First Tennessee National Corporation and General Mills, Inc. Philip G. Satre (44)............... Director, President and Chief Operating Officer of Promus since April 1991. Director and Senior Vice President of Promus (1989-1991). President (since 1984) and Chief Executive Officer (1984-1991) of Harrah's and Senior Vice President (1987-1990) and a Director (1988-1990) of Holiday. Effective April 29, 1994, Mr. Satre will become Chief Executive Officer of Promus in addition to his position as President. He also is a director of Goody's Family Clothing, Inc. John M. Boushy (39)................ Senior Vice President, Information Technology and Corporate Marketing of Promus since June 1993. Vice President, Strategic Marketing of Harrah's April 1989 to June 1993. Charles A. Ledsinger, Jr. (44)..... Senior Vice President and Chief Financial Officer of Promus since August 1990. Treasurer of Promus from November 1989 to February 1991. Vice President of Promus from November 1989 to August 1990. Vice President, Project Finance (1986-1990) of Holiday. He also is a director of Perkins Management Company, Inc., a privately-held general partner of Perkins Family Restaurants, L.P., a publicly-traded limited partnership. Ben C. Peternell (48).............. Senior Vice President, Corporate Human Resources and Communications of Promus since November 1989. Senior Vice President, Corporate Human Resources (1985-1990) of Holiday. Colin V. Reed (46)................. Senior Vice President, Corporate Development of Promus since May 1992. Vice President, Corporate Development of Promus from November 1989 to May 1992. Vice President (1988-1990) of Holiday. He also is a director of Sodak Gaming, Inc. E. O. Robinson, Jr. (54)........... Senior Vice President and General Counsel of Promus since April 1993 and Secretary of Promus since November 1989. Vice President and Associate General Counsel of Promus from November 1989 to April 1993. Vice President (1988-1990) of Holiday. PART II ITEM 5. ITEM 5. MARKET FOR THE COMPANY'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS. Information as to the principal markets in which the Company's Common Stock is traded and the high and low prices of such stock for the last two years is set forth on the inside back cover of Book Two of the Annual Report, which information is incorporated herein by reference. On February 26, 1993, the Company's Board of Directors authorized a two-for-one stock split (the "First Stock Split"), in the form of a stock dividend, which was effected by the distribution on March 29, 1993 of one additional share of Common Stock for each share of Common Stock owned by stockholders of record on March 8, 1993. On October 29, 1993, the Company's Board of Directors authorized a three-for-two stock split (the "Second Stock Split"), in the form of a stock dividend, which was effected by the distribution on November 29, 1993 of one additional share Common Stock for each two shares of Common Stock owned by stockholders of record on November 8, 1993. All references herein to dividends paid, numbers of common shares, per share prices and earnings per share amounts have been restated to give retroactive effect to the First Stock Split and the Second Stock Split. The approximate number of holders of record of the Company's Common Stock as of March 4, 1994, is as follows: The Company paid a special, one-time $10 (retroactively adjusted for the First Stock Split and the Second Stock Split) per share dividend to its common stockholders on February 22, 1990. The Company does not presently intend to declare any other cash dividends. The terms of the Company's Bank Facility substantially limit the Company's ability to pay cash dividends on Common Stock and limitations are also contained in agreements covering other debt of the Company. See "Management's Discussion and Analysis--Intercompany Dividend Restriction" on page 9 of Book Two of the Annual Report and Note 6 to the financial statements on pages 16 and 17 of Book Two of the Annual Report, which pages are incorporated herein by reference. When permitted under the terms of the Bank Facility and the other debt, the declaration and payment of dividends is at the discretion of the Board of Directors of the Company. The Board of Directors of the Company intends to reevaluate its dividend policy in the future in light of the Company's results of operations, financial condition, cash requirements, future prospects and other factors deemed relevant by the Board of Directors. There can be no assurance that any cash dividends on Common Stock will be paid in the future. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. See the information for the years 1989 through 1993 set forth under "Selected Financial Data" in Book Two of the Annual Report on page 24, which page is incorporated herein by reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. See the information set forth in Book Two of the Annual Report on pages 2 through 9, which pages are incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. See the information set forth in Book Two of the Annual Report on pages 10 through 24, which pages are incorporated herein by reference. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. Not Applicable PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS. DIRECTORS See the information regarding the names, ages, positions and prior business experience of the directors of the Company set forth on pages 4 through 6 of the Proxy Statement, which pages are incorporated herein by reference. EXECUTIVE OFFICERS See "Executive Officers of the Registrant" on page 31 in Part I hereof. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. See the information set forth in the Proxy Statement on pages 6 and 7 thereof entitled "Compensation of Directors" and the information on pages 13 through 23 thereof. The information on pages 6 and 7 of the Proxy Statement entitled "Compensation of Directors" and the information on pages 18 through 23 of the Proxy Statement entitled "Summary Compensation Table," "Option Grants in the Last Fiscal Year," "Aggregated Option Exercises in 1993 and December 31, 1993, Option Values," and "Certain Employment Arrangements" are incorporated herein by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. See the information set forth in the Proxy Statement on page 3 thereof entitled "Share Ownership of Directors and Executive Officers" and on pages 24 and 25 thereof entitled "Certain Stockholders," which information on said pages is incorporated herein by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. See the information set forth in the Proxy Statement entitled "Certain Transactions" on pages 23 and 24 thereof, which information is incorporated herein by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a) 1. Financial statements (including related notes to consolidated financial statements)* filed as part of this report are listed below: Report of Independent Public Accountants Consolidated Balance Sheets as of December 31, 1993 and December 31, 1992. Consolidated Statements of Income for the Fiscal Years Ended December 31, 1993, December 31, 1992, and January 3, 1992. Consolidated Statements of Stockholders' Equity for the Fiscal Years Ended December 31, 1993, December 31, 1992, and January 3, 1992. Consolidated Statements of Cash Flows for the Fiscal Years Ended December 31, 1993, December 31, 1992, and January 3, 1992. - --------------- * Incorporated by reference from pages 10 through 23 of Book Two of the Annual Report. 2. Schedules for the fiscal years ended December 31, 1993, December 31, 1992, and January 3, 1992, are as follows: NO. - ----- II -Consolidated amounts receivable from related parties and underwriters, promoters, and employees other than related parties III -Condensed financial information of registrant V -Consolidated property and equipment VI -Consolidated accumulated depreciation and amortization of property and equipment VIII -Consolidated valuation and qualifying accounts X -Consolidated supplementary income statement information Schedules I, IV, VII, IX, XI, XII, XIII and XIV are not applicable and have therefore been omitted. 3. Exhibits (footnotes appear on pages 38 and 39): NO. - ------- 3(1) -Certificate of Incorporation of The Promus Companies Incorporated. (1) 3(2) -Bylaws of The Promus Companies Incorporated, as amended. (16) 4(1) -Rights Agreement dated as of February 7, 1990, between The Promus Companies Incorporated and The Bank of New York as Rights Agent. (12) 4(2) -Offering Circular dated February 9, 1988, for $200,000,000 Holiday Inns, Inc. 8 5/8% Notes due 1993 and $200,000,000 9% Notes due 1995; Indenture dated as of February 15, 1988, among Holiday Inns, Inc., Holiday Corporation and Sumitomo Bank of New York Trust Company, Trustee; Irrevocable Letter of Credit dated February 25, 1988, by The Sumitomo Bank, Limited, New York Branch. (3) 4(3) -Indenture Supplement No. 1 dated as of February 7, 1990, under Indenture dated as of February 15, 1988, among Holiday Inns, Inc., Holiday Corporation and Sumitomo Bank of New York Trust Company, Trustee; Amendment No. 1 dated February 7, 1990, to Irrevocable Letter of Credit dated February 25, 1988, by The Sumitomo Bank, Limited, New York Branch. (12) 4(4) -Indenture dated as of March 30, 1987, between Holiday Inns, Inc., Issuer, Holiday Corporation, Guarantor, and Commerce Union Bank (now Sovran Bank/Central South), Trustee; Prospectus dated March 5, 1987, for $900,000,000 Holiday Inns, Inc. 10 1/2% Senior Notes due 1994. (4) 4(5) -First Supplemental Indenture dated as of January 12, 1990, with respect to the 10 1/2% Senior Notes due 1994, among Sovran Bank/Central South, as trustee, Holiday Corporation, as guarantor, The Promus Companies Incorporated and Holiday Inns, Inc., as issuer; Second Supplemental Indenture dated as of February 7, 1990, with respect to the 10 1/2% Senior Notes due 1994, among Holiday Inns, Inc., Holiday Corporation, Embassy Suites, Inc., The Promus Companies Incorporated and Sovran Bank/Central South; Form of Note for 10 1/2% Senior Notes due 1994. (12) 4(6) -Indenture dated as of March 30, 1987, between Holiday Inns, Inc., Issuer, Holiday Corporation, Guarantor, and LaSalle National Bank, Trustee; Prospectus dated March 5, 1987, for $500,000,000 Holiday Inns, Inc. 11% Subordinated Debentures due 1999. (5) 4(7) -First Supplemental Indenture dated as of January 8, 1988, under Indenture dated as of March 30, 1987, among Holiday Inns, Inc., Holiday Corporation and LaSalle National Bank. (3) 4(8) -Second Supplemental Indenture dated as of February 23, 1988, under Indenture dated as of March 30, 1987, among Holiday Inns, Inc., Holiday Corporation, Guarantor, and LaSalle National Bank. (3) NO. - ------- 4(9) -Third Supplemental Indenture dated as of January 17, 1990, with respect to the 11% Subordinated Debentures due 1999, among LaSalle National Bank, as trustee, Holiday Corporation, as guarantor, The Promus Companies Incorporated and Holiday Inns, Inc., as issuer; Fourth Supplemental Indenture dated as of February 7, 1990, with respect to the 11% Subordinated Debentures due 1999, among Holiday Inns, Inc., Holiday Corporation, Embassy Suites, Inc., The Promus Companies Incorporated and LaSalle National Bank; Form of Debenture for 11% Subordinated Debentures due 1999. (12) 4(10) -Letter to Bank of New York dated March 18, 1993 constituting Certificate under Section 12 of the Rights Agreement dated as of February 7, 1990. (11) 4(11) -Interest Swap Agreement between Bank of America National Trust and Savings Association and Embassy Suites, Inc. dated May 14, 1993. (6) 4(12) -Interest Swap Agreement between NationsBank of North Carolina, N.A. and Embassy Suites, Inc. dated May 18, 1993. (6) 4(13) -First Supplemental Indenture dated as of July 15, 1987, among Irving Trust Company, as resigning trustee with respect to the 1999 Notes, Indiana National Bank as successor trustee with respect to the 1999 Notes and Holiday Inns, Inc.; Second Supplemental Indenture dated as of January 8, 1988, under Indenture dated as of January 15, 1984, between Holiday Inns, Inc., and Irving Trust Company, as trustee with respect to 8 3/8% Notes due 1996; Third Supplemental Indenture dated as of January 8, 1988, under Indenture dated as of January 15, 1984, among Holiday Inns, Inc., Irving Trust Company, as resigning trustee with respect to the 8 3/8% Notes due 1996, and LaSalle National Bank as successor trustee with respect to the 8 3/8% Notes due 1996; Fourth Supplemental Indenture dated as of February 23, 1988, under Indenture dated as of January 15, 1984, between Holiday Inns, Inc. and LaSalle National Bank, as trustee with respect to the 8 3/8% Notes due 1996. (3) 4(14) -Fifth Supplemental Indenture dated as of January 23, 1990, with respect to the 8 3/8% Notes due 1996, among LaSalle National Bank, as trustee, The Promus Companies Incorporated and Holiday Inns, Inc., as issuer; Sixth Supplemental Indenture dated as of February 7, 1990, with respect to the 8 3/8% Notes due 1996, among Holiday Inns, Inc., Embassy Suites, Inc., The Promus Companies Incorporated and LaSalle National Bank; Form of Note for 8 3/8% Notes due 1996. (12) 4(15) -Indenture dated as of April 1, 1992, with respect to the 10 7/8% Senior Subordinated Notes due 2002, among The Bank of New York, as trustee, The Promus Companies Incorporated, as guarantor, and Embassy Suites, Inc., as issuer; Form of Note for 10 7/8% Senior Subordinated Notes due 2002. (18) 4(16) -Indenture dated as of August 1, 1993, with respect to the 8 3/4% Senior Subordinated Notes due 2000, among The Bank of New York, as trustee, The Promus Companies Incorporated, as guarantor, and Embassy Suites, Inc., as issuer; Form of Note for 8 3/4% Senior Subordinated Notes due 2000. (6) 4(17) -Interest Swap Agreement between The Sumitomo Bank, Limited and Embassy Suites, Inc. dated October 22, 1992; Interest Swap Agreement between The Bank of Nova Scotia and Embassy Suites, Inc. dated October 22, 1992; Interest Swap Agreement between The Nippon Credit Bank and Embassy Suites, Inc. dated October 22, 1992; (18) 10(1) -Amended and Restated Agreement and Plan of Merger among Holiday Corporation, Holiday Inns, Inc., The Promus Companies Incorporated, Bass plc, Bass (U.S.A.) Hotels, Incorporated (a Delaware corporation) and Bass (U.S.A.) Hotels, Incorporated (a Tennessee corporation), dated as of August 24, 1989. (1) 10(2) -First Amendment to the Amended and Restated Agreement and Plan of Merger among Holiday Corporation, Holiday Inns, Inc., The Promus Companies Incorporated, Bass plc and Bass (U.S.A.) Hotels, Incorporated, dated as of February 7, 1990. (2) 10(3) -Tax Sharing Agreement dated as of February 7, 1990, among Holiday Corporation, Holiday Inns, Inc., The Promus Companies Incorporated, Bass plc, Bass European Holdings, N.V., Bass (U.S.A.), Inc. and Bass (U.S.A.) Hotels, Incorporated. (12) +10(4) -Form of Indemnification Agreement entered into by The Promus Companies Incorporated and each of its directors and executive officers. (1) +10(5) -The Promus Companies Incorporated 1990 Stock Option Plan. (12) - --------------- + Management contract or compensatory plan or arrangement required to be filed as an exhibit to this form pursuant to Item 14(a)(3) of Form 10-K. NO. - ------- +10(6) -The Promus Companies Incorporated 1990 Restricted Stock Plan. (12) +10(7) -The Promus Companies Incorporated Savings and Retirement Plan Trust Agreement. (12) +10(8) -Amendment to The Promus Companies Incorporated Savings and Retirement Plan dated May 1, 1991. (15) +10(9) -Financial Counseling Plan of The Promus Companies Incorporated as amended February 25, 1993. (11) +10(10) -Form of Severance Agreement dated July 30, 1993, entered into with E. O. Robinson, Jr. and John M. Boushy. (22) 10(11) -Credit Agreement, dated as of July 22, 1993, among Embassy Suites, Inc., The Promus Companies Incorporated, the Banks parties thereto, Marina Associates and Bankers Trust Company, as Administrative Agent. (19) 10(12) -Amended and Restated Reimbursement Agreement, dated as of July 22, 1993, among Embassy Suites, Inc., The Promus Companies Incorporated, Marina Associates and The Sumitomo Bank, Limited, New York Branch. (19) 10(13) -Master Collateral Agreement, dated as of July 22, 1993, among The Promus Companies Incorporated, Embassy Suites, Inc., the other Collateral Grantors parties thereto, Bankers Trust Company, as Administrative Agent, and Bankers Trust Company as Collateral Agent. (19) 10(14) -Security Agreement dated as of July 22, 1993, among Embassy Suites, Inc., the Collateral Grantors parties thereto and Bankers Trust Company, as Collateral Agent. (19) 10(15) -Deed of Trust, Leasehold Deed of Trust, Assignment, Assignment of Leases and Rents, Security Agreement and Financing Statement, dated as of July 22, 1993, from Embassy Suites, Inc., Harrah's Laughlin, Inc., and Harrah's Reno Holding Company, Inc., the Grantors, to First American Title Company of Nevada, as Trustee, for the benefit of Bankers Trust Company, as Beneficiary. (19) 10(16) -Mortgage, Leasehold Mortgage, Assignment, Assignment of Leases and Rents and Security Agreement, dated as of July 22, 1993, from Marina Associates and Embassy Suites, Inc., the Mortgagors, to Bankers Trust Company, as Collateral Agent and the Mortgagee. (19) 10(17) -Pledge Agreement, dated as of July 22, 1993, between The Promus Companies Incorporated and Bankers Trust Company, as Collateral Agent. (19) 10(18) -Pledge Agreement, dated as of July 22, 1993, among Embassy Suites, Inc., ESI Equity Development Corporation, Harrah's, Harrah's Club, Casino Holding Company, and Bankers Trust Company, as the General Collateral Agent, and Bank of America Nevada as the Nevada Collateral Agent. (19) 10(19) -Form of License Agreement for Hampton Inns. (7) 10(20) -Form of License Agreement for Hampton Inns revised 1988. (8) 10(21) -Form of License Agreement for Hampton Inns revised 1991. (15) 10(22) -Form of License Agreement for Hampton Inns revised 1992. (18) 10(23) -Form of License Agreement for Embassy Suites. (9) 10(24) -Form of License Agreement for Embassy Suites revised 1989. (12) 10(25) -Form of License Agreement for Embassy Suites revised 1990. (13) 10(26) -Form of License Agreement for Embassy Suites revised 1991. (15) 10(27) -Form of License Agreement for Embassy Suites revised 1992. (18) 10(28) -Form of Short-Term License Agreement for Embassy Suites. (12) 10(29) -Form of Short-Term License Agreement for Embassy Suites revised 1990. (13) 10(30) -Form of Short-Term License Agreement for Embassy Suites revised 1991. (15) 10(31) -Form of Short-Term License Agreement for Embassy Suites revised 1992. (18) 10(32) -Form of License Agreement for Homewood Suites. (3) 10(33) -Form of License Agreement for Homewood Suites revised 1992. (18) - --------------- + Management contract or compensatory plan or arrangement required to be filed as an exhibit to this form pursuant to Item 14(a)(3) of Form 10-K. NO. - ------- **10(34) -Form of License Agreement for Homewood Suites revised 1993. **10(35) -Form of License Agreement for Embassy Suites revised 1993. **10(36) -Form of Short-Term License Agreement for Embassy Suites revised 1993. **10(37) -Form of License Agreement for Hampton Inns revised 1993. **10(38) -Form of License Agreement for Hampton Inn & Suites. 10(39) -Management Agreement dated as of December 17, 1986, between Hampton Inns, Inc. and Hampton/GHI Associates No. 1. (10) 10(40) -Form of Management Agreement between Embassy Suites, Inc. and affiliates of General Electric Pension Trust. (10) +10(41) -Employment Agreement dated August 1, 1987 between Holiday Corporation and Michael D. Rose; Amendment to Employment Agreement dated as of January 31, 1990 between The Promus Companies Incorporated and Michael D. Rose. (12) +10(42) -Amended and Restated Severance Agreement dated as of May 1, 1992 between The Promus Companies Incorporated and Michael D. Rose. (18) +10(43) -Summary Plan Description of Executive Term Life Insurance Plan. (18) +10(44) -Forms of Stock Option (1990 Stock Option Plan). (12) +10(45) -Revised Forms of Stock Option (1990 Stock Option Plan). (18) +10(46) -Form of The Promus Companies Incorporated's Annual Bonus Plan, as amended, for Managers and Executives. (13) +10(47) -Forms of Restricted Stock Award (1990 Restricted Stock Plan). (12) +10(48) -Deferred Compensation Plan dated October 16, 1991. (15) +10(49) -Form of Deferred Compensation Agreement. (12) +10(50) -Form of Deferred Compensation Agreement revised November 1991. (15) +10(51) -Executive Deferred Compensation Plan. (12) +10(52) -First Amendment to Executive Deferred Compensation Plan, dated as of October 25, 1990. (13) +10(53) -Second Amendment to Executive Deferred Compensation Plan, dated as of October 25, 1991. (15) +10(54) -Third Amendment to Executive Deferred Compensation Plan, dated as of October 29, 1992. (18) +10(55) -Forms of Restricted Stock Award (1990 Restricted Stock Plan). (18) +10(56) -First Amendment to Escrow Agreement dated January 31, 1990 among Holiday Corporation, certain subsidiaries thereof and Sovran Bank, as escrow agent. (12) +10(57) -Escrow Agreement dated February 6, 1990 between The Promus Companies Incorporated, certain subsidiaries thereof, and Sovran Bank, as escrow agent. (12) +10(58) -Form of Amended and Restated Severance Agreement dated November 5, 1992, entered into with Charles A. Ledsinger, Jr., Ben C. Peternell, Philip G. Satre and Colin V. Reed. (18) +10(59) -Form of memorandum agreement dated July 2, 1991, eliminating stock appreciation rights under stock options held by Charles A. Ledsinger, Jr., Ben C. Peternell and Philip G. Satre. (14) +10(60) -The Promus Companies Incorporated Amended and Restated Savings and Retirement Plan dated as of February 6, 1990. (18) +10(61) -Administrative Regulations, Long Term Compensation Plan (Restricted Stock Plan and Stock Option Plan), dated as of January 1, 1992. (17) +10(62) -Amendment dated October 29, 1992 to The Promus Companies Incorporated Savings and Retirement Plan Trust Agreement; Amendment dated September 21, 1992 to The Promus Companies Incorporated Savings and Retirement Plan Trust Agreement (18) +10(63) -Revised Form of Stock Option. (21) +10(64) -The Promus Companies Incorporated 1990 Stock Option Plan (as amended as of April 30, 1993). (20) - --------------- ** Filed herewith + Management contract or compensatory plan or arrangement required to be filed as an exhibit to this form pursuant to Item 14(a)(3) of Form 10-K. NO. - ------- **10(65)-Limited Partnership Agreement of Des Plaines Limited Partnership between Harrah's Illinois Corporation and John Q. Hammons, dated February 28, 1992; First Amendment to Limited Partnership Agreement of Des Plaines Limited Partnership dated as of October 5, 1992. +**10(66)-Amendment to Escrow Agreement dated as of October 29, 1993 among The Promus Companies Incorporated, certain subsidiaries thereof, and NationsBank, formerly Sovran Bank. **10(67)-Amended and Restated Partnership Agreement of Harrah's Jazz Company, dated as of March 15, 1994, among Harrah's New Orleans Investment Company, New Orleans/Louisiana Development Corporation and Grand Palais Casino, Inc.; First Amendment to the Amended and Restated Partnership Agreement of Harrah's Jazz Company, effective as of March 15, 1994. 10(68) -Form of Rivergate Ground Lease by and among Harrah's Jazz Company, Rivergate Development Corporation and the City of New Orleans. (23) 10(69) -Form of General Development Agreement among Harrah's Jazz Company, Rivergate Development Corporation and the City of New Orleans. (23) 10(70) -Form of Temporary Casino Lease by and among Harrah's Jazz Company, Rivergate Development Corporation and the City of New Orleans. (23) 10(71) -Form of Casino Management Agreement between Harrah's Jazz Company and Harrah's New Orleans Management Company. (23) **11 -Computations of per share earnings. **12 -Computations of ratios. **13 -Portions of Annual Report to Stockholders for the fiscal year ended December 31, 1993. (24) **21 -List of subsidiaries of The Promus Companies Incorporated. 99(1) -Proxy Statement--Information Statement--Prospectus dated December 13, 1989 of Holiday Corporation, The Promus Companies Incorporated and Bass Public Limited Company. (12) - --------------- ** Filed herewith + Management contract or compensatory plan or arrangement required to be filed as an exhibit to this form pursuant to Item 14(a)(3) of Form 10-K. FOOTNOTES (1) Incorporated by reference from the Company's Registration Statement on Form 10, File No. 1-10410, filed on December 13, 1989. (2) Incorporated by reference from the Company's Current Report on Form 8-K dated February 16, 1990, File No. 1-10410. (3) Incorporated by reference from Holiday Corporation's Annual Report on Form 10-K for the fiscal year ended January 1, 1988, filed March 31, 1988, File No. 1-8900. (4) Incorporated by reference from Holiday Inns, Inc.'s Registration Statement on Form S-3, File No. 33-11770, filed February 24, 1987. (5) Incorporated by reference from Holiday Inns, Inc's Registration Statement on Form S-3, File No. 33-11163, filed December 31, 1986. (6) Incorporated by reference from the Company's and Embassy Suites, Inc.'s Amendment No. 2 to Form S-4 Registration Statement, File No. 33-49509-01, filed July 16, 1993. (7) Incorporated by reference from Holiday Inns, Inc.'s Annual Report on Form 10-K for the fiscal year ended December 30, 1983, filed March 21, 1984, File No. 1-4804. (8) Incorporated by reference from Holiday Corporation's Annual Report on Form 10-K for the fiscal year ended December 30, 1988, filed March 30, 1989, File No. 1-8900. (9) Incorporated by reference from Holiday Corporation's Annual Report on Form 10-K for the fiscal year ended January 3, 1986, filed March 28, 1986, File No. 1-8900. (10) Incorporated by reference from Holiday Corporation's Annual Report on Form 10-K for the fiscal year ended January 2, 1987, filed March 27, 1987, File No. 1-8900. (11) Incorporated by reference from the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1993, filed May 13, 1993, File No. 1-10410. (12) Incorporated by reference from the Company's Annual Report on Form 10-K for the fiscal year ended December 29, 1989, filed March 28, 1990, File No. 1-10410. (13) Incorporated by reference from the Company's Annual Report on Form 10-K for the fiscal year ended December 28, 1990, filed March 21, 1991, File No. 1-10410. (14) Incorporated by reference from the Company's Quarterly Report on Form 10-Q for the quarter ended September 27, 1991, filed November 8, 1991, File No. 1-10410. (15) Incorporated by reference from Amendment No. 2 to the Company's and Embassy's Registration Statement on Form S-1, file No. 33-43748, filed March 18, 1992. (16) Incorporated by reference from the Company's Annual Report on Form 10-K for the fiscal year ended January 3, 1992, filed March 26, 1992, File No. 1-10410. (17) Incorporated by reference from the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1992, filed May 13, 1992, File No. 1-10410. (18) Incorporated by reference from the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1992, filed March 12, 1993, File No. 1-10410. (19) Incorporated by reference from the Company's Current Report on Form 8-K filed August 6, 1993, File No. 1-10410. (20) Incorporated by reference from Post-Effective Amendment No. 1 to the Company's Form S-8 Registration Statement, File No. 33-32864-01, filed July 22, 1993. (21) Incorporated by reference from the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993, filed August 12, 1993, File No. 1-10410. (22) Incorporated by reference from the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993, filed November 12, 1993, File No. 1-10410. (23) Incorporated by reference from Amendment No. 1 to Form S-1 Registration Statement of Harrah's Jazz Company and Harrah's Jazz Finance Corp., File No. 33-73370, filed February 22, 1994. (24) Filed herewith to the extent provisions of such report are specifically incorporated herein by reference. (b) The following Reports on Form 8-K were filed during the fourth quarter of 1993 and thereafter through March 24, 1994: NONE SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 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. THE PROMUS COMPANIES INCORPORATED Dated: March 28, 1994 By: MICHAEL D. ROSE .................................. (Michael D. Rose, Chairman and Chief Executive 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 IN THE CAPACITIES AND ON THE DATES INDICATED. Signature Title Date - ------------------------------------- ------------------------ -------------- JAMES L. BARKSDALE Director March 28, 1994 ..................................... (James L. Barksdale) JAMES B. FARLEY Director March 28, 1994 ..................................... (James B. Farley) JOE M. HENSON Director March 28, 1994 ..................................... (Joe M. Henson) MICHAEL D. ROSE Director and Chief March 28, 1994 ..................................... Executive Officer (Michael D. Rose) WALTER J. SALMON Director March 28, 1994 ..................................... (Walter J. Salmon) PHILIP G. SATRE Director, President and March 28, 1994 ..................................... Chief Operating (Philip G. Satre) Officer BOAKE A. SELLS Director March 28, 1994 ..................................... (Boake A. Sells) RONALD TERRY Director March 28, 1994 ..................................... (Ronald Terry) EDDIE N. WILLIAMS Director March 28, 1994 ..................................... (Eddie N. Williams) SHIRLEY YOUNG Director March 28, 1994 ..................................... (Shirley Young) CHARLES A. LEDSINGER, JR. Chief Financial Officer March 28, 1994 ..................................... (Charles A. Ledsinger, Jr.) MICHAEL N. REGAN Controller and Principal March 28, 1994 ..................................... Accounting Officer (Michael N. Regan) REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To The Promus Companies Incorporated: We have audited in accordance with generally accepted auditing standards, the financial statements included in The Promus Companies Incorporated 1993 annual report to stockholders, incorporated by reference in this Form 10-K, and have issued our report thereon dated February 8, 1994. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed under Item 14(a)2 on page 34 are the responsibility of the Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audit of the basic financial statements, and in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN & CO. Memphis, Tennessee, February 8, 1994. SCHEDULE II THE PROMUS COMPANIES INCORPORATED CONSOLIDATED AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES S-1 SCHEDULE III THE PROMUS COMPANIES INCORPORATED CONDENSED FINANCIAL INFORMATION OF REGISTRANT BALANCE SHEETS (IN THOUSANDS) The accompanying Notes to Financial Statements are an integral part of these balance sheets. S-2 SCHEDULE III (CONTINUED) THE PROMUS COMPANIES INCORPORATED CONDENSED FINANCIAL INFORMATION OF REGISTRANT STATEMENTS OF INCOME (IN THOUSANDS) The accompanying Notes to Financial Statements are an integral part of these statements. S-3 SCHEDULE III (CONTINUED) THE PROMUS COMPANIES INCORPORATED CONDENSED FINANCIAL INFORMATION OF REGISTRANT STATEMENTS OF CASH FLOWS (IN THOUSANDS) The accompanying Notes to Financial Statements are an integral part of these statements. S-4 SCHEDULE III (CONTINUED) THE PROMUS COMPANIES INCORPORATED CONDENSED FINANCIAL INFORMATION OF REGISTRANT NOTES TO FINANCIAL STATEMENTS DECEMBER 31, 1993 NOTE 1--BASIS OF ORGANIZATION The Promus Companies Incorporated (Promus), a Delaware corporation, is a holding company, the principal assets of which are the capital stock of two subsidiaries, Embassy Suites, Inc. (Embassy) and Aster Insurance Ltd. (Aster). These condensed financial statements should be read in conjunction with the consolidated financial statements of Promus and subsidiaries. NOTE 2--FISCAL YEAR As of the beginning of fiscal 1992, Promus changed from a fiscal year to a calendar year for financial reporting purposes. The impact of this change on Promus' financial statements was immaterial. NOTE 3--ORGANIZATIONAL COSTS Organizational costs are being amortized on a straight-line basis over a five year period. NOTE 4--OWNERSHIP OF ASTER The value of Promus' investment in Aster has been reduced below zero. Promus' negative investment in Aster at December 31, 1993 and 1992 was $12.8 million and $10.9 million, respectively, and is included in investments in and advances to subsidiaries on the accompanying balance sheets. In addition, Promus has guaranteed the future payment by Aster of certain insurance-related liabilities. NOTE 5--LONG-TERM DEBT Promus has no long-term debt obligations. Promus has guaranteed certain long-term debt obligations of Embassy. NOTE 6--STOCKHOLDERS' EQUITY On October 29, 1993, Promus' Board of Directors approved a three-for-two stock split (the October split), in the form of a stock dividend, effected by a distribution on November 29, 1993, of one additional share for each two shares owned by stockholders of record on November 8, 1993. The October split followed a two-for-one split, also effected as a stock dividend, approved by the Board on February 26, 1993, and distributed on March 29, 1993. The $1.50 par value per share of Promus' common stock was unchanged by these splits. The par value of the additional shares issued as a result of these splits was capitalized into common stock on the accompanying balance sheets by means of a transfer from capital surplus. All references in these financial statements to numbers of common shares and earnings per share have been restated to give retroactive effect to both stock splits. During the second quarter of 1993, Sodak Gaming, Inc. (Sodak), in which a subsidiary of Embassy owns an equity investment, completed an initial public offering of its common stock. As required by equity accounting rules, Embassy's subsidiary increased the carrying value of its investment in Sodak by an amount equal to its pro rata share of the proceeds of Sodak's offering, approximately $6.4 million. A corresponding increase was recorded in the combination of the subsidary's capital surplus and S-5 SCHEDULE III (CONTINUED) THE PROMUS COMPANIES INCORPORATED CONDENSED FINANCIAL INFORMATION OF REGISTRANT NOTES TO FINANCIAL STATEMENTS DECEMBER 31, 1993 NOTE 6--STOCKHOLDERS' EQUITY (CONTINUED) deferred income tax liability accounts. As a result of this activity, Promus increased its investment in Embassy and its capital surplus by approximately $3.8 million. In addition to its common stock, Promus has the following classes of stock authorized but unissued: Preferred stock, $100 par value, 150,000 shares authorized Special stock, 5,000,000 shares authorized- Series B, $1.125 par value NOTE 7--INCOME TAXES Promus files a consolidated tax return with its subsidiaries. During 1992, Promus and its subsidiaries adopted Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes. The provisions of the statement were applied retroactively to the Spin-off date (February 7, 1990), and the cumulative effect of this change in accounting for income taxes of approximately $9.5 million was charged against stockholders' equity. There were no changes in the amounts of previously reported income from continuing operations or net income resulting from the application of this statement. NOTE 8--EXTRAORDINARY ITEMS Promus' equity in Embassy's net extraordinary items for fiscal 1993 and 1992 was as follows: S-6 SCHEDULE V THE PROMUS COMPANIES INCORPORATED CONSOLIDATED PROPERTY AND EQUIPMENT - --------------- (A) Principally construction of new casino facilities and refurbishment of existing casino and hotel properties, including transfers from construction-in-progress. (B) Land held for future development or disposition is included in property held for future use and amounted to $42.1 million, net of an $11.0 million reserve for property dispositions. S-7 SCHEDULE V (CONTINUED) THE PROMUS COMPANIES INCORPORATED CONSOLIDATED PROPERTY AND EQUIPMENT - --------------- (A) Principally refurbishment and expansion of casino and hotel properties, including transfers from construction-in-progress. (B) Land held for future development or disposition is included in property held for future use and amounted to $41.4 million, which is net of an $11.0 million reserve for property dispositions. S-8 SCHEDULE V (CONTINUED) THE PROMUS COMPANIES INCORPORATED CONSOLIDATED PROPERTY AND EQUIPMENT - --------------- (A) Principally refurbishment and expansion of casino and hotel properties, including transfers from construction-in-progress. (B) Principally transfers from deferred charges of $7.8 million, partially offset by the transfer to investments in nonconsolidated affiliates of $1.0 million in assets contributed to a joint venture. (C) Land held for future development or disposition is included in property held for future use and amounted to $41.4 million, which is net of an $11.0 million reserve for property dispositions. S-9 SCHEDULE VI THE PROMUS COMPANIES INCORPORATED CONSOLIDATED ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY AND EQUIPMENT S-10 SCHEDULE VIII THE PROMUS COMPANIES INCORPORATED CONSOLIDATED VALUATION AND QUALIFYING ACCOUNTS - --------------- (A) Uncollectible accounts written off, net of amounts recovered. (B) Amortization of reserve balance. (C) Write-off at time of property dispositions. S-11 SCHEDULE X THE PROMUS COMPANIES INCORPORATED CONSOLIDATED SUPPLEMENTARY INCOME STATEMENT INFORMATION S-12 CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our reports dated February 8, 1994, included in or incorporated by reference in this Form 10-K for the year ended December 31, 1993, into the Company's previously filed Registration Statements File Nos. 33-32863, 33-32864 and 33-32865. ARTHUR ANDERSEN & CO. Memphis, Tennessee, March 28, 1994. EXHIBIT INDEX NO. - ------- 3(1) -Certificate of Incorporation of The Promus Companies Incorporated. (1) 3(2) -Bylaws of The Promus Companies Incorporated, as amended. (16) 4(1) -Rights Agreement dated as of February 7, 1990, between The Promus Companies Incorporated and The Bank of New York as Rights Agent. (12) 4(2) -Offering Circular dated February 9, 1988, for $200,000,000 Holiday Inns, Inc. 8 5/8% Notes due 1993 and $200,000,000 9% Notes due 1995; Indenture dated as of February 15, 1988, among Holiday Inns, Inc., Holiday Corporation and Sumitomo Bank of New York Trust Company, Trustee; Irrevocable Letter of Credit dated February 25, 1988, by The Sumitomo Bank, Limited, New York Branch. (3) 4(3) -Indenture Supplement No. 1 dated as of February 7, 1990, under Indenture dated as of February 15, 1988, among Holiday Inns, Inc., Holiday Corporation and Sumitomo Bank of New York Trust Company, Trustee; Amendment No. 1 dated February 7, 1990, to Irrevocable Letter of Credit dated February 25, 1988, by The Sumitomo Bank, Limited, New York Branch. (12) 4(4) -Indenture dated as of March 30, 1987, between Holiday Inns, Inc., Issuer, Holiday Corporation, Guarantor, and Commerce Union Bank (now Sovran Bank/Central South), Trustee; Prospectus dated March 5, 1987, for $900,000,000 Holiday Inns, Inc. 10 1/2% Senior Notes due 1994. (4) 4(5) -First Supplemental Indenture dated as of January 12, 1990, with respect to the 10 1/2% Senior Notes due 1994, among Sovran Bank/Central South, as trustee, Holiday Corporation, as guarantor, The Promus Companies Incorporated and Holiday Inns, Inc., as issuer; Second Supplemental Indenture dated as of February 7, 1990, with respect to the 10 1/2% Senior Notes due 1994, among Holiday Inns, Inc., Holiday Corporation, Embassy Suites, Inc., The Promus Companies Incorporated and Sovran Bank/Central South; Form of Note for 10 1/2% Senior Notes due 1994. (12) 4(6) -Indenture dated as of March 30, 1987, between Holiday Inns, Inc., Issuer, Holiday Corporation, Guarantor, and LaSalle National Bank, Trustee; Prospectus dated March 5, 1987, for $500,000,000 Holiday Inns, Inc. 11% Subordinated Debentures due 1999. (5) 4(7) -First Supplemental Indenture dated as of January 8, 1988, under Indenture dated as of March 30, 1987, among Holiday Inns, Inc., Holiday Corporation and LaSalle National Bank. (3) 4(8) -Second Supplemental Indenture dated as of February 23, 1988, under Indenture dated as of March 30, 1987, among Holiday Inns, Inc., Holiday Corporation, Guarantor, and LaSalle National Bank. (3) 4(9) -Third Supplemental Indenture dated as of January 17, 1990, with respect to the 11% Subordinated Debentures due 1999, among LaSalle National Bank, as trustee, Holiday Corporation, as guarantor, The Promus Companies Incorporated and Holiday Inns, Inc., as issuer; Fourth Supplemental Indenture dated as of February 7, 1990, with respect to the 11% Subordinated Debentures due 1999, among Holiday Inns, Inc., Holiday Corporation, Embassy Suites, Inc., The Promus Companies Incorporated and LaSalle National Bank; Form of Debenture for 11% Subordinated Debentures due 1999. (12) 4(10) -Letter to Bank of New York dated March 18, 1993 constituting Certificate under Section 12 of the Rights Agreement dated as of February 7, 1990. (11) 4(11) -Interest Swap Agreement between Bank of America National Trust and Savings Association and Embassy Suites, Inc. dated May 14, 1993. (6) 4(12) -Interest Swap Agreement between NationsBank of North Carolina, N.A. and Embassy Suites, Inc. dated May 18, 1993. (6) NO. - ------- 4(13) -First Supplemental Indenture dated as of July 15, 1987, among Irving Trust Company, as resigning trustee with respect to the 1999 Notes, Indiana National Bank as successor trustee with respect to the 1999 Notes and Holiday Inns, Inc.; Second Supplemental Indenture dated as of January 8, 1988, under Indenture dated as of January 15, 1984, between Holiday Inns, Inc., and Irving Trust Company, as trustee with respect to 8 3/8% Notes due 1996; Third Supplemental Indenture dated as of January 8, 1988, under Indenture dated as of January 15, 1984, among Holiday Inns, Inc., Irving Trust Company, as resigning trustee with respect to the 8 3/8% Notes due 1996, and LaSalle National Bank as successor trustee with respect to the 8 3/8% Notes due 1996; Fourth Supplemental Indenture dated as of February 23, 1988, under Indenture dated as of January 15, 1984, between Holiday Inns, Inc. and LaSalle National Bank, as trustee with respect to the 8 3/8% Notes due 1996. (3) 4(14) -Fifth Supplemental Indenture dated as of January 23, 1990, with respect to the 8 3/8% Notes due 1996, among LaSalle National Bank, as trustee, The Promus Companies Incorporated and Holiday Inns, Inc., as issuer; Sixth Supplemental Indenture dated as of February 7, 1990, with respect to the 8 3/8% Notes due 1996, among Holiday Inns, Inc., Embassy Suites, Inc., The Promus Companies Incorporated and LaSalle National Bank; Form of Note for 8 3/8% Notes due 1996. (12) 4(15) -Indenture dated as of April 1, 1992, with respect to the 10 7/8% Senior Subordinated Notes due 2002, among The Bank of New York, as trustee, The Promus Companies Incorporated, as guarantor, and Embassy Suites, Inc., as issuer; Form of Note for 10 7/8% Senior Subordinated Notes due 2002. (18) 4(16) -Indenture dated as of August 1, 1993, with respect to the 8 3/4% Senior Subordinated Notes due 2000, among The Bank of New York, as trustee, The Promus Companies Incorporated, as guarantor, and Embassy Suites, Inc., as issuer; Form of Note for 8 3/4% Senior Subordinated Notes due 2000. (6) 4(17) -Interest Swap Agreement between The Sumitomo Bank, Limited and Embassy Suites, Inc. dated October 22, 1992; Interest Swap Agreement between The Bank of Nova Scotia and Embassy Suites, Inc. dated October 22, 1992; Interest Swap Agreement between The Nippon Credit Bank and Embassy Suites, Inc. dated October 22, 1992; (18) 10(1) -Amended and Restated Agreement and Plan of Merger among Holiday Corporation, Holiday Inns, Inc., The Promus Companies Incorporated, Bass plc, Bass (U.S.A.) Hotels, Incorporated (a Delaware corporation) and Bass (U.S.A.) Hotels, Incorporated (a Tennessee corporation), dated as of August 24, 1989. (1) 10(2) -First Amendment to the Amended and Restated Agreement and Plan of Merger among Holiday Corporation, Holiday Inns, Inc., The Promus Companies Incorporated, Bass plc and Bass (U.S.A.) Hotels, Incorporated, dated as of February 7, 1990. (2) 10(3) -Tax Sharing Agreement dated as of February 7, 1990, among Holiday Corporation, Holiday Inns, Inc., The Promus Companies Incorporated, Bass plc, Bass European Holdings, N.V., Bass (U.S.A.), Inc. and Bass (U.S.A.) Hotels, Incorporated. (12) 10(4) -Form of Indemnification Agreement entered into by The Promus Companies Incorporated and each of its directors and executive officers. (1) 10(5) -The Promus Companies Incorporated 1990 Stock Option Plan. (12) 10(6) -The Promus Companies Incorporated 1990 Restricted Stock Plan. (12) 10(7) -The Promus Companies Incorporated Savings and Retirement Plan Trust Agreement. (12) 10(8) -Amendment to The Promus Companies Incorporated Savings and Retirement Plan dated May 1, 1991. (15) NO. - ------- +10(9) -Financial Counseling Plan of The Promus Companies Incorporated as amended February 25, 1993. (11) +10(10) -Form of Severance Agreement dated July 30, 1993, entered into with E. O. Robinson, Jr. and John M. Boushy. (22) 10(11) -Credit Agreement, dated as of July 22, 1993, among Embassy Suites, Inc., The Promus Companies Incorporated, the Banks parties thereto, Marina Associates and Bankers Trust Company, as Administrative Agent. (19) 10(12) -Amended and Restated Reimbursement Agreement, dated as of July 22, 1993, among Embassy Suites, Inc., The Promus Companies Incorporated, Marina Associates and The Sumitomo Bank, Limited, New York Branch. (19) 10(13) -Master Collateral Agreement, dated as of July 22, 1993, among The Promus Companies Incorporated, Embassy Suites, Inc., the other Collateral Grantors parties thereto, Bankers Trust Company, as Administrative Agent, and Bankers Trust Company as Collateral Agent. (19) 10(14) -Security Agreement dated as of July 22, 1993, among Embassy Suites, Inc., the Collateral Grantors parties thereto and Bankers Trust Company, as Collateral Agent. (19) 10(15) -Deed of Trust, Leasehold Deed of Trust, Assignment, Assignment of Leases and Rents, Security Agreement and Financing Statement, dated as of July 22, 1993, from Embassy Suites, Inc., Harrah's Laughlin, Inc., and Harrah's Reno Holding Company, Inc., the Grantors, to First American Title Company of Nevada, as Trustee, for the benefit of Bankers Trust Company, as Beneficiary. (19) 10(16) -Mortgage, Leasehold Mortgage, Assignment, Assignment of Leases and Rents and Security Agreement, dated as of July 22, 1993, from Marina Associates and Embassy Suites, Inc., the Mortgagors, to Bankers Trust Company, as Collateral Agent and the Mortgagee. (19) 10(17) -Pledge Agreement, dated as of July 22, 1993, between The Promus Companies Incorporated and Bankers Trust Company, as Collateral Agent. (19) 10(18) -Pledge Agreement, dated as of July 22, 1993, among Embassy Suites, Inc., ESI Equity Development Corporation, Harrah's, Harrah's Club, Casino Holding Company, and Bankers Trust Company, as the General Collateral Agent, and Bank of America Nevada as the Nevada Collateral Agent. (19) 10(19) -Form of License Agreement for Hampton Inns. (7) 10(20) -Form of License Agreement for Hampton Inns revised 1988. (8) 10(21) -Form of License Agreement for Hampton Inns revised 1991. (15) 10(22) -Form of License Agreement for Hampton Inns revised 1992. (18) 10(23) -Form of License Agreement for Embassy Suites. (9) 10(24) -Form of License Agreement for Embassy Suites revised 1989. (12) 10(25) -Form of License Agreement for Embassy Suites revised 1990. (13) 10(26) -Form of License Agreement for Embassy Suites revised 1991. (15) 10(27) -Form of License Agreement for Embassy Suites revised 1992. (18) 10(28) -Form of Short-Term License Agreement for Embassy Suites. (12) 10(29) -Form of Short-Term License Agreement for Embassy Suites revised 1990. (13) 10(30) -Form of Short-Term License Agreement for Embassy Suites revised 1991. (15) 10(31) -Form of Short-Term License Agreement for Embassy Suites revised 1992. (18) 10(32) -Form of License Agreement for Homewood Suites. (3) 10(33) -Form of License Agreement for Homewood Suites revised 1992. (18) - --------------- + Management contract or compensatory plan or arrangement required to be filed as an exhibit to this form pursuant to Item 14(a)(3) of Form 10-K. NO. - ------- **10(34) -Form of License Agreement for Homewood Suites revised 1993. **10(35) -Form of License Agreement for Embassy Suites revised 1993. **10(36) -Form of Short-Term License Agreement for Embassy Suites revised 1993. **10(37) -Form of License Agreement for Hampton Inns revised 1993. **10(38) -Form of License Agreement for Hampton Inn & Suites. 10(39) -Management Agreement dated as of December 17, 1986, between Hampton Inns, Inc. and Hampton/GHI Associates No. 1. (10) 10(40) -Form of Management Agreement between Embassy Suites, Inc. and affiliates of General Electric Pension Trust. (10) +10(41) -Employment Agreement dated August 1, 1987 between Holiday Corporation and Michael D. Rose; Amendment to Employment Agreement dated as of January 31, 1990 between The Promus Companies Incorporated and Michael D. Rose. (12) +10(42) -Amended and Restated Severance Agreement dated as of May 1, 1992 between The Promus Companies Incorporated and Michael D. Rose. (18) +10(43) -Summary Plan Description of Executive Term Life Insurance Plan. (18) +10(44) -Forms of Stock Option (1990 Stock Option Plan). (12) +10(45) -Revised Forms of Stock Option (1990 Stock Option Plan). (18) +10(46) -Form of The Promus Companies Incorporated's Annual Bonus Plan, as amended, for Managers and Executives. (13) +10(47) -Forms of Restricted Stock Award (1990 Restricted Stock Plan). (12) +10(48) -Deferred Compensation Plan dated October 16, 1991. (15) +10(49) -Form of Deferred Compensation Agreement. (12) +10(50) -Form of Deferred Compensation Agreement revised November 1991. (15) +10(51) -Executive Deferred Compensation Plan. (12) +10(52) -First Amendment to Executive Deferred Compensation Plan, dated as of October 25, 1990. (13) +10(53) -Second Amendment to Executive Deferred Compensation Plan, dated as of October 25, 1991. (15) +10(54) -Third Amendment to Executive Deferred Compensation Plan, dated as of October 29, 1992. (18) +10(55) -Forms of Restricted Stock Award (1990 Restricted Stock Plan). (18) +10(56) -First Amendment to Escrow Agreement dated January 31, 1990 among Holiday Corporation, certain subsidiaries thereof and Sovran Bank, as escrow agent. (12) +10(57) -Escrow Agreement dated February 6, 1990 between The Promus Companies Incorporated, certain subsidiaries thereof, and Sovran Bank, as escrow agent. (12) +10(58) -Form of Amended and Restated Severance Agreement dated November 5, 1992, entered into with Charles A. Ledsinger, Jr., Ben C. Peternell, Philip G. Satre and Colin V. Reed. (18) +10(59) -Form of memorandum agreement dated July 2, 1991, eliminating stock appreciation rights under stock options held by Charles A. Ledsinger, Jr., Ben C. Peternell and Philip G. Satre. (14) +10(60) -The Promus Companies Incorporated Amended and Restated Savings and Retirement Plan dated as of February 6, 1990. (18) +10(61) -Administrative Regulations, Long Term Compensation Plan (Restricted Stock Plan and Stock Option Plan), dated as of January 1, 1992. (17) +10(62) -Amendment dated October 29, 1992 to The Promus Companies Incorporated Savings and Retirement Plan Trust Agreement; Amendment dated September 21, 1992 to The Promus Companies Incorporated Savings and Retirement Plan Trust Agreement (18) +10(63) -Revised Form of Stock Option. (21) +10(64) -The Promus Companies Incorporated 1990 Stock Option Plan (as amended as of April 30, 1993). (20) - --------------- ** Filed herewith + Management contract or compensatory plan or arrangement required to be filed as an exhibit to this form pursuant to Item 14(a)(3) of Form 10-K. NO. - ------- **10(65)-Limited Partnership Agreement of Des Plaines Limited Partnership between Harrah's Illinois Corporation and John Q. Hammons, dated February 28, 1992; First Amendment to Limited Partnership Agreement of Des Plaines Limited Partnership dated as of October 5, 1992. +**10(66)-Amendment to Escrow Agreement dated as of October 29, 1993 among The Promus Companies Incorporated, certain subsidiaries thereof, and NationsBank, formerly Sovran Bank. **10(67)-Amended and Restated Partnership Agreement of Harrah's Jazz Company, dated as of March 15, 1994, among Harrah's New Orleans Investment Company, New Orleans/Louisiana Development Corporation and Grand Palais Casino, Inc.; First Amendment to the Amended and Restated Partnership Agreement of Harrah's Jazz Company, effective as of March 15, 1994. 10(68) -Form of Ground Lease by and among Harrah's Jazz Company, Rivergate Development Corporation and the City of New Orleans. (23) 10(69) -Form of General Development Agreement among Harrah's Jazz Company, Rivergate Development Corporation and the City of New Orleans. (23) 10(70) -Form of Temporary Casino Lease by and among Harrah's Jazz Company, Rivergate Development Corporation and the City of New Orleans. (23) 10(71) -Form of Casino Management Agreement between Harrah's Jazz Company and Harrah's New Orleans Management Company. (23) **11 -Computations of per share earnings. **12 -Computations of ratios. **13 -Portions of Annual Report to Stockholders for the fiscal year ended December 31, 1993. (24) **21 -List of subsidiaries of The Promus Companies Incorporated. 99(1) -Proxy Statement--Information Statement--Prospectus dated December 13, 1989 of Holiday Corporation, The Promus Companies Incorporated and Bass Public Limited Company. (12) - --------------- ** Filed herewith + Management contract or compensatory plan or arrangement required to be filed as an exhibit to this form pursuant to Item 14(a)(3) of Form 10-K. FOOTNOTES (1) Incorporated by reference from the Company's Registration Statement on Form 10, File No. 1-10410, filed on December 13, 1989. (2) Incorporated by reference from the Company's Current Report on Form 8-K dated February 16, 1990, File No. 1-10410. (3) Incorporated by reference from Holiday Corporation's Annual Report on Form 10-K for the fiscal year ended January 1, 1988, filed March 31, 1988, File No. 1-8900. (4) Incorporated by reference from Holiday Inns, Inc.'s Registration Statement on Form S-3, File No. 33-11770, filed February 24, 1987. (5) Incorporated by reference from Holiday Inns, Inc's Registration Statement on Form S-3, File No. 33-11163, filed December 31, 1986. (6) Incorporated by reference from the Company's and Embassy Suites, Inc.'s Amendment No. 2 to Form S-4 Registration Statement, File No. 33-49509-01, filed July 16, 1993. (7) Incorporated by reference from Holiday Inns, Inc.'s Annual Report on Form 10-K for the fiscal year ended December 30, 1983, filed March 21, 1984, File No. 1-4804. (8) Incorporated by reference from Holiday Corporation's Annual Report on Form 10-K for the fiscal year ended December 30, 1988, filed March 30, 1989, File No. 1-8900. (9) Incorporated by reference from Holiday Corporation's Annual Report on Form 10-K for the fiscal year ended January 3, 1986, filed March 28, 1986, File No. 1-8900. (10) Incorporated by reference from Holiday Corporation's Annual Report on Form 10-K for the fiscal year ended January 2, 1987, filed March 27, 1987, File No. 1-8900. (11) Incorporated by reference from the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1993, filed May 13, 1993, File No. 1-10410. (12) Incorporated by reference from the Company's Annual Report on Form 10-K for the fiscal year ended December 29, 1989, filed March 28, 1990, File No. 1-10410. (13) Incorporated by reference from the Company's Annual Report on Form 10-K for the fiscal year ended December 28, 1990, filed March 21, 1991, File No. 1-10410. (14) Incorporated by reference from the Company's Quarterly Report on Form 10-Q for the quarter ended September 27, 1991, filed November 8, 1991, File No. 1-10410. (15) Incorporated by reference from Amendment No. 2 to the Company's and Embassy's Registration Statement on Form S-1, file No. 33-43748, filed March 18, 1992. (16) Incorporated by reference from the Company's Annual Report on Form 10-K for the fiscal year ended January 3, 1992, filed March 26, 1992, File No. 1-10410. (17) Incorporated by reference from the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1992, filed May 13, 1992, File No. 1-10410. (18) Incorporated by reference from the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1992, filed March 12, 1993, File No. 1-10410. (19) Incorporated by reference from the Company's Current Report on Form 8-K filed August 6, 1993, File No. 1-10410. (20) Incorporated by reference from Post-Effective Amendment No. 1 to Form S-8 Registration Statement, File No. 33-32864-01, filed July 22, 1993. (21) Incorporated by reference from the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993, filed August 12, 1993, File No. 1-10410. (22) Incorporated by reference from the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993, filed November 12, 1993, File No. 1-10410. (23) Incorporated by reference from Amendment No. 1 to Form S-1 Registration Statement, File No. 33-73370, filed February 22, 1994. (24) Filed herewith to the extent provisions of such report are specifically incorporated herein by reference.

1993 ITEM 1. BUSINESS GENERAL DSC Communications Corporation was incorporated under the laws of the State of Delaware in 1976. As used herein, the term "Company" refers to DSC Communications Corporation and, unless the context clearly indicates otherwise, all of its subsidiaries. The Company's executive offices are located at 1000 Coit Road, Plano, Texas 75075. Its telephone number is (214) 519-3000. The Company designs, develops, manufactures, and markets digital switching, transmission, access, and private network system products for the worldwide telecommunications marketplace. These products allow telecommunications service providers to build and upgrade their networks to support a wide range of voice, data, and video services. The Company offers a comprehensive product line including digital switching systems, intelligent network products, cellular switching systems, digital loop carrier products, and digital cross-connect products. The Company develops hardware and software to meet both United States and international standards, and the specific requirements of its customers. The Company supplies products to both local exchange companies and long- distance carriers. Its customers include all seven of the Regional Bell Holding Companies ("RHCs") and most major domestic independent telephone companies, including GTE Communications Systems Corporation ("GTE"), United Telecommunications, Inc. ("United"), and Alltel Supply, Inc. ("Alltel"). The Company's long-distance carrier customers include MCI Communications Corporation ("MCI"), DDI Corporation of Japan ("DDI"), Sprint Communications Company L.P. ("Sprint"), and AAP Communications Pty Ltd. of Australia ("AAP"). The Company is also a manufacturer of high-capacity cellular switches for Motorola, Inc. ("Motorola"), a global supplier of wireless communication systems. PRODUCTS GENERAL. The Company's principal products are sophisticated microprocessor-controlled systems which incorporate advanced hardware and software technology. The Company develops such systems to meet United States and international telecommunications standards, and the specific requirements of the operating companies of the RHCs, independent telephone companies, long-distance carriers, private networks, and companies operating public and private communication networks in other countries. The percentage of consolidated revenue from the Company's product groups, which represented ten percent or more of consolidated revenue, was as follows: SWITCHING AND INTELLIGENT NETWORK PRODUCTS. The Company's switching and intelligent network products include the MegaHub product line, the Bandwidth Allocation System for Integrated Services ("BASiS"), the Integrated Broadband Service Switch ("iBSS"), cellular switching platforms, and the Company's family of digital tandem switches. The MegaHub family of products is based upon the Message Transfer Network ("MTN") architecture. The MTN architecture affords a high degree of flexibility by interconnecting clusters of independent application processors over high-speed links, using fast-packet switching technology and multifunctional software. Because of the MTN's flexible architecture, the MegaHub platform can serve as a tandem switch, a signal transfer point, a service control point, or as a platform for a variety of wideband and broadband services. One of the Company's first applications of the MegaHub technology was the MegaHub Signal Transfer Point ("MegaHub STP"), a high-capacity switching system used to route or switch signaling messages through the Common Channel Signaling System No. 7 network ("SS7"). The MegaHub STP can be used as an access facility to information services such as 700, 800, and 900 numbers and alternate billing arrangements. The Company is delivering the MegaHub STP to a majority of the major local telephone companies in the United States, including the RHCs and several of the RHCs' cellular subsidiaries, and various long-distance carriers in the United States and DDI, a long-distance competitor of Nippon Telegraph and Telephone in Japan. First introduced in 1989, the MegaHub Service Control Point (the "MegaHub SCP") combines the functionalities of the Company's MegaHub STP and standard UNIX-based computing systems. The MegaHub SCP can act as a central storehouse for information about calls and callers, and can answer network requests for such information in an expeditious manner. In 1992, the Company introduced the Programmable Advanced Intelligent Network Computing Environment (the "MegaHub PACE SCP") which builds upon the Company's initial SCP system by creating an open, state-of-the-art computing environment. The capabilities of the MegaHub PACE SCP will provide the user with extremely high transaction rates needed to support applications like credit and calling card validation and cellular fraud detection. The Company has provided the MegaHub PACE SCP to DDI; to a large independent local exchange carrier in the United States; and to Optus Communications Pty Ltd. ("Optus"), a newly-licensed competitive telecommunications service provider in Australia. In March, 1994, the Company entered into an agreement with Cable & Wireless plc, a global telecommunications carrier, who will initially deploy the MegaHub PACE SCP and related equipment in the network of its subsidiary, Mercury Communications Ltd, the first company licensed to compete against British Telecom in the United Kingdom. In 1991, the Company announced the development and testing of the BASiS switching system. BASiS is a circuit switching platform which will allow telecommunications carriers to provide their customers with bandwidth on demand. This capability will serve as the foundation for numerous high-speed applications existing in the market today, including video teleconferencing, medical imaging, high-speed facsimile transmission, local area network interconnection, and certain residential applications such as video-on-demand. The BASiS switching system will allow customer-to-customer connections at data rates ranging from 1.5Mb per second to 45Mb per second. The BASiS switching system is presently being deployed in the network of a major long-distance carrier. In addition, Bell Atlantic chose BASiS as its video switch to provide video-on-demand service for its field trial in northern Virginia. In 1992, the Company announced the development and testing of the iBSS, an Asynchronous Transfer Mode ("ATM") switching platform. The iBSS uses ATM technology to provide a multiservice platform which is designed to provide network-based applications for high-speed data, image, and video. Use of the iBSS will allow network service providers to respond more quickly to customer demands for current and evolving broadband communication services, and to meet the increasing demand for the transfer of information at rates much higher than current data services. The most likely first application of the iBSS will be in those situations, such as the interconnection of local area networks, that demand high-speed transmission rates and easy integration of data, voice, and video applications. The iBSS is currently undergoing laboratory evaluations with both local and long-distance carriers. The Company has developed a group of cellular telephone switches utilizing its tandem switching technology. The Company has supplied cellular switches to Motorola since 1985, and currently has an agreement to license software and sell equipment to Motorola on a nonexclusive basis. In July, 1993, the Company and Motorola expanded their ongoing relationship by agreeing that the Company would provide repackaged, smaller configurations of its existing cellular switching system to Motorola as an alternative to Motorola's line of older and smaller cellular switching systems. Motorola has incorporated the Company's cellular switches into cellular communications systems in the United States and in numerous other countries including, most recently, the People's Republic of China and Russia. The Company is a vendor of tandem switches to those United States and Canadian companies which compete with AT&T and Bell Canada as alternate long-distance carriers. In addition, the Company provides tandem switches to DDI and to AAP, an Australian private network provider of value added and virtual private network services. Tandem switches are generally used to route calls over long-distance networks. The MegaHub version of the tandem switch, the MegaHub 600E, was first placed into service in 1990. ACCESS PRODUCTS. The Company designs, manufactures, and sells equipment for the local loop, that portion of the public telecommunications network which extends from the local telephone company's central office switch to the individual home or business user. Such products include the Litespan-2000, which is the world's first digital loop carrier to meet North American Synchronous Optical Network ("SONET") fiber optic standards and related fiber optic interface requirements set forth by the RHCs. The Litespan-2000 allows telecommunications service providers to introduce the high-capacity technology of fiber optics into the local loop, while supporting basic services, in a cost-effective manner. The Company has entered into multi-year agreements with a majority of the seven RHCs for purchase of the Litespan-2000 system. The Company's Starspan-R- product is an optical fiber distribution system which extends the capabilities of the Litespan-2000 through fiber cables to optical network units at the customer's premises. Starspan is a cost-effective means of extending the capacity of optical fibers from the telephone company central office to cover the entire local loop. The Starspan system is currently being deployed and is carrying traffic with several RHCs. In addition to improving network reliability, fiber optic technology will be key to local service providers such as the RHCs as they expand services for business and residential users to include voice, data, and video. The Litespan- 2000 and Starspan provide high-capacity capability to transmit large amounts of voice, data, and video simultaneously to and from business or residential users. The Company believes that the introduction of multi-media services, such as video-on-demand, will increase the demand for fiber optics-based products such as the Litespan-2000 and Starspan. In 1993, the Company introduced a new product, Metrospan, which extends the capabilities of the Litespan-2000 technology base outside of the local loop. Metrospan will be used as a broadband transport system within a campus-type setting or a metropolitan communication network. Metrospan has already been selected for use by a leading Canadian utility company. During 1993, the Company developed a new product which will be called Airspan. The Airspan product, which was developed initially in cooperation with a major European carrier, will be used to connect end-user customers to central office facilities via cellular or radio connections. In November, 1993, the Company entered into a cooperative agreement with General Instrument Corporation ("GI"), a leading supplier of equipment to the cable television industry. The Company and GI have agreed to combine the Company's expertise in fiber optics and switching systems and GI's expertise in cable television equipment. The Company and GI plan to develop joint proposals for customers who need to capitalize on emerging digital video cable processing technologies for the distribution of enhanced pay-per-view, video-on-demand, interactive multimedia, and other new video services. The Company also announced in 1993 an agreement with Westell, Inc. to jointly develop systems which allow cost-effective deployment of interactive video services over existing copper wire transmission facilities. TRANSMISSION PRODUCTS. The Company's digital cross-connect systems provide switching, multiplexing, and termination of digital transmission services. The Company's various digital cross-connect products are distinguished from one another principally by the capacity which each system handles. Digital cross-connect products are widely deployed in the United States by the RHCs, long-distance carriers, independent local exchange carriers, and a number of large corporations. In 1992, the Company announced the development and testing of a major new transmission platform, the Integrated Multi-Rate Transport Node ("iMTN"). Building on the Company's experience with digital cross-connect systems, the iMTN will provide for the public telecommunications network's evolution to SONET-based transmission and the deployment of automated administration functions. The iMTN will enable network service providers to offer their customers, on an integrated basis, narrowband services such as voice communications, high-speed wideband data services, and broadband services such as video-on-demand. The iMTN has been designed to meet the interconnectivity requirements of SONET in North America, SDH/CCITT in Europe, and the unique standards of Japan. In 1993, the Company entered into an agreement to supply the iMTN to carriers in both the local and long-distance marketplace. MCI, one of the carriers with whom an agreement was signed, is expected to use the iMTN to support SONET-based broadband and wideband network requirements. The Company also develops, manufactures, and markets a variety of digital transmission products such as echo cancellers and transcoders. CUSTOMER PREMISE PRODUCTS. The Company's customer premise products allow service providers and corporate customers with high-capacity networks to transport multiple types of data, voice, and video traffic over public and private network facilities. The Company develops, manufactures, and sells a complete line of T1/E1 multiplexers which have been sold to private and public network service providers throughout the world. In 1993, the Company introduced the iMPAX line of products. The iMPAX product will serve as the Company's next generation multiservice platform. The iMPAX will support voice circuits, frame relay, and cell-based ATM traffic. The iMPAX can be deployed in a telephone company central office, at the site of an independent service provider, or on the premises of an end user. Use of the iMPAX will give service providers access to network elements through which they can offer new wideband and broadband services such as LAN-to-LAN internetworking, video conferencing, and supercomputer connectivity. REGULATION The telecommunications industry is subject to regulation in the United States and other countries. Federal and state regulatory agencies, including the Federal Communications Commission ("FCC") and the various state Public Utility Commissions ("PUCs") and Public Service Commissions ("PSCs"), regulate most of the Company's domestic customers. In addition, the RHCs are restricted by the terms of the Modified Final Judgment which resulted from the court-ordered divestiture of the RHCs by AT&T, and currently prohibits the RHCs from manufacturing telecommunications equipment and providing interexchange or long-distance services. Legislation has been introduced which would lift these restrictions on manufacturing and interexchange services. Should this legislation be enacted, the Company cannot predict the impact on its business, although it is possible that passage of legislation allowing the RHCs to manufacture telecommunications equipment could create additional competition in the markets addressed by the Company's products. In addition, the FCC and a majority of the states have enacted or are considering regulations based upon alternative pricing methods. Under traditional rate of return pricing, telecommunications service providers were limited to a stated percentage profit on their investment. Under the new method of pricing, many PUCs have entered into agreements with the local exchange carriers where the PUCs have relaxed or eliminated the profit cap in return for the carrier's promise to reduce or hold service prices at current levels. In some states, the PUCs and the carriers have further agreed, in order to win relaxation of profit limits, that the carriers would invest large sums to further upgrade the digital and optical capabilities of the network. The Company believes that the new methods of price regulation could increase the demand for its products which enhance the efficiency of the network or allow the expedited introduction of new revenue-producing services. Outside the United States, telecommunications networks are primarily owned by the government or are strictly regulated by the government. Although potential growth rates of some international markets are higher than those of the United States, access to such markets is often difficult due to the established relationship between the government owned or controlled telecommunications operating company and its traditional indigenous suppliers of telecommunications equipment. However, there has been a global trend towards privatization and deregulation of the state-owned telecommunications operations. This trend has found favor in the industrialized world, the emerging markets of the newly-industrialized countries, and various developing market countries which want to both capitalize on the value of the existing network and promote the development of the telecommunications network as an integral part of the economic infrastructure. The Company believes that the current trend of privatization and deregulation will continue, and that such trend could provide the Company with additional international opportunities. MARKETING The Company sells products and services on a domestic and international basis to both the public and private network markets through various sales and distribution channels. The Company's internal sales group is a direct sales force, divided into market business segments. The Company also sells through third-party distributors such as original equipment manufacturers ("OEMs") and sales representatives. In 1993, the Company entered into separate agreements with Nokia Telecommunications Oy of Finland ("Nokia") and a European subsidiary of Northern Telecom Ltd. ("Northern") to distribute the iMTN. The agreement with Nokia, a leading worldwide supplier of wireless communications systems, will allow Nokia to market the iMTN on a nonexclusive basis in Scandinavia and certain other countries. The agreement with Northern grants the European subsidiary of Northern the exclusive right to market the iMTN system in certain European countries and a nonexclusive right to market the iMTN system in certain other countries. INTERNATIONAL OPERATIONS AND MAJOR CUSTOMERS Revenue generated from export sales in 1991 was $48,012,000. Revenue generated from export sales was less than ten percent of consolidated revenue in 1993 and 1992. Revenue and assets of the Company's foreign operations for those same periods were less than ten percent of the Company's consolidated revenue and total assets, respectively. For the year ended December 31, 1993, MCI, Ameritech, Motorola, Bell Atlantic, and NYNEX accounted for 18 percent, 13 percent, 12 percent, 11 percent, and 11 percent, respectively, of the Company's consolidated revenue. The termination or material reduction of the purchases of the Company's products by any of the above-named companies could have a material effect on the Company. BACKLOG The Company's backlog, calculated as the aggregate of the sales price of orders received from customers less revenue recognized, was approximately $320,000,000 and $200,000,000 on December 31, 1993 and December 31, 1992, respectively. Approximately $70,000,000 of orders included in the December 31, 1993 backlog are scheduled for delivery after December 31, 1994. However, all orders are subject to possible rescheduling by customers. While the Company believes that the orders included in the backlog are firm, some orders may be cancelled by the customer without penalty, and the Company may elect to permit cancellation of orders without penalty where management believes that it is in the Company's best interest to do so. RESEARCH AND PRODUCT DEVELOPMENT The industry in which the Company operates is characterized by rapidly- changing technological and market conditions which may shorten product life cycles. The Company's future competitive position will depend not only upon successful production and sales of its existing products, but also upon its ability to develop and produce, on a timely basis, new products to meet existing and anticipated industry demands. The Company is currently engaged in the development of several new products, including the iMTN and the iBSS. During the product development process, the Company invests a substantial amount of resources in products which often require extensive field testing and evaluation prior to actual sales to its customers. The Company's research and product development costs charged to expense were $86,620,000, $68,303,000, and $63,842,000 for the years ended December 31, 1993, 1992, and 1991, respectively. Additionally, approximately $21,947,000, $18,097,000, and $22,793,000 of software development costs were capitalized in the Consolidated Balance Sheets in 1993, 1992, and 1991, respectively. COMPETITION The segments of the telecommunications industry in which the Company competes are intensely competitive and are characterized by continual advances in technology. The Company believes that it enjoys a strong competitive position due to its large installed base, its strong relationship with key customers, and its technological leadership and new product development capabilities. However, many of the Company's foreign and domestic competitors have more extensive engineering, manufacturing, marketing, financial, and personnel resources than those of the Company. The Company's ability to compete is dependent upon several factors, including product features, innovation, quality, reliability, service support, price, and the retention and attraction of qualified design and development personnel. Due to its breadth of product offerings, the Company has different competitors in each of the markets which it serves. The Company's primary competitors in the tandem switching and intelligent network markets are AT&T and Northern. In the ATM switching market, AT&T and Fujitsu, Ltd. ("Fujitsu") are the Company's primary competitors. The Company's primary competitors in the digital cross-connect market are AT&T, Alcatel Network Systems, and Tellabs, Inc. The Company's primary competitors in the access market are AT&T, R-TEC, a wholly-owned subsidiary of Reliance Electric Co., and Fujitsu. MANUFACTURING AND SUPPLIERS The Company generally uses standard parts and components for its products, and believes that, in most cases, there are a number of alternative, qualified vendors for most of those parts and components. The Company purchases certain custom components and products from single suppliers. The Company believes that the manufacturers of the particular custom components and products should be able to meet expected future demands. Although the Company has not experienced any material adverse effects from the inability to obtain timely delivery of needed components, an unanticipated failure of any significant supplier to meet the Company's requirements for an extended period, or an interruption of the Company's ability to secure comparable components could have an adverse effect on the Company's revenues and profitability. In addition, the Company's products contain a number of subsystems or components acquired from other manufacturers on an OEM basis. These OEM products are often available only from a limited number of manufacturers. In the event that an OEM product was no longer available from a current OEM vendor, second sourcing would be required and could delay customer deliveries which could have an adverse effect on the Company's revenues and profitability. PATENTS AND PROTECTION OF OTHER PROPRIETARY INFORMATION The Company has been awarded patents and has patent applications pending in the United States and certain foreign countries. There can be no assurance that any of these applications will result in the award of a patent, or that the Company would be successful in defending its patent rights in any subsequent infringement actions. Because of the existence of a large number of third-party patents in the telecommunications field and the rapid rate of issuance of new patents, some of the Company's products, or the use thereof, could infringe third-party patents. If any such infringement exists, the Company believes that, based upon historical industry practice, it or its customers should be able to obtain any necessary licenses or rights under such patents upon terms which would not be materially adverse to the Company. In addition to the patent protection described above, the Company protects its software through contractual arrangements with its customers and through copyright protection procedures. ENVIRONMENTAL AFFAIRS The Company's manufacturing operations are subject to numerous federal, state, and local laws and regulations designed to protect the environment. Compliance with these laws and regulations has not had, and is not expected to have, a material effect upon the capital expenditures, earnings, or the competitive position of the Company. EMPLOYEES As of December 31, 1993, the Company had a total of 4,041 employees. The Company is not a party to any collective bargaining agreement. ITEM 2. ITEM 2. PROPERTIES The Company owns two buildings and approximately 250 acres of land in Plano, Texas, of which 148 acres were acquired in 1994. One of the buildings is a 282,000 square foot office building. The other building is a 421,000 square foot manufacturing and assembly facility. As of December 31, 1993, the Company had under lease approximately 949,280 square feet of office, manufacturing, and warehouse space in suburban Dallas, Texas; Santa Clara, California; Petaluma, California; and Aguadilla, Puerto Rico under leases expiring between September 30, 1994 and September 30, 2002. Subsequent to December 31, 1993, the Company entered into a lease for approximately 65,000 square feet of office space in Feltham, England expiring on March 25, 2004, which replaced a lease in Weybridge, England for 10,000 square feet expiring March 31, 1994. The Company also has under lease smaller facilities, including sales offices, in the United States, Canada, Japan, Australia, Singapore, and Taiwan, with leases expiring between June 30, 1994 and June 30, 2002. The Company believes that the above-described facilities are suitable and adequate to meet the Company's production requirements. ITEM 3. ITEM 3. LEGAL PROCEEDINGS In July, 1991, three complaints were filed in the United States District Court for the Northern District of Texas by three individuals on behalf of themselves and, purportedly, on behalf of an alleged class of persons who purchased common stock of the Company during the period from February 7, 1991 through July 9, 1991. Named as defendants in these actions are the Company, two of the Company's principal officers, and a former principal officer of the Company. In December, 1991, four plaintiffs, including each of the three original plaintiffs, filed a Consolidated Complaint (the "Consolidated Complaint") in the United States District Court for the Northern District of Texas against the Company and six individuals, each of whom is either a present or former officer of the Company, including two present directors and one former director. The Consolidated Complaint amends and consolidates the three original complaints and purports to be a class action on behalf of an alleged class of persons who purchased common stock of the Company during the period from February 7, 1991 through October 31, 1991. The Consolidated Complaint alleges violations of Sections 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder, and negligent misrepresentation as a result of alleged misrepresentations and omissions with respect to information contained in press releases, reports to the Company's shareholders, and certain filings and periodic reports filed with the Securities and Exchange Commission by the Company. The plaintiffs allege that the Company made certain misleading statements regarding the quality and reliability of its products and the Company's financial condition and its prospects. The Consolidated Complaint seeks actual and punitive damages in unspecified amounts, prejudgment interest, and attorneys' fees. On February 3, 1992, the Company filed a motion with the Court seeking dismissal of the complaint. In March, 1993, the Court dismissed the Consolidated Complaint without prejudice. On February 25, 1994, the United States Fifth Circuit Court of Appeals affirmed the Court's decision to dismiss the Consolidated Complaint. The plaintiffs filed a petition for a rehearing on March 25, 1994. On January 26, 1994, C. L. Grimes, a shareholder of the Company, filed a suit in Delaware Chancery Court, derivatively purportedly on behalf of the Company as the real party in interest and as a shareholder of the Company, seeking a declaration that the Employment Agreement of James L. Donald, his Executive Income Continuation Plan, and the 1990 Long-Term Incentive Compensation Plan, as it applies to Mr. Donald and all other benefits of Mr. Donald, including previously-granted Company stock options, are null and void. The defendants in the suit are Mr. Donald, all current non-employee directors, and two former directors of the Company. The Company itself is a nominal defendant. The plaintiff contends that Mr. Donald's employment contract contains an improper delegation of the Board of Directors' authority to Mr. Donald and excess payments. The suit also contends that the salary and benefits established for Mr. Donald pursuant to the Donald agreements referred to above and by the Company's Board of Directors are excessive and constitute a diversion and waste of corporate assets. The suit seeks an injunction restraining Mr. Donald from exercising any stock options, taking any action to implement any of the Donald agreements, or declaring a constructive termination of his employment, and also seeks unspecified damages against the defendants and Grimes' legal fees. The individual defendants will file a responsive pleading and intend to vigorously contest Grimes' claims. On July 20, 1993, the Company filed suit against Advanced Fibre Communications ("AFC"), a California corporation; Quadrium Corporation ("Quadrium"), a California corporation; Alan E. Negrin ("Negrin"); and Henri Sulzer ("Sulzer") in the United States District Court for the Eastern District of Texas, Marshall Division, Civil Action No. 2-93CV126. The Company seeks a declaratory judgment that Negrin and Sulzer are not entitled to any stock options or cash payments under the Company's 1990 Stock Option and Cash Payment Plan because of these defendants' alleged breaches of certain employment-related agreements entered into with the Company. The Company further seeks a declaration that AFC's products, including the UMC 1000 digital loop carrier, are the proprietary property of the Company under the terms of certain Proprietary Information Agreements and certain Consulting Agreements with Quadrium. The Company also seeks unspecified damages for breach of contract, civil conspiracy, and tortious interference. The individual defendants have both filed counterclaims whereby they claim entitlement to certain stock options and cash payments under several of the Company's stock option plans. AFC has also filed a counterclaim alleging that the Company has violated the Sherman Antitrust Act and a California statutory antitrust act known as the Cartwright Act. AFC further claims that the Company has (a) tortiously interfered with existing and prospective contractual relationships, (b) committed industrial espionage and misappropriation, (c) trespassed on AFC's business premises, (d) converted certain property of AFC, and (e) committed unfair competition. AFC also seeks a declaratory judgment that it owns all rights to its product, the UMC Digital Loop Carrier. AFC asks the court to award unspecified actual damages, treble damages under the antitrust statutes, punitive damages, injunctive relief, and attorneys' fees. Although the outcome of litigation is inherently uncertain, the Company believes that it has valid and substantial claims against all of the defendants and valid defenses to all of the counterclaims. The case is in the early stages of discovery, and the Company intends to vigorously prosecute its claims and defend all of the defendants' counterclaims. The Company does not believe that the ultimate resolution of any of these suits will have a material adverse effect on its consolidated financial position. The Company is also a party to other legal proceedings which, in the opinion of management, are not expected to have a material adverse effect on the Company's consolidated financial position. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the fourth quarter of 1993. EXECUTIVE OFFICERS OF THE REGISTRANT Executive officers are elected annually and serve at the pleasure of the Board of Directors. No family relationships exist among the executive officers of the Company. As of March 1, 1994, the executive officers of the Company are as follows: Allen R. Adams joined the Company in 1979, as Director of Hardware and Systems Development. Since 1979, Mr. Adams has held a variety of project and design engineering positions. In May, 1991, Mr. Adams was elected Vice President. Mr. Adams was elected Senior Vice President in February, 1993. Wylie D. Basham was named to the position of Vice President, Transmission Products Division in 1993. Mr. Basham has held a variety of management positions since joining the Company in 1983. Michael R. Bernique joined the Company in 1989, as Vice President, Sales. Since joining the Company, Mr. Bernique has held a number of management positions. In 1993, Mr. Bernique was named to the position of Senior Vice President, North American Sales. John W. Bischoff joined the Company in 1989, as Vice President, Quality and Reliability Assurance. David T. Boyce joined the Company in 1989, as Managing Director, DSC Communications (Europe) Limited. In March, 1992, Mr. Boyce was named to the position of Vice President, International Sales and Service. Gerald G. Carlton joined the Company in 1988, as Vice President, Administration, responsible for all of the Company's national and international human resource functions and corporate facilities management activities. Robert W. Clark has held a variety of positions since joining the Company in 1982, including Vice President, Program Management. In 1991, Mr. Clark was named to the position of Vice President, Customer Service. James L. Donald became President and a director of the Company in March, 1981. He was elected Chief Executive Officer in August, 1981. Mr. Donald was elected Chairman of the Company's Board of Directors in 1989. Daryl J. Eigen joined the Company in 1993, as Vice President, Corporate Marketing and Planning. Prior to joining the Company, Mr. Eigen was employed by Siemens Stromberg-Carlson since 1984, where his most recent position was that of Vice President, Central Region. John H. Montgomery joined the Company as Vice President, Customer Premises Products in 1990, when the Company acquired Integrated Telecom Corporation ("Integrated"). Since 1988, Mr. Montgomery served as President of Integrated. From 1981 through 1987, Mr. Montgomery was employed by the Company in various senior management capacities. Gerald F. Montry joined the Company in 1986, as Senior Vice President and Chief Financial Officer. In 1989, Mr. Montry was elected to the Company's Board of Directors. William R. Tempest joined the Company in October, 1982, as General Counsel. He was elected Secretary of the Company in December, 1982, and Vice President in 1986. Hensley E. West joined the Company in 1987, as Vice President, Sales. Since joining the Company, Mr. West has held a variety of management positions, including his present position as Senior Vice President, Access Products Division. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's common stock prices are listed daily in THE WALL STREET JOURNAL and other publications under the NASDAQ National Market System of the over-the-counter listing with the abbreviation "DSC Commun" or "DSC". The stock is traded in the NASDAQ National Market System with the ticker symbol "DIGI". The following were the high and low close prices of the Company's stock per the NASDAQ National Market System: The Company has not paid or declared any cash dividends on the common stock since its organization. The closing price of the Company's common stock on March 1, 1994, was $53.125 per share. As of December 31, 1993, there were 3,462 shareholders of record of the Company's common stock. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA (Dollars in thousands, except per share data) ITEM 6. SELECTED FINANCIAL DATA (Continued) (Dollars in thousands, except per share data) ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS In 1993, DSC Communications Corporation achieved record revenue levels, a strong operating performance, and ended 1993 with a significantly improved financial position. Revenue grew 36%, while net income increased to $81.7 million, or $1.53 per share, compared to net income of $11.6 million, or $0.25 per share, in 1992. Cash and marketable securities grew to over $313 million at the end of 1993, and debt as a percentage of shareholders' equity declined to 11.4% from 69.3% at the end of 1992. FINANCIAL CONDITION AND LIQUIDITY The Company ended 1993 and 1992 with the following: Two major transactions in 1993 significantly impacted the Company's financial condition and enhanced its long-term liquidity. The Company sold 3.5 million shares of its common stock in a public offering which generated $231.1 million in cash. In addition, the $71.5 million of outstanding 7 3/4% subordinated convertible debentures were converted into 3.8 million shares of common stock. Cash of $79.3 million was also generated from operating activities. Income, before depreciation and amortization, exceeded receivable and inventory growth of $72.0 million, while non-debt current liabilities did not change significantly during 1993. Receivables and inventory grew as business levels increased. Inventory velocity improved to approximately four turns by the end of 1993. Capital expenditures were $71.0 million during 1993. The Company's business expansion during 1993 and expected future domestic and international growth have and will continue to increase capital requirements including facilities, and manufacturing and development equipment and software. As a result of this expected business expansion, it is anticipated that 1994 capital requirements should substantially exceed 1993 capital expenditures. In February 1994, the Company acquired 148 acres of land for approximately $16.4 million. This acreage, along with 42 acres acquired in late 1993, is located near the Company's present campus location and will be used for future building expansion. The timing and extent of building expansion will be dependent on future business growth. The Company's commitment to research and product development continued in 1993 with $86.6 million expensed for research and product development costs and $21.9 million capitalized as software development costs. These costs are primarily related to expenditures for various new products which are expected to contribute to revenue in future periods. In addition to the sale of stock to the public, other financing activities included $20.1 million of proceeds from the issuance of common stock under employee stock plans, additional secured borrowings of $20.1 million, and scheduled payments under existing loan agreements of $18.5 million. Scheduled long-term debt maturities for the three years ending December 31, 1996 are $13.7 million, $11.1 million, and $9.2 million, respectively. The Company periodically finances facilities and equipment requirements under operating leases. At December 31, 1993, operating lease obligations were $62.8 million, of which scheduled lease payments for 1994 - 1996 were $17.7 million, $13.7 million and $8.9 million, respectively. In February 1994, the Company entered into a new unsecured revolving credit agreement providing for borrowings up to $50.0 million, reduced by the amount of outstanding letters of credit not to exceed $25.0 million. The new agreement expires in February 1997. See "Credit Agreements" in Notes to Consolidated Financial Statements. The new agreement replaces a $22.5 million credit agreement which was secured by domestic receivables and inventories and expired on February 28, 1994. The Company had no borrowings under existing credit agreements during 1993. In January 1994, the Company called for redemption of all of its $36.4 million outstanding 8% subordinated convertible debentures. As a result, in February 1994, debenture holders converted approximately $34.7 million of debentures into approximately 637,000 shares of the Company's common stock and redeemed approximately $1.7 million for cash. The Company believes that it has the financial resources required to support its expected business growth, including working capital expansion, necessary capital expenditure requirements, operating lease obligations, and scheduled debt payments. The Company is a party to certain litigation, as discussed in "Commitments and Contingencies" in Notes to Consolidated Financial Statements, the outcome of which the Company believes will not have a material adverse effect on its consolidated financial position. RESULTS OF OPERATIONS 1993 Compared to 1992 Revenue for 1993 increased 36% to $730.8 million compared to $536.3 million in 1992. Net income was $81.7 million, or $1.53 per share, compared to a net income of $11.6 million, or $0.25 per share, for the year ended December 31, 1992. The Company's 1993 revenue growth was due to a higher volume of switching and access product shipments. Switching products revenue increased 13% over 1992 and represented 45% of consolidated revenue compared to 54% in 1992. The increase in switching products revenue was due, in part, to a higher volume of hardware and software deliveries for customer expansion and upgrades of existing switching systems. This more than offset a reduction in signal transfer point (STP) system product deliveries from the volume achieved in 1992 when several domestic customers populated their networks with the Company's STP's. Access products revenue accounted for approximately 28% of consolidated revenue in 1993 compared to 8% in 1992 as the Company began delivery on several major customer orders received in 1992 and 1993. While the access products group achieved profitability in the last half of 1993, a loss was recorded for the full year. Future profitability will be dependent upon product mix, cost reduction activities, and economies and benefits from continued higher levels of customer deliveries. As a result, the Company believes that as deliveries of access products continue to increase, and as further cost reduction activities are successful, the Company's operating performance will be favorably impacted in the future. Revenue of transmission products grew slightly in 1993 over 1992 and represented 19% of 1993 revenue compared to 24% of 1992 revenue. Cost of revenue of $412.8 million in 1993 represented 56.5% of total revenue, compared to 62.2% in 1992. The Company benefited from cost reduction activities, increased operating efficiencies, and production efficiencies due to the higher business volumes, while the higher volume of lower margin access products revenue impacted product cost as a percentage of revenue. Certain of the Company's products typically produce gross margin content greater than other Company products. As a result, shifts in the product mix of the Company's consolidated revenue in the future could impact gross margin as a percentage of revenue. Research and product development expenses increased in 1993 to $86.6 million, or 11.9% of revenue, compared to $68.3 million in 1992, or 12.7% of revenue. This increase reflects the Company's continued commitment to the development of new products which are targeted to high growth markets. Selling, general and administrative expenses were $112.7 million in 1993, or 15.4% of revenue, compared to $87.0 million, or 16.2% of revenue, in 1992. The higher expense level reflects increased domestic and international selling and marketing activities, expansion of the Company's customer base and an increased level of incentive compensation. See "Incentive Compensation" in the Notes to Consolidated Financial Statements for further information. Interest expense declined $15.1 million in 1993 compared to the 1992 period. This reduction was due to the repayment of over $134.0 million of senior unsecured debt during the last half of 1992 and conversion of $71.5 million of 7 3/4% subordinated convertible debentures into approximately 3.8 million shares of the Company's common stock during the 1993 first quarter. Other expense, net in 1993 declined by $8.2 million from $8.3 million in 1992. The 1993 amount includes a $2.2 million gain from the sale of securities acquired several years ago as part of financing provided to a customer. The 1992 amount included provisions for litigation, senior unsecured debt restructuring costs, certain facilities costs and higher cash discounts taken by customers in the first half of 1992 for early payment on receivables. The Company's effective income tax rate was 25% for the year ended December 31, 1993. See "Income Taxes" in Notes to Consolidated Financial Statements for further information. As discussed in Financial Condition and Liquidity above, the Company issued approximately 3.5 million shares of common stock in a public offering in October 1993, which will increase the amount of weighted average shares outstanding used to compute earnings per share in 1994. Until required to support expected future business growth, the proceeds from the public offering are expected to be invested in interest bearing marketable securities which will increase interest income in the future. During the first quarter of 1993, the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Post Retirement Benefits Other Than Pensions." The implementation of this standard had no financial impact to the Company since post retirement benefits currently provided are reimbursed by the retirees. 1992 Compared to 1991 The Company's 1992 operating results reflect significant improvement in operating performance. Overall, revenue for 1992 increased 16% to $536.3 million compared to $461.5 million in 1991. Net income was $11.6 million, or $0.25 per share, compared to a net loss of $108.3 million, or $2.62 per share, in 1991. The results for the year ended December 31, 1991 included non-cash charges of (i) approximately $48.1 million related primarily to a write-down of assets, provision for doubtful receivables, and restructuring and consolidation costs and (ii) approximately $7.0 million of charges (included in costs of revenue) relating primarily to excess and obsolete inventory. The Company's 1992 revenue growth was due to a higher volume of switching products and an increase in shipments of access products. Switching revenue represents 54% of consolidated revenue in 1992 compared to 49% of consolidated revenue in 1991. The significant increase in switching revenue was in part due to increased shipments of signal transfer points (STP's) including a growth in software revenue, partially offset by a lower volume of certain tandem products. Deliveries of STP's in 1991 were unfavorably impacted by a number of factors, including service outages experienced by certain customers. Revenue of transmission products represented 24% of 1992 revenue compared to 29% of 1991 revenue. Access products revenue accounted for approximately 8% of consolidated revenue in 1992 compared to 3% in 1991 with substantial volume increases during the last half of 1992. While shipments have increased, the access products division did not have the volumes necessary in 1992 to achieve profitability. Cost of revenue of $333.5 million in 1992 represented 62.2% of total revenue, compared to 73.3% in 1991. The 1992 improvement was due to increased deliveries of higher margin switching products, including a larger component of software revenue, higher production levels which lowered fixed costs as a percentage of revenue, cost reductions and increased operating efficiencies. Research and product development expenses increased in 1992 to $68.3 million, or 12.7% of revenue, compared to $63.8 million in 1991, or 13.8% of revenue. Selling, general and administrative expenses were $87.0 million in 1992 or 16.2% of revenue compared to $88.6 million or 19.2% of revenue in 1991. The decrease is primarily due to the impact of the Company's 1991 actions to improve operating efficiency and reduce costs. Other operating costs in 1992 were $5.1 million as compared to $4.4 million in 1991, exclusive of the $48.1 million of special charges recorded in 1991. Interest expense of $21.3 million declined $4.1 million from 1991 due to an overall decline in the average outstanding borrowings and a decline in the average cost of borrowing. Other expense, net, of $8.3 million in 1992 increased by $4.7 million from $3.6 million in 1991 primarily as a result of provisions recorded in 1992 for litigation, senior unsecured debt restructuring costs and certain idled facilities costs. In addition, higher cash discounts taken by customers, primarily in the first half of 1992, for early payments on receivables increased other expense, net, in 1992. See "Other expense, net" in Notes to Consolidated Financial Statements. See "Income Taxes" in Notes to Consolidated Financial Statements for further information relating to income taxes. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA DSC Communications Corporation and Subsidiaries CONSOLIDATED STATEMENTS OF OPERATIONS (In thousands, except per share data) See accompanying Notes to Consolidated Financial Statements. DSC Communications Corporation and Subsidiaries CONSOLIDATED BALANCE SHEETS (In thousands) See accompanying Notes to Consolidated Financial Statements. DSC Communications Corporation and Subsidiaries CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) (Continued) DSC Communications Corporation and Subsidiaries CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued) (In thousands) See accompanying Notes to Consolidated Financial Statements. DSC Communications Corporation and Subsidiaries CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (In thousands) See accompanying Notes to Consolidated Financial Statements. DSC Communications Corporation and Subsidiaries NOTES TO CONSOLIDATED FINANCIAL STATEMENTS SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation DSC Communications Corporation (the "Company") is a leading designer, developer, manufacturer and marketer of digital switching, transmission, access and private network system products for the worldwide telecommunications marketplace. The consolidated financial statements of the Company include the accounts of the Company and all its majority-owned subsidiaries. All significant intercompany transactions and balances are eliminated. Certain prior years' financial statement information has been reclassified to conform with the current year financial statement presentation. Revenue Recognition Revenue is generally recognized when the Company has completed substantially all manufacturing and/or software development to customer specifications, factory testing has been completed and the product has been shipped. Additionally, for systems where installation requirements are the responsibility of the Company and payment terms are related to installation completion, revenue is generally recognized when the system has been shipped to the customer's final site for installation. Revenue under contracts with customers for development and customization of software is accounted for using the percentage-of-completion method as certain contracted milestones are completed. Revenue from technical assistance service contracts is recognized ratably over the period the services are performed. The Company establishes an allowance for potential returns pending completion of customer product acceptance and payment. Warranty Costs The Company provides for estimated future warranty costs at the time revenue is recognized. Cash and Cash Equivalents Cash equivalents are primarily short-term, interest bearing, high credit quality investments with major financial institutions and are subject to minimal risk. These investments have maturities at the date of purchase of three months or less (see "Investments in Debt and Equity Securities"). Investments in Debt and Equity Securities The Company has elected to adopt Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities" (FAS 115), in 1993. In accordance with FAS 115, prior years' financial statements have not been restated to reflect the change in accounting method. There was no cumulative effect as a result of adopting FAS 115 in 1993. Management determines the appropriate classification of its investments in debt and equity securities at the time of purchase and reevaluates such determination at each balance sheet date. Debt securities for which the Company does not have the intent or ability to hold to maturity are classified as available for sale, along with the Company's investment in equity securities. Securities available for sale are carried at fair value, with the unrealized gains and losses, net of tax, reported in a separate component of shareholders' equity. At December 31, 1993, the Company had no investments that qualified as trading or held to maturity. The amortized cost of debt securities classified as available for sale is adjusted for amortization of premiums and accretion of discounts to maturity or, in the case of mortgage-backed securities, over the estimated life of the security. Such amortization and interest are included in interest income. Realized gains and losses are included in other income or expense. The cost of securities sold is based on the specific identification method. At December 31, 1993, the Company's investments in debt and equity securities were classified as cash and cash equivalents and marketable securities. These investments are diversified among high credit quality securities in accordance with the Company's investment policy. Inventories Inventories are valued at the lower of average cost or market. Inventories consisted of the following (in thousands): Contract Development Costs Costs incurred in the development of software and hardware which pertain to specific contracts with customers are capitalized at the lower of cost or net realizable value and charged to cost of revenue when the related revenue is recognized. Property and Equipment Property and equipment are recorded at cost and depreciated on a straight-line basis over their estimated useful lives as follows: Capital leases and equipment leased to customers under operating leases are amortized on a straight-line basis over the term of the lease. Amortization of these leases is included in depreciation expense. Capitalized Interest Interest costs related to certain qualifying assets (primarily capitalized software development costs) are capitalized during their construction or development period and amortized over the economic life of the related assets. For the years ended December 31, 1993, 1992 and 1991, the Company capitalized $895,000, $1,112,000 and $725,000, respectively, of such interest costs. Cost in Excess of Net Assets of Businesses Acquired, Net Cost in excess of net assets of businesses acquired generally is amortized on a straight-line basis over its estimated life. The Company periodically reviews the original assumptions and rationale utilized in the establishment of the carrying value and estimated life. The carrying value would be adjusted if significant facts and circumstances altered the Company's original assumptions and rationale. Cost in excess of net assets of businesses acquired, net, was $50,317,000 and $62,238,000 at December 31, 1993 and 1992, respectively. This represents the cost of acquiring businesses over the fair value of net assets received at the date of acquisition, net of accumulated amortization of $12,430,000 and $8,809,000 at December 31, 1993 and 1992, respectively. Amortization was computed by use of the straight-line method over the estimated life of the benefits received from the acquisitions and was included in "Other operating costs" in the Consolidated Statements of Operations. Additionally, the carrying value was reduced in 1993 by $8,300,000 as a result of utilization of preacquisition net operating loss carryforwards (see "Income Taxes"). Research and Development Expenditures Certain software development costs are capitalized when incurred. Capitalization of software development costs begins upon the establishment of technological feasibility. The establishment of technological feasibility and the ongoing assessment of recoverability of capitalized software development costs require considerable judgment by management with respect to certain external factors, including, but not limited to, technological feasibility, anticipated future gross revenues, estimated economic life and changes in software and hardware technologies. Amortization of capitalized software development costs is provided on a product-by-product basis at the greater of the amount computed using (a) the ratio of current gross revenues for a product to the total of current and anticipated future gross revenues or (b) the straight-line method over the remaining estimated economic life of the product. Generally, an original estimated economic life of two years is assigned to capitalized software development costs. Capitalized software development costs were $33,485,000 and $29,083,000 at December 31, 1993 and 1992, respectively, net of accumulated amortization costs of $18,638,000 and $13,365,000, respectively. During 1991, the Company reduced the carrying value of certain capitalized software development costs by approximately $9,500,000 to their estimated net realizable value (see "Special Charges"). All other research and development expenditures are charged to research and development expense in the period incurred. Debt Issuance Cost Costs associated with the borrowing of funds and placement of debt are deferred and amortized over the term of the related debt as interest expense or included as an additional cost if the debt is paid prior to its scheduled maturity (see "Other Expense, Net"). Income Taxes Effective January 1, 1992, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (FAS 109). As permitted by FAS 109, prior year financial statements have not been restated to reflect the change in accounting method. Under FAS 109, the liability method is used in accounting for income taxes. Under this method, deferred tax assets and liabilities are determined based on differences between financial reporting and the tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. Prior to the adoption of FAS 109, income tax expense was determined using the liability method prescribed by Statement of Financial Accounting Standards No. 96, "Accounting for Income Taxes" (FAS 96), which is superseded by FAS 109. Among other changes, FAS 109 changes the recognition and measurement criteria for deferred tax assets included in FAS 96 and requires that the tax benefit of net operating loss carryforwards, tax credits and future taxable deductions be recorded as deferred tax assets net of an appropriate valuation reserve. Income tax benefits related to stock option exercises are credited to additional capital when recognized. Provision is made for U.S. income taxes, net of available credits, on the earnings of foreign subsidiaries which are in excess of amounts being held for reinvestment in overseas operations. Additionally, Puerto Rican tollgate taxes are not provided on a portion of the undistributed earnings in Puerto Rico, which are considered to be indefinitely invested (see "Income Taxes"). Foreign Currency Translation For the majority of the Company's foreign subsidiaries, the functional currency is the U.S. dollar. Accordingly, most foreign entities translate monetary assets and liabilities at year-end exchange rates while non monetary items are translated at historical rates. Revenue and expense items are translated at the average exchange rates in effect during the year, except for depreciation and cost of sales, which are translated at historical rates. The resulting translation adjustments and transaction gains and losses are included in "Other Expense, Net" in the Consolidated Statements of Operations and were not material in 1993, 1992 or 1991. Income (Loss) Per Share Income (loss) per share is based upon weighted average common shares outstanding and common stock equivalents. Common stock equivalents have been determined assuming the exercise of all dilutive stock options and warrants adjusted for the assumed repurchase of common stock, at the average market price, from the exercise proceeds. The fully diluted per share computation also assumes the conversion of the convertible subordinated debentures, when dilutive, and the assumed repurchase of common stock at the ending market price. Primary and fully diluted income (loss) per share are essentially the same for all periods presented except for 1992 when primary income per share was $0.26 and fully diluted income per share was $0.25. INVESTMENTS IN DEBT AND EQUITY SECURITIES The following is a summary of the estimated fair value of available for sale securities by balance sheet classification at December 31, 1993 (in thousands): The estimated fair value of each investment approximates the amortized cost, and therefore, there are no unrealized gains or losses as of December 31, 1993. The estimated fair value of debt securities available for sale by contractual maturity at December 31, 1993 is as follows (in thousands): Expected maturities will differ from contractual maturities because the issuers of the securities may have the right to prepay obligations without prepayment penalties. RECEIVABLES Receivables consisted of the following (in thousands): To meet market competition, the Company finances sales of equipment to certain of its customers through sales-type and operating leases. The repayment terms vary from one to five years. The components of the receivables from sales-type leases are as follows (in thousands): Future minimum lease payments to be received on sales-type leases are as follows (in thousands): PROPERTY AND EQUIPMENT The Company's property and equipment consisted of the following (in thousands): In late 1993, the Company acquired 42 acres of land for approximately $1,833,000. In February 1994, the Company acquired an additional 148 acres for approximately $16,400,000 in cash. The land will be used for future building expansion. ACCRUED LIABILITIES AND CUSTOMER ADVANCES Accrued liabilities consisted of the following (in thousands): At December 31, 1992, customer advances included $34,300,000 of cash advanced against future purchases from a customer as part of a settlement of certain litigation. During 1993, the customer purchases exceeded the December 31, 1992 advances, and there is no advance from the customer at December 31, 1993. CREDIT AGREEMENTS In June 1993, the Company entered into a new revolving credit agreement with a bank, which expired on February 28, 1994, providing for borrowings up to $22,500,000 reduced by the value of outstanding letters of credit issued by the bank on behalf of the Company up to $14,000,000. This agreement replaced an earlier agreement which had expired. Letters of credit issued by the bank on behalf of the Company were $8,081,000 at December 31, 1993. The Company paid a fee on the unused portion of the credit facility of 0.125% per annum. The agreement was collateralized by current domestic receivables and inventories. There were no borrowings under the credit agreements during 1993. On February 24, 1994, the Company entered into an uncollateralized revolving credit facility, which expires on February 24, 1997, with two banks providing for borrowings up to $50,000,000. The maximum available borrowings are reduced by the value of outstanding letters of credit issued by the banks on behalf of the Company up to $25,000,000. Borrowings under the facility bear interest at the prime rate or at 0.75% to 1.50% above the LIBOR rate. A commitment fee of 0.35% on the daily average unused portion of the facility will also be assessed. The agreement contains various financial covenants. DEBT Total debt consisted of the following (in thousands): The prime interest rate at December 31, 1993 and 1992 was 6.0%. The aggregate maturities of long-term debt for the next five years are as follows: 1994 - $13,664,000; 1995 - $11,052,000; 1996 - $9,231,000; 1997 - $49,000; 1998 - $0. In June 1993, the Company borrowed $19,975,000 under a loan agreement which is secured by certain long-term lease receivables. This note is due in installments through June 29, 1996, and bears interest at the prime rate plus one-half percent. All of the senior debt contains various financial convenants, including, among other things, minimum working capital levels, maintenance of certain ratios of assets to liabilities, and maximum allowable indebtedness to tangible net worth. Subordinated Convertible Debentures 7.75% Debentures In 1993, the Company issued approximately 3,842,000 shares of the Company's common stock upon conversion of its outstanding 7.75% subordinated convertible debentures. As a result, approximately $68,561,000 was credited to common stock and additional capital, which was net of $2,906,000 of remaining deferred debt costs associated with the original issuance of the subordinated convertible debentures and costs related to the conversion. On a pro forma basis, income per share for the year ended December 31, 1993 would have been $1.51 had the 7.75% subordinated convertible debentures been converted on January 1, 1993. 8.0% Debentures On January 14, 1994, the Company called for the redemption of all of the outstanding 8% subordinated convertible debentures. The debentures were convertible, at the option of the holder, into shares of the Company's common stock at $54.50 per share. In February 1994, approximately $34,720,000 of debentures were converted into approximately 636,900 shares of common stock and approximately $1,696,000 of debentures were redeemed for cash. INCOME TAXES Effective January 1, 1992, the Company began accounting for income taxes under the method required by Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (FAS 109). See "Summary of Significant Accounting Policies" for additional details. As permitted under the new rules, prior years' financial statements have not been restated. Accordingly, amounts shown for 1991 reflect income tax accounting under FAS 96. At December 31, 1993 and 1992, the Company had a net deferred tax asset of $66,423,000 and $68,235,000, respectively, reflecting the tax benefits of U.S. and foreign subsidiary net operating loss carryforwards, tax credit carryforwards and net future tax deductions. FAS 109 requires a valuation reserve be established if it is "more likely than not" that realization of the tax benefits will not occur. In recent years, the Company has cumulative losses within its U.S. consolidated tax group which FAS 109 indicates is significant evidence that could require a valuation reserve. Similarly, certain foreign jurisdictions also have cumulative losses. As a result, a valuation allowance equal to the net deferred tax asset was established at December 31, 1993 and 1992, although the Company believes the tax benefits will ultimately be realized through future operations. Because a valuation reserve was established equal to the net deferred tax asset, there was no cumulative effect on pretax net income or cash flows as a result of the adoption of FAS 109 in 1992. The net deferred tax asset would have decreased an additional $1,397,000 had the Federal tax rate not increased from 34% to 35% retroactively effective to January 1, 1993. Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the Company's net deferred tax asset as of December 31, 1993 and 1992, are as follows (in thousands): Included in Noncurrent Income Taxes and Other Liabilities at December 31, 1993 and 1992 are $25,150,000 and $17,928,000, respectively, for noncurrent taxes related to foreign jurisdictions. The Federal and foreign loss carryforwards at December 31, 1993 shown above include approximately $33,000,000 of tax benefits related to the exercise of employee stock options which, when recognized, will increase "Additional capital" on the Consolidated Balance Sheet. Income tax expense (benefit) was composed of the following (in thousands): The current Federal tax expense included $5,800,000 and $1,860,000 for 1993 and 1992, respectively, representing the tax benefits of stock option deductions credited to "Additional capital" and $8,300,000 for 1993 representing all of the tax benefits of preacquisition net operating loss carryforwards utilized to reduce the Company's Cost in Excess of Net Assets of Businesses Acquired. The effective income tax rate on pretax income (loss) differed from the Federal income tax statutory rate for the following reasons (in thousands): At December 31, 1993, the Company had consolidated regular tax net operating loss carryforwards for Federal tax purposes of approximately $99,500,000 available to be carried to future periods. The loss carryforwards expire from 2002 to 2008 if not used. Also, a foreign subsidiary of the Company had approximately $9,000,000 of net operating and capital loss carryforwards available to be carried to future periods which do not expire. The Company has general business and other regular tax credit carryforwards of approximately $13,000,000 which expire from 1994 to 2005. The Company also has alternative minimum tax credits of approximately $1,500,000 which can be utilized against regular taxes in the future. Puerto Rican tollgate taxes (maximum rate of 10%) have not been provided on approximately $13,594,000 of undistributed earnings in Puerto Rico, which are considered to be indefinitely invested. DSC's Puerto Rican subsidiary has been granted a 90% tax exemption from Puerto Rican income taxes. The tax grant expires in 2005. Undistributed earnings of foreign subsidiaries are not material. INCENTIVE COMPENSATION The Company has an Incentive Awards Plan administered by the Compensation Committee of the Board of Directors which provides for payment of cash awards to officers and key employees based upon achievement of specific goals by the Company and the participating executives. For the years ended 1993 and 1992, provisions of approximately $6,100,000 and $2,900,000 were charged against income related to the plan. No incentive awards were granted under the plan for 1991. The Company also has a Long-Term Incentive Compensation Plan (LTIP) which awards performance units to certain key executives. Certain officers were awarded units in 1990 under the Company's LTIP by the Compensation Committee of the Board of Directors. The units vest to the officers over six years, and the value of a unit is determined annually based on the Company's operating performance, as defined in the plan. The value of the units charged to income in 1993 was approximately $2,300,000. Prior to 1993, the units awarded had no value. COMMON AND PREFERRED STOCK Description and Dividends At December 31, 1993 the Company was authorized to issue 100,000,000 shares of common stock, $.01 par value, and 5,000,000 shares of preferred stock, $1.00 par value. Since inception, the Company has not declared or paid a cash dividend. In October 1993, the Company issued 3,450,000 shares of the Company's common stock in a public offering for which the Company received net proceeds of approximately $231,149,000. In May 1986 and subsequently amended in April 1991, the Company declared a dividend distribution of one preferred stock purchase right on each outstanding share and each subsequently issued share of the Company's common stock. The rights will not become exercisable until the close of business ten days after a public announcement that a person or group has acquired 20% or more of the common stock of the Company, or a public announcement or commencement of a tender or exchange offer which would result in the offeror acquiring 30% or more of the common stock of the Company. Once exercisable, each right would entitle a holder to buy 1/100 of a share of the Company's Series A Junior Participating preferred stock at an exercise price of $45.00. The Company may redeem the rights for 5 cents per right prior to the close of business on the tenth day following the announcement that a person or group has acquired 20% or more of the outstanding common stock of the Company. The rights will expire in 1996 unless redeemed or exercised at an earlier date. Stock Purchase Plans Under provisions of the Company's employee stock purchase plans, employees can purchase the Company's common stock at a specified price through payroll deductions during an offering period, currently established on an annual basis. In July 1993, approximately 1,543,000 shares were issued to employees under the employee stock purchase plan. At December 31, 1993, approximately $3,151,000 had been contributed by employees that will be used to purchase shares at the end of the offering period in July 1994. The amount of shares issuable in July 1994 for the current offering is approximately 166,000 shares assuming no future withdrawals from the plan. At December 31, 1993, the Company could issue up to 4,450,000 shares under the employee stock purchase plans of which approximately 3,672,000 shares had been purchased and issued. Warrants and Options The Company has stock option plans providing for the issuance of both incentive stock options and nonqualified stock options exercisable for a period of ten years, as well as restricted stock issuances. The plans cover 13,420,000 shares of common stock. At December 31, 1993, plan options covering 3,382,000 shares had been granted and are outstanding, options granted under the plans covering 7,369,000 shares had been exercised, 658,000 restricted shares had been issued (net of forfeitures), 224,000 shares had expired and options covering 1,787,000 shares are available for grant. The exercise prices of stock options granted and warrants issued were at the market value of the Company's common stock at the date of grant or issuance. In the event of discontinuation of service by the optionees, all or a portion of the shares acquired pursuant to these options can be repurchased by the Company, at its option, based on the vesting terms in the option agreements. Other options at December 31, 1993 include 34,000 options granted to various current or prior members of the Company's Board of Directors and certain nonemployees who have performed services for the Company. Outstanding warrants and options are summarized as follows: Restricted Stock The Company's Board of Directors authorized the issuance of restricted shares of the Company's common stock to certain key employees under its 1993, 1988 and 1984 employee stock option plans. Holders of restricted stock retain all rights of a shareholder, except the shares cannot be sold until they are vested. Upon employee termination, all unvested shares are forfeited to the Company. The shares vest annually through 1996. The Company issued 255,000, 104,000 and 313,000 shares of restricted stock to employees in 1993, 1992, and 1991, respectively, and increased common stock and additional capital by the fair market value of the stock at the date of issuance ($7,348,000, $778,000 and $1,714,000 in 1993, 1992 and 1991, respectively), net of unearned compensation. At December 31, 1993, 1992 and 1991, unearned compensation related to the restricted shares was $3,266,000, $1,507,000 and $1,424,000, respectively. The unearned compensation will be charged to expense ratably over the vesting period. During 1992, 14,000 restricted shares were forfeited. Reserved Stock Common stock has been reserved for the following purposes (in thousands): SPECIAL CHARGES Special charges for 1991 included the following (in thousands): These charges resulted from the Company's reassessment in 1991 of anticipated near-term business levels in light of the current economic environment and the related impact on estimated revenue levels. Also during 1991, the Company realigned its management structure on a product line basis to refocus key management on product line performance. This realignment resulted in the restructuring charge of $4,184,000 related to excess lease and personnel related costs. OTHER OPERATING COSTS The agreement to acquire a company (Optilink) in 1990 requires the Company to pay certain former employees of Optilink up to $7,900,000 if certain revenue targets are achieved through December 31, 1995. At December 31, 1993, approximately $5,514,000 had been earned under the agreement, including $4,052,000 in 1993, $912,000 in 1992 and $288,000 in 1991. Such amounts are included in "Other Operating Costs" on the Consolidated Statements of Operations. OTHER EXPENSE, NET Other expense, net for the year ended December 31, 1993 included a gain of $2,154,000 from the sale of securities acquired several years ago as part of financing provided to a customer. Other expense, net for the year ended December 31, 1992 included provisions of approximately $1,500,000 for legal and related costs associated with litigation activities and approximately $2,000,000 for costs related to the restructuring of the Company's senior unsecured debt. RELATED PARTIES The Company has agreements to pay consulting fees, which amounted to $486,000 in 1993, $424,000 in 1992 and $411,000 in 1991 to members of the Company's Board of Directors. The Company paid legal fees of $175,000 in 1992 and $199,000 in 1991 to a legal firm with a shareholder who became a member of the Company's Board of Directors during 1989 and subsequently resigned during 1992. During 1992, the Company purchased approximately 98,000 shares of its outstanding common stock from various employees and an officer of the Company, who is also a member of the Board of Directors, at the existing market price at the date of the transactions. FAIR VALUE OF FINANCIAL INSTRUMENTS Statement of Financial Accounting Standards No. 107, "Disclosures about Fair Value of Financial Instruments," requires disclosure of the fair value of certain financial instruments. Cash and cash equivalents, accounts receivable, accounts payable and accrued liabilities are reflected in the financial statements at fair value. Marketable securities are recorded in the financial statements at current market values (see "Investments in Debt and Equity Securities"). The following methods and assumptions were used by the Company in estimating its fair value disclosures for the Company's financial instruments: Debt The carrying amounts of the Company's borrowings under its senior unsecured debt agreement and other debt approximate their fair value at December 1993 and 1992 due to renegotiation of the senior unsecured debt in December 1992 combined with similar interest rates at December 1993 and 1992, and the other debt containing market interest rates. The subordinated convertible debentures are based on quoted market values. Forward foreign exchange contracts, letters of credit and guarantees The fair values of the Company's off-balance sheet instruments are based on current settlement values (forward foreign exchange contracts) and fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties' credit standing (guarantees and letters of credit). The difference between these contract values and the fair value of these instruments is included when it is material. The carrying amounts and fair values of the Company's significant financial instruments at December 31, 1993 and 1992 are as follows (in thousands): COMMITMENTS AND CONTINGENCIES Operating Lease Commitments The Company leases certain facilities and equipment which require future rental payments. These rental arrangements do not impose any financing or dividend restrictions on the Company or contain contingent rental provisions. Certain of these leases have renewal and purchase options generally at the fair value at the renewal or purchase option date. Future minimum rental commitments under operating leases with noncancellable lease terms in excess of one year were as follows at December 31, 1993 (in thousands): Operating lease rental expense was $19,268,000, $17,296,000 and $18,203,000, for the years ended December 31, 1993, 1992 and 1991, respectively. Additionally, for the year ended December 31, 1991, the Company received sublease rental income of $2,530,000. Contingent Liabilities The Company periodically sells customer receivables and operating leases under agreements which contain recourse provisions. The Company could be obligated to repurchase receivables and operating leases which were previously sold on a partial recourse basis, the terms of which allow the Company to limit its risk of loss to approximately $5,328,000 at December 31, 1993. The Company has guarantees of approximately $12,973,000 outstanding at December 31, 1993, supporting Company and third-party performance bonds to customers and others, of which approximately $8,081,000 was collateralized by letters of credit issued under the Company's credit facility. The Company believes it has adequate reserves for any ultimate losses associated with these contingencies. The Company enters into forward foreign exchange contracts to hedge certain receivables and firm contracts for delivery of products and services which are denominated in foreign currencies. At December 31, 1993, the Company had forward foreign exchange contracts of $22,277,000 to hedge future receipts in such currencies. Gains and losses related to the forward contracts are recognized as part of the cost of the underlying transactions being hedged. Forward foreign exchange contracts generally have maturities of one year or less and contain an element of risk that the counterparty may be unable to meet the terms of the agreement. However, the Company minimizes such risk exposure by limiting the counterparty to major financial institutions. Management believes the risk of incurring such losses is remote and any losses therefrom would be immaterial. Litigation In February 1994, the United States Fifth Circuit Court of Appeals (the "Court of Appeals") affirmed dismissal by the United States District Court for the Northern District of Texas of a shareholder suit against the Company and certain of its present and former officers and directors. The suit was purportedly filed as a class action on behalf of an alleged class of persons who purchased common stock of the Company from February 7, 1991, through October 31, 1991. The complaint had alleged violations of Section 10(b) of the Securities and Exchange Act of 1934, Rule 10b-5 promulgated thereunder and negligent misrepresentation. The complaint sought actual and punitive damages in unspecified amounts. The plaintiffs have been granted an extension of time through March 25, 1994, in which to determine whether or not to request a rehearing by the Court of Appeals. In addition, the plaintiffs have the option to seek further review by the United States Supreme Court. The Company does not believe the ultimate resolution of this matter will have a material adverse effect on the Company's consolidated financial position. On July 20, 1993, the Company filed suit against Advanced Fibre Communications ("AFC"), Quadrium Corporation and two former employees in the United States District Court for the Eastern District of Texas. The Company seeks: (i) a declaratory judgment that the two former employees are not entitled to any stock options or cash payments under certain employee plans due to alleged breaches of certain employment related agreements; (ii) a declaration that AFC's products are proprietary property of the Company; and (iii) unspecified damages for breach of contract, civil conspiracy and tortious interference. Counterclaims have been filed by the former employees claiming entitlement to certain stock options and cash payments. Additionally, AFC has filed counterclaims including various tort claims and claims based on alleged violations of various Federal and State antitrust and unfair competition laws. AFC also seeks a declaratory judgment that it owns all rights to its products and seeks unspecified damages, including treble damages under antitrust statutes and punitive damages. The case is in the early stages of discovery, and the Company intends to vigorously prosecute its claims and defend all of the defendants' counterclaims. The Company believes that it has valid and substantial claims against all of the defendants and valid defenses to all of the counterclaims and does not believe the ultimate resolution of this matter will have a material adverse effect on the Company's consolidated financial position. The Company is a party to other legal proceedings which, in the opinion of management, are not expected to have a material adverse effect on the Company's consolidated financial position. INTERNATIONAL OPERATIONS AND MAJOR CUSTOMERS Export Sales Revenue generated from export sales in 1991 was $48,012,000. Revenue generated from export sales was less than 10% of total revenue in 1993 and 1992. Major Customers Customers that accounted for 10% or more of consolidated revenue and their related percentage of consolidated revenue were as follows: REPORT OF INDEPENDENT AUDITORS To the Board of Directors and Shareholders of DSC Communications Corporation: We have audited the accompanying consolidated balance sheets of DSC Communications Corporation and subsidiaries (the "Company") as of December 31, 1993 and 1992 and the related consolidated statements of operations, changes in shareholders' equity and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules 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 financial statements referred to above present fairly, in all material respects, the consolidated financial position of the Company at December 31, 1993 and 1992, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. Ernst & Young Dallas, Texas January 24, 1994 DSC Communications Corporation and Subsidiaries QUARTERLY RESULTS (Unaudited) (In thousands, except per share data) ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required by this item with respect to the directors and nominees for election to the Board of Directors of the Company is incorporated by reference from the information set forth on page 1 of the definitive proxy statement of the Company, previously filed in connection with its 1994 Annual Meeting of Stockholders under the heading "ELECTION OF DIRECTORS", and on pages 11 and 12 of such definitive proxy material under the heading "DIRECTORS CONTINUING IN OFFICE". The information regarding executive officers of the Company is contained in Part I of this Annual Report on Form 10-K. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information required by this item is incorporated by reference from the information set forth under the heading "EXECUTIVE COMPENSATION" on pages 5 through 11 of the definitive proxy statement of the Company, previously filed in connection with its 1994 Annual Meeting of Stockholders. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this item is incorporated by reference from the information set forth under the heading "SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT" on page 14 of the definitive proxy statement of the Company, previously filed in connection with the 1994 Annual Meeting of Stockholders. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this item is incorporated by reference from the information set forth under the heading "COMPENSATION OF DIRECTORS" on pages 12 and 13 of the definitive proxy statement of the Company, previously filed in connection with the 1994 Annual Meeting of Stockholders. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) The following is a list of the consolidated financial statements and financial statement schedules which are included in this Form 10-K or which are incorporated herein by reference. 1. Financial Statements: As of December 31, 1993 and 1992: Consolidated Balance Sheets For the Years Ended December 31, 1993, 1992, and 1991 -- Consolidated Statements of Operations -- Consolidated Statements of Cash Flows -- Consolidated Statements of Changes in Shareholders' Equity Notes to Consolidated Financial Statements Report of Independent Auditors 2. Financial Statement Schedules: As of December 31, 1993: -- Schedule I -- Marketable Securities - Other Investments For the years Ended December 31, 1993, 1992, and 1991: -- Schedule II -- Amounts Receivable From Related Parties, Underwriters, Promoters, and Employees Other Than Related Parties -- Schedule V -- Property and Equipment -- Schedule VI -- Accumulated Depreciation and Amortization of Property and Equipment -- Schedule VIII -- Valuation and Qualifying Accounts -- Schedule IX -- Short Term Borrowings -- Schedule X -- Supplementary Income Statement Information All other financial statements and financial statement schedules have been omitted because they are not applicable, or the required information is included in the consolidated financial statements or notes thereto. 3. Exhibits: 3.1 Amended and Restated Certificate of Incorporation of the Company (1) 3.2 Amended and Restated By-laws of the Company (8) 4.3 Rights Agreement, Dated as of May 12, 1986, Between the Company and The Chase Manhattan Bank, N.A., as Rights Agent (3) 4.4 Form of Letter to the Company's Stockholders, Dated May 22, 1986, Relating to the Adoption of the Rights Agreement Described in Exhibit 4.3 (3) 10.1 Employment Agreement Between the Company and James L. Donald, Dated January 1, 1990 (9) 10.2 Executive Income Continuation Plan, Dated January 1, 1990, Between the Company and James L. Donald (9) 10.3 Insurance Ownership Agreement, Dated January 1, 1990, Between the Company and James L. Donald (9) 10.4 Management Consulting Agreement Among the Company, Nolan Consulting, Inc., and James M. Nolan, Dated March 15, 1982 (4) 10.5 Amended and Restated Note Agreement, Dated December 31, 1992, Between the Company and an Institutional Lender (10) 10.6 Revolving Credit Agreement, Dated as of February 24, 1994, Between the Company and Certain of its Subsidiaries and Certain Financial Institutions Providing for Secured Revolving Credit (13) 10.7 The Company's Amended and Restated 1979 Employee Stock Option Plan (5) 10.8 The Company's Amended and Restated 1981 Employee Stock Option Plan (5) 10.9 The Company's Amended and Restated 1984 Employee Stock Option Plan (7) 10.10 The Company's Amended and Restated 1988 Employee Stock Option Plan (7) 10.11 The Company's Amended and Restated 1985 Convertible Debenture Plan (2) 10.12 The Company's 1993 Employee Stock Option and Securities Award Plan (11) 10.13 The Company's 1993 Non-Employee Directors Stock Option Plan (11) 10.14 The Company's Employee Thrift Plan as Amended and Restated (2) 10.15 The Company's 1988 Employee Stock Ownership Plan (6) 10.16 Form of Amended and Restated Severance Compensation Agreement Between the Company and Certain of its Executive Officers (8) 10.17 The Company's Restoration Plan, Dated July 1, 1988 (6) 10.18 Form of Indemnification Agreement Between the Company and its Directors and Senior Officers as Approved by the Board of Directors and Entered Into on or After January 22, 1990, and the Related Trust Agreement, Dated March 1, 1990, Between the Company and First City, Texas-Dallas, as Trustee (7) 10.19 The Company's Long-Term Incentive Compensation Plan, Effective as of January 1, 1990 (9) 10.20 The 1990 Optilink Stock Option and Cash Payment Plan, Dated May 15, 1990 (9) 10.21 The Company's Long-Term Incentive Compensation Plan, Effective as of January 1, 1994 (12) 11.1 Statement re: Computation of Per Share Earnings (13) 22.1 Subsidiaries of the Registrant (13) 23.1 Consent of Ernst & Young (13) MANAGEMENT CONTRACTS OR COMPENSATORY PLANS AND ARRANGEMENTS The following above-described exhibits are management contracts or compensatory plans and arrangements: 10.1 Employment Agreement Between the Company and James L. Donald, Dated January 1, 1990; 10.2 Executive Income Continuation Plan, Dated January 1, 1990, Between the Company and James L. Donald; 10.3 Insurance Ownership Agreement, Dated January 1, 1990, Between the Company and James L. Donald; 10.4 Management Consulting Agreement Among the Company, Nolan Consulting, Inc., and James M. Nolan, Dated March 15, 1982; 10.7 the Company's Amended and Restated 1979 Exployee Stock Option Plan; 10.8 The Company's Amended and Restated 1981 Employee Stock Option Plan; 10.9 The Company's Amended and Restated 1984 Employee Stock Option Plan; 10.10 The Company's Amended and Restated 1988 Employee Stock Option Plan; 10.11 The Company's Amended and Restated 1985 Convertible Debenture Plan; 10.12 The Company's 1993 Employee Stock Option and Securities Award Plan; 10.13 The Company's 1993 Non-Employee Directors Stock Option Plan; 10.14 The Company's Employee Thrift Plan as Amended and Restated; 10.15 The Company's 1988 Employee Stock Ownership Plan; 10.16 Form of Amended and Restated Severance Compensation Agreement Between the Company and Certain of its Executive Officers; 10.17 The Company's Restoration Plan, Dated July 1, 1988; 10.18 Form of Indemnification Agreement Between the Company and its Directors and Senior Officers as Approved by the Board of Directors and Entered Into on or After January 22, 1990, and the Related Trust Agreement, Dated March 1, 1990, Between the Company and First City, Texas-Dallas, as Trustee; 10.19 The Company's Long-Term Incentive Compensation Plan, Effective as of January 1, 1990; 10.21 The Company's Long-Term Incentive Compensation Plan, Effective as of January 1, 1994. (b) Reports on Form 8-K: None - ------------------------------------------------------------------------------ (1) Incorporated by reference from the Company's Amendment to Application or Report on Form 8, dated July 28, 1989 (2) Incorporated by reference from the Company's Annual Report on Form 10-K for the year ended December 31, 1986 (3) Incorporated by reference from the Company's Registration Statement on Form 8-A, dated May 21, 1986, as amended by Amendment No. 1 on Form 8, dated July 28, 1989, and Amendment No 2. on Form 8, dated May 28, 1991, each as filed with the Securities and Exchange Commission pursuant to Section 12(g) of the Exchange Act (4) Incorporated by reference from the Company's Annual Report on Form 10-K for the year ended December 31, 1981 (5) Incorporated by reference from the Company's Registration Statement on Form S-8 (Registration No. 2-83398) (6) Incorporated by reference from the Company's Annual Report on Form 10-K for the year ended December 31, 1988 (7) Incorporated by reference from the definitive proxy statement of the Company, filed in connection with the 1990 Annual Meeting of Stockholders (8) Incorporated by reference from the Company's Annual Report for the year ended December 31, 1989 (9) Incorporated by reference from the Company's Annual Report on Form 10-K for the year ended December 31, 1990 (10) Incorporated by reference from the Company's Annual Report on Form 10-K for the year ended December 31, 1992 (11) Incorporated by reference from the definitive proxy statement of the Company, filed in connection with the 1993 Annual Meeting of Stockholders (12) Incorporated by reference from the definition proxy statement of the Company, filed in connection with the 1994 Annual Meeting of Stockholders (13) Filed herewith 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. DSC COMMUNICATIONS CORPORATION (Registrant) /s/ James L. Donald ------------------------------ James L. Donald, Chairman of the Board, President, Chief Executive Officer, and Director 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 dates indicated. Signature and Title Date ------------------- ---- /s/ James L. Donald March 30, 1994 - ------------------------------ James L. Donald, Chairman of the Board, President, Chief Executive Officer, and Director (Principal Executive Officer) /s/ Clement M. Brown, Jr. March 30, 1994 - ------------------------------ Clement M. Brown, Jr. Director /s/ Frank J. Cummiskey March 30, 1994 - ------------------------------ Frank J. Cummiskey Director /s/ Sir John Fairclough March 30, 1994 - ------------------------------ Sir John Fairclough Director /s/ Raymond J. Dempsey March 30, 1994 - ------------------------------ Raymond J. Dempsey Director /s/ James L. Fischer March 30, 1994 - ------------------------------ James L. Fischer Director /s/ Robert S. Folsom March 30, 1994 - ------------------------------ Robert S. Folsom Director Signature and Title Date ------------------- ---- /s/ Gerald F. Montry March 30, 1994 - ------------------------------ Gerald F. Montry, Senior Vice President, Chief Financial Officer, and Director (Principal Financial Officer) /s/ James M. Nolan March 30, 1994 - ------------------------------ James M. Nolan Director /s/ Kenneth R. Vines March 30, 1994 - ------------------------------ Kenneth R. Vines Vice President and Controller (Principal Accounting Officer) DSC COMMUNICATIONS CORPORATION AND SUBSIDIARIES SCHEDULE I MARKETABLE SECURITIES-OTHER INVESTMENTS FOR THE YEAR ENDED DECEMBER 31, 1993 (In Thousands) DSC COMMUNICATIONS CORPORATION AND SUBSIDIARIES SCHEDULE II AMOUNTS RECEIVABLE FROM RELATED PARTIES, UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES FOR THE YEAR ENDED DECEMBER 31, 1993 (CONTINUED) DSC COMMUNICATIONS CORPORATION AND SUBSIDIARIES SCHEDULE II (CONTINUED) AMOUNTS RECEIVABLE FROM RELATED PARTIES, UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES FOR THE YEAR ENDED DECEMBER 31, 1991 DSC COMMUNICATIONS CORPORATION AND SUBSIDIARIES SCHEDULE V PROPERTY AND EQUIPMENT (In Thousands) FOR THE YEAR ENDED DECEMBER 31, 1993 (CONTINUED) DSC COMMUNICATIONS CORPORATION AND SUBSIDIARIES SCHEDULE V (CONTINUED) PROPERTY AND EQUIPMENT (In Thousands) FOR THE YEAR ENDED DECEMBER 31, 1991 DSC COMMUNICATIONS CORPORATION AND SUBSIDIARIES SCHEDULE VI ACCUMULATED DEPRECIATION OF PROPERTY AND EQUIPMENT (In Thousands) FOR THE YEAR ENDED DECEMBER 31, 1993 (CONTINUED) DSC COMMUNICATIONS CORPORATION AND SUBSIDIARIES SCHEDULE VI (CONTINUED) ACCUMULATED DEPRECIATION OF PROPERTY AND EQUIPMENT (In Thousands) FOR THE YEAR ENDED DECEMBER 31, 1991 DSC COMMUNICATIONS CORPORATION AND SUBSIDIARIES SCHEDULE VIII VALUATION AND QUALIFYING ACCOUNTS ALLOWANCE FOR DOUBTFUL ACCOUNTS (In Thousands) DSC COMMUNICATIONS CORPORATION SCHEDULE IX SHORT-TERM BORROWINGS (In thousands) DSC COMMUNICATIONS CORPORATION SCHEDULE X SUPPLEMENTARY INCOME STATEMENT INFORMATION (In thousands) EXHIBIT INDEX 10.6 Revolving Credit Agreement, Dated as of February 24, 1994, Between the Company and Certain of its Subsidiaries and Certain Financial Institutions Providing for Secured Revolving Credit 11.1 Statement re: Computation of Per Share Earnings 22.1 Subsidiaries of the Registrant 23.1 Consent of Ernst & Young

1993 Item 1. Business: (a) Description of Business: The operations of Harsco Corporation (Harsco or the Company) are broadly diversified and include products serving thousands of customers engaged in steel, industrial, commercial, construction and infrastructure, and defense applications. These operations fall into three operating Groups: Industrial Services and Building Products, Engineered Products and Defense. The Company primarily serves its customers through its own salaried sales forces and independent manufacturers' representatives, commission agents and distributors. Harsco utilizes both Company-owned and leased sales offices and warehouses. There were several significant changes in products, services, and markets, but not in methods of distribution during the 1993 fiscal year. In February 1993, the Company purchased certain assets of the Wayne Corporation, a manufacturer of school buses located in Richmond, Indiana for approximately $2.1 million. In a defense conversion activity, production of these school buses was transferred to the BMY-Wheeled Vehicles Division in Marysville, Ohio, and Wayne Wheeled Vehicles was formed. Harsco entered into six new contracts for metal reclamation and specialized steel mill services in Mexico in 1993. In addition, the Company initiated service at a steelmaking location in Canada to provide environmental recycling of steel production residual materials, which is a new service developed through the Company's research and development efforts. On August 31, the Company completed the largest acquisition in Harsco's history by purchasing all of the outstanding capital stock of MultiServ International, N.V., the leading international provider of specialized steel mill services, for a consideration of $384 million. MultiServ's operations were combined with the Company's Heckett Division, and Harsco is now the world leader in the provision of specialized steel mill services to over 130 locations in 27 countries on six continents. Harsco acquired Electroforjados Nacionales, S.A. de C.V., a producer of steel and fiberglass grating products, with annual revenues of about $10 million, located in Queretaro, Mexico during the fourth quarter. The Company also restructured and renamed the Patent Scaffolding Division to Patent Construction Systems Division to better describe the range of products and to emphasize a wide array of services in the construction marketplace. In January 1994, Harsco and FMC Corporation formed a joint venture, United Defense, L.P., by combining the BMY-Combat Systems Division with FMC's Defense Systems Group. Harsco obtained a 40% ownership in United Defense, L.P., which expects to achieve $1 billion in revenues in 1994. The Company's operations are conducted through 10 divisions, each of which has its own executive, supervisory and operating personnel. Each division has general responsibility for its own activities, including marketing. At the Company's headquarters, an executive management group, most of whom have been associated with the Company for many years, manages and provides leadership for business activities. This management group is responsible for establishing basic Company policy and strategic direction, especially in the areas of long-range planning, capital expenditures and finance, and, in addition, makes available to operating personnel technical assistance in a number of specialized fields. (b) Financial Information about Industry Groups: Financial information concerning Industry Groups is included in Note 12 to the consolidated financial statements of the 1993 Annual Report to Shareholders under Exhibit 13. (c) Narrative Description of Business: (1) A narrative description of the businesses by Operating Group is as follows: Industrial Services and Building Products The major product classes in this Group are metal reclamation and scaffolding, shoring and concrete forming equipment. Other classes include: slag abrasives, steel mill services, rental of plant equipment, roofing granules and miscellaneous. Under metal reclamation the Company provides specialized services to steel producers worldwide which includes metal reclamation, scrap handling, cleaning of slag pits, handling of raw material and molten slag, filling and grading of specified areas and the renting of various types of plant equipment. Highly specialized recovery and cleaning equipment, installed and operated on the property of steel producers, together with standard materials handling equipment, including drag lines, cranes, bulldozers, tractors, hauling equipment, lifting magnets and buckets, are employed to reclaim metal. The customer uses this metal in lieu of steel scrap and makes periodic payments to the Company based upon the amounts of metal reclaimed. The nonmetallic residual slag is graded into various sizes at on-site Company-owned processing facilities and sold commercially. Graded slag is used as an aggregate material in asphalt paving applications, railroad ballast and building blocks. The Company also provides in-plant transportation and other specialized services. The Company obtained a significant amount of new business in 1993, including six new contracts in Mexico to provide a variety of services at mini-mills and large, integrated producers. In Germany, the Company received a new contract for in-plant transportation services and expanded the scope of services performed in Holland to include responsibility for blast furnace and steel slag products. The Heckett MultiServ Division was established, effective January 1, 1994 and is the world leader in providing specialized steel mill services to over 130 locations in 27 countries, including Brazil, China, Russia and Slovakia, spanning six continents. Heckett MultiServ locations account for some 30 percent of the world's steelmaking capacity. Slag abrasives and roofing granules are products derived from utility coal slag and are processed at 15 locations in 12 states. Slag abrasives are used for industrial surface preparation and cleaning of bridges, ship hulls and various structures. Roofing granules are sold to roofing shingle manufacturers. In research and development activities, the Company continued to test market a dust suppressant product, designed to improve dusting conditions during the transfer of abrasives. In another project, Harsco, in an effort to identify future alternative materials for colored roofing granules, continued extensive lab testing, including coloring and weathering exposure. Harsco anticipates that the demand for slag abrasives will strengthen in 1994 because of increased activity in the infrastructure repair and rebuild market, particularly in the Northeast. The Group's scaffolding, shoring and concrete forming operations include steel and aluminum support systems that are leased or sold to customers through a North American network of some 35 branch offices. The Division was renamed Patent Construction Systems, effective in December, to better describe the range of products and to emphasize a wide array of services in the construction marketplace. In addition, Patent Plant Services, headquartered in New Orleans, was organized to enhance marketing efforts and long-term scaffolding service contracts to paper mills, refineries, chemical and petrochemical applications and power plants. Several large orders were received from refineries in 1993. During the second half, the Company introduced the Pro 1000 Scaffold Hoist_, part of the motorized swinging scaffold line, which will be marketed worldwide. For 1993, percentages of consolidated net sales of certain product classes were as follows: metal reclamation, 15%; scaffolding, shoring and concrete forming equipment, 6%; and five others, including mill services, rental of plant equipment, roofing granules, slag abrasives and miscellaneous, 7% Engineered Products Major product classes in this Group are gas control and containment, grating, pipe fittings, process equipment and railway maintenance equipment. Other classes include composite products, metal fabrication, wear products and miscellaneous. Gas containment products include propane tanks, cryogenic equipment, high pressure cylinders, and composite products, while gas control products include valves and regulators serving a variety of markets. The cryogenics facility in Germany achieved ISO 9000 certification during the first quarter of 1993, which will enhance product quality and international marketing opportunities. At the cylinder plant in Harrisburg, Pennsylvania, installation of a new high-efficiency billet furnace was underway at year-end. During the fourth quarter of 1993, Harsco formed a long-term commercial agreement with INFLEX, S.A., a manufacturer of a broad line of industrial cylinders, including NGV fuel tanks, located in Buenos Aires, Argentina. Early in 1994, the Division name was changed from Plant City Steel to Taylor-Wharton Gas Equipment to reflect the Company's broader strategic objective of continuing to grow this business through selective international acquisitions in a wide product range. Several new proprietary products were brought to market in the gas control product class in 1993. Production was underway on the innovative new propane valve for 20-pound cylinders on gas grills in Canada during the first quarter, and the full program started in September. A disposable refrigerant valve, developed to meet evolving environmental market demands, was also introduced, as was a unique scuba mouthpiece. The Company's product class of railroad maintenance equipment includes track machinery, which services private and government-owned railroads and urban transit systems. This machinery is classified in the categories of sleeper renewal, spike driving, Hy-Rail, rail grinding, tamping, ballast maintenance, track renewal, track geometry, utility vehicle and rail and overload line equipment. Fairmont Tamper completed work on a Pony Track Renewal System for Japan Railways East, under a contract valued at over $5 million, which was delivered in January 1994, and will be used to upgrade railroad track in that country over a course of 140 kilometers. The Company witnessed increased demand for products in China and Mexico, which included an order for over 25 HY-RAIL units, valued at more than $5 million. At year-end, the backlog was significantly ahead of that at December 31, 1992. Harsco's diverse product class of process equipment includes these product lines: heat transfer equipment, mass transfer equipment, air-cooled heat exchangers, process equipment, protective linings and wear products, including bar, plate and fabrication, and manganese products. Demand for the Thermific boiler, first introduced in 1988, was again at a record level, paced by the institutional building and retrofit market. Two new commercial water heaters were brought to market early in the year, and the lab blender redesign program was completed near year-end. Plans were underway to achieve ISO 9000 certification for major lines, which will aid in international marketing. In wear products, the Company conducted a research and development project to achieve enhanced weld requirements for product improvement. Harsco manufactures a varied line of industrial grating products at numerous plants in North America. The Company produces riveted, pressure-locked and welded grating in steel and aluminum, used mainly in industrial flooring applications for power, paper, chemical, refining and processing applications, among others. The Company also produces varied products for bridge and decking uses, as well as fiberglass grating used principally in the process industries. Production operations at a facility in Canada were phased out late in 1993, although sales and service continue in that country. A state-of-the-art slitting machine, the most powerful of its type in this country, was fully operational at the facility in Channelview, Texas during the first quarter. During the fourth quarter, the Company completed the acquisition of Electroforjados Nacionales, S.A. de C.V. (ENSA), a producer of steel and fiberglass grating products located in Queretaro, Mexico. ENSA, with annual sales of about $10 million, and the Company's other grating operations were consolidated into the Queretaro facility. The Division now operates at 13 facilities in North America. The Company is a major supplier of pipe fittings for the plumbing, industrial, hardware and energy industries and produces a variety of product lines, including forged and stainless steel fittings, conduit fittings, nipples and couplings. During the first quarter, machinery, tooling and equipment were installed at the facility in Houston for the new line of swaged nipples and bull plugs, primarily serving industrial and energy-related applications, which went on stream during the second half. Also during the same quarter, production ceased at a plant in Detroit, but service there is ongoing. The Division headquarters was relocated to another facility in the metropolitan Columbus, Ohio region. For 1993, percentages of consolidated net sales of certain product classes were as follows: gas control and containment, 13%; grating products, 6%; pipe fittings, 6%; process equipment, 5%; railway maintenance equipment, 6%; and four others, including structural composites, specialty metal fabrications, wear products and miscellaneous, 4%. Defense The Defense Group had two divisions at year-end 1993, which were BMY-Combat Systems and BMY-Wheeled Vehicles. In 1993, this Group led the Company in earnings. In January 1994, Harsco and FMC Corporation completed the joint venture, first announced in December 1992, to combine the BMY-Combat Systems Division with FMC's Defense Systems Group. The new partnership, known as United Defense, L.P., was effective on January 1, 1994 and expects to achieve annual sales of about $1 billion in 1994. Harsco holds a 40 percent ownership in United Defense, L.P., and FMC will manage the business. United Defense, L.P. produces tracked vehicles, including self-propelled howitzers, ammunition resupply units, military earthmovers and battle tank recovery vehicles for the U.S. Government and several international customers. Research and development programs are also performed, and United Defense, L.P. is a coproducer of tracked vehicles with the Republic of Korea. Additional products of United Defense, L.P. include the Bradley Fighting Vehicle and its derivatives, the Armored Gun System, the Multiple Launch Rocket System carrier, and the M113 Armored Personnel Carrier family of vehicles. The partnership also makes naval guns and launching systems, military track for armored vehicles and provides overhaul and conversion services. In 1993, BMY-Combat Systems delivered 70 M109A6 Paladin Howitzers to the U.S. Government. Deliveries of this vehicle are scheduled through 1994, and the Company will continue to participate in the production of Paladin Howitzers through the defense business partnership, United Defense, L.P. In 1993, the Company continued its nine-year coproduction contract for M109 SPH vehicle kits with the Republic of Korea and delivered 110 Howitzer kits. BMY-Combat Systems delivered 57 Armored Combat Earthmover (ACE) kits in 1993 to the Republic of Korea, and deliveries are scheduled into 1995. In October, the Company received a new contract from the U.S. Government for production of these M9 ACE units, valued at about $78 million. The Company delivered 68 M88A1 Recovery Vehicles for international customers in 1993. In October, the Company leased a facility in Fayette County, Pennsylvania to expand its role in military vehicle maintenance and support activities. BMY-Wheeled Vehicles produces various models of the five-ton truck and other commercial vehicles. In 1993, the BMY-Wheeled Vehicles Division delivered 861 five-ton trucks to the U.S. Government and international customers. The Company has produced over 25,000 of these units in various configurations and anticipates the receipt of additional orders in 1994. The Division will restart the production line in 1994 to accommodate foreign production booked as of year-end. In February 1993, the Company acquired certain assets from the Wayne Corporation, a manufacturer of school buses, for approximately $2.1 million, and production of these buses was transferred to the Marysville facility. This is a significant defense conversion effort on the part of Harsco to use the skills of a work force in another highly-regulated industry. The Company will continue to seek additional commercial opportunities for production at that location. For 1993, percentages of consolidated net sales of certain product classes were as follows: tracked vehicles, 24% and wheeled vehicles, 8%. (1) (i) The products and services of Harsco can be divided into a number of classes. The product classes that contributed 10% or more as a percentage of consolidated net sales in either of the last three fiscal years are as set forth in the following table. (1) (ii) New products and services are added from time to time; however, currently none require the investment of a material amount of the Company's assets. (1) (iii) The manufacturing requirements of the Company's operations are such that no unusual sources of supply for raw materials are required. The raw materials used by the Company include steel and aluminum which usually are readily available. (1) (iv) While Harsco has a number of trademarks, patents and patent applications, it does not consider that any material part of its business is dependent upon them. (1) (v) Harsco furnishes building products and materials and a wide variety of specialized equipment for commercial, industrial, public works and residential construction which are seasonal in nature. In 1993, construction related operations accounted for 9% of total sales. (1) (vi) The practices of the Company relating to working capital items are not unusual compared with those practices of other manufacturers servicing mainly industrial and commercial markets. Under the Defense Group, due to the nature of long-term contracts, sizable amounts of inventory are carried by the Company; however, these are partially funded through progress payments by the U.S. Government and advance payments by Foreign Governments. See Note 3 to consolidated financial statements and "Advances on long-term contracts" on the balance sheets in selected portions of the 1993 Annual Report to Shareholders under Exhibit 13. (1) (vii) Other than in the Defense Group of the Company's business, whose principal customer has been the U.S. Government, as further described under the Defense Group, no material part of the business of the Company is dependent upon a single customer or a few customers, the loss of any one of which would have a material adverse effect upon the Company. Sales to U.S. Government agencies in 1993, 1992 and 1991 amounted to 21%, 35% and 44% of the total sales, respectively. (1) (viii) Backlog of orders stood at $146,751,000 and $738,978,000 as of December 31, 1993 and 1992, respectively. It is expected that approximately 22% of the total backlog at December 31, 1993, will not be filled within 1994. Excluded from the 1993 backlog is $397,939,000 contributed to United Defense, L.P. There is no significant seasonal aspect to the Company's backlog. (1) (ix) Under the terms and regulations applicable to government contracts, the Government has the right to terminate its contracts with the Defense Group in accordance with procedures specified in the regulations and, under certain circumstances, has the right to renegotiate profits. In 1993, this group accounted for 32% of total sales. (1) (x) The various fields in which Harsco operates are highly competitive and the Company encounters active competition in all of its activities from both larger and smaller companies who produce the same or similar products or services or who produce different products appropriate for the same uses. (1) (xi) The expense for internal product improvement and product development activities was $5,156,000, $4,590,000 and $3,647,000 in 1993, 1992 and 1991, respectively. Customer-sponsored research and development expenditures were $23,008,000, $17,889,000 and $8,872,000, in 1993, 1992 and 1991, respectively. (1) (xii) The Company has become subject, as have others, to more stringent air and water quality control legislation. The Clean Air Act Amendments of 1990 will impose greater costs on the Company and most other domestic manufacturers in the future but the effect on the Company's business is not yet determinable. In general, the Company has not experienced substantial difficulty in complying with these environmental regulations in the past and does not anticipate making any major capital expenditures for environmental control facilities in 1994 or 1995. While the Company expects that environmental regulations may expand, and its expenditures for air and water quality control will continue, it cannot predict the effect on its business of such expanded regulations. Additional information regarding environmental consideration is incorporated by reference to Note 1 and Note 10 to the Consolidated Financial Statements under Exhibit No. 13. (1) (xiii) As of December 31, 1993, the Company had approximately 14,200 employees. (d) Financial Information about Foreign and Domestic Operations and Export Sales: Financial information concerning foreign and domestic operations and export sales is included in Note 12 to consolidated financial statements in selected portions of the 1993 Annual Report to Shareholders under Exhibit 13. Item 2. Item 2. Properties: Information as to the principal plants owned and operated by Harsco is summarized in the following table: * This property is under a lease-purchase agreement, with purchase price at a nominal amount. Harsco also operates the following plants which are leased: Harsco operates from a number of other plants, branches, warehouses and offices in addition to the above. In particularly, the Company has over 130 locations related to metal reclamation in twenty-seven countries, however since these facilities are on the property of the steel mill being serviced they are not listed. The Company considers all of its properties to be in satisfactory condition. Item 3. Item 3. Legal Proceedings: Information regarding legal proceedings is incorporated by reference to Note 10 to the Consolidated Financial Statements, under Exhibit 13. Item 4. Item 4. Submission of Matters to a Vote of Security Holders: There were no matters that were submitted during the fourth quarter of the year covered by this report to a vote of security holders, through the solicitation of proxies or otherwise. PART II Item 5. Item 5. Market for Registrant's Common Stock and Related Stockholder Matters: Harsco common stock is traded on the New York, Pacific, Boston, and Philadelphia Stock Exchanges under the symbol HSC. At the end of 1993, there were 24,967,801 shares outstanding. In 1993, the stock traded in a range of 45-35 and closed at a year-end high of 40 5/8 . For additional information regarding Harsco common stock market price, dividends declared, and numbers of shareholders see Part II, Item 6. Item 6. Selected Financial Data: Five-year selected financial data is included under Exhibit 13. Item 7. Item 7. Management's Discussion of Financial Condition and Results of Operations: Management's Discussion of Financial Condition and Results of Operations is included in selected portions of the 1993 Annual Report to Shareholders under Exhibit 13. Item 8. Item 8. Financial Statements and Supplementary Data: The financial statements and supplementary data is included in selected portions of the 1993 Annual Report to Shareholders under Exhibit 13. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure: None. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant: (a) Identification of Directors: Information regarding the identification of directors and positions held is incorporated by reference to the Proxy Statement dated March 25, 1994. M. W. Gambill informed the Board of Directors that he is retiring as non-executive Chairman of the Board and Director effective April 1, 1994. Upon his retirement as Chief Executive Officer on January 1, 1994, the Company entered into a Retirement and Consulting Agreement with Mr. Gambill. Under the Agreement, Mr. Gambill will receive monthly compensation at the rate of $370,000 per annum ending June 9, 1995. Mr. Gambill's age and employment background are as follows. Name Age M. W. Gambill 63 Principal Occupation or Employment Served as non-executive Chairman of the Board since January 1, 1994 and is a Director. Chairman of the Board and Chief Executive Officer from May 1, 1991 to January 1, 1994. From 1987 to 1991, President and Chief Executive Officer. From 1985 to 1987 served as President and Chief Operating Officer and from 1984 to 1985 served as Executive Vice President of the Corporation and from 1975 to 1984 served as President of the Heckett Division of the Corporation. Mr. Gambill is a director of York International Corporation. (b) Identification of Executive Officers: Set forth below, as of March 24, 1994, are the executive officers (this excludes certain corporate officers who are not deemed "executive officers" within the meaning of applicable Securities and Exchange Commission regulations) of the Company and certain information with respect to each of them. The executive officers were elected to their respective offices on April 27, 1994, or at various times during the year as noted. All terms expire on April 30, 1994. There are no family relationships between any of the officers. Corporate Officers: Name Age D. C. Hathaway 49 Principal Occupation or Employment President and Chief Executive Officer effective January 1, 1994, and has been elected Chairman of the Board effective April 1, 1994. Director since 1991. From May 1, 1991 to December 31, 1993, served as President and Chief Operating Officer. From 1986 to 1991 served as Senior Vice President-Operations of the Corporation. Served as Group Vice President from 1984 to 1986 and as President of the Dartmouth Division of the Corporation from 1979 until October 1984. Name Age W. D. Etzweiler 58 Principal Occupation or Employment Senior Vice President and Chief Operating Officer - Commercial and Industrial Products of the Corporation effective January 25, 1994. From 1992 to January 24, 1994, served as Senior Vice President - Operations of the Corporation. Served as President of the Corporation's Patterson-Kelley Division from 1982 to 1991, Vice President Sales and Marketing of the Patterson-Kelley Division from 1979 to 1982, Vice President of Marketing for the Patterson-Kelley Division from 1971 to 1979, and various manager positions with the Patterson-Kelley Division from 1966 to 1971. Name Age B. W. Taussig 54 Principal Occupation or Employment Senior Vice President and Chief Operating Officer - Defense of the Corporation effective January 25, 1994. From 1992 to January 24, 1994, served as Senior Vice President - Operations of the Corporation. Served as President of the BMY Defense Group from July 1, 1991 to year-end, as President of the BMY Combat Systems Division from 1989 to 1991, and as Vice President Business Development of the BMY Combat Systems Division from July 1989 to November 1989. From 1984 to 1989, was Vice President and General Manager of the Naval Systems Division of FMC Corporation, where he was responsible for a unit manufacturing defense products with 3,100 employees and sales of approximately $350 million per year. Name Age L. A. Campanaro 45 Principal Occupation or Employment Senior Vice President-Finance and Chief Financial Officer of the Corporation effective December 1, 1992 and served as Vice President and Controller from April 1, 1992 to November 30, 1992. Served as Vice President of the BMY-Wheeled Vehicles Division from February 1, 1992 to March 31, 1992, and previously served as Vice President and Controller of the BMY-Wheeled Vehicles Division from 1988 to 1992, Vice President Cryogenics of the Plant City Steel Division from 1987 to 1988, Senior Vice President Taylor-Wharton Division from 1985 to 1987, Vice President and Controller of Taylor-Wharton from 1982 to 1985, and Director of Auditing of the Corporation from 1980 to 1982. Name Age P. C. Coppock 43 Principal Occupation or Employment Senior Vice President, General Counsel, Secretary and Chief Administrative Officer of the Corporation effective January 1, 1994. Served as Vice President, General Counsel and Secretary of the Corporation from May 1, 1991 to December 31, 1993. From 1989 to 1991 served as Secretary and Corporate Counsel and as Assistant Secretary and Corporate Counsel from 1986 to 1989. Served in various Corporate Attorney positions for the Corporation since 1981. Name Age S. D. Fazzolari 41 Principal Occupation or Employment Vice President and Controller of the Corporation effective January 25, 1994. Served as Controller of the Corporation from January 26, 1993 to January 24, 1994. Previously served as Director of Auditing from 1985 to January 25, 1993, and served in various auditing positions from 1980 to 1985. Item 11. Item 11. Executive Compensation: Information regarding compensation of executive officers and directors is incorporated by reference to the Sections entitled "Executive Compensation and Other Information", and "Directors' Compensation" of the Proxy Statement dated March 25, 1994. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management: Information regarding security ownership of certain beneficial owners and management is incorporated by reference to the section entitled "Share Ownership of Management" of the Proxy Statement dated March 25, 1994. Item 13. Item 13. Certain Relationships and Related Transactions: Information regarding certain relationships and related transactions is incorporated by reference to the section entitled "Employment Agreements with Officers of the Company" of the Proxy Statement dated March 25, 1994. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K: The following portions of the Company's 1993 Annual Report to Shareholders are incorporated herein by reference under Exhibit 13: The consolidated financial statements and notes thereto, the related report of Coopers & Lybrand, independent accountants, Management's Discussion of Financial Condition and Results of Operations, Selected Financial Data for the years 1989 through 1993, Market for Registrant's Common Stock and Related Security Holder Matters, and the supplemental financial data, Three-Year Summary of Quarterly Results. Exhibit Number (a) 1. Consolidated Financial Statements: Consolidated Balance Sheets December 31, 1993 and 1992 Consolidated Statements of Income for the years 1993, 1992 and 1991 Consolidated Statements of Cash Flows for the years 1993, 1992 and 1991 Consolidated Statements of Changes in Shareholders' Equity for the years 1993, 1992 and 1991 Notes to Consolidated Financial Statements Report of Independent Accountants Management's Discussion of Financial Condition and Results of Operations Selected Financial Data for the Years 1989 through 1993 Three-Year Summary of Quarterly Results (a) 2. Consolidated Financial Statement Schedules: Report of Independent Accountants on Consolidated Financial Statement Schedules V. Property, Plant and Equipment for the years 1993, 1992 and 1991 VI. Accumulated Depreciation of Property, Plant and Equipment for the years 1993, 1992 and 1991 VIII. Valuation and Qualifying Accounts and Reserves for the years 1993, 1992 and 1991 IX. Short-Term Borrowings for the years 1993, 1992 and 1991 X. Supplementary Income Statement Information for the years 1993, 1992 and 1991 Schedules other than those listed above are omitted for the reason that they are either not applicable or not required or because the information required is contained in the financial statements or notes thereto. Condensed financial information of the registrant is omitted since there are no substantial amounts of "restricted net assets" applicable to the Company's consolidated subsidiaries. Financial statements of 50% or less owned associated companies are not submitted inasmuch as (1) the registrant's investment in and advances to such companies do not exceed 20% of the total consolidated assets, (2) the registrant's proportionate share of the total assets of such companies does not exceed 20% of the total consolidated assets, (3) the registrant's equity in the income before income taxes of such companies does not exceed 20% of the total consolidated income before income taxes. Exhibits other than those listed above are omitted for the reason that they are either not applicable or not material. The foregoing Exhibits are available from the Secretary of the Company upon receipt of a fee of $10 to cover the Company's reasonable cost of providing copies of such Exhibits. (b) The Company filed a Report on Form 8-K dated January 8, 1993 reporting that the Company had received the decision of The Armed Services Board of Contract Appeals in case ASBCA No. 36805 concerning the Company's claim for reimbursement of after-imposed Retail Federal Excise Tax paid on sales to the United States Government of certain five-ton trucks under a 1986 contract. The decision holds that, as a result of the extension of the Federal Excise Tax law beyond its original October 1, 1988 expiration date, Harsco is entitled to payment of a price adjustment to the contract to reimburse Federal Excise Tax paid on vehicles to be delivered after October 1, 1988. The Company filed a Report on Form 8-K dated July 8, 1993 reporting that the Company had signed a definitive purchase agreement with the shareholders representing the majority of the shares of MultiServ International, N.V. for the acquisition of all of the outstanding capital stock of MultiServ International, N.V. The Company filed a Report on Form 8-K dated August 31, 1993 reporting that the Company had acquired all of the outstanding capital stock of MultiServ International, N.V. 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. HARSCO CORPORATION Date March 18, 1994 By /S/ Leonard A. Campanaro Leonard A. Campanaro Senior Vice President-Finance 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 dates indicated. SIGNATURE CAPACITY DATE Chairman (Malcolm W. Gambill) President & Chief Executive (Derek C. Hathaway) Officer Senior Vice President-Finance and (Leonard A. Campanaro) Chief Financial Officer (Principal Financial Officer) Vice President and Controller (Salvatore D. Fazzolari) (Principal Accounting Officer) Director (Jeffrey J. Burdge) Director (Robert L. Kirk) Director (James E. Marley) Director (Frank E. Masland III) Director (Robert F. Nation) Director (Nilon H. Prater) Director (DeWitt C. Smith, Jr.) Director (Roy C. Smith) Director (Andrew J. Sordoni III) Director (Dr. Robert C. Wilburn) 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. HARSCO CORPORATION Date March 18, 1994 By /S/ Leonard A. Campanaro Leonard A. Campanaro Senior Vice President-Finance 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 dates indicated. SIGNATURE CAPACITY DATE /S/ Malcolm W. Gambill Chairman March 23, 1994 (Malcolm W. Gambill) /S/ Derek C. Hathaway President & Chief Executive March 24, 1994 (Derek C. Hathaway) Officer /S/ Leonard A. Campanaro Senior Vice President-Finance and March 24, 1994 (Leonard A. Campanaro) Chief Financial Officer (Principal Financial Officer) /S/ Salvatore D. Fazzolari Vice President and Controller March 25, 1994 (Salvatore D. Fazzolari) (Principal Accounting Officer) /S/ Jeffrey J. Burdge Director March 18, 1994 (Jeffrey J. Burdge) /S/ Robert L. Kirk Director March 18, 1994 (Robert L. Kirk) /S/ James E. Marley Director March 18, 1994 (James E. Marley) /S/ Frank E. Masland III Director March 18, 1994 (Frank E. Masland III) /S/ Robert F. Nation Director March 18, 1994 (Robert F. Nation) /S/ Nilon H. Prater Director March 18, 1994 (Nilon H. Prater) /S/ DeWitt C. Smith, Jr. Director March 18, 1994 (DeWitt C. Smith, Jr.) /S/ Roy C. Smith Director March 18, 1994 (Roy C. Smith) /S/ Andrew J. Sordoni III Director March 18, 1994 (Andrew J. Sordoni III) /S/ Dr. Robert C. Wilburn Director March 18, 1994 (Dr. Robert C. Wilburn) REPORT OF INDEPENDENT ACCOUNTANTS To the Shareholders of Harsco Corporation Our report on the consolidated financial statements of Harsco Corporation and subsidiary companies, which includes explanatory paragraphs regarding (i) uncertainties concerning the Company's involvement in various disputes regarding Federal Excise Tax and other contract matters primarily relating to the five-ton truck contract and the ultimate outcome of the Company's claims against the Government relating to certain contracts and (ii) changes in the Company's method of accounting for income taxes and postretirement benefits other than pensions, has been incorporated by reference in this Form 10-K from page 56 of the 1993 Annual Report to Shareholders of Harsco Corporation. In connection with our audits of such consolidated financial statements, we have also audited the related consolidated financial statement schedules listed in the index (Item 14(a) 2.) on page 20 of this Form 10-K. In our opinion, the consolidated financial statement schedules referred to above, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. COOPERS & LYBRAND Philadelphia, Pennsylvania February 1, 1994, except as to the first and third paragraphs of Note 10, for which the dates are February 25, 1994 and March 4, 1994, respectively. SCHEDULE V. PROPERTY, PLANT AND EQUIPMENT (dollars in thousands) NOTE: For domestic and foreign facilities, property, plant and equipment is depreciated over the estimated useful lives of the assets using principally the straight-line method. The estimated useful lives of various classes of assets are as follows: SCHEDULE V. PROPERTY, PLANT AND EQUIPMENT (dollars in thousands) SCHEDULE V. PROPERTY, PLANT AND EQUIPMENT (dollars in thousands) SCHEDULE VI. ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT (dollars in thousands) SCHEDULE VIII. VALUATION AND QUALIFYING ACCOUNTS (dollars in thousands) SCHEDULE IX. SHORT-TERM BORROWINGS (dollars in thousands) SCHEDULE X. SUPPLEMENTARY INCOME STATEMENT INFORMATION (dollars in thousands) COLUMN A COLUMN B Item Charged to Costs and Expenses 1993 1992 1991 Maintenance and repairs $55,947 $47,670 $47,826

1993 Item 1. Business. - ------ -------- GENERAL. Consolidated Rail Corporation ("the Company") is a ------- Pennsylvania corporation incorporated on February 10, 1976 to acquire, pursuant to the Regional Rail Reorganization Act of 1973, the rail properties of many of the railroads in the northeast and midwest region of the United States that had gone bankrupt during the early 1970's, the largest of which was the Penn Central Transportation Company. Pursuant to the Conrail Privatization Act, the United States Government sold 85% of the Company's common stock in a public offering on March 26, 1987. The remaining 15% of the Company's common stock, which was then held in connection with an employee stock ownership plan, was distributed to then present and former employees or their beneficiaries in 1987. On July 1, 1993, pursuant to an Agreement and Plan of Merger approved by the shareholders of the Company on May 26, 1993, each share of the Company's common stock that was issued and outstanding or held in the treasury, and each share of the Company's outstanding preferred stock, all of which were held by the Non- union Employee Stock Ownership Plan (the "ESOP"), were automatically converted into one share of the common stock and preferred stock, respectively, of Conrail Inc., a Pennsylvania corporation incorporated on February 12, 1993. On July 1, 1993, Conrail Inc. became the publicly held entity and holding company of the Company, which remains Conrail Inc.'s only significant subsidiary and primary asset. RAIL OPERATIONS. The Company provides freight transportation --------------- services within the northeast and midwest United States. The Company interchanges freight with other United States and Canadian railroads for transport to destinations within and outside the Company's service region. The Company operates no significant line of business other than the freight railroad business and does not provide common carrier passenger or commuter train service. The Company serves a heavily industrial region that is marked by dense population centers which constitute a substantial market for consumer durable and non-durable goods, and a market for raw materials used in manufacturing and by electric utilities. The Company's traffic levels are substantially affected by its ability to compete with trucks and other railroads, the economic strength of the industries and metropolitan areas that produce and consume the freight the Company hauls, and the traffic generated by the Company's connecting railroads. The Company remains dependent on non-bulk traffic, which tends to generate higher revenues than bulk commodities, but also involves higher costs and is more vulnerable to truck competition. The Company's significant freight commodity groups include chemicals and related products, coal, intermodal, automotive parts and finished vehicles, metals and related products, food and grain products, and forest products. In late 1993, the Company announced the reorganization of its Marketing and Sales and Operating Departments into four service networks: Intermodal Service, Automotive Service, Unit Trains Service and Core Service. The Unit Trains network will handle coal and ore traffic, with the remaining commodities, other than automobiles and intermodal, to be handled by the Core network. Effective in 1994, each of these groups controls the integrated planning, pricing and operating functions that will enable them to tailor services, develop products and make capital investments directed toward the special requirements of their respective customers. GOVERNMENT REGULATION. The Company is subject to --------------------- environmental, safety and other regulations generally applicable to all businesses, and its rail operations are also regulated by the Interstate Commerce Commission ("ICC"), the Federal Railroad Administration ("FRA"), state Departments of Transportation and some state and local regulatory agencies. The ICC has jurisdiction over, among other things, rates charged for certain traffic movements, service levels, freight car rents, and issuance or guarantee of railroad securities. It also has jurisdiction over the situations and terms under which one railroad may gain access to another railroad's traffic or facilities, extension or abandonment of rail lines, consolidation, merger, or acquisition of control of rail common carriers and of other carriers by rail common carriers and labor protection provisions in connection with the foregoing. Federal regulation of rates and services has been reduced. The ICC has deregulated rates for intermodal traffic, most boxcar traffic and, most recently, a series of miscellaneous commodities, including steel and automobiles. In addition, railroads are free to negotiate contracts with shippers setting rates, service standards and the terms for movements of other kinds of traffic. As a result, railroads have greater flexibility in adjusting rates and services to meet revenue needs and competitive conditions. The FRA has jurisdiction over safety and railroad equipment standards. The Company's operations are also subject to a variety of governmental laws and regulations relating to the protection of the environment. In addition to being involved as a potentially responsible party at numerous Superfund sites (see Item 3 - "Legal Proceedings"), the Company is subject to increasing regulation of its transportation and handling of certain hazardous and non- hazardous commodities and waste, which has resulted in additional administrative and operating costs. See Note 12 to the Consolidated Financial Statements elsewhere in this Annual Report. Item 2. Item 2. Properties. - ------ ---------- As of December 31, 1993, the Company (excluding its subsidiaries) maintained 20,109 miles of track including track for crossovers, turnouts, second main, other main, passing and switch track, on its 11,831 mile route system. Of total route miles, 9,961 are owned, 56 are leased or operated under contract and 1,814 are operated under trackage rights, including approximately 300 miles operated pursuant to an easement over Amtrak's Northeast Corridor. As of December 31, 1993, virtually all track over which at least 10 million gross tons moved annually (6,276 track miles) was heavy-weight rail of at least 127 pounds per yard, and approximately 98% of such track had continuous welded rail. Continuous welded rail reduces track maintenance costs and, in general, permits trains to travel at higher speeds. As of December 31, 1993, the Company had 9,412 miles of continuous welded rail on track it maintained. As of December 31, 1993, all of the 5,647 track miles maintained for fast freight traffic had a maximum operating speed of 50 MPH or more, and 33% had a maximum operating speed of at least 70 MPH. As of December 31, 1993, approximately 96% of the track over which at least 10 million gross tons moved annually was governed by automatic signal systems. In all, as of December 31, 1993, 7,610 miles of track were controlled by automatic signal systems. The Company owns (or uses subject to capitalized leases) 2,187 locomotives with an average age of 16.6 years and 60,017 freight cars of various types (including 17,595 freight cars under operating leases) with an average age of 21.0 years. Item 3. Item 3. Legal Proceedings. - ------ ----------------- Occupational Disease Litigation. The Company has been named ------------------------------- as a defendant in lawsuits filed pursuant to the provisions of the Federal Employers' Liability Act ("FELA") by persons alleging (1) personal injury or death caused by exposure to asbestos in connection with railroad employment; (2) complete or partial loss of hearing caused by exposure to excessive noise in the course of railroad employment; and (3) repetitive motion injury in connection with railroad employment. As of December 31, 1993, the Company is a defendant in 694 pending asbestosis suits, 1,262 pending hearing loss suits and 16 pending repetitive motion injury suits, and had notice of 609 potential asbestosis claims, 4,746 potential hearing loss claims and 1,049 potential repetitive motion injury claims. The Company expects to be named as a defendant in a significant number of occupational disease cases in the future. Structure and Crossing Removal Disputes in Connection With ---------------------------------------------------------- Lines Abandoned Under NERSA. The Company may be responsible, in - --------------------------- whole or in part, for the costs of removal of several hundred overhead and underpass crossings located on railroad lines it has abandoned under the Northeast Rail Service Act of 1981 ("NERSA") (and, in some instances, responsible for the removal of the lines of railroad themselves as well as appurtenant structures). The Company's liability for the removal of such lines, crossings and structures will be determined on a case-by-case basis. Some states have imposed upon the Company the obligation to remove certain crossings. In 1989, an organization of interests that own property under and adjacent to the Company's elevated West 30th Street rail line running along the west side of lower Manhattan filed a petition with the ICC seeking to force the Company to abandon the line and finance its removal, which could cost in excess of $30 million. The ICC voted in January 1992 to grant the property owners' petition, subject to the owners posting a bond indemnifying the Company for any demolition costs exceeding $7 million. The property owners have refused to post the bond. The parties have appealed to the United States Court of Appeals for the District of Columbia. Withdrawal from RCAF Master Tariff. The Rail Cost Adjustment ---------------------------------- Factor ("RCAF") is an index of rail costs issued by the ICC according to which railroads may adjust their regulated rates for inflation and cost increases free of regulatory interference. In March 1989, the ICC decided to offset the quarterly RCAF by the entirety of the average rail industry productivity gain, in a proceeding previously disclosed by the Company in its quarterly report on Form 10-Q for the period ended June 30, 1992 ("Productivity Adjustment to Cost Recovery Process"). On January 1, 1990, the Company ceased applying RCAF increases to its regulated rates, by ending its participation in the RCAF master tariff. Effective July 1, 1990, the Company published a series of independent rate increases approximately equal to its increases in costs as reflected by the RCAF. The Company's action was contested, but was upheld by the ICC. Since July 1, 1990, the Company has continued to make independent selective increases to its regulated rates. These regulated rates will continue to be subject to individual challenge to the extent the levels of the increases exceed those previously permitted pursuant to the RCAF and no other statutory provisions bar ICC jurisdiction. In January 1991, the ICC commenced a proceeding at the request of a shippers' organization to clarify the legal effect of the Company's (and other railroads') withdrawal from the RCAF master tariff, including the shippers' assertion that railroads thereby lose protection from challenge for rates previously adjusted under these procedures. In April 1991, the Company individually opposed and participated in the rail industry's opposition to the petition. A decision is awaited. Engelhart v. Consolidated Rail Corp. In connection with the ----------------------------------- Special Voluntary Retirement Program offered to certain employees in late 1989 and early 1990, the Company used surplus funds in its overfunded Supplemental Pension Plan ("Plan") to fund certain aspects of that program. In December 1992, certain former employees of the Company brought suit challenging the use of surplus Plan funds (i) to pay administrative Plan expenses previously paid by the Company, (ii) to fund the Special Voluntary Retirement Program, and (iii) to pay life insurance and medical insurance premiums of former employees as improper and unlawful, and alleging that employees who have made contributions to the Plan or its predecessor plans are entitled to share in the surplus assets of the Plan. In August 1993, the federal district court granted the Company's Motion to Dismiss the majority of counts in the complaint, but declined to dismiss the issue of the Company's use of Plan assets to pay administrative expenses of the Plan, which are estimated to be approximately $25 million as of December 31, 1993. However, the Company believes that the use of surplus Plan assets for this purpose is lawful and proper. The Company intends to use surplus Plan assets in a similar manner in connection with its 1994 early retirement program. Environmental Litigation. The Company is subject to various ------------------------ federal, state and local laws and regulations regarding environmental matters. In certain instances, the Company has received notices of violations of such laws and regulations and either has taken or plans to take appropriate steps to address the problems cited or to contest the allegations of violation. As of December 31, 1993, the Company had received inquiries from governmental agencies or had been identified, together with other companies, as a potentially responsible party for cleanup and/or removal costs due to its status as an alleged transporter, generator or property owner at 114 locations throughout the country. However, the Company, through its own investigations and assessments, believes it may have some potential responsibility at only 54 of these sites. The significant environmental proceedings, including Superfund sites, are discussed below. United States v. Southeastern Pennsylvania Transportation --------------------------------------------------------- Authority ("SEPTA"), National Railroad Passenger Corporation - ------------------------------------------------------------ ("Amtrak"), and Consolidated Rail Corp. In March 1986, the United - -------------------------------------- States Environmental Protection Agency ("EPA") filed an action in the United States District Court for the Eastern District of Pennsylvania for cost recovery, injunctive relief, and a declaratory judgment against the Company, Southeastern Pennsylvania Transportation Authority ("SEPTA") and National Railroad Passenger Corp. ("Amtrak") under the Comprehensive Environmental Response, Compensation, and Liability Act of 1980 ("CERCLA" or "Superfund Law"), as amended. In 1990, the Pennsylvania Department of Environmental Resources intervened as a plaintiff. Suit is based on the release or threatened release at the Paoli Railroad Yard, Paoli, Chester County, Pennsylvania, of polychlorinated biphenyls ("PCBs"), a listed hazardous substance under CERCLA. The Company is sued in its capacity as the operator of the rail yard from April 1, 1976 through December 31, 1982, under an agreement with SEPTA to provide commuter rail service. In March 1992, Penn Central brought suit before the Special Court arguing that the terms of the transfer of its properties to the Company did not contemplate environmental liability for conditions existing at the time of the transfer. The Special Court has determined it has jurisdiction to hear the matter. In February 1993, Penn Central petitioned the district court to stay all proceedings with respect to it pending the outcome of the proceeding before the Special Court. The EPA has responded by filing a petition to stay the district court proceeding in its entirety pending resolution of the Special Court proceeding. Motions and cross-motions for summary judgment by the parties are pending. Pursuant to a series of partial preliminary consent decrees, defendants have performed a series of cleanup actions both on and off-site and have conducted a Remedial Investigation/Feasibility Study ("RI/FS"). As of December 31, 1993, the cost of the RI/FS and of the interim cleanup measures performed by the three defendants is approximately $9 million. Those costs have been shared equally among the three defendants but are subject to reallocation. All work done to date has been performed subject to a denial of liability and without waiving any defense to the governmental claim for cleanup costs or other relief. On September 16, 1992, the EPA issued a Special Notice Letter to the Company, SEPTA, Amtrak and Penn Central Corporation requesting the parties to provide, within 60 days, a good-faith offer to perform all necessary remediation of the Paoli rail yard site, as well as reimbursement of approximately $2.6 million in past response costs of the EPA. The EPA estimates that its remediation plan as set forth in its Record of Decision will cost approximately $28 million. On November 16, 1992, the parties submitted an offer to pay a portion of the estimated cost of the remediation action selected by the EPA. On January 8, 1993, the EPA rejected the parties' offer on several bases, including that the proposal addressed only a portion of the EPA's recommended remedy for the site. The EPA may now issue an administrative order directing any party to carry out its remediation plan, subject to treble damages and daily penalties for failure to comply without sufficient cause. The estimated cost of the Company's portion of the parties' proposed remedy was included in the 1991 special charge and subsequent adjustments to accruals. United States v. Consolidated Rail Corp. The EPA has --------------------------------------- listed the Company's Elkhart Yard in Indiana on the National Priorities List. The EPA contends that chemicals have migrated from the yard and contaminated drinking wells in the area. On February 14, 1990, the EPA filed a civil action against the Company in the U.S. District Court for the Northern District of Indiana seeking recovery of approximately $345,000 for costs incurred in protecting the water supply. In addition, the EPA seeks a declaratory judgment against the Company for all future costs incurred in responding to the release or threatened release of hazardous substances from the site. The Company believes it is not the sole source and may not be a contributing source to the contamination alleged by the EPA. The Company filed a third-party action joining Penn Central as a defendant, to which Penn Central has responded by filing a declaratory judgment action in Special Court. (See previous discussion regarding the Special Court under "United States v. SEPTA, et al"). On July 7, 1992, the EPA issued an order requiring the Company and Penn Central to implement the interim remedy set forth in the Record of Decision. The Company is performing the interim remedy in compliance with the EPA order and is simultaneously in litigation with the EPA over the implementation of the remedy. Penn Central has declined to participate. The estimated cost of remediation was included in the Company's 1991 special charge and subsequent adjustments to accruals. United States v. Consolidated Rail Corp., et al. The Company ----------------------------------------------- has been identified as the fifth largest generator of waste oil at the Berks Associates Superfund site in Douglasville, Pennsylvania. In addition, the Company has become aware that it and its predecessor, Penn Central, owned a small portion of land that was leased to the operator of the Berks site. As such, the Company's liability could increase due to its questionable status as both an owner and a generator. In August 1991, the EPA issued an administrative order against the Company and thirty-five other entities mandating the implementation of an approximately $2 million partial remedy and filed a complaint in the U.S. District Court for the recovery of approximately $8 million in costs incurred by the government. The parties have negotiated an administrative order with the EPA and have filed an answer to the civil action. A group of potentially responsible parties (including the Company) undertook compliance with the administrative order. The Company and the 35 other defendants have filed a third-party complaint against approximately 630 entities seeking contribution for the costs of the remedy and government costs. The Company, along with other defendants, is negotiating a settlement with the EPA. On June 30, 1993, the EPA issued another administrative order against the Company and 33 other entities, mandating the remediation of the southern portion of the site. The effective date of the order has been delayed in light of the negotiations. The most expensive aspect of the remediation of the site is the clean-up of Source Area 2, which the government estimates at between $45 and $55 million. This Source Area was closed prior to the Company's incorporation, and therefore the Company has maintained that it is not liable for the cost of remediating Source Area 2. United States v. Consolidated Rail Corp., et al. The Company ----------------------------------------------- is a potentially responsible party ("PRP"), along with more than 50 other parties, in the United Scrap Lead federal Superfund action in Troy, Ohio, where substantial quantities of batteries were disposed of over a period of several years. The EPA sued the Company and nine other parties in August 1991 in the Southern District of Ohio for the recovery of approximately $2 million in past costs. The Company and other PRP's have commissioned treatability studies. The court has imposed a stay to discuss whether this matter can be settled. The parties are negotiating over the nature of the remediation to be undertaken at the site. Commonwealth of Massachusetts v. Consolidated Rail Corp. On ------------------------------------------------------- April 21, 1992, the Massachusetts Attorney General filed suit in Superior Court of Massachusetts alleging the Company's violation of the Massachusetts Clean Air Act and its implementing regulations by allowing diesel engines to idle unnecessarily and/or in excess of thirty minutes. On May 4, 1992, the court entered a preliminary injunction, the terms of which are substantially consistent with the Company's existing idling policy. The Attorney General subsequently filed a complaint alleging the Company's violation of the preliminary injunction. On February 2, 1993, the parties entered into a partial settlement agreement; however, the Attorney General has alleged that the Company has failed to comply with certain provisions of the settlement. United States v. Consolidated Rail Corp., The Monongahela --------------------------------------------------------- Railway Company, et al. On September 30, 1992, Region VIII of the - ---------------------- EPA filed an administrative action for civil penalties against the Company and its former wholly-owned subsidiary, The Monongahela Railway Company (now merged into the Company), under the Toxic Substances Control Act for allegedly improper handling of a shipment of PCB contaminated soil. The other railroads in the movement and the shipper were served with similar complaints. The Company is currently negotiating with EPA. New York State Department of Environmental Conservation Order ------------------------------------------------------------- On Consent. On February 18, 1993, the New York State Department of - ---------- Environmental Conservation ("NYSDEC") served the Company with a draft Order on Consent requiring the payment of fines in connection with its inspection of Selkirk Yard. The Order also seeks compensation for the hiring of three full-time NYSDEC employees to monitor the Company's compliance at Selkirk and two other rail yards in New York. The Company is negotiating the terms of the Order with NYSDEC. Conway Yard, Pittsburgh. In 1991, the Company received ----------------------- Notices of Violation ("NOV") from the Pennsylvania Department of Environmental Resources ("PADER") alleging violations of the Clean Streams Act for discharges of oil into the Ohio River. In September 1993, PADER sent to the Company a draft Consent Order and Agreement requiring a comprehensive site remediation for soil, ground water, surface waters and sediments at the Conway rail yard and requiring the payment of an undisclosed amount of civil fines in connection with violations at the yard, including continuing ground water contamination. The Company and PADER are negotiating the extent of the investigation and remediation to be undertaken at the yard. Other. In addition to the above proceedings, the Company has ----- been named in various legal proceedings arising out of its activities as an employer and as an operator of a freight railroad, including personal injury actions brought by its employees under FELA, as well as administrative proceedings with and investigation by government agencies. In view of the inherent difficulty of predicting the outcome of legal proceedings, particularly in certain matters described above in which substantial damages are or may be sought, the Company cannot state what the eventual outcomes of such legal proceedings will be. Certain of these matters, if determined adversely to the Company, could result in the imposition of substantial damage awards against, or increased costs to, the Company that could have a material adverse effect on the Company's results of operations and financial position. The Company's management believes, however, based on current knowledge, that such legal proceedings will not have a material adverse effect on the Company's financial position. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. - ------ --------------------------------------------------- Information omitted in accordance with General Instruction J(2)(c). PART II Item 5. Item 5. Market for Registrant's Common Equity - ------ ------------------------------------- and Related Stockholder Matters. ------------------------------- All of the common stock of the Company is held by Conrail Inc. Accordingly, there is no market for the Company's common stock. Item 6. Item 6. Selected Financial Data. - ------ ----------------------- Information omitted in accordance with General Instruction J(2)(a). Item 7. Item 7. Management's Discussion and Analysis of Financial - ------ ------------------------------------------------- Condition and Results of Operations. ----------------------------------- See General Instruction J (2)(a). Results of Operations - --------------------- 1993 Compared with 1992 Net income for 1993 was $164 million compared with 1992 net income of $282 million. The decrease in net income is attributable primarily to the following unusual or one-time charges in 1993: one-time after tax charges of $70 million for adoption of required changes in accounting for income taxes and postretirement benefits other than pensions; the reserve for intercompany receivables related to the planned disposition of Concord Resources Group, Inc., ("Concord") a subsidiary of Conrail Inc., $58 million (net of estimated income tax benefits of $31 million); and the one-time effects on deferred taxes of the increase in the 1993 federal corporate income tax rate, $34 million (see Notes 1, 3, 7 and 8 to the Consolidated Financial Statements elsewhere in this Annual Report). Absent these charges, the Company's net income for 1993 would have been $326 million. Operating revenues (primarily freight line haul revenues, but also including switching, demurrage and incidental revenues) increased $93 million, or 2.8%, from $3,345 million in 1992 to $3,438 million in 1993. A 5.0% increase in traffic volume, as measured in units (freight cars and intermodal trailers and containers), primarily as the result of improvement in the economy and growth in the Company's market share, resulted in a $160 million increase in revenues that was partially offset by a 1.6% decrease in average revenue per unit which reduced revenues $54 million. The decline in average revenue per unit is attributable to decreases in average rates which reduced revenue by $62 million, partially offset by a favorable mix of traffic which increased revenues $8 million. Traffic volume increases occurred in the following freight commodity groups: automotive parts and finished vehicles, 13.4%; intermodal, 11.2%; forest products, 6.5%; chemicals and related products, 6.4%; metals and related products, 5.1%; and food and grain products, 3.6%. Coal traffic decreased 9.2%. Switching, demurrage and incidental revenues decreased $13 million. Operating expenses increased $34 million, or 1.2%, from $2,811 million in 1992 to $2,845 million in 1993. The following table sets forth the operating expenses for the two years: Compensation and benefits costs decreased $9 million, or 0.7%, with relatively stable employment levels. The decrease is attributable primarily to a decrease in payroll taxes, partially offset by increases in fringe benefit costs and increased wage rates. Compensation and benefits as a percent of revenues was 35.7% in 1993 compared with 37.0% in 1992. The increase of $15 million, or 5.2%, in equipment rents reflects the effects of new operating leases for equipment and the increase in traffic volume, partially offset by improvement in equipment utilization. Depreciation and amortization expense decreased $13 million, or 4.4%, primarily due to lower depreciation rates for locomotives and freight cars as a result of a depreciation study required by the Interstate Commerce Commission. Other operating expenses increased $38 million, or 7.8%, primarily due to increases in property and corporate taxes, increases in write-downs of uncollectible accounts, and a reduction in 1992 due to reducing accruals related to a 1991 special charge with no corresponding reduction in 1993. The Company's operating ratio (operating expenses as a percent of revenues) was 82.8% for 1993 compared with 84.0% for 1992. The reserve for intercompany receivables of $89 million relates to advances made to Concord. Other income, net, (representing interest and rental income, property sales and other non-operating items, net) increased $16 million, or 16.3%, from $98 million in 1992 to $114 million in 1993, principally due to higher gains from property sales and increased equity income as a result of higher net income of the Company's affiliated companies. Liquidity and Capital Resources - ------------------------------- The Company's cas and cash equivalents decreased $14 million, from $40 million at December 31, 1992 to $26 million at December 31, 1993. Cash generated from operations, and borrowings are the Company's principal sources of liquidity and are used primarily for capital expenditures, debt service, and dividends. Operating activities provided cash of $495 million in 1993, compared with $496 million in 1992 and $570 million in 1991. Issuance of long-term debt provided cash of $485 million in 1993. The principal uses of cash in 1993 were for property and equipment acquisitions, $566 million, payment of long-term debt including capital lease and equipment obligations, $195 million, and the net repayment of commercial paper, $48 million. Through June 30, 1993, at which time the Company's common stock was converted to Conrail Inc. common stock, $32 million was used for the repurchase of common stock. The Company also paid $142 million in cash dividends on common and preferred stock, including $87 million to Conrail Inc. during the last six months of 1993. A working capital (current assets less current liabilities) deficiency of $29 million existed at December 31, 1993, compared with a deficiency of $489 million at December 31, 1992. The decrease in the deficiency is attributable primarily to the increase of $57 million in accounts receivable; the recording of $218 million of current deferred tax assets as a result of adopting SFAS 109 (see Note 7 to the Consolidated Financial Statements elsewhere in this Annual Report); and reductions in short-term borrowings, $48 million, current maturities of long-term debt, $61 million, and accrued and other current liabilities, $86 million. Management believes that the Company's financial position allows it sufficient access to credit sources on investment grade terms, and, if necessary, additional intermediate or long-term debt could be issued for working capital requirements. During 1993, the Company issued an additional $114 million of commercial paper and repaid $162 million. Of the remaining $179 million outstanding at December 31, 1993, $100 million is classified as long-term debt since it is expected to be refinanced through subsequent issuances of commercial paper and is supported by a long-term credit facility. In February 1993, the Company issued $94 million of Pass Through Certificates to finance the acquisition of equipment. Of these certificates, $54 million are direct obligations of the Company and are secured by the acquired equipment. The remaining $40 million of certificates were issued to finance equipment which the Company will utilize under a capital lease, and while such certificates are not direct obligations of or guaranteed by the Company, the amounts payable by the Company under the lease will be sufficient to pay principal and interest on the certificates. The Company issued $79 million of medium-term notes during the first quarter of 1993 under a shelf registration statement filed in April 1990. In May 1993, the Company sold $250 million of 7 7/8% Debentures due 2043 under the same shelf registration statement. During 1993, the Company redeemed $85 million of medium-term notes that were issued in 1988 and 1989. In June 1993, Conrail Inc. and the Company filed a new shelf registration statement on Form S-3 which will enable the Company to issue up to $500 million in debt securities or Conrail Inc. to issue up to $500 million in convertible debt or equity securities. The Company issued approximately $63 million of 1993 Equipment Trust Certificates, Series A, in September 1993, under this registration statement. The certificates were used to finance approximately 80% of the cost of certain rebuilt and new freight cars, which the Company will utilize under an operating lease. Although the certificates are not direct obligations of, or guaranteed by the Company, the amounts payable by the Company under the lease will be sufficient to pay principal and interest on the certificates. In November 1993, the Company issued $102 million of 1993 Equipment Trust Certificates, Series B, to finance approximately 85% of the cost of 80 new locomotives. These certificates are direct obligations of the Company and were not issued pursuant to the 1993 shelf registration statement. During the third quarter of 1993, the Company reached a settlement with the Internal Revenue Service related to the audit of the Company's consolidated federal income tax returns for the fiscal years 1987 through 1989. Under the settlement, the Company paid $51 million, including interest (see Note 7 to the Consolidated Financial Statements elsewhere in this Annual Report). Capital Expenditures - -------------------- Capital expenditures totalled $650 million, $491 million and $398 million in 1993, 1992 and 1991, respectively. Of these capital expenditures, the Company directly financed $232 million in 1993, $13 million in 1992, and $76 million in 1991 through private third-party financing. In addition, the proceeds of notes and debentures sold in those years, $329 million, $80 million, and $30 million, respectively, were available to fund capital expenditures. Capital expenditures for 1993, $650 million, exceeded planned expenditures by $100 million principally due to the accelerated acquisition of locomotives originally expected to be acquired in 1994. Capital expenditures for 1994 are expected to be approximately $490 million. Item 8. Item 8. Financial Statements and Supplementary Data - ------ ------------------------------------------- REPORT OF INDEPENDENT ACCOUNTANTS The Stockholder and Board of Directors Consolidated Rail Corporation We have audited the consolidated financial statements and financial statement schedules of Consolidated Rail Corporation and subsidiaries listed in Item 14(a) of this Form 10-K. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules 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 financial statements referred to above present fairly, in all material respects, the consolidated financial position of Consolidated Rail Corporation and subsidiaries as of December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. As discussed in Note 1 to the consolidated financial statements, the Company changed its methods for accounting for income taxes and postretirement benefits other than pensions in 1993. COOPERS & LYBRAND 2400 Eleven Penn Center Philadelphia, Pennsylvania January 24, 1994 See accompanying notes. See accompanying notes. See accompanying notes. See accompanying notes. CONSOLIDATED RAIL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Summary of Significant Accounting Policies ------------------------------------------ Industry -------- Consolidated Rail Corporation (the "Company"), operates a freight railroad system in the Northeast-Midwest quadrant of the United States and the Province of Quebec. Principles of Consolidation --------------------------- The consolidated financial statements include the Company and majority-owned subsidiaries. Investments in 20% to 50% owned companies are accounted for by the equity method. Cash Equivalents ---------------- Cash equivalents consist of commercial paper, certificates of deposit and other liquid securities purchased with a maturity of three months or less, and are stated at cost which approximates market value. Material and Supplies --------------------- Material and supplies consist mainly of fuel oil and items for maintenance of property and equipment, and are valued at the lower of cost, principally weighted average, or market. Property and Equipment ---------------------- Property and equipment are recorded at cost. Depreciation is provided using the composite straight-line method. The cost (net of salvage) of depreciable property retired or replaced in the ordinary course of business is charged to accumulated depreciation and no gain or loss is recognized. Revenue Recognition ------------------- Revenue is recognized proportionally as a shipment moves on the the Company's system from origin to destination. Earnings Per Share ------------------ Earnings per share amounts are not presented for 1993 as the Company became a wholly owned subsidiary of Conrail Inc. on July 1, 1993 (Note 2). For 1992 and 1991, primary earnings (loss) per share are based on net income (loss) adjusted for the effects of preferred dividends net of income tax benefits, divided by the weighted average number of shares outstanding during the period including the dilutive effect of stock options. Fully diluted earnings (loss) per share assume conversion of Series A ESOP Convertible Junior Preferred Stock ("ESOP Stock") into common stock unless they are antidilutive as they were in 1991. Net income amounts CONSOLIDATED RAIL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) applicable to fully diluted earnings per share in 1992 have been adjusted by the increase, net of income tax benefits, in ESOP-related expenses assuming conversion of all ESOP Stock to common stock. The weighted average number of shares of common stock outstanding during each of the two years ended December 31, 1992 are as follows: 1992 1991 ---------- ---------- Primary weighted average shares 81,743,648 81,883,970 Fully diluted weighted average shares 91,856,193 81,883,970 Ratio of Earnings to Fixed Charges ---------------------------------- Earnings used in computing the ratio of earnings to fixed charges represent income before income taxes plus fixed charges, less equity in undistributed earnings of 20% to 50% owned companies. Fixed charges represent interest expense together with interest capitalized and a portion of rent under long-term operating leases representative of an interest factor. In 1991, when the Company recorded a special charge (Note 10), earnings were insufficient to cover fixed charges. New Accounting Standards ------------------------ Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("SFAS 106") (Note 8) and Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS 109") (Note 7). As a result, the Company recorded cumulative after tax charges of $22 million and $48 million for SFAS 106 and SFAS 109, respectively. In November 1992, the Financial Accounting Standards Board issued a standard (SFAS 112) related to accounting for postemployment benefits, which is effective January 1994. This standard requires employers to recognize their obligation to provide salary continuation, supplemental unemployment benefits, and other benefits provided after employment but before retirement when certain conditions are met. The Company has determined that this standard would not have a material effect on its financial statements. 2. Corporate Reorganization and Presentation ----------------------------------------- In May 1993, the shareholders of the Company approved a plan for the adoption of a holding company structure. Under the Plan, each share of the Company's common stock which was CONSOLIDATED RAIL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) issued and outstanding or held in the treasury of the Company, and each share of the Company's preferred stock, all of which were held by the Non-union Employee Stock Ownership Plan (the "ESOP"), were automatically converted into one share of common stock and one share of preferred stock, respectively, of a newly created holding company, Conrail Inc. on July 1, 1993. As a result, effective July 1, 1993, Conrail Inc. became the publicly held entity and the Company became a wholly-owned subsidiary of Conrail Inc. The promissory note receivable, plus accrued interest, which the Company received in 1990 from the ESOP in exchange for its preferred shares remained with the Company and is recorded in the stockholder's equity section of its balance sheet. As part of the establishment of the holding company, a wholly- owned subsidiary of the Company was transferred to Conrail Inc. The financial position and results of operations of this subsidiary are not material to the accompanying consolidated financial statements. In 1992, the Company's Board of Directors authorized a two-for- one common stock split which was effected in the form of a common stock dividend. An amount equal to the par value of the common shares issued was transferred from additional paid- in capital to the common stock account. In addition, a stock dividend on the ESOP Stock in the amount of one share of ESOP Stock for each share of ESOP Stock outstanding was also distributed. All references in the financial statements with regard to the number of shares, and related dividends and per share amounts for both common stock (including treasury shares) and ESOP Stock have been restated to reflect the stock split. Stock compensation and other plans that provide for the issuance of common stock, ESOP Stock, or an amount equivalent to their respective fair market values, have also been amended to reflect the stock split. 3. Related Party Transactions -------------------------- The Company engages in various transactions with Conrail Inc. The Company funds the cash requirements of Conrail Inc., primarily through cash dividends, which in 1993 totalled $87 million (excluding $44 million paid to shareholders prior to July 1, 1993). The Company is obligated to pay a management fee to Conrail Inc. equal to the amount of preferred dividends declared by the holding company in connection with the ESOP which totalled $11 million in 1993 and is recorded in "Other income, net" on the consolidated statement of income (Notes 8 CONSOLIDATED RAIL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) and 11). Advances between the two companies accrue interest at the Federal Reserve Bank's 30-day average interest rate. The resulting interest income and interest expense on advances to and from Conrail Inc. were immaterial to the Company's financial statements. A summary of the Company's transactions with Conrail Inc. are as follows: (In Millions) Short-term receivable $ 9 Short-term payable 21 In September 1993, the Company recorded a reserve of $89 million relating to advances made to Concord Resources Group, Inc. ("Concord"), a subsidiary of Conrail Inc. 4. Property and Equipment ---------------------- The Company acquired equipment and incurred related long-term debt under various capital leases of $75 million in 1993, $13 million in 1992, and $76 million in 1991. CONSOLIDATED RAIL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) 5. Accrued and Other Current Liabilities ------------------------------------- 6. Long-Term Debt -------------- Long-term debt outstanding, including the weighted average interest rates at December 31, 1993, is composed of the following: Using current market prices when available, or a valuation based on the yield to maturity of comparable debt instruments having similar characteristics, credit rating and maturity, the total fair value of the Company's long-term debt, including the current portion, but excluding capital leases, is $1,782 million in 1993 and $1,310 million in 1992, compared with carrying values of $1,544 million and $1,200 million in 1993 and 1992, respectively. The Company's noncancelable long-term leases generally include options to purchase at fair value and to extend the terms. CONSOLIDATED RAIL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Capital leases have been discounted at rates which average 8.3% and are collateralized by assets with a net book value of $439 million at December 31, 1993. Minimum commitments, exclusive of executory costs borne by the Company, are: Operating lease rent expense was $88 million in 1993, $71 million in 1992, and $50 million in 1991. The Company filed a shelf registration statement on Form S-3 with the Securities and Exchange Commission in April 1990 for $1.25 billion of debt securities. In May 1993, the Company issued $250 million of 7 7/8% Debentures Due 2043, and has $11 million remaining to be issued under this shelf registration at December 31, 1993. In June 1993, the Company and Conrail Inc. filed a new shelf registration statement on Form S-3 which will enable the Company to issue up to $500 million in debt securities or Conrail Inc. to issue up to $500 million in convertible debt or equity securities. In February 1993, the Company issued $94 million of Pass Through Certificates, Series 1993-A1 and 1993-A2 to finance the acquisition of equipment. The Series 1993-A1 certificates, $41 million, have an interest rate of 5.71%, and Series 1993-A2 certificates, $53 million, have an interest rate of 6.86%. Certificates issued in the amount of $54 million are direct obligations of the Company and are secured by the acquired equipment. The remaining certificates, $40 million, were issued to finance equipment which the Company will utilize under a capital lease, and while such certificates are not direct obligations of, or guaranteed by the Company, the amounts payable by the Company under the lease will be sufficient to pay principal and interest on the certificates. CONSOLIDATED RAIL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) In September 1993, the Company issued approximately $63 million of 5.98% 1993 Equipment Trust Certificates, Series A, due 2013, pursuant to the 1993 registration statement. The certificates were used to finance approximately 80% of the cost of certain rebuilt and new freight cars, which the Company will utilize under an operating lease. Although the certificates are not direct obligations of, or guaranteed by the Company, amounts payable by the Company under the lease will be sufficient to pay principal and interest on the certificates. In November 1993, the Company issued $102 million of 1993 Equipment Trust Certificates, Series B, with interest rates ranging from 3.57% to 5.90%, maturing annually from 1994 through 2008. These certificates are obligations of the Company issued for the purchase of locomotives which will serve as collateral for the obligations. Equipment and other obligations mature in 1994 through 2013 and are collateralized by assets with a net book value of $200 million at December 31, 1993. Maturities of long-term debt other than capital leases and commercial paper are $74 million in 1994, $62 million in 1995, $95 million in 1996, $10 million in 1997, $40 million in 1998, and $1,163 million in total from 1999 through 2043. The Company had $179 million of commercial paper outstanding at December 31, 1993. Of the total amount outstanding, $100 million is classified as long-term since it is expected to be refinanced through subsequent issuances of commercial paper and is supported by the long-term credit facility mentioned below. The Company maintains a $300 million uncollateralized revolving credit facility with a group of banks under which no borrowings were outstanding at December 31, 1993. The credit facility, which expires in 1995, requires interest to be paid on borrowings at rates based on various defined short-term market rates and an annual maximum fee of .1% of the facility amount. The credit facility contains, among other conditions, restrictive covenants relating to leverage ratio, debt, and consolidated tangible net worth. Interest payments were $164 million in 1993, $162 million in 1992, and $167 million in 1991. CONSOLIDATED RAIL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) 7. Income Taxes ------------ The provisions for (benefits from) income taxes are composed of the following: Effective January 1, 1993, the Company adopted the provisions of SFAS 109 which requires a liability approach for measuring deferred tax assets and liabilities based on differences between the financial statement and tax bases of assets and liabilities at each balance sheet date using enacted tax rates in effect when those differences are expected to reverse. As a result, the Company recorded a cumulative adjustment of $48 million. The primary effects of the adoption of this standard on the balance sheet were the recording of a current deferred tax asset of $147 million with a corresponding increase in the long-term deferred income tax liability and the net deferred income tax liabilities related to the cumulative accounting adjustment for the adoption of SFAS 109 and SFAS 106 (Note 8). Prior years' financial statements have not been restated to apply the provisions of the new standard. In conjunction with the public sale in 1987 of the 85% of the Company's common stock owned by the U.S. Government, federal legislation was enacted which resulted in a reduction of the tax basis of certain of the Company's assets, particularly property and equipment, thereby substantially decreasing tax depreciation deductions and increasing future federal income tax payments. Also, net operating loss and investment tax CONSOLIDATED RAIL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) credit carryforwards were cancelled. As a result of the sale- related transactions, a special income tax obligation was recorded in 1987 based on an estimated effective federal and state income tax rate of 37.0%. As a result of the increase in the federal corporate income tax rate from 34% to 35% enacted August 10, 1993, and effective January 1, 1993, income tax expense for 1993 was increased by $38 million, of which $34 million related to the effects of adjusting deferred income taxes and the special income tax obligation for the rate increase. The Company and its subsidiaries will be included in the consolidated federal income tax return filed by Conrail Inc. for periods subsequent to July 1, 1993. The consolidated federal income tax expense or benefit will be allocated to the Company and its subsidiaries as though the Company filed a separate consolidated tax return. During the third quarter of 1993, the Company reached a settlement with the Internal Revenue Service related to the audit of the Company's consolidated federal income tax returns for the fiscal years 1987 through 1989. Under the settlement, the Company paid $51 million, including interest, all of which had been previously provided for in prior years resulting in no income statement effect in 1993. Federal and state income tax payments were $39 million in 1993 (excluding tax settlement), $31 million in 1992, and $45 million in 1991. Significant components of the Company's special income tax obligation and deferred income tax liabilities and (assets) as of December 31, 1993 are as follows: CONSOLIDATED RAIL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) The tax effects of each source of deferred income taxes and special income tax obligation (disclosure for 1993 is not required nor applicable under SFAS 109)are as follows: 1992 1991 ----- ----- (In Millions) Deferred taxes Tax depreciation over book $ 84 $ 130 Other property transactions 80 61 Casualty, wage and other accruals 78 (152) Alternative minimum tax (40) (58) Other 6 (6) ----- ----- $208 $ (25) ===== ===== Special income tax obligation Reduced tax basis depreciation (31) (35) Other property transactions (27) (134) ---- ----- $(58) $(169) ==== ===== CONSOLIDATED RAIL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) As of December 31, 1993, the Company has approximately $77 million of alternative minimum tax credits available to offset future U.S. federal income taxes on an indefinite carryforward basis. Deferred income taxes and the special income tax obligation for 1991 include reductions of $159 million and $113 million, respectively, related to the 1991 Special Charge (Note 10). Reconciliations of the U.S. statutory tax rates with the effective tax rates follow: 1993 1992 1991 ----- ----- ------ Statutory tax rate 35.0% 34.0% (34.0)% State income taxes, net of federal benefit 5.1 3.9 (3.5) Effect of federal tax increase on deferred taxes 7.7 Other (0.9) .8 (.7) ----- ----- ----- Effective tax rate 46.9% 38.7% (38.2)% ===== ===== ===== 8. Employee Benefits ----------------- Pension Plans ------------- The Company and certain subsidiaries maintain defined benefit pension plans which are noncontributory for all non- union employees and generally contributory for participating union employees. Benefits are based primarily on credited years of service and the level of compensation near retirement. Funding is based on the minimum amount required by the Employee Retirement Income Security Act of 1974. Pension credits include the following components: CONSOLIDATED RAIL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) The funded status of the pension plans and the amounts reflected in the balance sheets are as follows: The assumed weighted average discount rates used in 1993 and in 1992 are 7.25% and 8.0%, respectively, and the rate of increase in future compensation levels used in determining the actuarial present value of the projected benefit obligation as of December 31, 1993 and 1992 is 6.0%. The expected long-term rate of return on plan assets (primarily equity securities) in 1993 and 1992 is 9.0%. Savings Plans ------------- The Company and certain subsidiaries also provide 401(k) savings plans for union and non-union employees. Under the Non-union ESOP, 100% of employee contributions are matched in the form of Conrail Inc. ESOP Stock (Note 2) for the first 6% of a participating employee's base pay. Under the union employee plan, employee contributions are not matched by the Company. Savings plan expense, including Non-union ESOP expense, was $5 million in 1993 and $4 million in 1992 and 1991. In connection with the Non-union ESOP, the Company issued 9,979,562 of the authorized 10 million shares of its ESOP Stock to the Non-union ESOP in exchange for a 20 year promissory note with interest at 9.55% from the Non-union ESOP in the principal amount of $288 million. In addition, unearned ESOP compensation of $288 million was recognized as a charge to stockholders' equity coincident with the Non- union ESOP's issuance of its $288 million promissory note to the Company. The debt of the Non-union ESOP was recorded by the Company and offset against the promissory note from the Non-union ESOP. Prior to the corporate reorganization CONSOLIDATED RAIL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) (Note 2), unearned ESOP compensation was charged to expense as shares of ESOP Stock were allocated to participants. An amount equivalent to the preferred dividends declared on the ESOP Stock partially offset compensation and interest expense related to the Non-union ESOP. In conjunction with the formation of the holding company on July 1, 1993 (Note 2), each share of the Company's preferred stock, all of which were held by the Non-union ESOP, was automatically converted into one share of preferred stock of Conrail Inc. and the debt of the Non-union ESOP and the unearned ESOP compensation accounts were transferred to Conrail Inc. The promissory note receivable from the Non- union ESOP plus the accrued interest were reclassified by the Company to the stockholder's equity section of its balance sheet. Unearned ESOP compensation is now amortized and charged to the Company by Conrail Inc. as shares of ESOP Stock are allocated to participants. An amount equivalent to the preferred dividends declared on the ESOP Stock proportionally offsets compensation expense of the Company and interest expense of Conrail Inc. related to the Non-union ESOP. Conrail Inc. makes dividend payments at a rate of 7.51% on the ESOP Stock and Consolidated Rail Corporation makes additional contributions in an aggregate amount sufficient to enable the Non-union ESOP to make the required interest and principal payments on its note. Interest expense incurred by the Non-union ESOP on its debt to the Company before the corporate reorganization on July 1, 1993 (Note 2) was $15 million in 1993, and $28 million in 1992 and 1991. Compensation expense related to the Non-union ESOP was $10 million in 1993, $9 million in 1992, and $8 million in 1991. Preferred dividends paid to the Non-union ESOP by the Company prior to the corporate reorganization (Note 2) were $11 million in 1993, and $21 million in 1992 and 1991. The Company received debt service payments from the Non-union ESOP of $26 million in 1993, and $21 million in 1992 and 1991. Postretirement Benefits Other Than Pensions ------------------------------------------- The Company provides health and life insurance benefits to certain eligible retired non-union employees. Certain non- union employees are eligible for retiree medical benefits, while substantially all non-union employees are eligible for retiree life insurance benefits. Generally, company-provided health care benefits terminate when covered individuals reach age 65. Retiree medical benefits are funded by a combination of CONSOLIDATED RAIL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) Company and retiree contributions. The cost of medical benefits provided by the Company as self-insurer was previously recognized as claims and administrative expenses were paid. Retiree life insurance benefits are provided by insurance companies whose premiums are based on claims paid during the year and the cost of such benefits was previously recognized as the annual insurance premium. The expense of providing both non-union retiree medical and life insurance benefits for 1992 and 1991 was $5 million and $2 million, respectively. Retiree life insurance plan assets consist of a retiree life insurance reserve held in the Company's group life insurance policy. There are no plan assets for the retiree health benefits plan. Effective January 1, 1993, the Company adopted SFAS 106, which requires that the cost of retiree benefits other than pensions be accrued during the period of employment rather than when benefits are paid. The Company elected the immediate recognition method allowed under the statement and accordingly recorded a cumulative, one-time charge of $22 million (net of tax benefits of $14 million). This accrual was in addition to the remaining balance of $21 million which had been accrued for postretirement health benefits for employees who participated in the Company's 1989 non-union voluntary retirement program. The accumulated postretirement obligation at January 1, 1993 was $41 million for the medical plan and $21 million for the life insurance plan. Plan assets attributed to the life insurance plan at January 1, 1993 totalled $5 million. CONSOLIDATED RAIL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) The following sets forth the plan's funded status reconciled with amounts reported in the Company's balance sheet at December 31, 1993: An 11.5 percent rate of increase in per capita costs of covered health care benefits was assumed for 1994, gradually decreasing to 6 percent by the year 2008. Increasing the assumed health care cost trend rates by one percentage point in each year would increase the accumulated postretirement benefit obligation as of December 31, 1993 by $4 million and would have an immaterial effect on the service cost and interest cost components of net periodic postretirement benefit cost for 1993. A discount rate of 7.0% was used to determine the accumulated postretirement benefit obligations for both the medical and life insurance plans. The assumed rate of compensation increase is 5.0%. 9. Capital Stock ------------- The Company is authorized to issue 25 million shares of preferred stock with no par value. The Board of Directors has the authority to divide the preferred stock into series and to determine the rights and preferences of each. As a result of the holding company structure that became effective on July 1, 1993 (Note 2), each share of the Company's common stock which was issued and outstanding or held in the treasury of the Company, was automatically converted into one share of Conrail Inc. common stock. Subsequent to July 1, 1993, the Company had 100 shares of common stock outstanding, all held by Conrail Inc. All of CONSOLIDATED RAIL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) the long-term incentive plans of the Company were amended to reflect the use of Conrail Inc.'s common stock. The activity and status of treasury stock follow: 1993 1992 1991 --------- --------- ------- Shares, beginning of year 3,690,002 546,400 Acquired 611,182 3,143,602 546,400 Reclassified as authorized but unissued (43,800) Corporate reorganization (Note 2) (4,257,384) --------- --------- ------- Shares, end of year - 3,690,002 546,400 Conrail Inc.'s 1987 Long-Term Incentive Plan (the "1987 Incentive Plan") authorizes the granting to the Company's officers and key employees of up to 4 million shares of Conrail Inc. common stock through stock options, stock appreciation rights, and awards of restricted or performance shares. A stock option is exercisable for a specified term commencing after grant at a price not less than the fair market value of the stock on the date of grant. The 1987 Incentive Plan also provides for the granting of Conrail Inc. stock to employees, contingent on either a specified period of employment or achievement of certain financial or performance goals. Conrail Inc.'s 1991 Long-Term Incentive Plan (the "1991 Incentive Plan") authorizes the granting to the Company's officers and key employees of up to 3.2 million shares of Conrail Inc. common stock, through stock options, stock appreciation rights and awards of restricted or performance shares. As of December 31, 1993, Conrail Inc. had granted 169,005 shares of restricted stock under the incentive plans. CONSOLIDATED RAIL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) The activity and status of stock options under the incentive plans follow: Non-qualified Stock Options -------------------------------- Option Price Shares Per Share Under Option ----------------- ------------ Balance, January 1, 1991 $14.000 - $25.065 3,271,920 Granted $24.530 - $36.595 339,400 Exercised $14.000 - $25.065 (1,361,922) Cancelled $14.000 - $25.065 (83,718) --------- Balance, December 31, 1991 $14.000 - $36.595 2,165,680 Granted $42.625 - $45.125 1,383,600 Exercised $14.000 - $25.063 (674,652) Cancelled $42.625 (3,750) --------- Balance, December 31, 1992 $14.000 - $45.125 2,870,878 Granted $49.375 - $60.500 73,027 Exercised $14.000 - $53.875 (928,822) Cancelled $31.813 - $45.125 (48,762) --------- Balance, December 31, 1993 $14.000 - $60.500 1,966,321 ========= Exercisable, December 31, 1993 $14.000 - $53.875 995,827 ========= Available for future grants December 31, 1992 1,792,726 ========= December 31, 1993 1,698,036 ========= 10.1991 Special Charge ------------------- In 1991, the Company recorded in operating expenses a special charge totalling $719 million which was composed of $362 million for disposition of certain under-utilized rail lines and other facilities, $212 million for labor settlements primarily representing certain expected costs associated with a new labor agreement that reduced the size of train crews, $57 million for certain environmental clean up costs, and $88 million for legal matters including settlement of the Amtrak collision with the Company at Chase, Maryland in January 1987. The 1991 special charge reduced net income by $447 million, and without the special charge net income would have been $240 million ($2.73 and $2.48 per share, primary and fully diluted, respectively). CONSOLIDATED RAIL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) 11.Other Income, Net ----------------- 1993 1992 1991 ---- ----- ---- (In Millions) Interest income $ 40 $ 40 $ 48 Rental income 56 60 53 Property sales, net 20 6 9 Management fee (11) Other, net 9 (8) (3) ---- ---- ---- $114 $ 98 $107 ==== ==== ==== 12.Commitments and Contingencies ----------------------------- Non-union Voluntary Retirement Program -------------------------------------- On December 15, 1993, the Board of Directors approved a voluntary early retirement program for eligible members of its non-union workforce. The eligible employees have until February 28, 1994 to elect to retire under the program, and based on the results of a similar program completed in 1990, the cost of the program is expected to have a material effect on the income statement for the first quarter of 1994. The transaction will not significantly affect the Company's cash position as approximately 85% of the cost will be paid from the Company's overfunded pension plan (Note 8). Environmental ------------- The Company is subject to various federal, state and local laws and regulations regarding environmental matters. The Company is a party to various proceedings brought by both regulatory agencies and private parties under federal, state and local laws, including Superfund laws, and has also been named as a potentially responsible party in many governmental investigations and actions for the cleanup and removal of hazardous substances due to its alleged involvement as either a transporter, generator or property owner. Due to the number of parties involved at many of these sites, the wide range of costs of possible remediation alternatives, the changing technology and the length of time over which these matters develop, it is often not possible to estimate the Company's liability for the costs associated with the assessment and remediation of contaminated sites. Although the Company's operating results and liquidity could be significantly affected in any quarterly or annual reporting period if it were held principally liable in certain of these actions, at December 31, 1993, the Company had accrued $77 million, an CONSOLIDATED RAIL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) amount it believes is sufficient to cover the probable liability and remediation costs that will be incurred at Superfund sites and other sites based on known information and using various estimating techniques. The Company believes the ultimate liability for these matters will not materially affect its consolidated financial condition. The Environmental Quality Department of the Company is charged with promoting the Company's compliance with laws and regulations affecting the environment and instituting environmentally sound operating practices. The department monitors the status of the sites where the Company is alleged to have liability and continually reviews the information available and assesses the adequacy of the recorded liability. Other Contingencies ------------------- The Company is involved in various legal actions, principally relating to occupational health claims, personal injuries, casualties, property damage and loss and damage. The Company has recorded liabilities on its balance sheet for amounts sufficient to cover the expected payments for such actions. At December 31, 1993 these liabilities are presented net of estimated insurance recoveries of approximately $80 million. The Company may be contingently liable for approximately $102 million at December 31, 1993 under indemnification provisions related to sales of tax benefits. CONSOLIDATED RAIL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued) 13. Condensed Quarterly Data (Unaudited) ------------------------------------ Due to the formation of the holding company (Note 2), earnings, dividends, and market price per share amounts are not presented for periods subsequent to July 1, 1993. Effective January 1, 1993, the Company adopted SFAS 106 and SFAS 109, related to the accounting for postretirement benefits other than pensions and income taxes, respectively. As a result, the Company recorded cumulative after tax charges totalling $74 million in the first quarter of 1993. The cumulative after tax charges were reduced to $70 million as a result of the transfer of a wholly owned subsidiary to Conrail Inc. (Notes 1, 7 and 8). In September 1993, the Company recorded a reserve of $89 million relating to advances made to Concord Resources Group, Inc., a subsidiary of Conrail Inc. Also, in the third quarter, as a result of the increase in the federal corporate income tax rate enacted August 10, 1993 and effective January 1, 1993, income tax expense for the third quarter of 1993, includes a charge of $36 million, primarily related to the adjustment of deferred taxes and the special income tax obligation as required by SFAS 109 (Note 7). Item 9. Item 9. Changes in and Disagreements with Accountants - ------- ---------------------------------------------- on Accounting and Financial Disclosure. -------------------------------------- Previously reported in the Company's Current Report on Form 8-K, filed February 18, 1994. PART III Item 10. Item 10. Directors and Executive Officers - ------- -------------------------------- of the Registrant. ----------------- Information Omitted in Accordance with General Instruction J(2)(c). Item 11. Item 11. Executive Compensation. - ------- ---------------------- Information Omitted in Accordance with General Instruction J(2)(c). Item 12. Item 12. Security Ownership of Certain Beneficial - ------- ---------------------------------------- Owners and Management. --------------------- Information Omitted in Accordance with General Instruction J(2)(c). Item 13. Item 13. Certain Relationships and Related Transactions. - ------- ---------------------------------------------- Information Omitted in Accordance with General Instruction J(2)(c). PART IV Item 14. Item 14. Exhibits, Financial Statement - ------- ----------------------------- Schedules, and Reports on Form 8-K. ---------------------------------- (a) The following documents are filed as a part of this report: 1. Financial Statements: Page ---- Report of Independent Accountants..................... 15 Consolidated Statements of Income for each of the three years in the period ended December 31, 1993... 16 Consolidated Balance Sheets at December 31, 1993 and 1992 ........................................... 17 Consolidated Statements of Stockholders' Equity for each of the three years in the period ended December 31, 1993...................... 18 Consolidated Statements of Cash Flows for each of the three years in the period ended December 31, 1993 .................................. 19 Notes to Consolidated Financial Statements............ 20 2. Financial Statement Schedules: The following financial statement schedules should be read in connection with the financial statements listed in Item 14(a)1 above. Index to Financial Statement Schedules -------------------------------------- Page ---- Schedule V - Property, Plant and Equipment...... S-1 Schedule VI - Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment.............. S-2 Schedule VIII - Valuation and Qualifying Accounts.. S-3 Schedule X - Supplementary Income Statement Information...................... S-4 Schedules other than those listed above are omitted for reasons that they are not required, are not applicable, or the information is included in the financial statements or related notes. 3. Exhibits: Exhibit No. ---------- 2 Agreement and Plan of Merger among Consolidated Rail Corporation, Conrail Inc. and Conrail Subsidiary Corporation, dated as of February 17, 1993, filed as Appendix A to the Proxy Statement of the Registrant, dated April 16, 1993 and incorporated herein by reference. 3.1 Amended and Restated Articles of Incorporation of the Registrant as amended through December 31, 1992, filed as Exhibit 3.1 to the Registrant's Report on Form 10-K for the year ended December 31, 1992 and incorporated herein by reference. 3.2 By-Laws of the Registrant, as amended through December 31, 1993. 4.1 Articles of Incorporation of the Registrant filed as Exhibit 3.1 to the Registrant's Report on Form 10-K for the year ended December 31, 1992 and incorporated herein by reference. 4.2 Form of Certificate of Common Stock, par value $1.00 per share, of the Registrant, filed as Exhibit 4.7 to the Registrant's Registration Statement on Form S-8 (No. 33-19155) and incorporated herein by reference. 4.3 Form of Indenture between the Registrant and The First National Bank of Chicago, as Trustee, with respect to the issuance of up to $1.25 billion aggregate principal amount of the Registrant's debt securities, filed as Exhibit 4 to the Registrant's Registration Statement on Form S-3 (Registration No. 33-34040) and incorporated herein by reference. In accordance with Item 601(b)(4)(iii) of Regulation S-K, copies of instruments of the Registrant with respect to the rights of holders of certain long-term debt are not filed herewith, or incorporated by reference, but will be furnished to the Commission upon request. 10.1 Second Amended and Restated Northeast Corridor Freight Operating Agreement dated October 1, 1986 between National Railroad Passenger Corporation and Consolidated Rail Corporation, filed as Exhibit 10.1 to the Registrant's Registration Statement on Form S- 1 (Registration No. 33-11995) and incorporated herein by reference. 10.2 Letter agreements dated September 30, 1982 and July 19, 1986 between Consolidated Rail Corporation and The Penn Central Corporation, filed as Exhibit 10.5 to the Registrant's Registration Statement on Form S- 1 (Registration No. 33-11995) and incorporated herein by reference. 10.3 Letter agreement dated March 16, 1988 between Consoli dated Rail Corporation and Penn Central Corporation relating to hearing loss litigation, filed as Exhibit 19.1 to the Registrant's Quarterly Report on Form 10- Q for the quarter ended March 31, 1988 and incorporated herein by reference. Management Compensation Plans and Contracts ------------------------------------------- 10.4 Retirement Plan for Non-employee Directors as amended February 21, 1990, filed as Exhibit 10.10 to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1989 and incorporated herein by reference. 11 Statement of earnings (loss) per share computations. 12 Computation of the ratio of earnings to fixed charges. 23 Consent of Independent Accountants. 24 Each of the officers and directors signing this Annual Report on Form 10-K has signed a power of attorney, contained on page 44 hereof, with respect to amendments to this Annual Report. (b) Reports on Form 8-K. Current Report on Form 8-K dated October 7, 1993, filed in connection with the Registrant's issuance of $63,156,000 of 5.98% 1993-A Equipment Trust Certificates Due 2013 pursuant to its current Registration Statement on Form S-3 (No. 33-64670). (c) Exhibits. The Exhibits required by Item 601 of Regulation S-K as listed in Item 14(a)3 are filed herewith or incorporated herein by reference. (d) Financial Statement Schedules. Financial statement schedules and separate financial state ments specified by this Item are included in Item 14(a)2 or are otherwise omitted for reasons that they are not required or are not applicable. POWER OF ATTORNEY ----------------- Each person whose signature appears below under "SIGNATURES" here by authorizes H. William Brown and Bruce B. Wilson, or either of them, to execute in the name of each such person, and to file, any amendment to this report and hereby appoints H. William Brown and Bruce B. Wil son, or either of them, as attorneys-in-fact to sign on his or her behalf, individually and in each capacity stated below, and to file any and all amendments to this report. SIGNATURES ---------- Pursuant to the requirements of Section 13 or 15(d) of the Securi ties Exchange Act 1934, Consolidated Rail Corporation has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. CONSOLIDATED RAIL CORPORATION. Date: March 16, 1994 By James A. Hagen ----------------------------- James A. Hagen Chairman, President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below on this 16th day of March, 1994, by the following persons on behalf of Consolidated Rail Corporation and in the capacities indicated. Signature Title - --------- ----- James A. Hagen Chairman, President and Chief - -------------- Executive Officer and James A. Hagen (Principal Executive Officer) Director H. William Brown Senior Vice President - Finance - ---------------- and Administration H. William Brown (Principal Financial Officer) John A. McKelvey Vice President - Controller - ---------------- (Principal Accounting Officer) John A. McKelvey H. Furlong Baldwin Director - ------------------ H. Furlong Baldwin Claude S. Brinegar Director - ------------------ Claude S. Brinegar Daniel B. Burke Director - --------------- Daniel B. Burke Kathleen Foley Feldstein Director - ------------------------ Kathleen Foley Feldstein Roger S. Hillas Director - --------------- Roger S. Hillas E. Bradley Jones Director - ---------------- E. Bradley Jones David B. Lewis Director - -------------- David B. Lewis John C. Marous Director - -------------- John C. Marous William G. Milliken Director - ------------------- William G. Milliken Raymond T. Schuler Director - ------------------ Raymond T. Schuler David H. Swanson Director - ---------------- David H. Swanson E-1 EXHIBIT INDEX Page Number in SEC Sequential Numbering Exhibit No. System - ----------- --------------------- 3.2 By-laws of the Registrant, as amended through December 31, 1993 11 Statement of earnings (loss) per share computations 12 Computation of the ratio of earnings to fixed charges 23 Consent of Independent Accountants Exhibits 2, 3.1, 4.1, 4.2, 4.3, 10.1, 10.2, 10.3 and 10.4 are incorporated herein by reference. Powers of attorney with respect to amendments to this Annual Report are contained on page 44.

1993 Item 1. Business (a) GENERAL DEVELOPMENT OF REGISTRANT BUSINESS The major business developments of Kansas City Southern Industries, Inc. ("Registrant" or "KCSI") and the Registrant's subsidiaries for 1993 are as follows: General 1993 Tax Legislation On August 10, 1993, President Clinton signed into law the Omnibus Budget Reconciliation Act of 1993 ("the 1993 Tax Act"). This new tax legislation changed numerous provisions to the then existing tax law. The most significant of these changes, affect the Registrant's Transportation Services operations. The new tax law increased the corporate tax rate from 34% to 35%. Accordingly, the Registrant's 1993 earnings include additional income tax expense attributable to the tax rate increases retroactive to January 1, 1993. These charges, which are included in the provision for taxes on income, represent $3.4 million ($.08 per share) related to deferred tax accruals and $900,000 ($.02 per share) related to current year earnings. In addition, the new tax law included provisions for higher fuel tax rates, which resulted in an additional expense to Transportation operations during 1993 of $400,000. Transportation Services MidSouth Acquisition. As previously disclosed in the Registrant's Annual Report on Form 10-K for the year ended December 31, 1992, the Registrant and MidSouth Corporation ("MidSouth") signed a definitive merger agreement on September 21, 1992. The merger agreement provided that holders of MidSouth Common stock receive $20.50 per share in cash. The transaction was approved by both boards of directors. At its Annual Meeting of Stockholders on April 30, 1993, MidSouth stockholders approved the merger agreement and on June 4, 1993 the Interstate Commerce Commission announced their approval of the transaction. On June 10, 1993, the Registrant closed the acquisition of MidSouth pursuant to the merger agreement. The purchase price for the acquisition of the MidSouth common stock aggregated approximately $213.5 million paid in cash by the Registrant to holders of MidSouth's common stock and in connection with the exercise of certain options held by MidSouth employees and others. Liabilities were assumed in the amount of $306.9 million. The acquisition was funded with proceeds from the Registrant's $250 million credit agreement. The MidSouth transaction, which was accounted for as a purchase, represents a significant transaction for the Registrant. Results of operations of the Registrant for the year ended December 31, 1993 include the operations of MidSouth as a consolidated subsidiary effective with the closing of the transaction. Adjustments were recorded to appropriate asset and liability balances based upon the fair value of such assets and liabilities. Based upon these adjustments, the total purchase price exceeded the fair value of the underlying net assets by a total of approximately $98.3 million and is being amortized over a period of 40 years. Additional assets are depreciated over lives ranging from 5-35 years. Certain unaudited proforma financial information regarding results of operations assuming the MidSouth transaction had been completed on January 1, 1993 and 1992, respectively, follows (in millions, except per share amounts): Effective January 1, 1994, MidSouth was operationally and administratively merged into The Kansas City Southern Railway Company ("KCSR", a wholly-owned subsidiary of the Registrant). Other Transportation Services Activity In May 1992, KCSR signed an agreement with the Santa Fe Railway to purchase portions of its rail line in the Dallas, Texas area. The sale consists of approximately 90 miles of track and an 80 acre piggyback intermodal facility. The agreement is being implemented in phases over a two year period and will gain KCSR direct access to the Dallas/Ft. Worth markets for the first time in the Registrant's history. Phase I of this agreement was completed on October 31, 1993. Phase I included the portion of Santa Fe's line between Farmersville, Texas and a switch at Zacka Junction, Texas. Phase II is anticipated to be completed in second quarter 1994 to acquire the Zacka Junction facility. In April 1992, KCSR signed a letter of intent for the purchase of all of the capital stock of the Graysonia, Nashville & Ashdown Railroad ("GNA") from Holnam, Inc. The GNA, which was wholly-owned by Holnam, connects with KCSR at Ashdown, Arkansas and extends 32 miles east. Acquisition of the GNA closed on December 31, 1992 and was operated in trust until ICC approval was obtained in June 1993, at which time it was merged into KCSR. During 1993, KCSR continued emphasis of important safety and quality programs, which includes the Safety Training Observation Program (S.T.O.P. - originally established by E.I. DuPont). The S.T.O.P. program is designed to curtail employee injuries through elimination of unsafe acts in the workplace. Increased safety awareness achieved positive results during 1991-1993 with an approximate 31% reduction in Federal Railroad Administration reportable employee injuries in 1993 as compared to 1992 and an approximate 28% reduction in employee injuries in 1992 when compared to 1991. The transportation business continued its substantial commitment towards a safer work environment in 1993 and remains committed to continuing safety awareness. Fuel costs represent approximately 7% of KCSR's operating expenses and have been declining as diesel fuel prices have decreased each of the past three years. The average 1993 price of fuel declined 8% from 1992 average prices. Fuel prices stabilized in 1992-1993 due to a general oversupply of crude oil in world petroleum markets. KCSR operations experienced lower fuel prices in 1992 and 1991, particularly in the latter half of 1991, stemming from resolution of the 1990-1991 Gulf War and stabilization of relations in the Middle East region. Average per gallon diesel fuel prices were 7% lower in 1992 compared to 1991 and were 6% lower in 1991 compared to 1990, resulting in lower transportation operating costs. Overall fuel costs are also affected by the ratio of fuel gallons consumed to gross ton miles. This ratio had declined in both 1991 and 1992, but rose slightly in 1993 from variances in traffic mix and length of haul. Fuel efficiencies are attributable to more efficient railway operating practices related to train schedules, reallocation of locomotive power and general fuel conservation. Fuel usage was also improved by the purchase of additional new fuel efficient locomotives during the period 1989-1991, totalling 46 new SD-60 locomotives placed in service. Additionally, as part of KCSR's locomotive fleet modernization program, 16 GP40 locomotives were refurbished in 1991 and another 17 GP40 used units were purchased and refurbished in 1993 and early 1994. In 1991, KCSR issued $32.2 million of privately placed Equipment Trust Certificates ("ETC's") to fund acquisition of 24 of the new locomotive units. The 46 new locomotive purchases during the period 1989-1991, have caused an improvement in the average age of KCSR's locomotive fleet. These new fuel efficient locomotives additionally helped effect a 1% reduction in fuel gallons consumed per gross ton miles in 1992 compared to 1991 and an 8% reduction in 1991 compared to 1990. However, in 1993 the ratio of fuel gallons consumed per gross ton miles increased 2% from a combination of increased carloading volumes, and variances in traffic mix and length of haul. KCSR 1993 revenues rose 3% compared to 1992. General commodity revenues, excluding intermodal traffic, rose 5.5% on generally higher traffic volumes. The higher traffic volumes resulted, in part, from a strengthening of U.S. economic conditions, which have continued to rise slowly from a recessionary period in 1990-1992. Higher traffic levels were experienced in carloadings of farm products, particularly corn & wheat, non-metallic ores, lumber/wood - pulp/paper, chemical and petroleum shipments. Intermodal carloadings declined 8% in 1993 as KCSR continues the process of upgrading its current "on-off ramp" loading facilities in anticipation of greater intermodal traffic in the future. Unit coal revenues rose modestly in 1993 on overall increased tonnage but were adversely affected by variances in length of haul and rates. As evidenced by the increased farm products carloadings, KCSR continues to use haulage rights with the Union Pacific Railroad (discussed later) allowing KCSR market access to the corn belt regions of Iowa and Nebraska. The flooding in the Midwest region of the United States during 1993 did not materially affect the Registrant's rail transportation operations. KCSR's trackage, facilities and physical properties were not directly hampered by the rising flood waters. However, a washout of trackage in the Pittsburg, Kansas area occurred during heavy rains. While none of KCSR's properties were directly affected, many of KCSR's interchange partners in the Kansas City gateway were affected, which resulted in congestion, rerouting of certain traffic and delays of commodity movements, particularly for grain and coal shipments. KCSR experienced revenue declines, during third quarter 1993, in certain commodities due to the inability to interchange shipments with other railroads. Overall the financial impact was immaterial. Transportation Division results also benefitted in 1993 from revenue and net income additions of MidSouth and continuing favorable operations at the Registrant's petroleum coke export facility (Pabtex, Inc.), which experienced increased volumes in 1993. MidSouth contributed $67.8 million in revenues to 1993 Transportation Division results, which surpassed comparative prior year revenues on increased carloadings. MidSouth's 1993 earnings, net of all acquisition related expenses, were positive after excluding the effect of the federal income tax rate increase. Information and Transaction Processing DST Systems, Inc. ("DST") Vantage Computer Systems, Inc./The Continuum Company, Inc. Transaction. Effective September 30, 1993, the Registrant's wholly-owned subsidiary, DST, completed the merger of its 90.5% owned subsidiary, Vantage Computer Systems, Inc. ("Vantage"), into a subsidiary of The Continuum Company, Inc. ("Continuum"). DST and the minority shareholder of Vantage received a total of 4 million shares of Continuum stock -- 2,939,000 shares at closing and the remainder after Continuum shareholder approval was obtained in late 1993. As a result of this transaction, and additional Continuum stock purchases made by DST, DST owned approximately 24% of the outstanding common stock of Continuum at December 31, 1993. In January 1994, DST acquired additional Continuum shares through privately negotiated transactions. Accordingly, DST currently owns approximately 29% of Continuum's outstanding common stock. In the initial exchange, DST exchanged Vantage stock with a book value of approximately $17 million for Continuum stock with a market value of approximately $62 million. DST accounted for the initial exchange as a non- cash, non-taxable exchange in investment basis of Vantage for an investment in Continuum. Accordingly, no gain recognition was associated with the transaction. Vantage revenues for the nine months ended September 30, 1993, were $32.6 million and $38.7 million for the year ended December 31, 1992. Continuum is a publicly traded international consulting and computer services firm based in Austin, Texas, which primarily serves the needs of life and property and casualty insurance companies for computer software and services. Continuum has annual revenues of approximately $250 million and total assets of approximately $160 million. The Vantage/Continuum transaction will allow DST to expand its presence in the information processing market for the insurance industry and combine the strengths of both Vantage and Continuum. Prior to the merger, Vantage's business was primarily centered in the U.S. domestic market while Continuum has a significant international and domestic presence. Subsequent to this transaction, DST assumed all of the North American operations data processing functions for Continuum. DST and Continuum signed an agreement whereby DST will make available the capabilities of the Winchester Data Center for Continuum processing requirements. This processing agreement will reduce overall Continuum processing costs, provide a revenue source for DST and present opportunities for greater Continuum growth. Other DST Activity. Financial institutions within the industries served by DST will continue to evaluate whether to internalize or outsource their technology needs. This process will have both positive and negative effects on DST's results; however, on an overall basis, DST's customer base is expected to grow. In 1993, DST experienced an overall increase in the number of mutual fund accounts serviced; at December 31, 1993, DST serviced a record total of 28 million mutual fund accounts, a 5.6 million account increase over the 22.4 million accounts serviced at December 31, 1992. The 1993 account increase is a result of overall mutual fund account growth. Kemper Financial Services ("Kemper"), a DST customer, began conversion of its mutual fund shareowner processing, which will result in the removal of its accounts from the DST system. The total number of Kemper accounts, approximately 2.5 million, will be converted from the DST system in stages by the end of 1994. In early July 1993, the first stage, which encompassed 500,000 Kemper accounts were converted from the DST system. The loss of 500,000 accounts in 1993 was offset by account growth from other mutual fund customers and accordingly, did not have a material financial impact. DST serviced 22.4 million mutual fund accounts at December 31, 1992, a 3.7 million increase from the 18.7 million accounts serviced at December 31, 1991 and 20.4 million accounts at December 31, 1990. The 1991 account decrease is in large part a result of the loss of the Vanguard group of funds in September 1991, comprising approximately 2.7 million shareowner accounts and the removal of 800,000 broker based accounts of Prudential Bache in late 1991. Excluding the loss of the Vanguard and Prudential Bache accounts, mutual fund accounts serviced by DST increased 1.8 million accounts in 1991 when compared to 1990. During 1993, DST continued marketing of its Automated Work Distributor System ("AWD" TM), an image-based clerical work management system which was completed and placed in service during 1990. The AWD System's image technology can also be combined with principles of an intelligent work station. AWD was initially implemented in several mutual fund transfer agencies, but through expansion, now resides on more than 4,200 work stations in companies throughout the world (a 75% increase since December 31, 1992) and is used to service approximately 53% of the mutual fund shareowner accounts on DST's system. AWD is also used in industries such as insurance, banking and health care. Concurrent with the Continuum/Vantage merger, discussed earlier, DST and Continuum reached a license agreement, whereby Continuum will market AWD for use in insurance industry applications. During 1993, DST continued marketing of its record keeping system for 401(k) plans, TRAC-2000 TM. TRAC-2000 TM, introduced in late 1991, represents a major commitment by DST to offer the mutual fund industry a fully integrated service for such plans. Integrated with TA2000 TM, DST's mutual fund record keeping system, TRAC-2000 TM delivers comprehensive 401(k) record keeping and ancillary services including full compliance testing in accordance with Department of Labor regulations. DST's printed output processing businesses, Output Technologies, Inc. ("OTI") continued to expand in 1993. During 1993, OTI completed the internal reorganization of its subsidiaries, which included renaming of certain subsidiaries and merging of certain operations. The overall objective of this reorganization was consolidation of output related activities, identification of businesses with the OTI name and alignment into geographic operating regions. OTI serves as a holding company for businesses which perform printed output processing, commercial printing, telecommunications and fulfillment, graphics design, computer output microfilm/microfiche and printing and mailing of laser printed output primarily for DST's mutual fund clients but also for a wide range of customers. The OTI concept, which was originally launched in 1990, achieved further growth in 1993 through acquisition and location expansion. At December 31, 1993, OTI operated in 35 locations throughout the U.S. During 1993 OTI's laser click volume was 669 million pages of printed output, an increase of 45% over the 460 million pages in 1992. Management expects growth in the OTI business will result from DST mutual fund account growth along with expansion and acquisitions in future years. During 1993, DST completed the acquisition of Clarke & Tilley Ltd., (96.25% owned), a United Kingdom company, which markets investment management software primarily for use in Europe and the Pacific Rim; Corfax Benefit Systems, Ltd., (100% owned), a Canadian company, which processes shareowner transactions for mutual funds and pension accounts in Canada; DBS Systems Corporation, (60% owned), a United States company, which is developing a software billing system for the direct broadcast satellite industry; and Belvedere Financial Systems, Inc. (100% owned), which develops and markets portfolio accounting, and investment management systems. Each of these transactions was accounted for as a purchase. The total purchase price exceeded the fair value of the underlying net assets, which will be amortized over a period of 7-20 years. Cash paid for these transactions was $15.3 million and liabilities assumed were $10.3 million. Financial Asset Management Janus Capital Corporation Janus Capital Corporation ("Janus"), which manages investments for the Janus group of mutual funds and the IDEX equity funds, insurance companies and other institutional accounts, continued to experience significant growth in terms of assets under management and accounts serviced during 1993. Janus assets under management grew from $15.5 billion at December 31, 1992 to a record $22.2 billion at December 31, 1993 from account growth and market appreciation. The number of Janus and IDEX Funds shareholders increased from 1.5 million at December 31, 1992 to a record 2.0 million at December 31, 1993. Janus' revenues and profitability both increased in 1993 as a result of the increased assets under management and greater number of shareholder accounts serviced. While Janus experienced significant growth during 1993, much of that growth occurred in the first half of 1993. During the third and fourth quarters of 1993 growth in assets under management slowed. Total fund sales were $3.3 billion during the second half of 1993 versus $5.5 billion during the first six months of 1993, while fund redemption increased to $2.2 billion versus $1.6 billion, respectively. During 1993, Janus continued to expand the distribution channels of the Janus funds by participating in "Schwabs' Mutual Fund OneSource" service of Charles Schwab as well as a similar program offered by Fidelity Investments. In addition, Janus introduced two new Janus fund portfolios; Janus Mercury Fund, an equity fund; Janus Federal Tax Exempt Fund, a tax exempt income fund; and the Janus Aspen Series, which consists of six portfolios funded through variable annuity contracts, such as the Janus Retirement Advantage. During 1992, Janus introduced three funds; Janus Enterprise Fund, an equity fund; Janus Balanced Fund, a combination equity/fixed income fund and Janus Short- Term Bond Fund, an income fund. Additional portfolio managers have joined the Janus staff concurrent with the growth in assets under management and new investment products. Janus has expanded its assets under management by marketing advisory services directly to pension plan sponsors, insurance, banking and brokerage firms for their proprietary investment products. These relationships generated approximately $920 million and $340 million in new assets in 1993 and 1992, respectively. Janus revenues and operating income increases are a direct result of increases in assets under management and Janus processing services. Assets under management and shareholder accounts have grown in recent years from a combination of new money investments or fund sales and market appreciation. Fund sales have risen in response to marketing efforts, favorable fund performance and the current popularity of no-load mutual funds. Market appreciation has resulted from increases in stock investment values. However, a decline in the stock and bond markets and/or an increase in the rate of return of alternative investments could negatively impact Janus revenues and operating income. In addition, the mutual fund market, in general, faces increasing competition as the number of mutual funds continues to increase, marketing and distribution channels become more creative and complex, and investors place greater emphasis on published fund recommendations and investment category rankings. These factors could also affect Janus and negatively impact revenues and operating income. Unconsolidated Affiliates (primarily DST related) A significant portion of DST and Registrant consolidated earnings are derived from operations of unconsolidated affiliates, primarily connected with DST. Major developments during 1993 for unconsolidated affiliates were: (i) Investors Fiduciary Trust Company ("IFTC", a 50% owned affiliate of DST) assets under custody increased to $125.1 billion at December 31, 1993 from $106.3 billion at December 31, 1992. IFTC earnings for 1993 were flat compared to 1992. While IFTC assets under custody grew, results were reduced by a change in the fiduciary fee arrangement between IFTC and its parent companies and lower investment earnings. Excluding the change in fiduciary fees, IFTC results were improved over 1992; (ii) as previously discussed, The Continuum Company, Inc. ("Continuum") became an equity affiliate of DST on September 30, 1993, when DST exchanged its 90.5% interest in Vantage Computer Systems, Inc. for an equity interest in Continuum. DST's ownership position in Continuum is approximately 29% of the outstanding common stock. DST recorded equity in earnings from Continuum, which contributed positively to DST 1993 results; (iii) Boston Financial Data Services, Inc. ("BFDS", a 50% owned affiliate of DST) recorded significantly improved earnings in 1993 primarily from volume related mutual fund growth; (iv) Argus Health Systems, Inc. ("Argus", a 50% owned affiliate of DST) recorded improved earnings on an increase in pharmaceutical insurance claims processing volumes. Argus processed approximately 78 million claims in 1993 versus approximately 49 million claims in 1992, an increase of 59%; (v) First of Michigan Capital Corp. ("FOM", a 21% owned affiliate of DST) recorded slightly lower earnings on costs incurred as a result of a failed merger with Comerica, Incorporated, discussed below; and (vi) Midland Data Systems, Inc. and Midland Loan Services, L.P. (collectively "Midland", 45-50% owned affiliates of DST) reported sharply lower earnings in 1993 compared to 1992 from a continuing trend of lower margins on loan securitizations and delays on receipt of certain loan processing work for the RTC. Midland provides operation of an Asset Management System and a Control Totals Module System for use by the Resolution Trust Corporation as well as commercial loan servicing for performing and non-performing commercial loans. In the Registrant's Annual Report on Form 10-K for the year ended December 31, 1992, the Registrant reported that Comerica Incorporated ("Comerica") and First of Michigan Capital Corporation ("FOM") had signed a definitive merger agreement in January 1993. According to the agreement, Comerica was to acquire all of the outstanding stock of FOM in exchange for approximately $45 million in Comerica stock. In late March 1993, Comerica abandoned its efforts to acquire FOM. Accordingly, FOM remains an unconsolidated affiliate of DST. Corporate and Other Debt Securities Registration and Offerings - 1993 On March 3, 1993, the Registrant issued the remaining $100 million of debt securities under a $300 million debt securities Registration Statement on Form S-3 filed in 1992. The Registrant issued the $100 million in debt securities as 6 5/8% Notes due 2005. Proceeds of this debt offering, net of discount and underwriting fees, of $98.5 million were delivered to the Registrant on March 10, 1993. In March 1993, $60 million of proceeds from this debt offering were transferred to DST and Southern Credit Corporation for use in repayment of debt and working capital needs. The Registrant used the remaining net proceeds for general corporate purposes, including debt repayments, working capital, capital expenditures, acquisitions of or investments in businesses and assets and acquisitions of the Registrant's capital stock. The Registrant filed a Registration Statement on Form S-3 with the Securities and Exchange Commission ("SEC") on March 29, 1993, (File No. 33-60192), registering $200 million in debt securities to be offered in the form of Medium Term Notes. The Registrant's Form S-3 was amended on May 3, 1993 and declared effective on May 10, 1993. Proceeds from the sale of the debt securities are expected to be added to the general funds of the Registrant and used to principally repay debt and for other general corporate purposes, including working capital, capital expenditures and acquisitions of or investments in businesses or assets. On June 24, 1993, pursuant to an Indenture and Purchase Agreement, the Registrant issued $100 million of debt securities under this Registration Statement. The transaction, which closed on July 8, 1993, is comprised of Notes bearing interest at a rate of 5.75% maturing in 1998. The net proceeds of this transaction of $99 million, along with certain proceeds from the Registrant's $250 million credit agreement, were used to refinance certain MidSouth debt in July 1993. $500 Million "Universal Shelf" Registration On September 29, 1993, the Registrant filed a Registration Statement on Form S-3 with the SEC (File No. 33-69648), registering $500 million in securities. The securities may be offered in the form of no par Common Stock, New Series Preferred Stock $1 par value, Convertible Debt Securities, Debt Securities or Equipment Trust Certificates (collectively, "the Securities"). Net proceeds from the sale of the Securities are expected to be added to the general funds of the Registrant and used principally for general corporate purposes, including working capital, capital expenditures and acquisitions of or investments in businesses and assets. The SEC has cleared the Registration Statement without review, but the Registrant has not yet requested that it be declared effective and no securities have been issued. Series B Convertible Preferred Stock On October 1, 1993, KCSI transferred one million shares of KCSI Series B Convertible Preferred Stock (the "Series B Preferred Stock") to the Kansas City Southern Industries, Inc. Employee Plan Funding Trust ("the Trust"), a grantor trust established by KCSI. The purchase price of the stock, based upon an independent valuation, was $200 million, which the Trust financed through KCSI. The indebtedness of the Trust to KCSI is repayable over 27 years with interest at 6% per year, with no principal payments in the first three years. The Trust, which is administered by an independent bank trustee, and is consolidated into the Registrant's financial statements, will repay the indebtedness to KCSI utilizing dividends and other income as well as other cash obtained from KCSI. As the debt is reduced, shares of the Series B Preferred Stock, or shares of common stock acquired on conversion, will be released and available for distribution to various KCSI employee benefit plans, including its ESOP, Stock Option Plan and Stock Purchase Plans. No principal payments have been made and accordingly, no shares have been released or are available for distribution to these plans. The Series B Preferred stock, which has a $10 per share (5%) annual dividend and a $200 per share liquidation preference, is convertible into common stock at an initial ratio of 4 shares of common stock for each share of Series B Preferred Stock. The Series B Preferred Stock is redeemable after 18 months at a specified premium and under certain other circumstances. The Series B Preferred Stock can be held only by the Trust or its beneficiaries, the employee benefit plans of KCSI. The full terms of the Series B Convertible Preferred Stock are set forth in a Certificate of Designations approved by the Board of Directors and filed in Delaware. Accounting Changes Postretirement Benefits - The Registrant adopted Statement of Financial Accounting Standards No. 106 "Employers' Accounting for Postretirement Benefits Other Than Pensions", ("SFAS 106"), effective January 1, 1993. The Registrant and its Transportation subsidiaries provide certain medical, life and other postretirement benefits other than pensions to its retirees. The medical and life plans are available to employees not covered under collective bargaining arrangements, who have attained age 60 and rendered ten years of service. Individuals employed as of December 31, 1992 were excluded from a specific service requirement. The medical plan is contributory and provides benefits for retirees, their covered dependents and beneficiaries. Benefit expense begins to accrue at age 40. The medical plan was amended effective January 1, 1993 to provide for annual adjustment of retiree contributions and also contains, depending on the plan coverage selected, certain deductibles, copayments, coinsurance and coordination with Medicare. The life insurance plan is non-contributory and covers retirees only. The Registrants' policy, in most cases, is to fund benefits payable under these plans as the obligations become due. However, certain plan assets do exist with respect to life insurance benefits. Prior to January 1, 1993, the Registrant recognized the cost of these benefits on a "pay as you go" basis. The entire accumulated postretirement benefit obligation was charged to earnings in first quarter 1993 in the amount of $5.5 million, net of applicable income taxes. The adoption of SFAS 106 is not expected to have a material effect on future annual expenses of the Registrant. Income Taxes - The Registrant also adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," ("SFAS 109"), effective January 1, 1993. SFAS 109 was issued as an amendment to Statement of Financial Accounting Standards No. 96, "Accounting for Income Taxes," ("SFAS 96"). The adoption of SFAS 109 resulted in a charge to earnings in first quarter 1993 of $970,000. Under the liability method specified by SFAS 109, the deferred tax liability is determined based on the difference between the financial statement and tax basis of assets and liabilities as measured by the enacted tax rates which will be in effect when these differences reverse. Deferred tax expense is the result of changes in the liability for deferred taxes. The principal difference between the Registrant's assets and liabilities recorded for financial statement and tax return purposes is accumulated depreciation. As a result of the Registrant's previous adoption of SFAS 96, the adoption of SFAS 109 did not have a material impact on the components of income tax expense or the effective income tax rates applicable to continuing operations versus the U.S. federal income tax statutory rate. Stock Splits On January 28, 1993, the Registrant's Board of Directors authorized a 2-for-1 stock split which was effected in the form of a stock dividend in the Registrant's Common stock and paid March 17, 1993. On January 30, 1992, the Registrant's Board of Directors authorized a 2-for-1 stock split which was effected in the form of a stock dividend in the Registrant's Common stock and paid March 17, 1992. All appropriate information in this report reflect the effects of both of these 2-for-1 stock splits. Employees Stock Purchase Plan In the fourth quarter 1993, the Registrant filed a Form S-8 with the Securities and Exchange Commission as the eighth offering under the Employees Stock Purchase Plan. Approximately 221,000 shares of Registrant Common stock were subscribed to under this offering, which will be funded through employee payroll deductions, over a two year period, at a price of $38.20 per share. (b) INDUSTRY SEGMENT FINANCIAL INFORMATION Financial information by industry segment for the three years ended December 31, 1993, which appears on pages 65 through 67 of Registrant's 1993 Annual Report to Stockholders, is hereby incorporated herein by reference (see Exhibit 13.1). (c) NARRATIVE DESCRIPTION OF THE BUSINESS The Registrant is a Delaware corporation, organized in 1962, with executive offices located at 114 West 11th Street, Kansas City, Missouri. The Registrant is a holding company which supervises the operations of its subsidiaries, supplying them with managerial, legal, tax, financial and accounting services, and manages its portfolio of other "non-operating" and more passive investments. As of December 31, 1993, the Registrant and its majority owned subsidiaries employed approximately 7,470 persons, with approximately 2,760 employed in the Transportation Services; 3,960 at DST, 700 at Janus and 50 in Corporate and Other. In addition, unconsolidated affiliates of the Registrant and its subsidiaries employed approximately 5,630 persons, including 2,400 and 1,600 at The Continuum Company Inc. ("Continuum") and Boston Financial Data Services, Inc., ("BFDS"), respectively, the largest employers of such ventures. The Registrant's business activities, by industry segment, with principal subsidiary companies are: Transportation Services - The Kansas City Southern Railway Company, their affiliated trucking subsidiaries (collectively "KCSR"), MidSouth Corporation ("MidSouth") prior to its merger into KCSR effective January 1, 1994, Pabtex, Inc. ("Pabtex") and Southern Leasing Corporation ("Southern Leasing"); along with other subsidiaries supporting the transportation segment. Information & Transaction Processing - DST Systems, Inc. ("DST") and its subsidiaries. Financial Asset Management - Janus Capital Corporation ("Janus") and its subsidiaries. Eliminations, Corporate & Other - Registrant's Corporate general and administrative operations, and passive investments. Unconsolidated Affiliates, (primarily DST related) - DST Joint Ventures, The Continuum Company, Inc., Investors Fiduciary Trust Company, Boston Financial Data Services, Inc., Argus Health Systems, Inc., First of Michigan Capital Corporation, Midland Data Systems, Inc. and Midland Loan Services, L.P. Transportation Services General Description of the Business-Commodities The Kansas City Southern Railway Company ("KCSR"), a wholly-owned subsidiary of the Registrant, comprises the largest percentage of the Registrant's revenue and assets employed. KCSR operates a rail system of 1,712 main and branch line route miles and 2,552 total track miles in a six state region. KCSR serves the states of Missouri, Kansas, Arkansas, Oklahoma, Louisiana, and Texas, and in conjunction with the Union Pacific haulage rights, the two additional states of Nebraska and Iowa. KCSR has the shortest rail route between Kansas City and the Gulf of Mexico, serving the ports of Beaumont and Port Arthur, Texas; and New Orleans, Baton Rouge, Reserve and West Lake Charles, Louisiana. Through haulage rights, KCSR also serves the ports of Houston and Galveston, Texas. Kansas City, Missouri, as the second largest rail center in the United States, represents an important gateway for KCSR where it interchanges freight with eight major rail carriers. KCSR also has important interchange gateways in the cities of New Orleans and Shreveport, Louisiana; and Dallas and Beaumont, Texas. The Registrant completed the acquisition of MidSouth Corporation ("MidSouth") in June 1993 at which time it became a wholly-owned subsidiary of the Registrant. MidSouth is a regional railroad holding company, which operates over 1,100 track miles. MidSouth, through four operating subsidiaries, serves the states of Mississippi, Louisiana, Alabama and Tennessee. The MidSouth acquisition provides an important East/West rail line, as a complement to KCSR's predominantly North/South route, and adds interchange gateways in Jackson and Meridian, Mississippi and Birmingham, Alabama. This East/West rail line running from Dallas, Texas to Meridian, Mississippi will allow the Registrant to be more competitive in the intermodal transportation market. In addition, the acquisition adds a base of MidSouth customers in the South Central U.S. to KCSR's already strong traffic base and presents opportunities for the rerouting of certain commodity movements over less circuitous routes. Through haulage rights, MidSouth also serves the city of Gulfport, Mississippi. Effective January 1, 1994, MidSouth was operationally and administratively merged into KCSR. Future MidSouth results will be included with KCSR. The combined KCSR/MidSouth operations will operate approximately 2,800 main and branch line route miles and approximately 3,700 total track miles over a nine state region. Major commodities handled by KCSR include coal, grain and farm products, petroleum, chemicals, paper and forest products as well as other general commodities and intermodal traffic. Coal continues to be the largest single commodity handled by KCSR since the advent of unit coal train shipments in the mid-1970's from the Powder River Basin in Wyoming, via the Burlington Northern and Union Pacific interchange at Kansas City, for movement south by KCSR. KCSR delivers coal to six electric generating plants located at Amsterdam, Missouri; Flint Creek, Arkansas; Welsh, Texas; Mossville (near Lake Charles), Louisiana, Kansas City, Missouri and Pittsburg, Kansas. KCSR also delivers lignite, originating on its line at Thermo, Texas, to an electric generating plant at Monticello, Texas ("Tumco"), a distance of approximately 30 miles. During 1993, the Tumco plant was shut down when one of its smoke stacks collapsed. The plant is not scheduled to be back in service until 1995. The MidSouth merger is strategically important in reducing KCSR's dependence on coal traffic. MidSouth derives only minimal revenues from coal. On a stand alone basis, KCSR coal revenues represented 30% of total revenues in 1993. However, when combined with MidSouth revenues since the June 1993 acquisition, the percentage of coal revenues to total combined revenues would have reduced to 25% and even further reduced to 23% assuming the MidSouth transaction had occurred at the beginning of 1993. Conversely, MidSouth's primary commodity traffic is in the pulp/paper and forest products area, which allows KCSR to complement its revenues in that industry. Gross revenue from unit coal trains aggregated $106, $106 and $107 million, in 1993-1991, respectively. Certain coal transportation contracts contain "take or pay" and volume discount clauses. Revenue from Southwestern Electric Power Company ("SWEPCO"), operator of two electric generating facilities served under long-term contracts by KCSR, continues to represent the greatest portion of coal revenues. In 1993, SWEPCO revenues approximated $60 million or 13% of Transportation Services revenues. (See Item 3. Legal Proceedings). KCSR serves the petroleum and chemicals industry, via refineries located in the Gulf states of Texas and Louisiana, through tank and hopper car service primarily to markets in the Southeast and Northeast through interchange with other rail carriers. Petroleum and chemical products represent the second largest commodity to KCSR in terms of revenues, trailing only coal. MidSouth provides rail transportation of chemical products, primarily vinyl chloride used in the production of polyvinyl chloride ("PVC") materials, as well as other chemical products, some used in paper production to customers primarily in the Mississippi and Alabama areas. These products are shipped via rail interchange to many destinations throughout the United States. As part of serving the petroleum and chemicals industry, KCSR/MidSouth transport hazardous materials and have a Shreveport, Louisiana based hazardous materials emergency team available to handle environmental problems which might occur in the transport of such materials. KCSR/MidSouth serve eleven paper mills directly and seven others indirectly through short-line connections. International Paper Co. at South Texarkana, Texas and Georgia Pacific at Ashdown, Arkansas, both served by KCSR, have completed plant expansions in recent years which increases their operating capacity. Paper/pulp and primary forest products represent the largest component of MidSouth revenue carloadings. MidSouth provides transportation of pulpwood, woodchips, poles and raw fiber used in the production of paper, pulp and paperboard. MidSouth also serves as the first leg of rail transportation throughout the United States for finished paper products from major manufacturers such as, International Paper, Riverwood International Corporation, Stone Container and Packaging Corporation of America. MidSouth's geographic location provides a stable market due to the abundance and fast growth of timber in the area. The cost effective nature of the plants served by MidSouth provide a competitive advantage over trucks for these bulk commodities. KCSR farm products carloadings increased 15% during 1993. Increased carloadings were experienced in the shipment of corn, wheat, soybeans and other farm products. Grain shipments are transported from the grain producing states of Iowa and Nebraska southward to poultry feed mills served by KCSR in the states of Missouri, Arkansas, Oklahoma, Louisiana and Texas. Consumer demand for poultry consumption remains constant thereby generating demand for feed grains delivered by KCSR. MidSouth also transports farm products, principally corn and processed soybean to customers on its rail line, which include poultry feed processing mills. KCSR has continued to implement its roadway capital improvement program to provide safer commodity movements. This long-term capital improvements project is designed to improve the integrity and quality of service to KCSR customers. Management expects this program to be completed in 1995. The MidSouth acquisition will require the Registrant to complete a capital improvement program for MidSouth roadbed, locomotives and facilities. This program will upgrade and expand MidSouth's track to handle greater traffic levels at higher train speeds and will be completed over the next five years with a large majority of these upgrades completed during the next two years. The Registrant currently anticipates the cost of this five year capital program will be approximately $150 million, 50% of which was planned by MidSouth management prior to the acquisition. KCSR/MidSouth marketing departments have primary responsibility for developing transportation services and are supported by field marketing offices at various locations throughout the United States. Heavy emphasis is placed on providing the highest quality of transportation service and on servicing the current needs of customers and also on the promotion of additional growth through efforts to locate industrial and manufacturing companies in the KCSR/MidSouth service area. Addition of new traffic resulting from combination of the two rail systems may affect this service. Other wholly-owned subsidiaries comprising the Transportation Services industry segment include Trans-Serve, Inc.; Carland, Inc.; Southern Leasing Corporation; Pabtex, Inc.; Rice-Carden Corporation; Tolmak, Inc.; Southern Development Company and Mid-South Microwave, Inc. Trans-Serve, Inc. owns and operates a railroad wood tie treating facility in Vivian, Louisiana and a vehicle fleet maintenance operation for the KCSR Engineering, Mechanical and Transportation department vehicles, with locations in Shreveport, Louisiana, Pittsburg, Kansas and Heavener, Oklahoma. Carland, Inc., a subsidiary of Southern Credit Corporation, headquartered in Kansas City, leases various types of equipment including railroad rolling stock, roadway maintenance equipment and vehicles. KCSR is the principal customer of Trans-Serve and Carland. Southern Leasing Corporation, a subsidiary of Southern Credit Corporation, was formed in late 1983 and is involved in finance leasing and other forms of secured financing, generally for equipment acquisition by small to medium sized businesses. Pabtex, Inc. ("Pabtex") owns and operates a bulk handling facility which stores and transfers coal and petroleum coke from trucks and rail cars to ships and barges primarily for export. This facility, located in Port Arthur, Texas, with deep water access to the Gulf of Mexico, is served on an inbound basis by KCSR and independent truckers. In 1990, under the provision of a twenty year capital lease commitment, which expired in that year, the Registrant exercised its right to purchase the facility improvements of Pabtex. This purchase was completed in the fourth quarter of 1991 at a purchase price of $9.2 million and will allow KCSR opportunities for future expansion of the petroleum coke and coal export business. In 1992, the Registrant purchased 530 acres of land adjacent to the Registrant's Pabtex coal and petroleum coke storage, barge and ship loading facility in Port Arthur, Texas. The 530 acres includes 4,000 linear feet of deep water frontage on the Sabine- Neches Waterway, which has direct access to the Gulf of Mexico via the Intercoastal Waterway. This acquisition increases the Transportation Services deep water access in the Port Arthur, Texas area and will permit capacity expansion of the Pabtex coal and coke facility and development of additional port operations in KCSR's service area. The Registrant currently owns 1,025 acres of property located on the waterfront in the Port Arthur, Texas area, which includes approximately 22,000 linear feet of deep water frontage and three docks. Port Arthur is an uncongested port with direct access to the Gulf of Mexico. Approximately 75% of this property is available for development. Mid-South Microwave, Inc. owns and leases a 1,600 mile industrial frequency microwave transmission system, which is a primary communications facility used by KCSR. Rice-Carden Corporation and Tolmak, Inc. both wholly-owned subsidiaries of the Registrant and both headquartered in Kansas City, own and operate various industrial real estate and spur rail trackage contiguous to the KCSR right of way. These properties are leased to various industrial businesses, many of whom are serviced by KCSR. Southern Development Company, a wholly-owned subsidiary of the Registrant, owns and operates the headquarters building of the Registrant and KCSR located in Downtown Kansas City. Southern Development leases a substantial portion of the building to KCSR for its executive, financial, marketing, operating and engineering departments. Regulatory Influence Transportation operations are subject to the regulatory jurisdiction of the Interstate Commerce Commission ("ICC"), various state regulatory agencies, the Department of Transportation ("DOT") and the Occupational Safety and Health Administration ("OSHA"). The ICC has jurisdiction over interstate rates charged, routes, service, issuance or guarantee of securities, extension or abandonment of rail lines, and consolidation, merger or acquisition of control of rail common carriers. State agencies regulate some aspects of rail operations with respect to health and safety and in some instances intrastate freight rates. The DOT and OSHA have jurisdiction over certain health and safety features of railroad operations. In addition, railway operations are subject to extensive regulation under environmental protection laws concerning, among other things, discharges to waters and the generation, handling, storage, transportation and disposal of waste and other materials, where environmental risks are inherent. KCSR and some of the Registrant's other subsidiaries land holdings have been used for industrial purposes or leased to commercial and industrial companies whose activities may have resulted in discharges onto the property. Accordingly, the Registrant and its subsidiaries may become subject from time to time to environmental clean-up and enforcement actions. In particular, the Registrant is subject to regulatory legislation such as; the Federal Comprehensive Environmental Response, Compensation and Liability Act ("CERCLA"), also known as the "superfund law"; the Toxic Substances Control Act ("TSCA"); the Federal Water Pollution Control Act, commonly known as the "Clean Water Act" and the Hazardous Materials Transportation Act ("HAZMAT"). This legislation generally imposes joint and several liability for clean up and enforcement costs, without regard to fault or legality of the original conduct, on current and predecessor owners and operators of a site. The discharge of hazardous materials or contamination of property by hazardous materials may arise from the transportation, production, storage, use and disposal of such materials by rail operations. Normal rail transportation operations may result in hazards and expose the Registrant to claims and potential liability for injuries to employees, other persons, property and the environment. Registrant management does not foresee that compliance with the requirements imposed by these agencies' standards under present statutes will impair its competitive capability or result in any material additional operating or maintenance costs. KCSR continued to implement extensive safety programs during 1993 designed to reduce employee injuries through promotion of a safe work environment. The Registrant expects these programs will exceed safety requirements of the various regulatory agencies governing transportation operations. Railroad Industry Trends and Competition KCSR is in direct competition with the Union Pacific Railroad ("UP") for certain freight traffic moving between Kansas City and Gulf Ports served by KCSR. KCSR, in conjunction with the Santa Fe Railroad, also competes with the Southern Pacific Transportation Company ("SP") for certain transcontinental freight traffic in the Dallas-New Orleans corridor. In 1992, KCSR signed an agreement with the Santa Fe Railway to purchase portions of its rail line in the Dallas, Texas area. The sale consists of approximately 90 miles of track and an 80 acre piggyback intermodal facility. The agreement is being implemented in phases over two years (Phase I of which was completed in 1993) and will gain KCSR direct access to the Dallas/Ft. Worth markets for the first time in the Registrant's history. Phase II is anticipated to be completed in second quarter 1994 to acquire the Zacka Junction facility. In 1988, the UP and KCSR signed a haulage and trackage rights agreement which facilitated and supported the acquisition of control of the Missouri-Kansas- Texas Railroad Company ("MKT") by the UP. This agreement gave KCSR haulage rights between Omaha and Lincoln, Nebraska; Council Bluffs, Iowa; Topeka and Atchison, Kansas and Kansas City, Missouri. KCSR also received haulage rights over UP tracks between Beaumont, Houston and Galveston, Texas. Under this haulage rights agreement, UP is required to move KCSR traffic in UP trains. Under the trackage rights, KCSR is allowed to operate its own trains over UP tracks. The "rights" between Beaumont, Houston and Galveston, Texas are restricted to transporting grain and grain products. However, the "North end rights" between Kansas City, Missouri and Omaha and Lincoln, Nebraska; Council Bluffs, Iowa and Atchison and Topeka, Kansas are unrestricted. These "rights" enable KCSR to be more competitive, particularly in feed grains, with the UP and Burlington Northern railroads in both the Gulf port and domestic transportation corridors. Beginning in 1990, KCSR made more extensive use of these haulage rights with the UP in accessing the corn belt states of Nebraska and Iowa. During 1993, the ICC ruled that it had jurisdiction regarding the UP acquisition of certain voting stock of CNW Holding Corp., ("CNW") a holding company for the Chicago North Western Railroad. UP was required by the ICC to submit evidence regarding marketing and operating coordination and related public benefits which UP alleges will stem from the CNW transaction. The Registrant filed a responsive application with the ICC supporting protective conditions designed to upgrade current haulage rights to Omaha/Council Bluffs and provide direct access, by way of additional haulage and local gathering rights to CNW grain origins in Iowa, Nebraska and South Dakota. Hearings on the matter are scheduled in second quarter 1994 with a final decision anticipated in late third quarter 1994. In addition to competition within the railroad industry, highway carriers compete with KCSR and MidSouth throughout its territory. Since deregulation of the railroad industry, competition has resulted in extensive downward pressure on freight rates. Truck carriers have eroded the railroad industry's share of total transportation revenues. However, rail carriers, including KCSR/MidSouth have, in recent years, placed a greater effort towards competing in the intermodal marketplace. Rail carriers are working together to provide end-to-end transportation of products and forming working partnerships with truck carriers in an effort to recapture market share. In some cases, additions to box car fleets and upgrade of existing box car equipment are underway to attract new business. KCSR/MidSouth are in the process of upgrading current "on-off ramps" intermodal facilities in anticipation of greater TOFC/COFC traffic. Mississippi and Missouri River barge traffic also compete with KCSR in the transportation of bulk commodities such as grains, steel, aluminum and petroleum products. Labor Relations Collective bargaining agreements with KCSR union employees, representing approximately 83% of KCSR's workforce were completed in 1992. Through a process of national negotiation and arbitration, KCSR and contract employees reached agreement on issues which will allow implementation of productivity improvements and partially reduce the costs of escalating health care premiums through a cost sharing arrangement with contract employees. In addition, the terms and conditions of the agreements allow KCSR to improve its operating income through savings to be realized by modification in the operation of its trains with reduced crew sizes. KCSR is initially permitted to operate any through freight train without limitation to the number of cars and train length with two man crews. Additionally, via a "phased in" approach through December 31, 1997, KCSR has the opportunity to operate one hundred percent of its trains with two man crews as it both achieves and demonstrates the ability to safely operate with reduced crews in a productive manner. These productivity improvements are necessary to enable the railroad industry to remain competitive with other modes of transportation. However railroads remain restricted by antiquated operating rules and uncompetitive employee benefit programs and they are prevented from achieving optimum productivity. These national agreements, with the exception of the International Association of Machinist and Aerospace Workers ("IAM"), discussed below, will be open for renegotiation on December 31, 1994. As a result of the arbitration process and a Registrant initiated voluntary buy out program offered in January 1992, approximately 150 trainmen were declared excess by the Registrant, of which 105 excess employees accepted the $60,000 buy out. The remaining excess employees were placed on a Reserve Board where they received 70% of their 1991 W-2 earnings (net of certain adjustments). During 1992, through attrition and increased business levels, all excess employees were removed from the Reserve Board. KCSR had fully reserved the cost of the buy outs in 1991, accordingly no charges to earnings were required in 1992 and none are anticipated in the future. In 1992, KCSR operations experienced a two day operational shutdown as part of an orderly shutdown of freight transportation operations by all Class I U.S. Railroads. This two day shutdown was precipitated when members of the IAM initiated a strike against the CSX Railway. The national rail shutdown ended through Congressional intervention, which ordered all IAM workers back to work. In ending the rail strike, Congress established a process intended to result in settlement of disputes between the parties or recommendation by an arbitrator on settlement terms. KCSR participated in the national bargaining of issues with the IAM through the National Railway Labor Conference ("NRLC"). In early August 1992, the NRLC and the IAM were able to resolve virtually all issues and the arbitrator's settlement recommendations on the remaining issues were accepted by President Bush. The resulting labor agreements will be open for renegotiation in 1995. The two day shutdown resulted in reduced KCSR revenues but, in total, the effect of the shutdown was immaterial to the Registrant. Approximately 87% of MidSouth's employees are also covered under collective bargaining agreements. MidSouth has numerous labor agreements with a variety of unions. These labor agreements, which were in place at the date of acquisition, will be open for renegotiation in varying periods beginning in 1994. As a result of completion of these labor agreements, management believes the Registrant has made progress in becoming able to compete with all railroads contiguous to the KCSR/MidSouth lines as well as other forms of transportation. Information & Transaction Processing DST Systems, Inc. General Description of the Business DST Systems, Inc., formed in 1968, together with its subsidiaries and joint ventures (principally The Continuum Company, Inc., Boston Financial Data Services, Inc., Investors Fiduciary Trust Company, Argus Health Systems, Inc., Midland Data Services, Inc. and Midland Loan Services L.P.), designs, maintains and operates proprietary on-line shareowner accounting and record keeping data processing systems, primarily for mutual funds and financial services institutions and insurance companies. Historically, the majority of DST's revenue has been derived from full-service and remote-service record keeping for the mutual fund industry. The growth of the mutual fund industry is a major contributor to the substantial increase in revenues of DST. Currently, DST's growth results from an increase in both existing and new mutual fund customers as well as acquisitions and expansion of existing business lines and products. Output Technologies, Inc. ("OTI"), a wholly-owned subsidiary of DST, was formed in early 1991 as a holding company for DST's business involved in the financial printing, mailing, output processing and related business lines. During 1993, OTI completed the internal reorganization of its subsidiaries, which included renaming of subsidiaries and merging of certain operations. The overall objective of the internal reorganization was a consolidation of output related activities, identification of businesses with the OTI name and alignment into geographic operating regions. Included under OTI are its wholly-owned subsidiaries; Output Technologies Central Region, Inc.; formerly United Micrographics Systems, Inc. and Network Graphics, Inc., which process computer output microfilm and microfiche, and printing and mailing of specialized laser printing output and perform graphics design services; Output Technologies SRI Group, Inc., formerly Support Resources, Inc. and Output Technologies Eastern Region, Inc., formerly Mail Processing Systems, Inc. provide laser printing and mailing of value-added customer information; Output Technologies of Illinois, Inc., was formed in 1992 and performs telemarketing and fulfillment services; Output Technologies Phoenix Litho Group, Inc., formerly Phoenix Litho, Inc. performs commercial printing services, and Output Technologies Vital Records Storage Group, Inc., formerly Data Retrieval Services, which performs vital records storage. Effective September 30, 1993, DST completed the merger of Vantage Computer Systems, Inc. ("Vantage") into a subsidiary of The Continuum Company, Inc. ("Continuum"). Vantage, a 90.5% owned subsidiary, along with its wholly-owned subsidiary Vantage P&C Systems, Inc., provide record keeping services and custom designed software packages to the life and property/casualty insurance industries. Vantage, using DST's computer systems on a remote basis, focus on the administration of universal life coverage and other non-traditional insurance products. DST and the minority shareholder of Vantage received a total of 4 million shares of Continuum stock -- 2,939,000 shares at closing and the remainder after Continuum shareholder approval was obtained in late 1993. As a result of this transaction and additional Continuum stock purchases made by DST, DST owned approximately 24% of the outstanding common stock of Continuum at December 31, 1993. In January 1994, DST acquired additional Continuum shares through privately negotiated transactions. Accordingly, DST currently owns approximately 29% of Continuum's outstanding common stock. DST accounted for the initial exchange transaction as a non- cash, non-taxable exchange in investment basis of Vantage for an investment in Continuum. Accordingly, no gain or loss recognition was associated with the transaction. Vantage revenues for the nine months ended September 30, 1993, were $32.6 million and $38.7 million for the year ended December 31, 1992. Continuum is a publicly traded international consulting and computer services firm based in Austin, Texas, which primarily serves the needs of life and property and casualty insurance companies for computer software and services. The Vantage/Continuum transaction will allow DST to expand its presence in the information processing market for the insurance industry and combine the strengths of both Vantage and Continuum. Prior to the merger, Vantage's business was primarily centered in the U.S. domestic market while Continuum has a significant international and domestic presence. Subsequent to this transaction, DST assumed all of the North American operations data processing functions for Continuum. DST and Continuum signed an agreement whereby DST will make available the capabilities of the Winchester Data Center for Continuum processing requirements. Concurrent with the Continuum/Vantage merger, DST and Continuum reached a license agreement, whereby Continuum will market AWD for use in insurance industry applications. Other services offered by DST include securities transfer services for debt securities and corporate stocks, portfolio accounting for investment fund managers and health care pharmaceutical insurance claim processing. DST also engages, directly and through its affiliates, in trust accounting, security clearing services, asset management administration, commercial loan servicing, broker-dealer services, pharmaceutical claim processing and processing for the insurance industry through Investors Fiduciary Trust Company, Boston Financial Data Services, Inc., Midland Data Systems, Inc., Midland Loan Services, L.P., First of Michigan Capital Corporation, Argus Health Systems, Inc. and The Continuum Company, Inc. in which DST is either a joint venture partner or investor. These affiliates are further described below: Investors Fiduciary Trust Company ("IFTC"), a 50% joint venture owned with Kemper Financial Services, Inc., is incorporated under the banking laws of Missouri and provides fiduciary and other custodial services to its clients. IFTC serves as trustee for unit trusts, tax deferred retirement and compensation plans, including IRAs, Keogh Plans and other deferred compensation plans offered by DST's clients. IFTC also serves as transfer agent and custodian for several mutual funds and sponsors a federally insured money market deposit account. Boston Financial Data Services, Inc. ("BFDS"), a Boston based 50% joint venture between DST and State Street Boston Corporation, performs full service transfer agency functions for open and closed end mutual funds and corporations using DST's proprietary software on a remote basis through telecommunication transmissions with DST's computer facility located in Kansas City. Midland Data Systems, Inc. and Midland Loan Services, L.P. (collectively "Midland") 45-50% joint ventures, respectively, provide comprehensive commercial loan servicing for assets, both performing and non-performing loans and related asset management services for governmental and institutional clients. Midland has been awarded contracts with the Resolution Trust Corporation ("RTC") for the operation of an Asset Management System and a Control Totals Module System for use by the RTC and for servicing RTC loans. Midland intends to expand its market by continuing to create innovative and responsive systems through technology and expanding its loan processing and asset management capabilities to the private sector. First of Michigan Capital Corporation, ("FOM"), a publicly held company, 21% owned by DST, provides full service retail securities brokerage services and maintains several offices throughout the State of Michigan. Argus Health Systems, Inc., ("Argus"), a 50% joint venture owned with Financial Holding Corporation provides pharmaceutical claim insurance processing services for several health care providers through a data base network. The Continuum Company, Inc. ("Continuum"), a publicly held company, approximately 29% owned by DST, is an international consulting and computer services firm based in Austin, Texas, serving the needs of life insurance, property and casualty insurance and other financial services companies for computer software and services. Product Base and Competitive Influence DST's reputation is based largely on service, ability to handle volume increases, commitment to software development and, to a lesser degree, price. The advantages of DST include its experience in providing service to the markets it serves, the number and size of its clients, its use of centralized data processing facilities which enables it to achieve economies of scale, the breadth of services it and its joint ventures offer, and the reputations of its joint venture partners. In addition, DST's systems are complex, having been enhanced over a number of years to provide a high quality service and to meet changing regulatory and user requirements. The complex nature of the business, the software systems and the significant resource base needed to operate and/or duplicate such systems make it difficult for new firms to enter these markets. Although market entry by new firms may be difficult, several strong competitors in DST's marketplace do exist. In recent years, the competitive environment for shareowners processing has changed as several major bank competitors exited from direct participation in the shareowner processing business. The balance of these accounts were absorbed by DST or its competitors. A further review of competitive factors for DST's principal product lines follows: Mutual Fund Shareowners Accounting System: Certain competitors provide remote processing services or engage in software sales. DST also considers in-house systems as a competitive alternative. DST does not ordinarily offer its software for sale; therefore, when customers purchase software, they do so as an alternative to DST's remote processing or full-service product offerings. The Shareholder Services Group ("TSSG"), a unit of First Data Resources, Sungard Data Systems Inc., Oppenheimer Industries, Provident National Bank and U.S. Trust are the primary competitors for full-service and remote processing. Oppenheimer Industries is the primary competitor for systems sales. DST currently processes approximately one- third of all United States mutual fund shareowner accounts. DST and its affiliates also provide a full-service product by acting in the capacity of a transfer agent either through direct appointment or subcontract. DST's main full service competitor is TSSG. Securities Transfer and Portfolio Accounting Systems: DST's Securities Transfer System competes with in-house systems and independent vendors, some of whom supply clerical support in connection with their software sys- tems. The Portfolio Accounting System competes primarily with in-house systems and systems offered by certain banks in conjunction with their custodial services. Banks and thrift institutions in competition with DST may have an advantage by considering the value of their client's funds on deposit when pricing their services. Moreover, such banks or thrift institutions generally have much greater financial resources available to them than DST. DST's 1993 acquisitions of Belvedere Financial Systems, Inc. ("Belvedere") and Clarke & Tilley, both of which develop and market portfolio accounting and investment management systems, expands DST's portfolio accounting opportunities. Belvedere's system will provide a common platform for DST future portfolio growth in both domestic and international markets. International Market Expansion: In 1991, DST began evaluating the feasibility of marketing its products outside the United States and also products that would serve foreign markets in DST's product lines. DST acquired a 50% interest in Talisman Services during 1991. Talisman is a European software company whose primary product is a multi-currency financial accounting package. In 1992, DST formed DST Systems International B.V. as a holding company for certain of its non-U.S. operations and a marketing unit for DST's software. Also in 1992, DST, together with State Street Bank and Clarke and Tilley, Ltd. (a United Kingdom software firm), formed Clarke and Tilley Data Services ("CTDS"). CTDS is developing a unit trust accounting system for the U.K. and Luxembourg markets, combining DST workflow management, image technology and unit trust software. During 1993, DST completed the acquisition of Clarke & Tilley Ltd., (96% owned), which markets investment management software primarily for use in Europe and the Pacific Rim and Corfax Benefit Systems, Ltd., (100% owned), a Canadian company, which processes shareowner transactions for mutual funds and pension accounts in Canada. This international expansion provides DST with a base of products which are multi-currency, as well as multi-platform, and creates avenues for greater market penetration of DST's U.S. products into international channels. Through these subsidiaries, sales and development offices currently reside in the United Kingdom, Switzerland, Netherlands, Belgium, Luxembourg, Canada, Australia and South Africa. DST foresees opportunities for further growth and expansion in international markets. The financial institutions served by DST, both mutual fund and insurance, will continue to evaluate whether to internalize or outsource their technology needs. This process will have both positive and negative effects on DST's results; however, on an overall basis, DST's customer base is expected to grow. During 1993, the financial markets as a whole experienced an increase in spite of certain uncertainties in domestic and global economies. DST's mutual fund shareowner accounts serviced also rose in 1993 to end the year at an all time high of 28 million accounts. In 1993, Kemper Financial Services ("Kemper"), a DST customer, mutual fund shareowner began conversion of its mutual fund shareowner processing, which will result in the removal of its accounts from the DST system. The total number of Kemper accounts, approximately 2.5 million, will be converted from the DST system in stages over the next few years. In early July 1993, the first stage, which encompassed 500,000 Kemper accounts were converted from the DST system. The remaining accounts will be removed in 1994. The loss of 500,000 Kemper accounts in 1993 was offset by account growth from other mutual fund customers and accordingly, did not have a material financial impact. Mutual fund shareowner accounts had also risen in 1992 even through weighted average monthly billable accounts lagged 1991 averages. In 1991, DST experienced an overall decline in the number of mutual fund shareowner accounts serviced. This decline is in large part the result of the Vanguard group of mutual funds, which exited the DST system in September 1991 and the removal of 800,000 broker based accounts of Prudential Bache in late 1991. Vanguard comprised approximately 2.7 million shareowner accounts. Excluding the Vanguard and Prudential Bache accounts, DST experienced growth in certain other fund groups serviced during 1991. Financial Asset Management Janus Capital Corporation Janus Capital Corporation, headquartered in Denver, Colorado and 81% owned by the Registrant, provides investment advisory and management services to the Janus and IDEX equity mutual fund groups, investment management services for individuals and institutions including large pension and profit sharing plans. Janus experienced substantial growth during 1993 in terms of both shareholder accounts and assets under management. Funds under management increased from $15.5 billion at December 31, 1992 to $22.2 billion at December 31, 1993 while total shareholder accounts increased 35% in 1993. This growth is largely attributable to successful marketing programs, an overall favorable performance of the Janus no-load and IDEX load funds compared to the market as a whole and general growth in the mutual fund marketplace. While Janus experienced significant growth during 1993, much of that growth occurred in the first half of 1993. During the third and fourth quarters of 1993 growth in assets under management slowed. Total fund sales were $3.3 billion during the second half of 1993 versus $5.5 billion during the first six months of 1993, while fund redemption increased to $2.2 billion versus $1.6 billion, respectively. Janus experiences competition in the form of alternative investment vehicles, which offer competitive investment returns and different investment objectives when compared to Janus. These alternatives have typically been other mutual funds, certificates of deposit, money market accounts and individual stocks and bonds. Janus management continues to strive in offering a variety of investment products. While Janus has historically been a primarily equity based fund group, management has sought to build a base of fixed income products. During 1993, Janus introduced three new fund products; Janus Mercury Fund, an equity fund; Janus Federal Tax Exempt Fund, a federal tax exempt income fund; and the Janus Aspen Series, which are variable annuity products. During 1992, Janus introduced three new mutual funds, Janus Enterprise Fund, an equity fund; Janus Balanced Fund, a combination equity /fixed income fund and Janus Short-Term Bond Fund, a fixed income fund. Janus revenues and operating income increases are a direct result of increases in assets under management. Assets under management have grown in recent years from a combination of new money investments or fund sales and market appreciation. Fund sales have risen in response to marketing efforts, favorable fund performance and the current popularity of no-load mutual funds. Market appreciation has resulted from increases in stock investment values. However, a decline in stock and bond markets and/or an increase in the rate of return of alternative investments could negatively impact Janus revenues and operating income. In addition, the mutual fund market, in general, faces increasing competition as the number of mutual funds continues to increase, marketing and distribution channels become more creative and complex, and investors place greater emphasis on published fund recommendations and investment category rankings. These factors could also affect Janus and negative impact revenues and operating income. Operating expenses are expected to increase as assets and service requirements grow. Janus, its subsidiaries and the funds it manages are subject to a variety of regulatory requirements including, but not limited to, the Securities and Exchange Commission, individual state Blue Sky laws, the National Association of Securities Dealers and various other state regulatory agencies. Janus management does not foresee that compliance with these various requirements will have a material impact upon operations. Eliminations, Corporate & Other This industry segment is comprised of passive investments, and the general administrative and corporate operations of the Registrant. Item 2. Item 2. Properties Transportation Services KCSR owns and operates approximately 1,633 miles of main and branch lines and approximately 752 miles of other tracks. In addition, approximately 79 miles of main and branch lines and 88 miles of other tracks are operated by KCSR under trackage rights and leases. Through the acquisition of MidSouth, an additional 1,100 track miles were added, primarily in the states of Louisiana, Mississippi and Alabama. MidSouth has no material classification yards or other building facilities. Kansas City Terminal Railway Company, of which KCSR is a one-twelfth owner, with other railroads, owns and operates approximately 80 miles of track, and operates an additional 8 miles of track under trackage rights in greater Kansas City, Missouri. KCSR also leases for operating purposes certain short sections of trackage owned by various other railroad companies and jointly owns certain other facilities with such railroads. KCSR also owns and operates repair shops, depots and office buildings along its right-of-way in support of its transportation operations. A major facility, Deramus Yard, is located in Shreveport, Louisiana and includes a general office building, locomotive repair shop, car repair shops, material warehouses and fueling facilities totalling approximately 210,000 square feet. KCSR and Registrant executive offices are located in an eight story office building in Kansas City, Missouri and are leased from a subsidiary of the Registrant. At December 31, 1993, KCSR's fleet of rolling stock consisted of 255 diesel locomotives, of which six were leased from non-affiliates; 7,179 freight cars, of which 1,828 were leased from non-affiliates; and 1,982 tractors, trucks and trailers, of which 1,961 were leased from non-affiliates. At December 31, 1993, MidSouth's fleet of rolling stock consisted of 110 diesel locomotives, none of which were leased from non-affiliates; 7,734 freight cars, of which 6,776 were leased from non-affiliates. Some of this equipment is subject to liens created under conditional sales agreements, equipment trust certificates and capitalized leases in connection with the original purchase or lease of such equipment. Maintenance expenses for Way and Structure and Equipment (pursuant to ICC accounting rules, which include depreciation) for the three years ended December 31, 1993 and as a percent of KCSR revenues are as follows (dollars in millions): Trans-Serve, Inc. operates a railroad wood tie treating plant in Vivian, Louisiana under an industrial revenue bond lease arrangement with an option to purchase. This facility contains buildings totaling approximately 12,000 square feet. Carland, Inc. leases approximately 1,400 square feet of office facilities in downtown Kansas City, Missouri from DST Realty, Inc. a wholly- owned subsidiary of DST. Pabtex, Inc. owns a 70 acre coal and petroleum coke bulk handling facility at Port Arthur, Texas. Southern Leasing leases 2,800 square feet of office space in downtown Kansas City, Missouri, from DST Realty, Inc., a wholly-owned subsidiary of DST. Mid-South Microwave, Inc. owns and operates a microwave system, which extends essentially along the right-of-way of KCSR from Kansas City, Missouri to Dallas, Beaumont-Port Arthur, Texas and New Orleans, Louisiana. This system is leased to KCSR. Other subsidiaries of the Registrant own approximately 8,000 acres of land at various points adjacent to the KCSR right-of-way. Other properties also include a 354,000 square foot warehouse at Shreveport, Louisiana, a bulk handling facility at Port Arthur, Texas, and several former railway buildings now being rented to non-affiliated companies, primarily as warehouse space. At December 31, 1993, the Registrant owns 1,025 acres of property located on the waterfront in the Port Arthur, Texas area, which includes 22,000 linear feet of deep water frontage and three docks. Port Arthur is an uncongested port with direct access to the Gulf of Mexico. Approximately 75% of this property is available for development. Information & Transaction Processing DST Systems, Inc. DST owns an 82,000 square foot Data Center, located in Kansas City, commonly known as its Winchester Data Center, which commenced operations in 1985. This facility is located on 13 acres of land within an overall 25 acre tract of land owned by DST. DST master-leases three downtown Kansas City office buildings consisting of approximately 353,000 square feet in which DST or its affiliates occupy approximately 330,000 square feet and the balance is leased to non-affiliated tenants. This space is utilized by DST for its shareholder operations, systems development and other support functions. DST and its wholly-owned subsidiary, DST Realty, Inc., own six buildings in Kansas City, Missouri, with approximately 413,000 square feet. DST utilizes 117,000 square feet in these buildings for its portfolio, laser printing and mailing operations, and leases 47,000 square feet to Argus Health Systems for its systems development, administrative and other support operations, 81,000 square feet are leased to Midland Data Systems and Midland Loan Services. In first quarter 1994, Argus purchased the building it had leased from DST. The balance of 168,000 square feet is available for business expansion needs. Output Technologies Central Region, Inc. (formerly United Micrographics Systems, Inc.), a 100% owned DST subsidiary, leases 97,000 square feet in several buildings representing its primary operating facilities in Kansas City and St. Louis, Missouri, along with remote locations throughout the Midwestern United States. Output Technologies Eastern Region, Inc. (formerly Mail Processing Systems, Inc.), a 100% owned DST subsidiary, leases 156,000 square feet of production, warehouse and office space facilities in East Hartford, Connecticut and Braintree, Massachusetts. Additionally, a 20,000 square foot facility in New York, New York was leased in 1993. In addition to the previously discussed office space, DST Realty, Inc. also owns six parking facilities in downtown Kansas City, Missouri having 1,670 parking spaces which are rented by the Registrant's and affiliates' employees, and the public. A 100% owned subsidiary of DST, Winchester Business Center, Inc., owns and operates an underground storage and office facility encompassing a total of 550,000 square feet. 191,000 square feet of this facility is leased to another DST subsidiary with the remaining space occupied by unaffiliated tenants or as yet unfinished space. At December 31, 1993, DST owned or leased mainframe computers which are capable of processing approximately 1.3 billion instructions per second. DST presently uses a substantial portion of the capacity of these mainframes. In addition, DST owns significant amounts of auxiliary computer support equipment such as disk and tape drives, CRT terminals, etc., all of which are necessary for its computer and communications operations. Financial Asset Management Janus Capital Corporation Janus leases 140,000 square feet of office space in two facilities from non- affiliated companies for its administrative and shareowner processing departments. In addition, in October, 1993, Janus leased approximately 34,000 square feet from a non-affiliated entity for its mail processing and storage requirements. Its corporate offices are located in Denver, Colorado. Corporate & Other The Registrant and DST are a combined 80% owner of Wyandotte Garage Corporation, a parking facility in downtown Kansas City, Missouri. The facility is located adjacent to the Registrant's and KCSR's headquarters building, and consists of 1,147 parking spaces which are utilized by the Registrant's and affiliates' employees and the public. Unconsolidated Affiliates, primarily DST related DST's 50% joint venture, Boston Financial Data Services, Inc., leases and occupies a 186,000 square foot office building in Quincy, Massachusetts. Additionally, DST's 50% joint venture, Investors Fiduciary Trust Co. leases and occupies a total of 86,000 square feet in a downtown Kansas City office building. DST formed Winchester Ventures II, for the purpose of acquiring land and subsurface areas near DST's Data Center. To date, twelve acres adjacent to the Data Center have been purchased for resale or development. Additionally, DST is a 50% joint venture partner of a 260,000 square foot downtown Kansas City, Missouri office building which is both leased by DST, affiliates and non-affiliates, and houses DST's corporate headquarters. The Continuum Company, approximately 29% owned by DST, occupies and owns a building of 186,000 square feet located in Austin, Texas, which is used for product development and administration. Continuum leases an additional 35,000 square feet of office in Austin, approximately 100,000 at several locations in Australia, and another approximately 100,000 square feet for various administrative premises in Europe. The Continuum Company, through Vantage (formerly 90.5% owned by DST) also leases 35,000 and 53,000 square feet of office space in Weatherfield, Connecticut and Kansas City, Missouri, respectively. Item 3. Item 3. Legal Proceedings SWEPCO Litigation. The Registrant's wholly-owned subsidiary, The Kansas City Southern Railway Company ("KCSR") is a defendant in a lawsuit filed in the District Court of Bowie County, Texas by Southwestern Electric Power Company ("SWEPCO"). SWEPCO has alleged that KCSR is required to reduce SWEPCO's coal transportation rate due to changed circumstances that allegedly create a "gross inequity" under the provisions of the existing coal transportation contract among SWEPCO, KCSR and the Burlington-Northern Railroad. SWEPCO is the largest single customer of KCSR. Although the suit is pending, KCSR and SWEPCO are negotiating an agreement to settle the major issues which are the subject of this litigation. Management is confident that the matter will be concluded without material adverse effect on the financial condition or future results of operation of KCSR. Environmental Matters. KCSR is a participant in certain federal and state environmental matters as follows: In the Ilada Superfund Site East Cape Girardeau, Ill., KCSR was cited for furnishing one carload of used oil to this petroleum recycling facility. Counsel advises that KCSR's liability, if any, should fall within the "de minimus" provisions of the Superfund law, representing minimal exposure. In Petroleum Products Corp. Hollywood, Fla., also a Superfund case, KCSR was cited, as a transporter only, in hauling two carloads of material in interchange from Princeton, Louisiana to New Orleans. KCSR was removed from the list of Potentially Responsible Parties during 1993 and is no longer involved in this proceeding. Louisiana Department of Environmental Quality, Docket No. IE-0-91-0001, is a proceeding involving the alleged contamination of Capitol Lake, Baton Rouge, Louisiana. This proceeding also names KCSR as a party due to its ownership of part of the lake bottom. Potentially Responsible Parties remain to be named in this proceeding. Studies commissioned by KCSR indicate that contaminants contained in the lake were not generated by KCSR. Management and counsel do not believe this proceeding will have a material effect on the Registrant. Louisiana Department of Environmental Quality, Docket No. IAS 88-0001-A, The Louisiana Department of Environmental Quality named KCSR in a state environmental proceeding involving contaminated land near Bossier City, Louisiana, which was the site of a wood preservative treatment plant (Lincoln Creosoting). KCSR is a former owner of part of the land in question. This matter was the subject of a trial in the United States District Court in Shreveport, Louisiana which was concluded in July of 1993. The Court found that Joslyn Manufacturing Company, an operator of the plant, is required to indemnify KCSR for damages arising out of plant operations. (KCSR's potential liability is as a property owner rather than as a generator or transporter of contaminants.) The case has been appealed to the United States Court of Appeals for the Fifth Circuit. On January 18, 1994, the Environmental Protection Agency ("EPA") published a list of potential sites that may be placed on the CERCLA national priority list. The Lincoln Creosoting site was included. Since major remedial work has been performed at this site by Joslyn and KCSR has been held by the Federal Court to be entitled to indemnity for such costs, it would appear that KCSR should not incur significant remedial liability. In any event, it is not possible to meaningfully evaluate the potential consequences of remediation at the site, since the EPA has made no announcement other than listing of the Lincoln Creosoting site for "potential" inclusion on the national list. Litigation Reserves. In the opinion of the Registrant, claims or lawsuits incidental to the business of the Registrant and its subsidiaries have been adequately provided for in the consolidated financial statements. Item 4. Item 4. Submission of Matters to a Vote of Security Holders No matters were submitted to a vote of security holders during the three month period ended December 31, 1993. Executive Officers of the Registrant Pursuant to General Instruction G(3) of Form 10-K, the following list is included as an unnumbered Item in Part I of this Report in lieu of being included in KCSI's Definitive Proxy Statement which will be filed no later than 120 days after December 31, 1993. Directors/Officers L.H. Rowland, age 56, has continuously served as President and Chief Executive Officer since January 1987. He has been employed by the Registrant since 1983, serving in numerous management positions and has served as a director of the Registrant continuously since 1983. T.A. McDonnell, age 48, has continuously served as Executive Vice President since February 1987. He has served as a director of the Registrant continuously since 1983 and has been Chief Executive Officer of DST since 1984. G.W. Edwards, Jr. age 54, has continuously served as Executive Vice President since April 1991. He has served as a director of the Registrant continuously since May 1991. He has also served as President and Chief Executive Officer of KCSR since April 1991. Prior to this, he served as Chairman of the Board and Chief Executive Officer of the United Illuminating Company, New Haven, Connecticut from 1985 to 1991. Vice Presidents and Other Corporate Officers (In alphabetical order) R.H. Bornemann, age 38, has continuously served as Vice President - Governmental Affairs since July 1992. From 1987 to July 1992 he was employed by United Illuminating Company, New Haven, Connecticut, serving most recently as Vice President - Corporate Affairs. P.S. Brown, age 57, has continuously served as Vice President and Assistant General Counsel since July 1992. From 1981 to July 1992, he served as Vice President - Governmental Affairs. R.L. Brown II, age 49, has continuously served as Vice President and Assistant Comptroller since January 1992. From October 1986 to January 1992, he served as Vice President and Comptroller. He also serves as Senior Vice President - Finance of KCSR. R.P. Bruening, age 55, has continuously served as Vice President and General Counsel since May 1982. He also serves as Senior Vice President and General Counsel of KCSR. D.R. Carpenter, age 47, has continuously served as Vice President - Tax Counsel since June 1993. From 1978 to June 1993, he was a partner in the law firm of Watson, Ess, Marshall & Enggas, Kansas City, Missouri. R.W. Comstock, age 63, has continuously served as Vice President - Administration since April 1992. From 1986 to April 1992, he served as Senior Vice President - Corporate Affairs with United Illuminating Company, New Haven, Connecticut. He also serves as Senior Vice President - Administration of KCSR. J.B. Dehner, age 48, has continuously served as Vice President since December 1989. From November 1987 to December 1989, he served as Assistant to the President. Prior to November 1987, he was Executive Vice President of Southern Group, Inc. and a principal officer of several other KCSI subsidiaries. He also serves as Executive Vice President and Chief Operating Officer of KCSR. A.P. McCarthy, age 47, has continuously served as Treasurer since December 1989. From 1984 to December 1989, he served as Assistant Treasurer. A.P. Mauro, age 64, has continuously served as Vice President and Corporate Secretary since August 1985. J.D. Monello, age 49, has continuously served as Vice President-Finance since October 1992. From January 1992 to October 1992, he served as Vice President - - Finance and Comptroller. From May 1989 to January 1992 he served as Vice President and Assistant Comptroller. From October 1986 to May 1989, he served as Assistant Comptroller. H.H. Salisbury, age 68, has continuously served as Vice President - Public Affairs since May, 1986. L.G. Van Horn, age 35, has continuously served as Comptroller since October 1992. From January 1992 to October 1992 he served as Assistant Comptroller. From January 1989 to January 1992 he served as Manager - Financial Reporting. From April 1988 to January 1989 he served as Supervisor - Internal Audit. None of the above officers are related to one another by family. Part II Item 5. Item 5. Market for the Registrant's Common Stock and Related Stockholder Matters See information on pages i and ii of this Form 10-K. Also, pages 68 and 69 of KCSI's 1993 Annual Report to Stockholders (Exhibit 13.1 hereto) are hereby incorporated herein by reference.* The Registrant's Board of Directors authorized an 11% increase in its Common stock dividend in January 1992. The dividend will be reviewed annually and adjustments considered that are consistent with growth in real earnings and prevailing business conditions. Unrestricted retained earnings of the Registrant at December 31, 1993 were $97.2 million. At December 31, 1993, there were 3,386 holders of the Registrant's Common stock based upon an accumulation of the registered stockholder listing. Item 6. Item 6. Selected Financial Data (In millions, except per share and ratio data) Above amounts reflect the 2-for-1 Common stock split to shareholders of record on February 19, 1993, payable March 17, 1993 and the 2-for-1 Common stock split to shareholders of record on February 14, 1992, payable March 17, 1992. See information under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 30 through 45 of KCSI's 1993 Annual Report to Stockholders (Exhibit 13.1 hereto) which are hereby incorporated herein by reference.* ____________________________ * Incorporated by reference pursuant to Rule 12b-23 and General Instruction G(2) to Form 10-K Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations See information under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 30 through 45 of KCSI's 1993 Annual Report to Stockholders (Exhibit 13.1 hereto) which is hereby incorporated herein by reference.* A listing of explanations of graphics used in the Managements' Discussion and Analysis of Financial Condition and Results of Operations for the year ended December 31, 1993, (Exhibit 99.2 hereto), which is hereby incorporated herein by reference.* Item 8. Item 8. Financial Statements and Supplementary Data The report of the independent accountants, the audited consolidated financial statements and the unaudited quarterly financial data appear on pages 46 through 70 of KCSI's 1993 Annual Report to Stockholders (Exhibit 13.1 hereto) and are hereby incorporated herein by reference.* Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None ____________________________ * Incorporated by reference pursuant to Rule 12b-23 and General Instruction G(2) to Form 10-K Part III Item 10. Item 10. Directors and Executive Officers of the Registrant (a) Directors of the Registrant See "Election of Directors" in the Registrant's Definitive Proxy Statement, incorporated herein by reference.** (b) Executive Officers of the Registrant Included under Part I pages 26 and 27. Item 11. Item 11. Executive Compensation See "Management Compensation" in the Registrant's Definitive Proxy Statement, incorporated herein by reference.** Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management (a) See "Principal Stockholders" in the Registrant's Definitive Proxy Statement, incorporated herein by reference.** (b) See "Election of Directors" in the Registrant's Definitive Proxy Statement, incorporated herein by reference.** Item 13. Item 13. Certain Relationships and Related Transactions See "Certain Transactions" in the Registrant's Definitive Proxy Statement, incorporated herein by reference.** _________ ___________________ **Incorporated by reference pursuant to Rule 12b-23 and General Instruction G(3) to Form 10-K. KCSI's Definitive 1993 Proxy Statement will be filed no later than 120 days after December 31, 1993 Part IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) List of Documents filed as part of this Report (1) Financial Statements The financial statements and related notes, together with the report of Price Waterhouse dated February 24, 1994, which appear on pages 46 through 70 of the accompanying 1993 Annual Report to Stockholders (Exhibit 13.1), are hereby incorporated herein by reference*. With the exception of the information explicitly incorporated by reference in this Form 10-K, the 1993 Annual Report to Stockholders is not to be deemed filed as a part of this Form 10-K. The following additional financial statement schedules should be read in conjunction with the financial statements in such 1993 Annual Report to Stockholders. Schedules and exhibits for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission not included with these additional financial statement schedules have been omitted because they are not applicable, insignificant or the required information is shown in the financial statements or notes thereto. (2) Financial Statement Schedules Supplementary Financial Information Page Report of independent accountants on financial statement thru schedules and consents of independent accountants Schedule V Property, plant and equipment - Years ended December 31, 1993, 1992 and 1991 Schedule VI Accumulated depreciation and amortization of property, plant and equipment - Years ended December 31, 1993, 1992 and 1991 Schedule X Supplementary income statement information - Years ended December 31, 1993, 1992 and 1991 The financial statements and related notes, together with the report of Ernst & Young dated January 12, 1994, of Investors Fiduciary Trust Company (a 50% owned affiliate of DST Systems, Inc., a 100% owned subsidiary of the Registrant and accounted for using the equity method) for the year ended December 31, 1993 (Exhibit 99.1) are hereby incorporated herein by reference*. ____________________________ * Incorporated by reference pursuant to Rule 12b-23 and General Instruction G(2) to Form 10-K (3) List of Exhibits (3) Articles of Incorporation and Bylaws Articles of Incorporation - Exhibit 4*** to Registrant's Registration Statement on Form S-8, Commission File No. 33-8880 - Certificate of Designation Establishing the New Series Preferred Stock, Series A, of Registrant, dated May 16, 1986 which is detailed as Exhibit A*** to Registrant's Report on Form 10-Q for the quarter ended June 30, 1986, Commission File No. 1-4717 - Exhibit 4.1*** to Registrant's Current Report on Form 8-K dated October 1, 1993 (Commission File No. 1-4717), Certificate of Designation of Series B Convertible Preferred Stock Bylaws - Exhibit 3.1***, Registrant's By-Laws, as amended and restated November 7, 1991, to Registrant's Form 10-K for the fiscal year ended December 31, 1991, Commission File No. 1-4717 (4) Instruments Defining the Right of Security Holders, Including Indentures - Exhibits incorporated by reference under Part IV Item 14 (a)(3)(3) of this Form 10-K - Item 5*** to Registrant's Current Report on Form 8-K dated December 8, 1992 (Commission File No. 1-4717), which is a brief description of the $250 million Revolving Credit Agreement, dated December 8, 1992. (9) Voting Trust Agreement (Inapplicable) (10) Material Contracts - The Director Indemnification Agreement attached as Exhibit I*** to Registrant's Form 10-K, for the fiscal year ended December 31, 1987, Commission File No. 1-4717 and Exhibit B*** to Registrant's Proxy Statement for 1987 Annual Stockholder Meeting, dated April 6, 1987 - The Deferred Directors Fee Plan attached as Exhibit 10*** to DST's Form 10-K, for the fiscal year ended December 31, 1986, Commission File No. 2-81678 - The Kansas City Southern Railway 1987 Restricted Stock Plan, attached as Exhibit C*** to Registrant's Form 10-K, for the fiscal year ended December 31, 1987, Commission File No. 1-4717 - The Indenture, dated July 1, 1992, to (i) a $300 million Shelf Registration of Debt Securities attached as Exhibit 4*** to Registrant's Form S-3 Commission File No. 33-47198, filed June 19, ____________________________ *** Incorporated by reference pursuant to Rule 12b-32 1992 (ii) a $200 million Medium Term Notes Registration of Debt Securities, attached as Exhibit 4(a)*** to Registrant's Form S-3 Commission File No. 33-60192, filed March 29, 1993 - The Rights Agreement, dated May 16, 1986 attached as Exhibit 1*** to Registrant's Registration Statement on Form 8-A , dated May 17, 1986, Commission File No. 1-4717 - The 1978 Employee Stock Option Plan as amended attached as Exhibit D*** to Registrant's Form 10-K, for the fiscal year ended December 31, 1987, Commission File No. 1-4717 - The 1983 Employee Stock Option Plan as amended attached as Exhibit E*** to Registrant's Form 10-K, for the fiscal year ended December 31, 1987, Commission File No. 1-4717 - The 1987 Employee Stock Option Plan as amended attached as Exhibit F*** to Registrant's Form 10-K, for the fiscal year ended December 31, 1987, Commission File No. 1-4717 - The Employment Continuation Agreements - KCSI and subsidiaries attached as Exhibit G*** to Registrant's Form 10-K, for the fiscal year ended December 31, 1987, Commission File No. 1-4717 extended to February 19, 1993 - The Officer Indemnification Agreement attached as Exhibit H*** to Registrant's Form 10-K, for the fiscal year ended December 31, 1987, Commission File No. 1-4717 - The DST ESOP Loan Agreement, dated December 18, 1987, and Amendment No. 1, dated February 3, 1988, attached as Exhibit J*** to Registrant's Form 10-K, for the fiscal year ended December 31, 1987, Commission File No. 1-4717 - The DST Guarantee Agreement, dated December 18, 1987, and Ratification and Amendment of Guarantee, dated February 3, 1988, attached as Exhibit K*** to Registrant's Form 10-K, for the fiscal year ended December 31, 1987, Commission File No. 1-4717 - The KCSI ESOP Loan Agreement, dated February 3, 1988, attached as Exhibit L*** to Registrant's Form 10-K, for the fiscal year ended December 31, 1987, Commission File No. 1-4717 - The KCSI Guarantee Agreement, dated February 3, 1988, attached as Exhibit M*** to Registrant's Form 10-K, for the fiscal year ended December 31, 1987, Commission File No. 1-4717 - The KCSI Directors' Deferred Fee Plan and Amendment to KCSI Directors' Fee Plan attached as Exhibit N*** to Registrant's Form 10- K, for the fiscal year ended December 31, 1987, Commission File No. 1-4717 - The Kansas City Southern Railway Company Directors' Deferred Fee Plan and Amendment to Kansas City Southern Railway Company Directors' Deferred Fee Plan attached as Exhibit O*** to Registrant's Form 10-K, for the fiscal year ended December 31, 1987, Commission File No. 1- _____________________________ *** Incorporated by reference pursuant to Rule 12b-32 - Exhibit 10.1*** Employee Stock Ownership Plan and Trust Note Agreement dated December 1, 1989 to Registrant's Form 10-K, for the fiscal year ended December 31, 1989, Commission File No. 1-4717 - Exhibit 10.3*** Employment Continuation Agreement, dated, May 5, 1987, between T.A. McDonnell and DST Systems, Inc. to Registrant's Form 10-K, for the fiscal year ended December 31, 1990, Commission File No. 1-4717 - Exhibit 10.4*** Description of the Registrant's 1991 incentive compensation plan to Registrant's Form 10-K, for the fiscal year ended December 31, 1990, Commission File No. 1-4717 - Exhibit 10.1*** The Registrant's 1991 Stock Option and Performance Award Plan to Registrant's Form 10-K, for fiscal year ended December 31, 1991, Commission File No. 1-4717 - Exhibit 10.2*** The Registrant's Directors Deferred Fee Plan, adopted August 20, 1982, amended and restated September 13, 1991, to Registrant's Form 10-K, for fiscal year ended December 31, 1991, Commission File No. 1-4717 - The Agreement and Plan of Merger dated September 19, 1992, among the Registrant, K&M Newco, Inc. (a wholly-owned subsidiary of the Registrant) and MidSouth Corporation as Exhibit 2*** to Registrant's Form 8-K dated September 19, 1992, Commission File No. 1-4717; and letter agreement dated August 4, 1992, between Registrant and MidSouth Corporation setting forth confidentiality and standstill agreements; letter dated September 24, 1992 modifying the Agreement and Plan of Merger dated September 19, 1992 and letter agreement dated August 4, 1992 as Exhibits 28.1*** and 28.2 *** respectively to Registrant's Form 8, dated September 28, 1992, Commission File No. 1- 4717. Third Amendment dated March 30, 1993 to the confidentiality letter dated August 4, 1992 as Exhibit 28.1*** to Registrant's Form 8-K, dated March 30, 1993, Commission File No. 1-4717. - Exhibit 10.1*** Employment Agreement, dated January 1, 1992, as amended and restated March 18, 1993, by and between Kansas City Southern Industries, Inc., and Landon H. Rowland to the Registrant's Form 10-K, for fiscal year ended December 31, 1992, Commission File No. 1-4717. - Exhibit 10.2*** Employment Agreement, dated January 1, 1992, as amended and restated March 18, 1993, by and between Kansas City Southern Industries, Inc., The Kansas City Southern Railway Company and George W. Edwards, Jr. to the Registrant's Form 10-K, for fiscal year ended December 31, 1992, Commission File No. 1-4717. - Exhibit 10.3*** Employment Agreement, dated January 1, 1992, as amended and restated March 18, 1993, by and between Kansas City Southern Industries, DST Systems, Inc. and Thomas A. McDonnell to the Registrant's Form 10-K, for fiscal year ended December 31, 1992, Commission File No. 1-4717. - Exhibit 10.4*** Employment Agreement, dated April 1, 1992, by and between Kansas City Southern Industries, Inc. and Roland W. Comstock to the Registrant's Form 10-K, for fiscal year ended December 31, 1992, Commission File No. 1-4717. - Exhibit 10.1 attached to this Form 10-K _____________________________ *** Incorporated by reference pursuant to Rule 12b-32# (11) Statement Re Computation of Per Share Earnings (Inapplicable) (12) Statements Re Computation of Ratios Exhibit 12.1 attached to this Form 10-K (13) Annual Report to Security Holders, Form 10-Q or Quarterly Report to Security Holders - Exhibit 13.1 attached to this Form 10-K (16) Letter Re Change in Certifying Accountant (Inapplicable) (18) Letter Re Change in Accounting Principles (Inapplicable) (21) Subsidiaries of the Registrant - Exhibit 21.1 attached to this Form 10-K (22) Published Report Regarding Matters Submitted to Vote of Security Holders (Inapplicable) (23) Consents of Experts and Counsel Page and to this Form 10-K (24) Power of Attorney (Inapplicable) (27) Financial Data Schedules (Inapplicable) (28) Information from Reports Furnished to State Insurance Regulatory Authorities (Inapplicable) (99) Additional Exhibits - The financial statements and related notes, together with the report of Ernst & Young dated January 12, 1994, of Investors Fiduciary Trust Company as listed under Item 14(a)2, for the year ended December 31, 1993 attached hereto as Exhibit 99.1 - A listing of explanations of graphics used in the Management's Discussion and Analysis of Financial Condition and Results of Operations for the year ended December 31, 1993, attached hereto as Exhibit 99.2 (b) Reports on Form 8-K The Registrant filed a Form 8-K dated October 1, 1993 under Items 5 and 7, reporting (a) the establishment of the KCSI Employee Plan Funding Trust and transfer of KCSI Series B Convertible Preferred Stock and (b) completion of the Vantage Computer Systems, Inc. merger into a wholly-owned subsidiary of The Continuum Company, Inc. 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. Kansas City Southern Industries, Inc. March 18, 1994 By: /s/L.H. Rowland L.H. Rowland, President, Chief Executive Officer and Director 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 indicated on March 18, 1994. Signature Capacity /s/P.H. Henson Chairman and Director P.H. Henson /s/L.H. Rowland President, Chief Executive L.H. Rowland Officer and Director /s/G.W. Edwards Jr. Executive Vice President G.W. Edwards Jr. and Director /s/T.A. McDonnell Executive Vice President T.A. McDonnell and Director /s/J.D. Monello Vice President-Finance J.D. Monello (Principal Financial Officer) /s/L.G. Van Horn Comptroller L.G. Van Horn (Principal Accounting Officer) /s/A.E. Allinson Director A.E. Allinson /s/P.F. Balser Director P.F. Balser /s/J.E. Barnes Director J.E. Barnes /s/T.S. Carter Director T.S. Carter /s/M.G. Fitt Director M.G. Fitt /s/M.M. Levin Director M.M. Levin /s/M.I. Sosland Director M.I. Sosland REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Board of Directors of Kansas City Southern Industries, Inc. Our audits of the consolidated financial statements referred to in our report dated February 24, 1994, appearing on page 70 of the 1993 Annual Report to Stockholders of Kansas City Southern Industries, Inc. (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an audit of the Financial Statement Schedules listed in Item 14(a) of this Form 10-K. In our opinion, these Financial Statement Schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. /s/ Price Waterhouse PRICE WATERHOUSE Kansas City, Missouri February 24, 1994 CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in the Registration Statements on Form S-8 (No. 33-69060, 33-50517, 33-50519), and in the Prospectuses constituting part of the Registration Statements on Form S-3 (No. 33-60192, 33-69648) of Kansas City Southern Industries, Inc. of our report dated February 24, 1994, appearing on page 70 of the Annual Report to Stockholders which is incorporated in this Annual Report on Form 10-K. We also consent to the incorporation by reference of our report on the Financial Statement Schedules, which appears above. /s/ Price Waterhouse PRICE WATERHOUSE Kansas City, Missouri March 18, 1994 Consent of Independent Auditors We consent to the incorporation by reference in the Registration Statements on Form S-8 and Form S-3 of Kansas City Southern Industries, Inc. and the related Prospectuses of our report dated January 12, 1994, with respect to the financial statements of Investors Fiduciary Trust Company included at page 1 of Exhibit 99.1 in this Annual Report on Form 10-K for the year ended December 31, 1993. /s/ Ernst & Young ERNST & YOUNG Kansas City, Missouri March 18, 1994 KANSAS CITY SOUTHERN INDUSTRIES, INC. 1993 FORM 10-K ANNUAL REPORT INDEX TO EXHIBITS Regulation SK Exhibit Item 14(a)(3) No. Document Exhibit No. 10.1 Employment Agreement, dated July 15, 1993, 10 by and between Kansas City Southern Industries, Inc. and Mark M. Levin 12.1 Ratio of Earnings to Fixed Charges 12 13.1 1993 Annual Report to Stockholders 13 21.1 Subsidiaries of the Registrant 21 99.1 The financial statements and related notes, together99 with the report of Ernst & Young dated January 12, 1994 of Investors Fiduciary Trust Company for the year ended December 31, 1993 99.2 Listing of explanations of graphics used in 99 Management's Discussion and Analysis of Financial Condition and Results of Operations

1993 Item 1. Business (a) General Development of Business. Lincoln Telecommunications Company ("the Company") was incorporated on November 24, 1980, as a Nebraska corporation, and is a holding company, with The Lincoln Telephone and Telegraph Company ("LT&T"), a Delaware corporation, as its principal subsidiary. The Company owns 100% of the issued and out- standing common stock of LT&T. Other subsidiaries which are wholly-owned by the Company are LinTel Systems Inc. ("LinTel") and Prairie Communications, Inc. ("Prairie Communications"), both of which are Nebraska corporations. For general development of business during the past five years and descriptions of the subsidiaries, see 1993 Exhibit 13.1 Building On Our Strengths and Exhibit 13.3 Management's Discussion and Analysis of Financial Conditions and Results of Operations (M D & A) which are included in Annual Report pages 2-5 and 31 - 37, respectively. (b) Financial Information About Industry Segments. See Exhibit 13.2 Auditors' Report and Financial Statements which are included in Annual Report pages 14 - 18. (c) Narrative Description of Business. Subsidiary Operations. LT&T, the Company's principal subsidiary, operates a telephone system for both local and long distance service in the southeastern 22 counties of Nebraska, having in service 238,142 landline customer access lines as of December 31, 1993. This is a contiguous geographical area. There are a total of 138 exchanges and 148 central offices (there being ten central offices in Lincoln). *The statistics in this table do not include cellular access lines and Company access lines in service as of the dates shown. TRAFFIC STATISTICS FOR 12 MONTHS ENDED DECEMBER 31, 1993 Long distance calls completed 98,569,280 Direct Distance Dialed 93,868,838 All other 4,700,442 Form 10-K Item 1. cont'd. LT&T provides access services by connecting the communications networks of interexchange and cellular carriers with the equipment and facilities of end users by use of its public switched networks or through private lines. Access charges, payable by interexchange and cellular carriers, provided $47,602,000, $44,513,000 and $43,620,000 of the Company's consolidated revenues for the years ended December 31, 1993, 1992 and 1991 respectively. Since 1986, telecommunications companies in Nebraska have been permitted to increase local exchange rates up to 10% in any consecutive 12-month period without review by the Nebraska Public Service Commission ("NPSC"). However, LT&T must provide at least 60 days notice to affected customers and conduct public informational meetings. If at least 3% of all affected subscribers sign a formal complaint within 120 days from such notice, opposing the rate increase, the NPSC must hold and complete a hearing with regard to the complaint within 90 days to determine whether the proposed rates are fair, just and reasonable, and within 60 days after the close of hearing, enter an order adjusting the rates at issue. Rates for all other services are not subject to regulation by the NPSC. Rates for other services may be revised by a telecommunications company by filing a rate list with the NPSC which is effective after ten days' notice to the NPSC. Quality of service regulation over interexchange and local exchange service is retained by the NPSC. Nebraska has completely deregulated the provision of mobile radio services and radio paging services. Regardless of whether a particular rate increase is subject to regulato- ry review, the Company's ability to raise rates will be determined by various factors, including economic and competitive circumstances in effect at the time. See Exhibit 13.3 M D & A which is included in Annual Report pages 35 and 36. LT&T's wireless services include cellular operations and wide area paging services. LT&T operates a cellular telecommunications system in the Lincoln, Nebraska Metropolitan Statistical Area ("MSA"). LT&T also manages the limited partnership which is the license holder for Iowa Rural Service Area ("RSA") 1 which serves the southwestern six counties of Iowa. On December 31, 1991, Prairie Communications acquired a 50% interest in Omaha Cellular General Partnership (OCGP). The remaining 50% interest in OCGP is owned by Centel Nebraska, Inc. (Centel-Neb). The Company purchased its 50 percent share from Centel Cellular Co. (Centel) for $11.9 million cash and a discount note from OCGP that it holds for $23.8 million, which note proceeds were paid to Centel and Centel Nebraska. For a two-year period beginning on December 31, 1996, Prairie Communications will have an opportunity to purchase Centel's remaining 50 percent interest in OCGP at fair market value. OCGP is the general partner of and holds approximately 55% of the partnership inter- ests in Omaha Cellular Limited Partnership, which provides cellular telecommu- nications services in Douglas and Sarpy Counties in Nebraska and Pottawattamie County, Iowa. Omaha Cellular Limited Partnership conducts business under the trade name First Cellular Omaha. Prairie Communications is the managing partner of OCGP. Form 10-K Item 1. cont'd. The Company also owns 13.1% of the outstanding shares of Nebraska Cellular Telephone Corporation ("NCTC"). NCTC is the holder of cellular operating licenses issued by the Federal Communications Commission ("FCC") for Nebraska RSA Nos. 533 through 542. The following table sets forth certain information about the Company's cellular operations. ________________________ (1) Systems are as follows: Lincoln MSA - Lancaster County, Nebraska Omaha MSA - Douglas and Sarpy Counties in Nebraska and Pottawattamie County in Iowa Nebraska RSAs - 89 of the 90 Nebraska counties not in the Omaha and Lincoln MSAs Iowa RSA 1 - Southwestern six counties of Iowa (2) The date LT&T's operating license was granted in the case of the Lincoln MSA, and the date of the Company's initial acquisition of an interest in the licensee in the case of other systems. (3) In addition, Prairie Communications has an option to purchase an additional 27.6% interest in the licensee of the Omaha MSA at fair market value. (4) Includes the allocable portion of the 14.1% interest in the licensee held by the Omaha MSA licensee. (5) Based upon Donnelley Marketing Information Services population data for 1992. Pops shown for Lincoln and Omaha MSAs are virtually all covered by the networks of these systems. According to estimates available to the Company, approximately 60% of the pops shown for Nebraska RSAs and approximately 90% of the pops shown for Iowa RSA 1 are covered by the networks of these systems. (6) Does not include the Omaha MSA licensee's 14.1% interest in Iowa RSA 1 (which system has been separately included in the table) or the Omaha MSA licensee's 8.3% interest in Iowa RSA 8 (representing 54,125 pops and 4,492 net pops). Form 10-K Item 1. cont'd. (7) The data regarding the subscribers and net subscribers is not disclosed herein because it is not considered material to the Company's consolidated operations. The licensing, ownership, construction, operation and sale of control- ling interests in cellular telephone systems are subject to regulation by the FCC. The FCC licenses for the Company's Lincoln MSA and Omaha MSA cellular operations expire between October 1994 and October 1996, while FCC licenses for the Company's Iowa RSA and Nebraska RSA cellular operations expire between July 1999 and August 2000. All renewal applications for these licenses must be received by the FCC not later than 30 and not more than 60 days in advance of their respective expiration dates and must be approved by the FCC. It is possible that there may be competition for these FCC licenses upon expiration, and any such competitors may apply for such licenses within the same time frame as the Company. However, incumbent cellular providers generally retain their FCC licenses upon a demonstration of substantial compliance with FCC regulations and substantial service to the public. The FCC will only consider competitors' applications if it determines the Company has not made such a demonstration. Although the Company has no reason to believe that the FCC renewal applications will not be granted by the FCC, no assurance can be given. For a five-year period ending after the date of the grant of a cellular license by the FCC (the "fill-in period"), the licensee has the exclusive right to apply to serve areas within the RSA or the MSA. At the end of the fill-in period, any person may apply to serve the unserved areas in the MSA or RSA. The fill-in period for both the Lincoln and Omaha MSAs has expired and no person has filed to serve any unserved areas in those locations. The fill- in periods for the Nebraska RSAs and the Iowa RSA expire between November 1994 and May 1995. LinTel is a "reseller" of long distance services, primarily in LT&T's exchange service area, and provides this service by aggregating its customers' traffic to take advantage of volume discounts offered by national networks. During 1992, the Company had 105.8 million minutes of long distance traffic, an increase of 2 million minutes from 1991. For 1993, the Company had 110.0 million minutes of long distance traffic, up 4.0% over 1992. The Company has a variety of calling programs for both residential and business customers. LinTel also sells and services a wide range of PBX, key system and other communications equipment to large and small businesses, including products manufactured by ROLM and Northern Telecom. These systems typically include a variety of special features such as automatic call distribution, voice mail, and LAN functionality. Nebraska State Income and Local Property Taxes In separate decisions during 1991, the Nebraska Supreme Court (the Court) decided that the personal property tax system of the State as applied in 1989 and in 1990 was unconstitutional. On January 22, 1993, the Court affirmed a determination by the Nebraska State Board of Equalization and Form 10-K Item 1. cont'd. Assessment whereby 18.81% of the taxes paid for 1990 should be refunded to the Company and certain other taxpayers. In mid-1993, LT&T and LinTel entered into agreements with the Nebraska Tax Commissioner pursuant to which LT&T and LinTel agreed to accept a refund of 18.81% of the property taxes paid for the 1989 and 1990 tax years. Such agreements were subsequently approved by the NPSC. As a result of these actions, the Company recorded refunds or credits of approximately $1,359,000 and $1,494,000 in 1993 and 1992, respectively. During 1991, the Nebraska Legislature responded to the 1991 Court decisions by eliminating personal property taxes for 1991 only, substituting increased rates for state corporate income taxes and creating a 4% surcharge on depreciation deductions. In July 1992, the Nebraska Supreme Court declared this action on taxes to be unconstitutional. Subsequently, the Nebraska Legislature replaced the 1991 action on taxes with a similar bill enacted in May 1992, including a 2% surcharge on depreciation deductions. The combina- tion of these two actions lowered the Company's state income taxes by approxi- mately $575,000 for 1992. Due to a constitutional amendment approved by the voters in 1992, the constitutional issues appear to have been resolved. Also in 1991, the Legislature adopted a measure requiring the NPSC to approve the disposition of tax reductions telephone companies might derive from changes in tax laws. LT&T set aside $2,017,000 in 1992 and $24,000 in 1993 to meet this anticipated requirement. To accomplish these objectives, LT&T has offered equipment for customers of Enhanced 911 services, frame relay services to governmental agencies or equipment or services to educational agencies, all at reduced rates. Competition. Competitors now offer private line and switched voice and data services in or adjacent to the territory served by LT&T, thus permitting bypass of local telephone facilities. In addition, satellite transmission services, cellular communications and other services permit bypass of the local exchange network. These alternatives to local exchange service represent a potential threat to LT&T's long-term ability to provide local exchange service at economical rates. In order to meet this competition, LT&T has deployed new technology for its local exchange network to increase operating efficiencies and to provide new services to its customers. These new technologies include conversion of all LT&T switches to digital technology, installation of over 1,250 miles of fiber optic cable, and installation of SS7, an out-of-band signalling system, to over 60 percent of its access lines. LT&T faces competition in the market for customer premises telephone equipment. LT&T offers state-of-the-art customer premises telephone equipment through well-trained and experienced market representatives with long term relationships with customers. In so doing, LT&T believes that it effectively competes in this market segment. Form 10-K Item 1. cont'd. With respect to cellular mobile communications service, the FCC has granted two licenses to provide cellular service in each MSA or RSA. One license was granted to a company that provides local telephone service in the area or to a group affiliated with the local service company (the "Wireline Carrier"). The other license was granted to a company that does not provide local telephone service and is not affiliated with a local service company in the area (the "Non-Wireline Carrier"). LT&T currently operates as the Wireline Carrier in the Lincoln, Nebraska MSA and Prairie Communications is the manager of the limited partnership which operates as the Wireline Carrier in the Omaha, Nebraska, MSA. The Company faces significant competition from the Non-Wireline Carrier in such markets and from other communications technologies that now exist, such as specialized mobile radio systems and paging services, or other communications technologies that may be developed or perfected. In addition to providing cellular mobile communications service, the Company sells and leases cellular mobile equipment in competition with numerous equipment retailers. The providers in each market compete for customers principally on the basis of services offered, the quality of customer service and price. The Company has designed and deployed cellular systemswith greater radio signal coverage than competitive systems, particularly for portable cellular tele- phone users. The Company believes it has benefited competitively from such design. In connection with provision of long distance telecommunications services, LinTel competes with other long distance service providers such as AT&T, MCI, and U.S. Sprint. This market is now competitive, and regulation by the FCC and the NPSC has been substantially reduced since divestiture by AT&T of the Bell Operating Companies and the advent of equal access. The prices for long distance services offered by LinTel compare favorably with prices of similar services offered by competitors. LinTel believes that pricing contributed to an increase of its minutes of use from 105.8 million minutes in 1992 to 110.0 million minutes in 1993, a 4.0 percent increase. Since the mid-1980's, the Company's business strategy has been to position itself as a "one-stop" telecommunications services provider. Long- term business relationships with its customers have strengthened the Company's business position. The Company believes that its customers value the fact that it is the "local company" whose goal is to meet the customers' total communications needs. The long-range effect of competition on the provision of telecommunica- tions services and equipment will depend on technological advances, regulatory actions at both the state and federal levels, court decisions, and possible future state and federal legislation. See 1993 Annual Report to Stockholders, pages 35, 36 and 37. Employees. The Company and its subsidiaries employed 1,618 persons (1,422 employed by its principal subsidiary, LT&T) at the end of 1993. As of December 1993, Form 10-K Item 2. Item 2. cont'd. approximately 62 percent of the Company's and subsidiaries' employees were represented by the Communications Workers of America ("CWA"), which is affiliated with the AFL-CIO. New three-year contracts with the CWA were signed in May 1992 as respects LinTel bargaining unit employees and October 1992 as respects LT&T bargaining unit employees. The LT&T contract with the CWA will expire on October 14, 1995, and the LinTel contract with the CWA will expire on May 19, 1995. The Company believes its relationship with its employees is good and constructive. See Exhibit 13.4 Selected Financial Data which is included in Annual Report pages 38 and 39. (d) Financial Information About Foreign and Domestic Operations and Export Sales. Not applicable. Item 2. Properties LT&T's telephone system consists of switching and transmission equipment, cellular radio facilities, fiber optic systems and distribution plant, through 138 communities within the state of Nebraska. Among the larger exchanges served are Lincoln, Hastings, Beatrice, York, Nebraska City, Plattsmouth and Seward. For fiscal year 1993, LT&T owned the equipment, plant and facilities which were utilized in its telephone system. LT&T leases four locations on which business offices are located. The total annual rentals for such leased offices are less than $100,000 and the duration of such leases range from one to six years. LT&T owns its remaining business office locations. Additional- ly, LT&T leases the majority of the locations on which the sites of towers for its Lincoln MSA cellular system are located. Annual rentals on the sites are approximately $40,000, and the duration of the unexpired portions of such leases range from four months to five years, with options to renew thereafter. LinTel leases transmission facilities and switching facilities in connection with its Lincoln Telephone Long Distance Division. All of its office locations are leased. Annual rentals are approximately $135,000, and the duration of the unexpired portions of such leases range from four months to four years. It is the opinion of Company management, including the Engineering Director of LT&T, that the properties of LT&T are suitable and adequate to provide modern and effective telecommunications services within its franchised area, including both local and long distance service. The capacity for furnishing these services, both currently and for forecast growth, are under constant surveillance by the Engineering Director and his staff. Facilities are put to full utilization after installation and appropriate testing, according to two-, three- and five-year construction plans. Form 10-K Item 2. cont'd. LT&T's continuing construction programs are divided between meeting growth demands (population and service) and upgrading its telephone equipment and plant. Conversion to digital switching systems was completed in 1992. Item 3. Item 3. Legal Proceedings None. Item 4. Item 4. Submission of Matters to a Vote of Security Holders Not Applicable. Form 10-K PART II Item 5. Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters (a) Market Information Company Common Stock is traded on the Nasdaq National Market under the symbol "LTEC." The following table sets forth the high and low bid quotations for the periods indicated, as reported in "The Wall Street Journal." These quotations represent prices between dealers without adjustments for markups, markdowns or commissions and may not represent actual transactions. (All market information and dividend amounts reflect adjustment for the Company's 100% stock dividend paid January 6, 1994.) (b) Holders The approximate number of holders of the Company's Common Stock on December 31, 1993 was 8,000. (c) Dividends The long-term debt agreements of LT&T contain various restric tions, including those relating to payment of dividends by LT&T to the Company and to holders of LT&T's 5% Preferred Stock. Notes payable to banks also contain various restrictions. At December 31, 1993, approximately $22,050,000 of LT&T's retained earnings were available for payment of cash dividends to the Company and to holders of LT&T's 5% Preferred Stock under the most restrictive provisions of such agreements. Item 6. Item 6. Selected Financial Data See Exhibit 13.4 Selected Financial Data which is included in Annual Report pages 38 and 39. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Form 10-K Item 7. cont'd. See Exhibit 13.3 M D & A which is included in Annual Report pages 31-37. On March 17, 1993, the Board of Directors elected to expense the entirety of the Company's post-retirement benefit obligation accumulated as of January 1, 1993, of approximately $38,450,000 in the first quarter of 1993 for financial reporting purposes. This obligation, net of related income taxes, is approximately $23,550,000. This one-time charge equals $1.45 per share of Common Stock, net of tax impact. This action was taken in compli ance with Statement of Financial Accounting Standards No. 106, which imposes new accounting rules regarding insurance and other benefits provided to retirees and allows employers to recognize this obligation either immediately or on an amortized basis. Recent Developments On March 16, 1994, the Company announced that due to changes in technology, customer growth and usage demand for cellular services in their respective markets, Lincoln Telephone Cellular and First Cellular Omaha have entered into an agreement with AT&T to purchase digital cellular telephone systems to replace the existing analog systems serving these markets. These digital systems are expected to increase capacity and performance in these markets. The new Omaha and Lincoln systems are expected to be operational in April, 1994 and mid-1995, respectively. The implementation of these system upgrades will cause the early retirement of existing analog equipment prior to the expiration of its anticipated useful life. As a result, Lincoln Telecommu- nications will, in the first quarter of 1994, write down the value of these assets. This write down is expected to result in a one- time, non-cash reduction of first quarter 1994 earnings of approximately $3.2 million, or $0.10 per share. Item 8. Item 8. Financial Statements and Supplementary Data See Exhibit 13.2 Auditors' Report and Financial Statements and Exhibit 13.4 Selected Financial Data which are included in Annual Report, pages 15 - 30 and 38 - 39, respectively. Item 9. Item 9. Changes In and Disagreements with Accountants on Accounting and Financial Disclosure None Form 10-K PART III Item 10. Item 10. Directors and Executive Officers of the Registrant See Proxy Statement for Annual Meeting of Stockholders, April 27, 1994, pages 3 - 7. See also Exhibit 13.5 Officers, Directors, and Committees which is included in Annual Report page 40. Item 10. cont'd. Form 10-K Term of office of above named executive officers: At the meeting of the Board of Directors each year held immediately following the Annual Meeting of Stock- holders, the officers are elected to serve for the ensuing year, or until their successors are duly elected and qualified. Compliance with Section 16(a) of the Exchange Act See Proxy Statement for Annual Meeting of Stockholders, April 27, 1994, page 16. Item 11. Item 11. Executive Compensation See Proxy Statement for Annual Meeting of Stockholders, April 27, 1994, page 14. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management (a) Security ownership of certain beneficial owners. See Proxy Statement for Annual Meeting of Stockholders, April 27, 1994, pages 1 and 2. (b) Security ownership of management. See Proxy Statement for Annual Meeting of Stockholders, April 27, 1994, pages 6 - 7. (c) Changes in control. None. Item 13. Item 13. Certain Relationships and Related Transactions (a) Transactions with management and others. On February 1, 1994, the Company entered into an agreement (Agreement) with Sahara Enterprises, Inc. (Sahara), then an owner of approximately 16.6% of the issued and outstanding common stock of the Company in connection with a firm commitment underwritten public offering of shares of the Company's common stock by Sahara (Offering). The Agreement provides (i) the Company with a right of first refusal to purchase additional shares of Company common stock from Sahara for 120 days following the closing of the Offering; (ii) that, concurrently with the closing of the Offering, the Company will purchase 250,000 shares of Company common stock from Sahara at the Offering price less 2 percent for future use in funding the Company's stock obligations under one or more of its employee benefit plans; and (iii) that Sahara will indemnify and reimburse the Company against payment of an amount not to exceed the first $200,000 of the Company's out-of-pocket expenses in connection with the Offering. Item 13. cont'd. Form 10-K On February 1, 1994, the Company filed a Form S-3 Registration Statement with the Securities and Exchange Commission in connec- tion with the Offering. On March 24, 1994, the Offering was closed and pursuant thereto, Sahara sold 1,850,000 shares of Company common stock to the public, reducing its ownership of the issued and outstanding Company common stock to approximately 10%. Concurrently therewith and pursuant to the Agreement, the Company purchased 250,000 shares of Company common stock from Sahara for a purchased price of $15.68 per share, a transaction which the Company financed with current assets. Exclusive of shares of common stock received by Sahara pursuant to Company stock dividends or stock splits, Sahara (or its wholly-owned subsidiary) beneficially owned the shares sold in the Offering and the 250,000 shares sold to the Company concurrently therewith since the Company's formation as a holding company effective February 23, 1981. See Proxy Statement for Annual Meeting of Stockholders, April 27, 1994, pages 6 - 7. (b) Certain business relationships. See Proxy Statement for Annual Meeting of Stockholders, April 27, 1994, pages 3 and 4. (c) Indebtedness of management. Not applicable. (d) Transactions with promoters. Not applicable. Form 10-K PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) The following documents are filed as part of this report: 1. Financial Statements: Independent Auditors' Report Consolidated Balance Sheets, December 31, 1993 and 1992 Consolidated Statements of Earnings, Years ended December 31, 1993, 1992, and 1991 Consolidated Statements of Common Stock Investment and Preferred Stock, Years ended December 31, 1993, 1992, and 1991 Consolidated Statements of Cash Flows Years ended December 31, 1993, 1992, and 1991 Summary of Significant Accounting Policies Notes to Consolidated Financial Statements, December 31, 1993, 1992, and 1991 Management's Discussion and Analysis of Financial Conditions and Results of Operations Statements listed in (a) 1 are all incorporated by reference, see Exhibit 13.2 Auditors' Report and Financial Statements, Exhibit 13.3 M D & A, and Exhibit 13.4 Selected Financial Data which are included in Annual Report pages 14 - 30, pages 31-37, and pages 38-39, respectively. 2. Financial Statement schedules required by Item 8 of this form. Schedule Independent Auditors' Report Temporary Investments and Cash Equivalents, Years ended December 31, 1993, 1992 and 1991 I Property and Equipment, Years ended December 31, 1993, 1992, and 1991 V Accumulated Depreciation and Amortization of Property and Equipment - Years ended December 31, 1993, 1992, and 1991 VI Valuation and Qualifying Accounts - Years ended December 31, 1993, 1992, and 1991 VIII Short-Term Borrowings - Years ended December 31, 1993, 1992, and 1991 IX Note Receivable from Related Party - Years ended December 31, 1993, 1992, and 1991 X Form 10-K Item 14. (a) cont'd. Schedule Supplementary Statements of Earnings Information - Years ended December 31, 1993, 1992, and 1991 XI All other schedules are omitted because they are not applicable or the information required is immaterial or is presented within the consoli- dated financial statements and notes thereto. 3. Exhibits Required by Item 601 of Regulation S-K Exhibit 3: Articles of Incorporation and By-Laws (3.1) Articles of Incorporation with amendments (incorpo- rated by reference to Exhibit 3 of the Company's Form S-3 Registration Statement No. 33-21557). (3.2) By-Laws as amended March 16, 1994 Exhibit 4: Instruments defining the rights of security holders, including indentures (4.1) Rights Agreement, dated as of June 21, 1989, between the Company and Harris Trust and Savings Bank (incorporated by reference to Exhibit 4.1 of the Company's Current Report on Form 8-K dated June 21, 1989). (4.2) Amendment to Rights Agreement, dated as of September 7, 1989, between the Company and Harris Trust and Savings Bank (incorporated by reference to Exhibit 4.2 to the Company's Current Report on Form 8-K dated September 7, 1989). (4.3) Amendment No. 2 to Rights Agreement dated June 15, 1993, between the Company and Mellon Securities Trust Company (incorporated by reference to Exhibit 4.5 of the Company's Form S-3 Registration Statement No. 33-52117.) (4.4) The Indenture issued by The Lincoln Telephone and Telegraph Company (incorporated by reference to LT&T's Form S-9, File 2-39373, effective March 1, 1971). (4.5) Supplemental Indenture Eleven dated June 1, 1990, (incorporated by reference to the Company's Annual Report on Form 10-K for the year ending December 31, 1990). Item 14. (a) cont'd. Form 10-K Exhibit 10: Material Contracts (10.1) The 1989 Stock and Incentive Plan approved by the Corporation's stockholders on April 26, 1989, was filed as an exhibit to Form S-8, File 33-39551, effective March 22, 1991, and is incorporated herein by this reference. (10.2) A specimen of the Executive Benefit Plan agreement, as amended through January 1, 1993, provided to the executive officers and director-level managers of the Corporation and its affiliates, and a specimen of the Key Executive Employment and Severance Agreement provided to the executive officers of the Corporation and its affiliates on December 23, 1987, were filed as Exhibit 10 to the Company's 1992 Form 10-K Report and are incorporated herein by reference. Exhibit 13: Annual Report to Security Holders (13.1) Building On Our Strengths (13.2) Auditors' Report and Financial Statements (13.3) Management's Discussion and Analysis of Financial Conditions and Results of Operations (M D & A) (13.4) Selected Financial Data (13.5) Officers, Directors and Committees Exhibit 21: Subsidiaries of the Registrant. The Company owns all the outstanding common stock of The Lincoln Telephone and Telegraph Company, LinTel Systems Inc., and Prairie Communications, Inc. See Exhibit 13.3 M D & A which is included in Annual Report pages 35-36. Exhibit 23: Accountants' Consent (23.1) Accountants' consent is attached hereto. Exhibits 9, 11, 12, 16, 18, 19, 22, 24 and 28 are not applicable. (b) No reports on Form 8-K have been filed during the last quarter of the period covered by this report. (c) All exhibits required by Item 601 of Regulation S-K incorporated by reference as indicated in paragraph (a) 3 above. (d) Not applicable. Form 10-K 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. LINCOLN TELECOMMUNICATIONS COMPANY By /s/ Michael J. Tavlin Date March 16, 1994 Michael J. Tavlin, Vice President-Treasurer 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 dates indicated. Signature Title Date President and Chief Executive Officer /s/ Frank H. Hilsabeck (Principal Executive Officer) Frank H. Hilsabeck Senior Vice President and Chief Financial Officer /s/ Robert L. Tyler (Principal Financial Officer) Robert L. Tyler Vice President - Treasurer /s/ Michael J. Tavlin and Secretary Michael J. Tavlin /s/ Duane W. Acklie Director Duane W. Acklie /s/ William W. Cook, Jr. Director William W. Cook, Jr. /s/ Terry L. Fairfield Director March 16, 1994 Terry L. Fairfield /s/ James E. Geist Director James E. Geist /s/ J. Taylor Greer Director J. Taylor Greer /s/ John Haessler Director John Haessler /s/ Charles R. Hermes Director Charles R. Hermes Form 10-K Signatures. cont'd. /s/ George Kelm Director George Kelm - ------------------------- Director Donald H. Pegler, Jr. /s/ Paul C. Schorr, III Director Paul C. Schorr, III /s/ William C. Smith Director William C. Smith /s/ James W. Strand Director James W. Strand /s/ Charles N. Wheatley Director Charles N. Wheatley /s/ Thomas C. Woods, III Director Thomas C. Woods, III /s/ Lyn Wallin Ziegenbein Director Lyn Wallin Ziegenbein KPMG PEAT MARWICK ACCOUNTANTS' CONSENT The Board of Directors Lincoln Telecommunications Company: We consent to the incorporation by reference in the registration statement on Forms S-3 and S-8 of Lincoln Telecommunications Company of our report, dated February 4, 1994, relating to the consolidated balance sheets of Lincoln Telecommunications Company and subsidiaries as of December 31, 1993 and 1992, and related consolidated statements of income, common stock investment and preferred stock and cash flows and relating to the schedules to Form 10-K for each of the years in the three-year period ended December 31, 1993, which reports appear in the December 31, 1993 annual report on Form 10-K of Lincoln Telecommunications Company. /s/ KPMG Peat Marwick March 15, 1994 Lincoln, Nebraska LINCOLN TELECOMMUNICATIONS COMPANY AND SUBSIDIARIES Independent Auditors' Report and Schedules Form 10-K Securities and Exchange Commission December 31, 1993, 1992 and 1991 (With Independent Auditors' Report Thereon) LINCOLN TELECOMMUNICATIONS COMPANY AND SUBSIDIARIES Index to Schedules Filed Schedule Independent Auditors' Report Temporary Investments and Cash Equivalents - Years ended December 31, 1993, 1992 and 1991 I Condensed Financial Information of Parent Company: Balance Sheets - December 31, 1993 and 1992 Statements of Income - Years ended December 31, 1993, 1992 and 1991 Statements of Stockholders' Equity - Years ended December 31, 1993, 1992 and 1991 Statements of Cash Flows - Years ended December 31, 1993, 1992 and 1991 III Property and Equipment - Years ended December 31, 1993, 1992 and 1991 V Accumulated Depreciation and Amortization of Property and Equipment - Years ended December 31, 1993, 1992 and 1991 VI Valuation and Qualifying Accounts - Years ended December 31, 1993, 1992 and 1991 VIII Short-term Borrowings - Years ended December 31, 1993, 1992 and 1991 IX Note Receivable from Related Party - Years ended December 31, 1993, 1992 and 1991 X Supplementary Statements of Earnings Information - Years ended December 31, 1993, 1992 and 1991 XI All other schedules are omitted because they are not applicable or the information required is immaterial or is presented within the consolidated financial statements and notes thereto. KPMG Peat Marwick Certified Public Accountants 1600 FirsTier Building Lincoln, NE 68508 Two Central Park Plaza Suite 1501 Omaha, NE 68102 INDEPENDENT AUDITORS' REPORT The Board of Directors and Stockholders Lincoln Telecommunications Company: Under date of February 4, 1994, we reported on the consolidated balance sheets of Lincoln Telecommunications Company and Subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, common stock investment and preferred stock and cash flows for each of the years in the three-year period ended December 31, 1993, as contained in the 1993 annual report to stockholders. These consolidated financial statements and our report thereon are incorporated by reference in the annual report on Form 10-K for the year ended December 31, 1993. In connection with our audits of the aforementioned consolidated financial statements, we also audited the related financial statement schedules as listed in the accompanying index. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statement schedules based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. /s/ KPMG Peat Marwick Lincoln, Nebraska February 4, 1994 Schedule I 4 Schedule I,cont. 6 Schedule I,cont. Schedule III 3 Schedule III,cont. Note: Effective January 6, 1994, the Company paid a 100% stock dividend to stockholders of record on December 27, 1993, which has been treated as a stock split for financial reporting reporting purposes. Common stock, premium on common stock and all per share information has been retroactively adjusted to give effect to the stock dividend for all periods presented. LINCOLN TELECOMMUNICATIONS COMPANY AND SUBSIDIARIES Statements of Cash Flows (Parent Company Only) Schedule V Note 1: Depreciation on property and equipment is determined by using the straight-line method based on estimated service and remaining lives. The composite depreciation rate for telephone property was 6.5% in 1993, 6.9% in 1992 and 6.7% in 1991. Schedule VI Schedule VIII Schedule IX Schedule X Schedule XI LINCOLN TELECOMMUNICATIONS COMPANY EMPLOYEE AND STOCKHOLDER DIVIDEND REINVESTMENT AND STOCK PURCHASE PLAN Notes to Financial Statements December 31, 1993, 1992 and 1991 (1) Statement of Purpose and Summary of Significant Accounting Policies The Lincoln Telecommunications Company Employee and Stockholder Dividend Reinvestment and Stock Purchase Plan (Plan) provides stockholders and eligible employees of Lincoln Telecommuni- cations Company (Company) and its subsidiaries with a convenient and economical way to invest cash dividends and optional cash contributions to purchase additional shares of common stock of the Company. Shares are offered for purchase to all stockholders and all regular full-time and regular part-time employees of the Company with not less than six months of service. Any individual who owns 5 percent or more of the total combined voting power of value of all classes of stock of the Company is not eligible to participate in the Plan. The Company paid, on January 6, 1994, a 100% stock dividend to stockholders of record on December 27, 1993. The accompanying financial statements have been prepared on an accrual basis and present the financial condition of the Plan and its revenues and common stock purchases. All assets are held for the purchase of common stock of the Company. Effective on June 15, 1993, Mellon Securities Trust Company became the transfer agent, registrar, rights agent and Plan administrator. Prior to that date, the Company was the transfer agent, registrar and Plan administrator and Harris Trust and Savings Bank was the rights agent. (2) Participation Stock for the Plan is purchased on the open market. The basis for the purchase price of the stock allocated to the Plan participants is the average price paid during the 5-day trading period preceding and including the dividend payment date. Employee purchases are at 95% of such price while purchases by non-employee participants are at 100% of such price. Participants in the Plan may use cash dividends declared on stock owned and optional cash contributions to purchase (Continued) LINCOLN TELECOMMUNICATIONS COMPANY EMPLOYEE AND STOCKHOLDER DIVIDEND REINVESTMENT AND STOCK PURCHASE PLAN Notes to Financial Statements (Cont'd) additional stock. Any contributions received by approximately eight days before the end of each calendar quarter will be used to purchase shares of stock as of the next dividend date. Shares purchased in the open market for the Plan aggregated 57,604, 60,636 and 51,171 during 1993, 1992 and 1991, respectively. At December 31, 1993, the agent for the Plan held 628,534 shares registered for participants. (3) Income Taxes No provision is made for income taxes relating to the operations of the Plan. Any income tax consequences of participation in the Plan are that of the participants. 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. LINCOLN TELECOMMUNICATIONS COMPANY EMPLOYEE AND STOCKHOLDER DIVIDEND REINVESTMENT AND STOCK PRUCHASE PLAN (Name of Plan) By /s/ Michael J. Tavlin Michael J. Tavlin Vice President-Treasurer Date March 16, 1994

1993 Item 1. Business Balcor Pension Investors-V (the "Registrant") is a limited partnership formed in 1983 under the laws of the State of Illinois. The Registrant raised $219,652,500 from sales of Limited Partnership Interests. The Registrant's operations currently consist of investment in wrap-around mortgage loans and first mortgage loans and, to a lesser extent, other junior mortgage loans. The Registrant is also currently operating eight properties acquired through foreclosure. All information included in this report relates to this industry segment. The Registrant originally funded a net of thirty-four loans. During 1993, two of these loans were prepaid in full, and prior to 1993, sixteen of these loans were prepaid in full, two were partially prepaid and one was partially prepaid and partially written-off. A portion of the Mortgage Reductions generated by the prepayments was reinvested by the Registrant in five mortgage loans and an additional funding on an existing loan, and a portion was distributed to Limited Partners. The remainder was added to the Registrant's working capital reserves. The Registrant acquired three properties through foreclosure during 1993 and six in prior years, one of which was subsequently sold. The Registrant also reclassified a loan as an investment in joint venture - affiliate in prior years. As of December 31, 1993, the Registrant has eleven loans in its investment portfolio, an investment in joint venture - affiliate and owns the eight properties described under Item 2. Item 2. Properties As of December 31, 1993, the Registrant owns the eight properties described below: Location Description of Property Dallas, Texas Comerica Plaza: two four-story office buildings containing approximately 113,000 square feet. Tampa, Florida Granada Apartments: a 110-unit apartment complex located on approximately 8 acres. Arlington, Texas Huntington Meadows: a 250-unit apartment complex located on approximately 11.4 acres. Alameda County, California International Teleport: a two-story office building containing approximately 120,000 square feet. Temple Terrace, Florida Plantation Apartments: a 126-unit apartment complex located on approximately 7.9 acres. Largo, Florida The Glades on Ulmerton: a 304-unit apartment complex located on approximately 18.3 acres. Lakewood, Colorado Union Tower: a fourteen-story office building containing approximately 196,000 square feet. Orlando, Florida Waldengreen Apartments: a 276-unit apartment complex located on approximately 15 acres. The Registrant also holds a minority joint venture interest in the Whispering Hills Apartments located in Overland Park, Kansas. In the opinion of the General Partner, the Registrant has provided for adequate insurance coverage for its real estate investment properties. See Notes to Financial Statements for other information regarding these properties. Item 3. Item 3. Legal Proceedings (a & b) Williams proposed class action In February 1990, a proposed class-action complaint was filed, Paul Williams and Beverly Kennedy, et al. vs. Balcor Pension Investors, et al., Case No.: 90- C-0726 (U. S. District Court, Northern District of Illinois) against the Registrant, the General Partner, The Balcor Company, Shearson Lehman Hutton, Inc., American Express Company, other affiliates, and seven affiliated limited partnerships (the "Related Partnerships") as defendants. Several parties have since been joined as additional named plaintiffs. The complaint alleges that the defendants violated Federal securities laws with regard to the adequacy and accuracy of disclosure of information in respect of the offering of limited partnership interests of the Registrant and the Related Partnerships and also alleges breach of fiduciary duty, fraud, negligence and violations under the Racketeer Influenced and Corrupt Organizations Act. The complaint seeks compensatory and punitive damages. The defendants filed their answer, affirmative defenses and a counterclaim to the complaint. The defendants' counterclaim asserts claims of fraud and breach of warranty against plaintiffs, as well as a request for declaratory relief regarding certain defendants' rights under their partnership agreements to be indemnified for their expenses incurred in defending the litigation. The defendants seek to recover damages to their reputations and business as well as costs and attorneys' fees in defending against the claims brought by plaintiffs. In May 1993, the Court issued an opinion and order denying the plaintiffs' motion for class certification based in part on the inadequacy of the individual plaintiffs representing the proposed class. Further, the Court granted defendants' motion for sanctions and ordered that plaintiffs' counsel pay the defendants' attorneys fees incurred with the class certification motion. The defendants have filed a petition for reimbursement of their fees and costs from plaintiffs' counsel, which remains pending. A motion filed by the plaintiffs is currently pending seeking to dismiss the defendants' counterclaim for fraud. In July 1993, the Court gave the plaintiffs leave to retain new counsel. In September 1993, the plaintiffs retained new counsel and filed a new amended complaint and motion for class certification which named three new class representatives. The defendants have conducted discovery with respect to the new representatives and, on February 16, 1994, filed a response to the plaintiffs' latest motion for class certification. The motion is expected to be briefed by March 30, 1994. The defendants intend to continue vigorously contesting this action. As of this time, no plaintiff class has been certified. Management of each of the defendants believes they have meritorious defenses to contest the claims. Whispering Hills Apartments Balcor Mortgage Advisors, Inc. ("BMA"), acting as nominee for the Registrant and an affiliate (together, the "Participants"), previously funded a $15,700,000 first mortgage loan (the "Loan") to three individuals (jointly, the "Borrower"), collateralized by a first mortgage on the Whispering Hills Apartments, Overland Park, Kansas. The Registrant funded $3,925,000 (25%) of the Loan. In March 1988, the Borrower filed suit against the entities from whom they bought the property (the "Seller"), alleging negligence, breach of warranty and fraudulent misrepresentation arising from construction defects at the property, and requesting either monetary damages or rescission of the Borrower's purchase of the property (the "Construction Case"). During May 1988, BMA intervened in the Construction Case and asserted claims for damages. In January 1992, the Court awarded BMA and the Borrower $4,586,844 and $3,897,522, respectively, but did not order rescission of the property. The Seller appealed the Court's decision and, additionally, in April 1992, the Seller and its general partner each filed for protection under Chapter 11 of the U.S. Bankruptcy Code in the U.S. Bankruptcy Court for the Eastern District of California, In re Catwil Corporation (Case No.: 92-91348) and In re Sixty-Ninth Street Associates (Case No.:92-91349) (together, the "Bankruptcy Case"). Due to these bankruptcy proceedings, the Participants have been unable to collect on the judgment and have filed a proof of claim in the Bankruptcy Case. In October 1989, two insurance carriers for the Seller filed a petition for declaratory judgment (the "Insurance Case") in the District Court of Johnson County, Kansas, Civil Court Department, Case No. 89-C-11370, Industrial Indemnity Insurance Company, et al. v. Catwil Corporation, et al., claiming no obligation to pay any portion of the judgment in the Construction Case. BMA and the Borrower intervened in this action and filed a motion for summary judgment against the insurance companies which was granted in part in February 1993. In December 1993, BMA and the Borrower reached a settlement with the insurance companies pursuant to which one of them will pay BMA and the Borrower a total of $1,000,000. As part of the settlement, the Participants and the Borrower have agreed to dismiss the Construction Case and withdraw their claims in the Bankruptcy Case. The settlement is subject to the approval of the Bankruptcy Court and is expected to be finalized during the second quarter of 1994. The entire $1,000,000 settlement will be paid to BMA, and applied to the outstanding amount due under the Loan. Additionally, in December 1991, BMA and the Borrower filed a suit against the Seller and additional related parties, in the Superior Court of California, San Joaquin County, Balcor Mortgage Advisors, Inc., et al. vs. Sixty Ninth Street Associates, et. al. Case No. 239584, alleging fraudulent transfers of assets and seeking $2,000,000 in compensatory damages, a return of the improperly transferred funds, punitive damages and costs. In November 1993, BMA and the Borrower entered into a settlement agreement with the defendants whereby the defendants paid BMA the sum of $125,000 in full satisfaction of BMA's claims against them, and the case was dismissed. This amount was applied to the amount due under the Loan. Villa Medici Apartments The Registrant previously funded a $10,850,000 loan ("Loan") to Wiston XXIV Limited Partnership (the "Borrower"), collateralized by a first mortgage on Villa Medici Apartments. In February 1991, the Loan was placed in default. In March 1991, the Borrower filed for protection under Chapter 11 of the U.S. Bankruptcy Code in the U.S. Bankruptcy Court for the District of Kansas, In re Wiston XXIV Limited Partnership (Case No.: 91-40410-11). The Registrant filed a motion to proceed with a foreclosure of the property, which was granted by the Bankruptcy Court. In October 1992, the Registrant commenced foreclosure proceedings against the Borrower in the District Court of Johnson County, Kansas, Balcor Pension Investors-V vs. Wiston XXIV Limited Partnership, et al., Case No. 92-C-11570, and a receiver was appointed by the court to manage the property. In April 1993, the Bankruptcy Court denied confirmation of the borrower's plan of reorganization and the borrower appealed. Subsequently, the Bankruptcy Court issued an order preventing the Registrant from proceeding with the foreclosure action while the appeal is pending. A ruling on the appeal is not expected until the latter half of 1994. Additionally, in November 1991, the Registrant filed an action against the general partners of the Borrower ("Principals"), for misappropriation of property funds, in the Circuit Court of Cook County, Illinois, Balcor Pension Investors-V v. Robert L. Thompson and Wiston Management, Inc., (Case No.: 91 L 18444). Pursuant to a court order, the Registrant received the amount initially sought and is now receiving net cash flow from the property on a current basis. The Registrant continues to review materials to determine whether all property funds are accounted for. Springwells Park Apartments In April 1985, the Registrant funded a $12,500,000 loan collateralized by a first mortgage on Springwells Park Apartments (the "Property"). Upon the partial repayment of the loan in 1990, the Registrant received three promissory notes evidencing the remaining balance of $3,300,000. In February 1993, one of the notes, in the amount of $2,300,000 which is collateralized by a second mortgage on the Property, was placed in default and, in May 1993, the Registrant commenced foreclosure proceedings in the Circuit Court of Wayne County, Michigan, Balcor Pension Investors-V vs. Springwells Properties Limited Partnership, et. al., Case No.: 93-313288CH, and filed a claim against the borrower and a principal of the borrower (the "Guarantor") to enforce a guarantee by the Guarantor. In May 1993, the borrower filed a counterclaim against the Registrant alleging lender liability claims and requesting unspecified damages. The terms of the Registrant's note require the consent of the new first mortgage holder prior to a foreclosure of the Property by the Registrant. The first mortgage holder would not grant its consent, and as a result, in July 1993, the Registrant withdrew its request for foreclosure and the appointment of a receiver. However, the complaint filed on the guarantee was not released and the Registrant continues to pursue the Guarantor under the $2,300,000 note. Proceedings on these matters continue and are in the discovery phase. The new first mortgage holder commenced non-judicial foreclosure proceedings in October 1993. On December 6, 1993, the borrower filed for protection under Chapter 11 of the U.S. Bankruptcy Code (In re Springwell Properties Limited Partnership, U.S. Bankruptcy Court for the Eastern District of Michigan, Case No.: 93-53186-G). The new first mortgage holder has filed a motion to lift the stay imposed by the bankruptcy court on the foreclosure proceedings. No hearing on this motion has been scheduled at this time. The remaining two notes held by the Registrant aggregate approximately $700,000. The Registrant commenced litigation in November 1992 against the Guarantor under these two notes, which are collateralized by a second mortgage on other real property owned by an affiliate of the borrower ("Affiliate") and which have been in default since 1990, to enforce a guarantee by the Guarantor (Balcor Pension Investors-V vs. Springwell Properties Limited Partnership and Anthony S. Brown, Circuit Court of Cook County, Case No.: 92-L-13994). This litigation is currently in the discovery phase. The Affiliate then filed for protection in March 1993, under Chapter 11 of the U.S. Bankruptcy Code (In re Aspen Hotel Partners Limited Partnership, U.S. Bankruptcy Court for the Eastern District of Michigan, Case No.: 93-42354). The Registrant has filed a proof of claim in this case. In February 1994, a plan of reorganization was confirmed by the court. The Registrant received $45,000 in February 1994, and is scheduled to receive $55,000 by May 1, 1994. Upon receipt of this payment, the Registrant will release the notes and its lien on this parcel of property. This settlement will have no impact, however, on the other cases described above. Item 4. Item 4. Submission of Matters to a Vote of Security Holders (a, b, c & d) No matters were submitted to a vote of the Limited Partners of the Registrant during 1993. PART II Item 5. Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters There has not been an established public market for Limited Partnership Interests and it is not anticipated that one will develop. For information regarding previous distributions, see Financial Statements, Statements of Partner's Capital and Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources. As of December 31, 1993, the number of record holders of Limited Partnership Interests of the Registrant was 41,645. Item 6. Item 6. Selected Financial Data Year ended December 31, 1993 1992 1991 1990 1989 Net interest income on loans receivable $10,736,753 $10,625,873 $10,505,134 $12,098,301 $13,490,294 Income from operations of real estate held for sale 1,845,385 1,815,619 2,928,056 1,587,139 1,565,534 Provision for po- tential losses on loans, real estate and accrued inter- est receivable 8,055,000 4,000,000 5,749,082 5,500,000 4,000,000 Interest on short- term investments 928,837 935,793 1,413,189 2,874,943 2,040,460 Administrative expenses 1,494,536 1,351,578 1,163,259 683,714 643,494 Net income 10,335,746 7,982,124 8,022,644 9,921,710 11,993,388 Net income per Limited Partner- ship Interest 21.17 16.35 16.44 20.33 24.57 Cash and cash equivalents 23,623,906 24,859,520 19,611,150 29,469,908 28,506,412 Net investment in loans receivable 38,952,112 53,961,219 75,462,395 97,371,771 124,405,045 Loans in substan- tive foreclosure 11,548,672 22,100,734 15,361,590 17,485,030 24,909,686 Real estate held for sale 41,430,697 37,121,109 42,699,025 35,024,205 20,541,371 Investment in joint venture - affiliate 3,222,981 3,222,705 2,964,048 2,213,075 1,794,646 Total assets 120,700,542 144,257,526 158,402,349 167,064,706 178,283,565 Distributions to Limited Partners 28,664,651 14,277,412 21,635,771 24,381,428 22,887,790 Distributions per Limited Partner- ship Interest 65.25 32.50 49.25 55.50 52.10 Number of loans 11 15 18 20 22 Properties owned 8 6 5 4 3 Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Balcor Pension Investors-V (the "Partnership") is a limited partnership formed in 1983 to invest in wrap-around mortgage loans and first mortgage loans and, to a lesser extent, other junior mortgage loans. The Partnership raised $219,652,500 from sales of Limited Partnership Interests and utilized these proceeds to fund a net of thirty-four loans. Currently, there are eleven loans outstanding in the Partnership's portfolio, and the Partnership is operating eight properties acquired through foreclosure and one investment in a joint venture with an affiliate. Operations Summary of Operations In March 1993, the borrower of the wrap-around mortgage collateralized by the Valley West Shopping Center prepaid the loan in full. In connection with this prepayment, the Partnership received additional interest and participation income of $7,910,750. As a result, net income increased during 1993 as compared to 1992. However, the provision for potential losses on loans and real estate increased during 1993 to provide for further declines in the fair value of certain properties in the Partnership's portfolio, which partially offset the increase in net income. During 1992, the provision for potential losses on loans, real estate and accrued interest receivable declined as compared to 1991. This was partially offset by a decrease in income from operations of real estate held for sale resulting primarily from the sale of the Northland Park Industrial building in January 1992, which had generated significant income from operations during 1991, and the acquisition of The Glades on Ulmerton apartment complex through foreclosure in December 1991, which was generating a significant deficit after debt service payments. Further discussion of the Partnership's operations is summarized below. 1993 Compared to 1992 Interest income on loans receivable decreased during 1993 as compared to 1992 as a result of a decrease in the total amount of loans outstanding, due to the foreclosure on the International Teleport office building in October 1992, and the prepayment of the Imperial Gardens loan in December 1992, the Valley West loan in March 1993 and the Lake Worth loan in April 1993. This was partially offset by additional interest income received as a result of the Valley West and Lake Worth loan prepayments. The Partnership also received significant participation income from the Valley West loan prepayment in 1993. Interest expense on loans payable decreased during 1993 as compared to 1992 due to the prepayment of the Valley West loan and the concurrent repayment of the underlying mortgage loan. The Partnership's four non-accrual loans at December 31, 1993 are collateralized by the 45 West 45th Street Office Building located in New York, New York; Fairview Plaza I and II Office Building located in Charlotte, North Carolina; Villa Medici Apartments located in Overland Park, Kansas; and Springwells Park Apartments located in Dearborn, Michigan. For non-accrual loans, income is recorded only as cash payments are received from the borrowers. The funds advanced by the Partnership for these non-accrual loans totaled approximately $23,830,000, representing approximately 12% of the original funds advanced. Certain of these non-accrual loans are collateralized by properties located in areas which are experiencing weak rental markets due to various factors, including adverse local economic conditions, which have resulted in declining rental and occupancy rates. The reduced cash flows from these properties have adversely affected the borrowers' abilities to make mortgage payments to the Partnership on a timely basis. During 1993, the Partnership received cash payments totaling approximately $1,771,000 of net interest income on these four loans. Under the terms of the original loan agreements, the Partnership would have received approximately $2,568,000 of net interest income during 1993. Of the loans on non-accrual status at December 31, 1993, those collateralized by the 45 West 45th Street Office Building, Springwells Park Apartments and Villa Medici Apartments are also classified in substantive foreclosure. Loans are classified in substantive foreclosure when a determination has been made that the borrower has little or no equity remaining in the collateral property in consideration of its current fair value, or the Partnership has taken certain actions which result in taking effective control of operations of the collateral property. Income from operations of real estate held for sale represents net property operations generated by the eight properties the Partnership has acquired through foreclosure. These eight properties comprise approximately 35% of the Partnership's portfolio based on original funds advanced. The increase in income generated in 1993 resulting from the foreclosures of the International Teleport office building in 1992 and the Plantation, Granada and Waldengreen apartment complexes in 1993, was substantially offset by higher property operating expenses due to the repair and renovation program at The Glades on Ulmerton apartment complex and by higher leasing activity at the Union Tower office building. The allowance for potential losses provides for potential loan losses and is based upon loan loss experience for similar loans and for the industry, upon prevailing economic conditions and the General Partner's analysis of specific loans in the Partnership's portfolio. While actual losses may vary from time to time because of changes in circumstances (such as occupancy rates, rental rates, and other economic factors), the General Partner believes that adequate recognition has been given to loss exposure in the portfolio at December 31, 1993. The Partnership recognized a provision for potential losses of $2,000,000 for its loans during 1993. In addition, in 1993 a provision of $6,055,000 was recognized related to the Partnership's real estate held for sale to provide for further declines in the fair value of certain properties in the Partnership's portfolio. As a result of the sale of the Northland Park Industrial building in January 1992, deferred expenses related to this property were fully amortized resulting in a decrease in amortization expense during 1993 as compared to 1992. Due to the loan foreclosures and prepayments during 1992 and 1993, the total amount of loans outstanding decreased, resulting in decreased mortgage servicing fees during 1993 as compared to 1992. Higher foreclosure related costs incurred during 1993 were the primary reason administrative expenses increased during 1993 as compared to 1992. 1992 Compared to 1991 Interest income on loans receivable decreased slightly during 1992 as compared to 1991. Decreased collections from certain of the loans currently on non-accrual status and decreased interest income as a result of the foreclosure of International Teleport in October 1992 were partially offset by the additional interest income received as a result of the prepayment on the Imperial Gardens loan in December 1992. The Partnership also received a prepayment premium in 1992 in connection with this loan. Interest expense on loans payable decreased primarily due to the reclassification of the interest expense related to The Glades on Ulmerton Apartments mortgage note payable to operations of real estate acquired through foreclosure beginning in December 1991. The Partnership's five non-accrual loans at December 31, 1992 were collateralized by the 45 West 45th Street and Fairview Plaza I and II office buildings and the Granada, Villa Medici and Waldengreen apartment complexes. The funds advanced by the Partnership for these non-accrual loans totaled approximately $30,425,000, representing approximately 16% of the original funds advanced. During the year ended December 31, 1992, the Partnership received cash payments totaling approximately $2,182,000 of net interest income on these five loans. Under the terms of the original loan agreements, the Partnership would have received approximately $3,724,000 of net interest income during the year ended December 31, 1992. Of the loans on non-accrual status at December 31, 1992, the loans collateralized by the 45 West 45th Street Office Building and the Granada, Villa Medici and Waldengreen apartment complexes were classified in substantive foreclosure. As a result of the sale of the Northland Park Industrial building in January 1992, which had generated significant income from operations during 1991, and the acquisition of The Glades on Ulmerton apartment complex through foreclosure in December 1991, which was generating a significant deficit after debt service payments, income from operations of real estate held for sale decreased during 1992 as compared to 1991. These decreases were partially offset by higher rental income at the Union Tower office building as a result of higher occupancy levels in 1992 as compared to 1991. In addition, the Partnership recognized a gain in 1992 in connection with the sale of the Northland Park Industrial building. Primarily as a result of lower interest rates during 1992, interest income on short-term investments decreased during 1992 as compared to 1991. The Partnership recognized a provision for potential losses of $4,000,000 for its loans and real estate during 1992. As a result of the sale of the Northland Park Industrial building in January 1992, deferred expenses related to this property were fully amortized resulting in an increase in amortization expense during 1992 as compared to 1991. As a result of higher legal expenses relating to the Partnership's loans in default and on non-accrual status, administrative expenses increased during 1992 as compared to 1991. Participation in income of joint venture - affiliate represents the Partnership's 25% share of the income of the Whispering Hills Apartments. The property was vacant during 1990 and early 1991 while repairs were being made to the property. Leasing commenced in February 1991, and as of December 31, 1992, the property's occupancy rate had increased to 99%. Property operations during 1992 generated income as compared to a slight loss in 1991. In addition, the provision for potential losses related to the property was higher in 1992. The increase in the provision for potential losses resulted in decreased net income during 1992 as compared to 1991 which decrease was partially offset by improved property operations during 1992. Liquidity and Capital Resources The Partnership's cash flow provided by operating activities during 1993 was generated by additional interest and participation income received from the Valley West Shopping Center and the Lake Worth Mobile Home Park loan prepayments, interest income received from the Partnership's loans receivable and short-term investments, and cash flow from the operation of the Partnership's properties held for sale. This cash flow was partially offset by the payment of administrative expenses and mortgage servicing fees. This cash flow, as well as cash received from investing activities generated primarily from the prepayment on the Valley West Shopping Center loan, was mostly utilized for financing activities consisting of distributions to Limited Partners and the General Partner, the prepayment of the underlying mortgage loans on the Valley West Shopping Center and Plantation Apartments, and the purchase of the underlying mortgage loan on Waldengreen Apartments prior to acquisition of the property through foreclosure. As of December 31, 1993, the Partnership had undistributed Mortgage Reductions of approximately $13,513,000, which have been retained while the Partnership determines its working capital needs. The Partnership's cash or near cash position also fluctuates during each quarter, initially decreasing with the payment of Partnership distributions for the previous quarter, and then gradually increasing each month in the quarter as mortgage payments and cash flow from property operations are received. The Partnership classifies the cash flow performance of its properties as either positive, a marginal deficit or a significant deficit, each after consideration of debt service payments unless otherwise indicated. A deficit is considered to be significant once it exceeds $250,000 annually or 20% of the property's rental and service income. Seven of the eight properties held by the Partnership at December 31, 1993, are generating positive cash flow, as compared to four of the five properties held by the Partnership at December 31, 1992. The Union Tower, Comerica Plaza and International Teleport office buildings and the Huntington Meadows, Plantation, Granada and Waldengreen apartment complexes have occupancy rates of 98%, 100%, 69%, 94%, 94%, 95% and 99% respectively, which, except for International Teleport which was foreclosed upon in October 1992, exceed the average occupancy rates in their respective markets. The average occupancy rate for office buildings in the Alameda, California area is approximately 81%. The General Partner's goals are to maintain high occupancy levels, while increasing rents where possible, and to monitor and control operating expenses and capital improvement requirements at the properties. The General Partner will also examine the terms of any mortgage loans collateralized by its properties, and may refinance or, in certain instances, use Partnership reserves to repay such loans. The General Partner is taking steps at the International Teleport office building to improve occupancy, which declined prior to the foreclosure by the Partnership due to the loss of several large tenants during 1992. The Glades on Ulmerton apartment complex, located in Largo, Florida, was acquired through foreclosure in December 1991 and generated a significant cash flow deficit after debt service payments during 1993 and 1992. The Partnership has completed a major repair and renovation program for the property aimed at arresting the deterioration of the property's value and improving the asset's performance. Approximately $1,172,000 and $458,000 was spent during 1993 and 1992, respectively, for non-recurring repair and maintenance expenditures which were completed during the fourth quarter of 1993. As of December 31, 1993, the property had an occupancy rate of 95% while the average occupancy rate for apartment complexes in the Largo, Florida area is 93%. Because of the current weak real estate markets in certain cities and regions of the country, attributable to local and regional market conditions such as overbuilding and recessions in local economies and specific industry segments, certain borrowers have requested that the Partnership allow prepayment of mortgage loans. The Partnership has allowed some of these borrowers to prepay such loans, in some cases without assessing prepayment premiums, under circumstances where the General Partner believed that refusing to allow such prepayment would ultimately prove detrimental to the Partnership in light of the probable inability of the properties to generate sufficient revenues to keep loan payments current. In other cases, borrowers have requested prepayment in order to take advantage of lower available interest rates. In these cases, the General Partner evaluates the request for prepayment along with the market conditions on a case by case basis, and in some cases the Partnership collects substantial prepayment premiums. In addition, certain borrowers have failed to make payments when due to the Partnership for more than ninety days and, accordingly, these loans have been placed on non-accrual status (income is recorded only as cash payments are received). The General Partner has negotiated with some of these borrowers regarding modifications of the loan terms and has instituted foreclosure proceedings under certain circumstances. Such foreclosure proceedings may be delayed by factors beyond the General Partner's control such as bankruptcy filings by borrowers and state law procedures regarding foreclosures. Further, certain loans made by the Partnership have been restructured to defer and/or reduce interest payments where the properties collateralizing the loans were generating insufficient cash flow to support property operations and debt service. In the case of most loan restructurings, the Partnership receives concessions, such as increased participations or additional interest accruals, in return for modifications, such as deferral or reduction of basic interest payments. There can be no assurance, however, that the Partnership will receive actual benefits from the concessions. In March 1993, the Partnership made a successful bid for the Plantation Apartments at a foreclosure sale, and, in April 1993, received title to the property. As part of this transaction, the Partnership assumed the underlying mortgage note, and repaid this loan in full in August 1993. In addition, in June 1993, the Partnership made a successful bid for the Granada Apartments at a foreclosure sale and received title to the property. The underlying mortgage note of $9,220 was repaid in June 1993. Also, in September 1993, the Partnership made a successful bid for the Waldengreen Apartments at a foreclosure sale and received title to the property. See Note 7 of Notes to Financial Statements for additional information on all of these properties. In July 1993, the Partnership purchased the first mortgage loan collateralized by the Waldengreen Apartments, leaving the Partnership with a senior lien on the property. The purchase price was $2,269,702, comprised of the principal ($2,000,000) and accrued interest ($344,576) less the balance of the tax escrow held by the lender ($74,874). In March 1993, the borrower of the wrap-around mortgage collateralized by Valley West Shopping Center located in West Des Moines, Iowa prepaid the loan in full in the amount of $21,834,548, comprised of the funds advanced on the loan ($10,472,551), accrued and unpaid interest thereon ($34,032), additional interest ($1,710,750), the amount representing the difference between the funds advanced by the Partnership and the outstanding principal balance due on the underlying loan ($3,417,215) and participation in the appreciation of the property ($6,200,000). The funds advanced by the Partnership represented the difference between the wrap-around loan receivable of $36,000,000 and the original balance of the underlying mortgage note payable of $25,527,449. The underlying mortgage note payable which had a current balance of $22,110,234 was also prepaid. In April 1993, the Partnership received $3,150,000 from the borrower on the Lake Worth Mobile Home Park loan as settlement in full on amounts owed to the Partnership. In September 1989, the borrower had prepaid the original principal balance of the loan and a portion of the accrual interest. The Partnership also received a $5,000,000 second mortgage note from the borrower which represented additional accrual interest and prepayment premiums due at the prepayment date. The Partnership had previously recorded $1,000,000 of this note in the financial statements which represented the balance of accrual interest recognized prior to the date of the prepayment. In December 1993, the Partnership purchased a 4.75 acre unimproved parcel of land adjacent to Granada Apartments in Tampa, Florida from unaffiliated parties for a purchase price of $52,873. The General Partner believes this parcel will enhance the sale potential of Granada Apartments. In February 1994, the Seven Trails West Apartments loan matured and was placed in default when the borrower failed to repay the loan. The General Partner is negotiating a two year extension of this loan on substantially the same terms as the previously modified loan. In addition, during February 1994, the Partnership prepaid the underlying mortgage on The Glades on Ulmerton Apartments. The loan collateralized by the Villa Medici apartment complex was placed in default by the Partnership in 1991. The borrower subsequently filed for protection under the U.S. Bankruptcy Code. In addition, in April 1993, the Partnership accelerated the second mortgage loan collateralized by the Springwells Park Apartments. During December 1993, the borrower filed for protection under the U.S. Bankruptcy Code. See Item 3. Legal Proceedings for additional information. The Partnership and three affiliated partnerships (together, the "Participants"), previously funded a $23,000,000 loan to 45 West 45th Street Office Building, New York, New York (the "Property"), of which the Partnership's share is $5,000,000 (approximately 22%). In September 1991, the loan was placed in default. Pursuant to a cash management agreement entered into between the Participants and the borrower, cash flow from property operations is received by the Participants and recognized as interest income. In May 1993, the Participants cashed a letter of credit which provided partial collateral for the loan, of which the Partnership's share was approximately $105,000. The Participants intend to file foreclosure proceedings during 1994. The loan collateralized by the Noland Fashion Square shopping center located in Independence, Missouri, is recorded by the Partnership as an investment in an acquisition loan. The Partnership has recorded its share of the collateral property's operations as equity in loss from investment in acquisition loan. The Partnership's share of operations has no effect on the cash flow of the Partnership. Amounts representing contractually required debt service are recorded as interest income. Distributions to Limited Partners can be expected to fluctuate for various reasons. Generally, distributions are made from Cash Flow generated by interest and other payments made by borrowers under the Partnership's mortgage loans and by the operations of the Partnership's properties. Loan prepayments and repayments can initially cause Cash Flow to increase as prepayment premiums and participations are paid; however, thereafter, prepayments and repayments will have the effect of reducing Cash Flow. If such proceeds are distributed, Limited Partners will receive a return of capital and the dollar amount of Cash Flow available for distribution thereafter can be expected to decrease. Distribution levels can also vary as loans are placed on non-accrual status, modified or restructured and, if the Partnership has taken title to properties through foreclosure or otherwise, as a result of property operations. The Partnership made distributions totaling $65.25 per Interest during 1993 as compared to $32.50 per Interest during 1992 and $49.25 per Interest in 1991. See Statements of Partners' Capital. Distributions were comprised of $42.00 of Cash Flow and $23.25 of Mortgage Reductions in 1993, $30.00 of Cash Flow and $2.50 of Mortgage Reductions in 1992 and $24.75 of Cash Flow and $24.50 of Mortgage Reductions in 1991. Cash Flow distributions increased in 1993 as compared to 1992 and 1991 due to two loan prepayments in 1993 and one loan prepayment and one property sale in 1992. Total distributions increased between 1993 and 1992 and decreased between 1992 and 1991 due to the distribution to Limited Partners of the Mortgage Reductions received from loan prepayments and the property sale. To date, including the distribution in January 1994, Limited Partners have received cumulative cash distributions of $438.60 per $500 Interest. Of this amount, $333.25 has been cash flow from operations and $105.35 represents a return of original capital. In January 1994, the Partnership made a distribution of $3,953,745 ($9.00 per Interest) to the holders of Limited Partnership Interests for the fourth quarter of 1993. This distribution includes a regular quarterly distribution of $4.00 per Interest from Cash Flow and a special distribution of $5.00 per Interest from Cash Flow. The level of the regular quarterly distribution remained the same as the third quarter of 1993. In addition, during October 1993, the Partnership paid $146,435 to the General Partner as its distributive share of the Cash Flow distributed for the third quarter of 1993 and made a contribution of $48,812 to the Early Investment Incentive Fund. The General Partner presently expects to continue making cash distributions from the Cash Flow generated from property operations and by the receipt of mortgage payments, less payments on the underlying loans, fees to the General Partner and administrative expenses. The General Partner believes it has retained, on behalf of the Partnership, an appropriate amount of working capital to meet current cash or liquidity requirements which may occur. In 1993, the Financial Accounting Standards Board issued Statement No. 114, "Accounting by Creditors for Impairment of a Loan." This statement addresses accounting by creditors for impairment of loans and also eliminates the classification of loans as "in substantive foreclosure." This statement has been adopted by the Partnership as of January 1, 1994, and will not have a material impact on the financial position or results of operations of the Partnership. Inflation has several types of potentially conflicting impacts on real estate investments. Short-term inflation can increase real estate operating costs which may or may not be recovered through increased rents and/or sales prices, depending on general or local economic conditions. In the long-term, inflation can be expected to increase operating costs and replacement costs and may lead to increased rental revenues and real estate values. The Partnership's use of participations for loans receivable is intended to provide a hedge against the impact of inflation; sharing in cash flow or rental income and/or the capital appreciation of the properties securing the loans should result in increases in the total yields on the loans as inflation rises. Item 8. Item 8. Financial Statements and Supplementary Data See Index to Financial Statements and Financial Statement Schedules in this Form 10-K. The supplemental financial information specified by Item 302 of Regulation S-K is not applicable. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure There have been no changes in or disagreements with accountants on any matter of accounting principles, practices or financial statement disclosure. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant (a) Neither the Registrant nor Balcor Mortgage Advisors-V, its General Partner, has a Board of Directors. (b, c & e) The names, ages and business experience of the executive officers and significant employees of the General Partner of the Registrant are as follows: Name Title Marvin H. Chudnoff Chairman Thomas E. Meador President and Chief Operating Officer Allan Wood Executive Vice President, Chief Financial Officer and Chief Accounting Officer Alexander J. Darragh Senior Vice President Robert H. Lutz, Jr. Senior Vice President Michael J. O'Hanlon Senior Vice President Gino A. Barra First Vice President Daniel A. Duhig First Vice President David S. Glasner First Vice President Josette V. Goldberg First Vice President G. Dennis Hartsough First Vice President Lawrence B. Klowden First Vice President Alan G. Lieberman First Vice President Lloyd E. O'Brien First Vice President Brian D. Parker First Vice President John K. Powell, Jr. First Vice President Jeffrey D. Rahn First Vice President Reid A. Reynolds First Vice President Marvin H. Chudnoff (April 1941) joined Balcor in March 1990 as Chairman. He has responsibility for all strategic planning and implementation for Balcor, including management of all real estate projects in place and financing and sales for a varied national portfolio valued in excess of $6.5 billion. Mr. Chudnoff also holds the position of Vice Chairman of Edward S. Gordon Company Incorporated, New York, a major national commercial real estate firm, which he joined in 1983. He has also served on the Board of Directors of Skippers, Inc. and Acorn Inc., both publicly held companies, and of Waxman Laboratories of Mt. Sinai Hospital, New York. Mr. Chudnoff has been a guest lecturer at the Association of the New York Bar and at Yale and Columbia Universities. Thomas E. Meador (July 1947) joined Balcor in July 1979. He is President and Chief Operating Officer and has responsibility for all ongoing day-to-day activities at Balcor. He is a Director of The Balcor Company. Prior to joining Balcor, Mr. Meador was employed at the Harris Trust and Savings Bank in the commercial real estate division where he was involved in various lending activities. Mr. Meador received his M.B.A. degree from the Indiana University Graduate School of Business. Allan Wood (January 1949) joined Balcor in August 1983 and, as Balcor's Chief Financial Officer and Chief Accounting Officer, is responsible for all financial and administrative functions. He is directly responsible for all accounting, treasury, data processing, legal, risk management, tax and financial reporting activities. He is also a Director of The Balcor Company. Mr. Wood is a Certified Public Accountant. Prior to joining Balcor, he was employed by Price Waterhouse where he was involved in auditing public and private companies. Alexander J. Darragh (February 1955) joined Balcor in September 1988 and has primary responsibility for the Portfolio Advisory Group. He is responsible for due diligence analysis in support of asset management, institutional advisory and capital markets functions as well as for Balcor Consulting Group, Inc., which provides real estate advisory services to Balcor affiliated entities and third party clients. In addition, Mr. Darragh has supervisory responsibility of Balcor's Investor Services Department. Mr. Darragh received masters degrees in Urban Geography from Queens University and in Urban Planning from Northwestern University. Robert H. Lutz, Jr. (September 1949) joined Balcor in October 1991. He is President of Allegiance Realty Group, Inc., formerly known as Balcor Property Management, Inc. and, as such, has primary responsibility for all its management and operations. He is also a Director of The Balcor Company. From March 1991 until he joined Balcor, Mr. Lutz was Executive Vice President of Cousins Properties Incorporated. From March 1986 until January 1991, he was President and Chief Operating Officer of The Landmarks Group, a real estate development and management firm. Mr. Lutz received his M.B.A. from Georgia State University. Michael J. O'Hanlon (April 1951) joined Balcor in February 1992 as Senior Vice President in charge of Asset Management, Investment/Portfolio Management, Transaction Management and the Capital Markets Group which includes sales and refinances. From January 1989 until joining Balcor, Mr. O'Hanlon held executive positions at Citicorp in New York and Dallas, including Senior Credit Officer and Regional Director. He holds a B.S. degree in Accounting from Fordham University, and an M.B.A. in Finance from Columbia University. He is a full member of the Urban Land Institute. Gino A. Barra (December 1954) joined Balcor's Property Sales Group in September 1983. He is First Vice President of Balcor and assists with the supervision of Balcor's Asset Management Group, Transaction Management, Quality Control and Special Projects. Daniel A. Duhig (October 1956) joined Balcor in November 1986 and is responsible for various asset management matters relating to investments made by Balcor and its affiliated partnerships, including negotiations for modifications or refinancings of real estate mortgage investments and the disposition of real estate investments. David S. Glasner (December 1955) joined Balcor in September 1986 and has primary responsibility for special projects relating to investments made by Balcor and its affiliated partnerships and risk management functions. Mr. Glasner received his J.D. degree from DePaul University College of Law in June 1984. Josette V. Goldberg (April 1957) joined Balcor in January 1985 and has primary responsibility for all human resources matters relating to Balcor personnel, including training and development, employment, salary and benefit administration, corporate communications and the development, implementation and interpretation of personnel policy and procedures. Ms. Goldberg also supervises Balcor's payroll operations and Human Resources Information Systems (HRIS). In addition, she has supervisory responsibility for Balcor's Facilities, Corporate and Field Services and Telecommunications Departments. Ms. Goldberg has been designated as a Senior Human Resources Professional (SHRP). G. Dennis Hartsough (October 1942) joined Balcor in July 1991 and is responsible for asset management matters relating to all investments made by Balcor and its affiliated partnerships in office and industrial properties. From July 1989 until joining Balcor, Mr. Hartsough was Senior Vice President of First Office Management (Equity Group) where he directed the firm's property management operations in eastern and central United States. From June 1985 to July 1989, he was Vice President of the Angeles Corp., a real estate management firm, where his primary responsibility was that of overseeing the company's property management operations in eastern and central United States. Lawrence B. Klowden (March 1952) joined Balcor in November 1981 and is responsible for supervising the administration of the investment portfolios of Balcor and its loan and equity partnerships. Mr. Klowden is a Certified Public Accountant and received his M.B.A. degree from DePaul University's Graduate School of Business. Alan G. Lieberman (June 1959) joined Balcor in May 1983 and is responsible for the Property Sales and Capital Markets Groups. Mr. Lieberman is a Certified Public Accountant. Lloyd E. O'Brien (December 1945) joined Balcor in April 1987 and has responsibility for the operations and development of Balcor's Information and Communication systems. Mr. O'Brien received his M.B.A. degree from the University of Chicago in 1984. Brian D. Parker (June 1951) joined Balcor in March 1986 and is responsible for Balcor's corporate and property accounting, treasury, budget activities and corporate purchasing. Mr. Parker is a Certified Public Accountant and holds an M.S. degree in Accountancy from DePaul University and an M.A. degree in Social Service Administration from the University of Illinois. John K. Powell, Jr. (June 1950) joined Balcor in September 1985 and is responsible for Balcor Consulting Group, Inc. which provides real estate advisory services to Balcor affiliated entities and third party clients. Mr. Powell received a Master of Planning degree from the University of Virginia. Jeffrey D. Rahn (June 1954) joined Balcor in February 1983 and has primary responsibility for Balcor's Asset Management Department. He is responsible for the supervision of asset management matters relating to equity and loan investments held by Balcor and its affiliated partnerships. Mr. Rahn received his M.B.A. degree from DePaul University's Graduate School of Business. Reid A. Reynolds (April 1950) joined Balcor in March 1981 and is involved with the asset management of residential properties for Balcor. Mr. Reynolds is a licensed Real Estate Broker in the State of Illinois. (d) There is no family relationship between any of the foregoing officers. (f) None of the foregoing officers or employees are currently involved in any material legal proceedings nor were any such proceedings terminated during the fourth quarter of 1993. Item 11. Item 11. Executive Compensation (a, b, c, d & e) The Registrant has not paid and does not propose to pay any compensation, retirement or other termination of employment benefits to any of the five most highly compensated executive officers of the General Partner. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management (a) No person owns of record or is known by the Registrant to own beneficially more than 5% of the outstanding Limited Partnership Interests of the Registrant. (b) Balcor Mortgage Advisors-V and its officers and partners own as a group through the Early Investment Incentive Fund and otherwise the following Limited Partnership Interests of the Registrant: Amount Beneficially Title of Class Owned Percent of Class Limited Partnership 15,332 Interests 3.49% Interests Relatives and affiliates of the officers and partners of the General Partner do not own any additional Interests. (c) The Registrant is not aware of any arrangements, the operation of which may result in a change of control of the Registrant. Item 13. Item 13. Certain Relationships and Related Transactions (a & b) See Note 9 of Notes to Financial Statements for information relating to transactions with affiliates. See Note 2 of Notes to Financial Statements for information relating to the Partnership Agreement and the allocation of distributions and profits and losses. (c) No management person is indebted to the Registrant. (d) The Registrant has no outstanding agreements with any promoters. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) (1 & 2) See Index to Financial Statements and Financial Statement Schedules in this Form 10-K. (3) Exhibits: (3) The Amended and Restated Agreement of Limited Partnership and Amended and Restated Certificate of Limited Partnership of Balcor Pension Investors-V previously filed as Exhibit 3 and 4.1, respectively, to Amendment No. 1 dated January 16, 1984 to the Registrant's Registration Statement on Form S-11 (Registration No. 2-87662) are incorporated herein by reference. (4) Form of Confirmation regarding Interests in the Registrant set forth as Exhibit 4.2 to the Registrant's Report on Form 10-Q for the quarter ended June 30, 1992 (Commission File No. 0-13233) is incorporated herein by reference. (b) Reports on Form 8-K: No reports were filed on Form 8-K during the quarter ended December 31, 1993. (c) Exhibits: See Item 14(a)(3) above. (d) Financial Statement Schedules: See Index to Financial Statements and Financial Statement Schedules in this Form 10-K. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of l934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. BALCOR PENSION INVESTORS-V By: /s/ Allan Wood Allan Wood Executive Vice President, and Chief Accounting and Financial Officer (Principal Accounting and Financial Officer) of Balcor Mortgage Advisors-V, the General Partner Date: March 30, 1994 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 dates indicated. Signature Title Date President and Chief Executive Officer (Principal Executive Officer) of Balcor Mortgage /s/ Thomas E. Meador Advisors-V, the General Partner March 30, 1994 Thomas E. Meador Executive Vice President, and Chief Accounting and Financial Officer (Principal Accounting and Financial Officer) of Balcor Mortgage /s/ Allan Wood Advisors-V, the General Partner March 30, 1994 Allan Wood INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES Report of Independent Auditors Financial Statements: Balance Sheets, December 31, 1993 and 1992 Statements of Partners' Capital, for the years ended December 31, 1993, 1992 and 1991 Statements of Income and Expenses, for the years ended December 31, 1993, 1992 and 1991 Statements of Cash Flows, for the years ended December 31, 1993, 1992 and 1991 Notes to Financial Statements Schedules: I - Marketable Securities - Other Investments, as of December 31, 1993 X - Supplementary Income Statement Information, for the years ended December 31, 1993, 1992 and 1991 Schedules, other than those listed, are omitted for the reason that they are inapplicable or equivalent information has been included elsewhere herein. REPORT OF INDEPENDENT AUDITORS To the Partners of Balcor Pension Investors-V We have audited the accompanying balance sheets of Balcor Pension Investors-V (An Illinois Limited Partnership) as of December 31, 1993 and 1992, and the related statements of partners' capital, income and expenses and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements and schedules 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 financial statements referred to above present fairly, in all material respects, the financial position of Balcor Pension Investors-V at December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. /s/ Ernst & Young Ernst & Young Chicago, Illinois March 17, 1994 BALCOR PENSION INVESTORS-V (An Illinois Limited Partnership) BALANCE SHEETS December 31, 1993 and 1992 ASSETS 1993 1992 ------------- ------------- Cash and cash equivalents $ 23,623,906 $ 24,859,520 Escrow deposits - restricted 379,685 122,381 Accounts and accrued interest receivable 1,285,486 2,723,712 Deferred expenses, net of accumulated amortization of $172,787 in 1993 and $137,053 in 1992 257,003 146,146 ------------- ------------- 25,546,080 27,851,759 ------------- ------------- Investment in loans receivable: Loans receivable - wrap-around and first mortgages 45,482,975 83,770,927 Investment in acquisition loan 8,587,042 8,664,085 Less: Loans payable - underlying mortgages 9,160,291 32,082,793 Allowance for potential loan losses 5,957,614 6,391,000 ------------- ------------- Net investment in loans receivable 38,952,112 53,961,219 Loans in substantive foreclosure (net of allowance of $1,200,000 in 1993) 11,548,672 22,100,734 Real estate held for sale (net of allowance of $6,055,000 in 1993) 41,430,697 37,121,109 Investment in joint venture - affiliate 3,222,981 3,222,705 ------------- ------------- 95,154,462 116,405,767 ------------- ------------- $120,700,542 $144,257,526 ============= ============= LIABILITIES AND PARTNERS' CAPITAL Accounts and accrued interest payable $ 266,687 $ 219,349 Due to affiliates 136,721 89,601 Other liabilities, principally escrow deposits and accrued real estate taxes 927,341 658,933 Security deposits 290,169 236,327 Mortgage notes payable 2,245,353 5,840,049 ------------- ------------- Total liabilities 3,866,271 7,044,259 Partners' capital (439,305 Limited Partnership Interests issued and outstanding) 116,834,271 137,213,267 ------------- ------------- $120,700,542 $144,257,526 ============= ============= The accompanying notes are an integral part of the financial statements. BALCOR PENSION INVESTORS-V (An Illinois Limited Partnership) STATEMENTS OF PARTNERS' CAPITAL for the years ended December 31, 1993, 1992 and 1991 Partners' Capital Accounts ----------------------------------------- General Limited Total Partner Partners ------------- ------------- ------------- Balance at December 31, 1990 $159,794,121 $ (1,430,612) $161,224,733 Cash distributions (A) (22,843,860) (1,208,089) (21,635,771) Net income for the year ended December 31, 1991 8,022,644 802,264 7,220,380 ------------- ------------- ------------- Balance at December 31, 1991 144,972,905 (1,836,437) 146,809,342 Cash distributions (A) (15,741,762) (1,464,350) (14,277,412) Net income for the year ended December 31, 1992 7,982,124 798,212 7,183,912 ------------- ------------- ------------- Balance at December 31, 1992 137,213,267 (2,502,575) 139,715,842 Cash distributions (A) (30,714,742) (2,050,091) (28,664,651) Net income for the year ended December 31, 1993 10,335,746 1,033,575 9,302,171 ------------- ------------- ------------- Balance at December 31, 1993 $116,834,271 $ (3,519,091) $120,353,362 ============= ============= ============= (A) Summary of cash distributions paid per Limited Partnership Interest: 1993 1992 1991 ------------- ------------- ------------- First quarter $ 6.25 $ 6.25 $ 11.00 Second quarter 46.00 11.25 10.75 Third quarter 9.00 8.75 21.25 Fourth quarter 4.00 6.25 6.25 The accompanying notes are an integral part of the financial statements. BALCOR PENSION INVESTORS-V (An Illinois Limited Partnership) STATEMENTS OF INCOME AND EXPENSES for the years ended December 31, 1993, 1992 and 1991 1993 1992 1991 ------------- ------------- ------------- Income: Interest on loans receivable, loans in substantive foreclosure and from investment in acquisition loans $ 12,035,758 $ 13,990,146 $ 14,221,182 Less interest on loans payable - underlying mortgages 1,299,005 3,364,273 3,716,048 ------------- ------------- ------------- Net interest income on loans receivable 10,736,753 10,625,873 10,505,134 Income from operations of real estate held for sale 1,845,385 1,815,619 2,928,056 Interest on short-term investments 928,837 935,793 1,413,189 Participation income 6,277,197 48,224 Participation in income of joint venture - affiliate 358,755 368,723 471,015 ------------- ------------- ------------- Total income 20,146,927 13,794,232 15,317,394 ------------- ------------- ------------- Expenses: Provision for potential losses on loans, real estate and accrued interest receivable 8,055,000 4,000,000 5,749,082 Amortization of deferred expenses 35,734 95,646 48,391 Mortgage servicing fees 148,867 218,359 241,228 Administrative 1,494,536 1,351,578 1,163,259 ------------- ------------- ------------- Total expenses 9,734,137 5,665,583 7,201,960 ------------- ------------- ------------- Income before equity in loss from investment in acquisition loans 10,412,790 8,128,649 8,115,434 Equity in loss from investment in acquisition loans (77,044) (146,525) (92,790) ------------- ------------- ------------- Net income $ 10,335,746 $ 7,982,124 $ 8,022,644 ============= ============= ============= Net income allocated to General Partner $ 1,033,575 $ 798,212 $ 802,264 ============= ============= ============= Net income allocated to Limited Partners $ 9,302,171 $ 7,183,912 $ 7,220,380 ============= ============= ============= Net income per Limited Partnership Interest (439,305 issued and outstanding) $ 21.17 $ 16.35 $ 16.44 ============= ============= ============= The accompanying notes are an integral part of the financial statements. BALCOR PENSION INVESTORS-V (An Illinois Limited Partnership) STATEMENTS OF CASH FLOWS for the years ended December 31, 1993, 1992 and 1991 1993 1992 1991 ------------- ------------- ------------- Operating activities: Net income $ 10,335,746 $ 7,982,124 $ 8,022,644 Adjustments to reconcile net income to net cash provided by operating activities: Equity in loss from investment in acquisition loans 77,044 146,525 92,790 Participation in income of joint venture - affiliate (358,755) (368,723) (471,015) Provision for potential losses on loans, real estate and accrued interest receivable 8,055,000 4,000,000 5,749,082 Amortization of deferred expenses 35,734 95,646 48,391 Accrued interest income due at maturity (837,826) (737,769) (744,530) Collection of interest income due at maturity 616,266 581,287 Net change in: Escrow deposits - restricted (257,304) 411,475 575,142 Accounts and accrued interest receivable 1,438,226 (1,408,076) 58,073 Accounts and accrued interest payable 47,338 (2,145,149) 2,194,868 Due to affiliates 47,120 3,346 8,045 Other liabilities 268,408 (500,726) (68,471) Security deposits 53,842 73,378 97,509 ------------- ------------- ------------- Net cash provided by operating activities 19,520,839 8,133,338 15,562,528 ------------- ------------- ------------- Investing activities: Capital contributions to joint venture - affiliate (5,625) (56,689) (279,958) Distributions from joint venture - affiliate 364,104 166,755 Collection of principal payments on loans receivable and loans in substantive foreclosure 37,341,491 6,213,222 136,141 Additions to real estate (733,315) (390,320) (874,354) Payment of expenses on real estate held for sale (344,577) (108,561) (148,721) Proceeds from sale of real estate 15,075,828 ------------- ------------- ------------- Net cash provided by or used in investing activities 36,622,078 20,900,235 (1,166,892) ------------- ------------- ------------- Financing activities: Distributions to Limited Partners (28,664,651) (14,277,412) (21,635,771) Distributions to General Partner (2,050,091) (1,464,350) (1,208,089) Principal payments on loans payable - underlying mortgages (812,268) (2,731,218) (1,180,984) Repayment of loans payable - underlying mortgages (22,110,234) Principal payments on mortgage notes payable (99,776) (123,664) (229,550) Repayment of mortgage notes payable (3,494,920) (5,088,361) Payment of deferred expenses (146,591) (100,198) ------------- ------------- ------------- Net cash used in financing activities (57,378,531) (23,785,203) (24,254,394) ------------- ------------- ------------- Net change in cash and cash equivalents (1,235,614) 5,248,370 (9,858,758) Cash and cash equivalents at beginning of period 24,859,520 19,611,150 29,469,908 ------------- ------------- ------------- Cash and cash equivalents at end of period $ 23,623,906 $ 24,859,520 $ 19,611,150 ============= ============= ============= The accompanying notes are an integral part of the financial statements. BALCOR PENSION INVESTORS-V (An Illinois Limited Partnership) NOTES TO FINANCIAL STATEMENTS 1. Accounting Policies: (a) The Partnership records wrap-around mortgage loans at the face amount of the mortgage instrument which includes the outstanding indebtedness of the borrower under the terms of the underlying mortgage obligation(s). The underlying mortgage obligation(s) are recorded as a reduction of the wrap-around mortgage loan and the resulting balance represents the Partnership's net advance to the borrower. The Partnership is responsible for making periodic payments to the underlying mortgage lender(s) only to the extent that payments as required by the wrap-around mortgage agreement are received by the Partnership from the borrower. (b) Net interest income on the Partnership's wrap-around mortgage loans is primarily comprised of the difference between the interest portion of the monthly payment received from the borrower and the interest portion of the underlying debt service paid to the mortgage lender(s). This interest is recorded in the period that it is earned as determined by the terms of the mortgage loan agreements. Certain mortgage loans also contain provisions for specific amounts of interest to accrue on a periodic basis and to be paid to the Partnership upon maturity of the loans. Interest of this type is recognized only to the extent of the net present value of the total amount due to date. The accrual of interest is discontinued when payments become contractually delinquent for ninety days or more unless the loan is in process of collection. Once a loan has been placed on non-accrual status, income is recorded only as cash payments are received from the borrower until such time as the borrower has demonstrated an ability to make payments under the terms of the original or renegotiated loan agreement. (c) The Partnership provides for potential loan losses based upon past loss experience for similar loans and prevailing economic conditions in the geographic area in which the collateral is located, delinquencies with respect to repayment terms and the valuation of specific loans in the Partnership's portfolio. (d) Under certain circumstances, the Partnership may accept promissory notes in satisfaction of a borrower's obligations for certain fees upon prepayment of a loan as required by the loan agreement. These fees include, among other things, prepayment penalties and participations in the borrower's appreciation in the collateral property. The Partnership's policy is to record such income on a cash basis as payments required under the terms of the promissory notes are received. (e) Deferred expenses consist of mortgage brokerage fees which are amortized on a straight-line basis over the term to maturity of the loans and leasing commissions which are amortized on a straight-line basis over the average term of the leases to which they apply. (f) Loans are classified in substantive foreclosure when a determination has been made that the borrower has little or no equity remaining in the collateral property in consideration of its current fair value, or the Partnership has taken certain actions which result in taking effective control of operations of the collateral property. These loans are on non-accrual status; therefore, income is recorded only as cash payments are received from the borrower. (g) Investment in acquisition loans represents first mortgage loans which, because the loan agreements include certain specified terms, must be accounted for as an investment in a real estate venture. The investment is therefore reflected in the accompanying financial statements using the equity method of accounting. Under this method, the Partnership records its investment at cost (representing total loan fundings) and subsequently adjusts its investment for its share of property income or loss. Amounts representing contractually required debt service are recorded in the accompanying statements of income and expenses as interest income and participation income. Equity from investment in acquisition loan represents the Partnership's share of the collateral properties' operations, including depreciation and interest expense. The Partnership's share of operations has no effect on cash flow of the Partnership. (h) Real estate held for sale and loans in substantive foreclosure are recorded at the lower of fair value less estimated costs to sell, or cost at the foreclosure date or substantive foreclosure date, respectively. Any future declines in fair value will be charged to income and recognized as a valuation allowance, while subsequent increases in value will reduce the valuation allowance, but not below zero. (i) In 1993, the Financial Accounting Standards Board issued Statement No. 114, "Accounting by Creditors for Impairment of a Loan." This statement addresses accounting by creditors for impairment of loans and also eliminates the classification of loans as "in substantive foreclosure." This statement has been adopted by the Partnership as of January 1, 1994, and will not have a material impact on the financial position or results of operations of the Partnership. (j) Investment in joint venture - affiliate represents the Partnership's 25% interest, under the equity method of accounting, in a joint venture with an affiliated partnership. Under the equity method of accounting, the Partnership records its initial investment at cost and adjusts its investment account for additional capital contributions, distributions and its share of joint venture income or loss. (k) Cash equivalents include all highly liquid investments with a maturity of three months or less when purchased. (l) The Partnership is not liable for Federal income taxes and each partner recognizes his proportionate share of the Partnership income or loss in his tax return; therefore, no provision for income taxes is made in the financial statements of the Partnership. (m) Several reclassifications have been made to the previously reported 1992 and 1991 statements in order to provide comparability with the 1993 statements. 2. Partnership Agreement: The Partnership was organized in October 1983. The Partnership Agreement provides for Balcor Mortgage Advisors-V to be the General Partner and for the admission of Limited Partners through the sale of Limited Partnership Interests at $500 per Interest, 439,305 of which were sold on or prior to August 31, 1984, the termination date of the offering. Pursuant to the Partnership Agreement, all income of the Partnership will be allocated 90% to the Limited Partners and 10% to the General Partner and all losses will be allocated 99% to the Limited Partners and 1% to the General Partner. To the extent that Cash Flow is generated, distributions will be made as follows: (i) 90% of such Cash Flow will be distributed to the Limited Partners, (ii) 7.5% of such Cash Flow will be distributed to the General Partner, and (iii) an additional 2.5% of such Cash Flow will be distributed to the General Partner and shall constitute the Early Investment Incentive Fund (the "Fund"). Upon the liquidation of the Partnership, the General Partner will return to the Partnership for distribution to Early Investors an amount not to exceed the 2.5% share, if necessary for Early Investors to receive a return of their Original Capital plus a specified Cumulative Return based on the date of investment. At the sole discretion of the General Partner, subject to certain limitations, amounts placed in the Fund have become available to repurchase Interests from existing Limited Partners. During 1993, the Fund repurchased 4,497 Interests at a total cost of $1,431,452. The amounts of the repurchases are as follows: Date Number of Repurchased Interests Cost First Quarter 1993 751 $264,099 Second Quarter 1993 140 43,883 Third Quarter 1993 2,371 729,541 Fourth Quarter 1993 1,235 393,929 Distributions of Cash Flow and Mortgage Reductions pertaining to such repurchased Interests will be paid to the Fund and will be available to repurchase additional Interests. 3. Investment in Loans Receivable Loans receivable and loans payable at December 31, 1993 consisted of the following: Loans Receivable Current Current Original Due Mortgage Monthly Interest Funding Date of Additional Property Balances(A) Payments Rate Date Loan Interest Apartments: Glen Apartments Falls Church, VA $5,142,293 $41,250 10.00% 2-86 12-97 (B,C,D) Meadow Run Fairborn, OH 5,264,258 43,063 13.25% 6-84 7-96 (B,C,D,E) Seven Trails West West St. Louis County, MO 15,250,823 (F) (F) 9-84 (F) (B,D) Office Building: Fairview Plaza I & II Charlotte, NC (G) 7,389,345 (H) (H) 6-84 6-97 Mobile Home Parks: Club Wildwood Hudson, FL 5,262,701 49,000 14.00% 9-84 10-96 (B,D) Four Seasons Estates Largo, FL 3,208,258 34,375 13.75% 9-84 10-96 (B,D) Pointe West Largo, FL 3,965,297 37,125 13.50% 9-84 10-96 (B,D) ----------- Total $45,482,975 =========== Loans Payable Underlying Current Current Due Mortgage Monthly Interest Date of Property Balances Payments Rate Loan Apartments: Glen Apartments Falls Church, VA $2,614,517 $19,235 7.50% 12-97 Seven Trails West West St. Louis County, MO 4,734,753 58,585 8.375% (I) Office Building: Fairview Plaza I & II Charlotte, NC 663,028 23,613 8.75% 7-96 Mobile Home Parks: Club Wildwood Hudson, FL 33,237 4,754 9.00% 9-94 Four Seasons Estates Largo, FL 842,335 12,857 10.125% 10-96 Pointe West Largo, FL 272,421 7,224 9.00% 10-96 ---------- Total $9,160,291 ========== (A) All loans are wrap-around mortgage loans except for Meadow Run which is a first mortgage loan. The notes receivable balance of the wrap-around mortgage loans includes the underlying loan balances. (B) An additional amount of interest accrues on a monthly basis and is payable to the Partnership upon maturity of the loan, prepayment or upon sale of the property. This interest is included in the loan balance. (C) The Partnership will receive participation income in the form of a share of gross or net income or cash flow of the property above specified levels. (D) The Partnership will receive a share in the future appreciation of the property by sharing in the sales price of the property, if it is sold, and/or by sharing in a percentage of the increase in the appraised value at maturity over the appraised value on the funding date or the date of the most recent previous sale. (E) The Partnership will receive a percentage of the reserve fund at any time reserve interest is due. The reserve fund is a fund held by the Partnership pursuant to a pledge agreement, into which the borrower is required to make monthly payments. (F) In July 1991, the terms of the loan were modified effective March 1991, and basic interest was reduced from 12.5% to 10.0%. Under the original terms of the loan agreement, the Partnership would have earned and received approximately $2,021,000, $1,883,000 and $1,838,000 during 1993, 1992 and 1991, respectively. The borrower made interest payments of approximately $1,470,000, $1,470,000 and $1,531,000 during 1993, 1992 and 1991, respectively, which were recorded as interest income. The loan matured in February 1994 and was subsequently placed in default when the borrower failed to pay the amounts due to the Partnership. The General Partner is currently negotiating an extension with the borrower on substantially the same terms as the modified loan. (G) This loan is on non-accrual status; therefore, income is recorded only as cash payments are received from the borrower. (H) In January 1992, a modification of this loan was executed. As part of the modification, the borrower made a principal payment of $1,600,000, and the Partnership forgave $1,000,000 from the outstanding principal balance. The new basic interest rate is 9.5% with monthly installments of principal and interest based on a 30 year amortization schedule through June 1, 1997, the new maturity date. This loan also originally provided for several types of additional interest. Under the terms of the modification, the Partnership has waived the payment of all outstanding accrued interest due to date. Under the original terms of the loan agreement (adjusted for the $1,600,000 principal payment in 1992), the Partnership would have earned and received approximately $1,045,000, $1,045,000 and $1,265,000 of interest income during 1993, 1992 and 1991, respectively. The borrower made interest payments of approximately $625,000, $638,000 and $1,156,000 during 1993, 1992 and 1991, respectively, which were recorded as interest income. (I) The underlying loan matured in February 1994. The Partnership expects to purchase this loan from the underlying lender on or about March 31, 1994. 4. Loans in Substantive Foreclosure: Loans in substantive foreclosure at December 31, 1993 consisted of the following: Carrying Property Value 45 West 45th Street Office Building New York, NY (A) $ 1,949,672 Springwells Park Apartments Dearborn, MI (B) 100,000 Villa Medici Apartments Overland Park, KS 9,499,000 ------------ Total $ 11,548,672 ============ (A) The Partnership and three affiliated partnerships entered into a participation agreement to fund a $23,000,000 first mortgage loan collateralized by this property. The Partnership participates ratably in approximately 22% of the original loan amount and interest income. The loan had been classified as an acquisition loan, therefore the balance includes the Partnership's share of the cumulative net loss of the property through December 31, 1992 and is shown net of its adjustment to fair value. (B) During 1993, $1,133,386 of the allowance for loan losses was used to reduce the carrying value of the loan to $100,000. Subsequent to this write-down, the loan was reclassified to loans in substantive foreclosure. The Partnership received $45,000 from the borrower in February 1994 and is scheduled to receive $55,000 in May 1994. 5. Investment in Acquisition Loan: The Partnership and two affiliated partnerships entered into a participation agreement to fund a $23,300,000 first mortgage loan collateralized by the Noland Fashion Square Shopping Center. The Partnership participates ratably in approximately 41% of the original loan amount, interest income and participation income. As of December 31, 1993, the balance of the loan was $8,587,042, which includes the partnership's share of the cumulative net loss of the property after the loan was funded. Current monthly payments of $74,061 are interest only with the entire principal balance due in December 1999. This loan also provides for several types of additional interest which include a percentage of the adjusted gross cash flow of the property, a percentage of the sale price over certain stated amounts and a percentage of the increase in the appraised value at maturity over the appraised value at funding. Additional interest amounts payable to the Partnership upon maturity of the loan or sale of the property are contingent upon certain conditions and, therefore, such interest has not been accrued. 6. Mortgage Notes Payable: Mortgage notes payable at December 31, 1993 and 1992 consisted of the following: Balance Balance Current Current Due at at Monthly Interest Date of Balloon Property 12/31/93 12/31/92 Payments Rate Loan Payment Real estate held for sale: The Glades on Ulmerton Apartments (carrying value $4,743,466)(A) $2,245,353 $2,291,079 $21,312 9.25% 7/99 $2,241,349 Granada Apartments (carrying value $2,848,979) (B) 54,050 Plantation Apartments (carrying value $3,414,738) (C) 1,494,920 Waldengreen Apartments (carrying value $6,035,166) (D) 2,000,000 ---------- ---------- Total $2,245,353 $5,840,049 ========== ========== (A) This loan was modified during April 1992, effective January 1992. The Partnership assumed the loan based on the existing terms except the interest rate was increased from 8% to 9.25%. In February 1994, the loan was prepaid. (B) The Partnership acquired title to this property through foreclosure in June 1993, and the loan fully amortized in June 1993. (C) The Partnership acquired title to this property through foreclosure in April 1993. The underlying mortgage was scheduled to mature in August 1992. Pursuant to negotiations with the lender, the maturity date was extended to August 1993, at which time the Partnership repaid the loan in full. (D) The Partnership acquired title to this property through foreclosure in September 1993. The Partnership purchased the first mortgage loan in July 1993 for $2,269,702, comprised of the principal ($2,000,000) and accrued interest ($344,576) less the balance of the tax escrow held by the lender ($74,874). During the years ended December 31, 1993, 1992 and 1991, the Partnership incurred interest expense on mortgage notes payable for properties held during the year of $275,882, $226,726 and $505,122, and paid interest expense on the mortgage notes payable of $275,882, $249,357 and $505,122, respectively. 7. Real Estate Held for Sale: (a) In September 1993, the Partnership received title to Waldengreen Apartments located in Orlando, Florida. The carrying value of the loan of $5,990,589 has been capitalized to the basis of the property, as well as expenses incurred in connection with the foreclosure of $344,577. (b) In June 1993, the Partnership received title to Granada Apartments located in Hillsborough County, Florida. The carrying value of the loan of $3,296,106 has been capitalized to the basis of the property, as well as $52,873 used to acquire vacant land adjacent to the property. (c) In April 1993, the Partnership received title to Plantation Apartments located in Temple Terrace, Florida, as a result of the foreclosure sale in March 1993. The $3,708,168 outstanding loan balance and accounts receivable of $3,860 were capitalized as part of the basis of the property upon foreclosure. The Partnership used $56,706 held in escrow to reduce the basis of the property upon foreclosure. As part of this transaction, the Partnership assumed the obligation to pay the underlying mortgage note. This property was classified as real estate held for sale at December 31, 1992. (d) In October 1992, the Partnership received title to the International Teleport office building located in Alameda County, California. The $14,000,000 outstanding loan balance and accrued interest of $313,055, together with other expenses incurred of $104,701 were capitalized as part of the basis of the property upon foreclosure. The Partnership used $96,274 held in escrow to reduce the basis of the property upon foreclosure. (e) In December 1991, the Partnership received title to The Glades on Ulmerton Apartments located in Largo, Florida. The $6,350,000 outstanding loan balance and accrued interest due at maturity of $285,030, together with other expenses paid of $148,721 were capitalized as part of the basis of the property upon foreclosure. The Partnership used $258,285 held in escrow to reduce the basis of the property upon foreclosure. As part of this transaction, the Partnership assumed the obligation to pay the underlying mortgage note. 8. Investment in Joint Venture - Affiliate: The Partnership has classified the first mortgage loan investment collateralized by the Whispering Hills Apartments as an equity investment in joint venture - affiliate. This investment represents a joint venture between the Partnership and an affiliated partnership. Profits and losses are allocated 25% to the Partnership and 75% to the affiliate. 9. Transactions with Affiliates: Fees and expenses paid and payable by the Partnership to affiliates are: Year Ended Year Ended Year Ended 12/31/93 12/31/92 12/31/91 Paid Payable Paid Payable Paid Payable Mortgage servicing fees $153,658 $10,951 $222,651 $15,742 $242,046 $20,034 Property management fees 361,175 39,167 277,401 23,888 135,534 20,576 Reimbursement of expenses to the General Partner, at cost: Accounting 75,896 6,300 76,751 6,197 66,344 8,867 Data processing 150,141 41,698 158,957 12,800 174,991 14,002 Investor communica- tions 11,381 945 36,557 2,945 23,522 3,144 Legal 12,197 1,012 19,911 1,608 17,136 2,290 Portfolio management 104,608 33,724 89,851 25,716 67,284 16,927 Other 35,224 2,924 9,394 705 3,104 415 10. Property Sale: In January 1992, the Partnership sold the Northland Park Industrial building, located in North Kansas City, Missouri for a sale price of $15,350,000. The carrying basis of the property at the date of sale was $15,063,040. The Partnership incurred selling expenses of $21,749, and paid a real estate commission of $150,000 to an unaffiliated broker in connection with the sale. A portion of the proceeds from the sale were used to prepay the three underlying mortgage loans totaling $5,088,361 and prepayment fees of $102,423 incurred in connection with the prepayment of the underlying mortgages. The Partnership recognized a gain on the sale of the property of $12,788. 11. Contingency: The Partnership is currently involved in a lawsuit whereby the Partnership and certain affiliates have been named as defendants alleging certain federal securities law violations with regard to the adequacy and accuracy of disclosures of information concerning the offering of the Limited Partnership Interests of the Partnership. The defendants continue to vigorously contest this action. As of this time, no plaintiff class has been certified and no judicial determination has been made. Although the outcome of these matters is not presently determinable, it is management's opinion that the ultimate outcome should not have a material adverse affect on the financial position of the Partnership. Management of the defendants believes they have meritorious defenses to contest the claims. 12. Subsequent Event: In January 1994, the Partnership made a distribution of $3,953,745 ($9.00 per Interest) to the holders of Limited Partnership Interests for the fourth quarter of 1993. This distribution includes a regular quarterly distribution of $4.00 per Interest from Cash Flow and a special distribution of $5.00 per Interest from Cash Flow. BALCOR PENSION INVESTORS-V (An Illinois Limited Partnership) SCHEDULE I - MARKETABLE SECURITIES - OTHER INVESTMENTS as of December 31, 1993 Col. A Col. B Col. C Col. D Col. E Amount at Which Each Number Portfolio of of Shares Equity Security or Units - Market Issues and Each Principal Value of Other Security Name of Issuer and Amounts Cost Each Issue Issue Carried Title of Each Issue of Bonds of Each at Balance in the and Notes Issue Sheet Date Balance Sheet Marketable Securities(A) Commercial Paper: ABB Treasury Centre Inc. 3.27% due 01/03/94 $1,000,000 $ 998,744 $ 998,744 $ 998,744 Cargill Financial Services Inc. 6.00% due 01/03/94 5,000,000 4,997,500 4,997,500 4,997,500 A.I. Credit Corp. 3.22% due 01/07/94 1,800,000 1,795,331 1,795,331 1,795,331 A.I. Credit Corp. 3.35% due 01/10/94 250,000 248,534 248,534 248,534 Consolidated Natural Gas 3.30% due 01/18/94 2,000,000 1,989,733 1,989,733 1,989,733 American Cyanamid Co. 3.18% due 01/19/94 1,000,000 996,997 996,997 996,997 USAA Capital Corp. 3.22% due 01/19/94 2,000,000 1,992,666 1,992,666 1,992,666 Cincinnati Bell Inc. 3.20% due 01/20/94 2,000,000 1,994,845 1,994,845 1,994,845 AIG Funding Inc. 3.19% due 01/21/94 4,000,000 3,986,531 3,986,531 3,986,531 Canadian Wheat Bread 3.08% due 01/21/94 2,000,000 1,994,011 1,994,011 1,994,011 Metropolitan Life Funding Inc. 3.20% due 01/31/94 2,000,000 1,990,756 1,990,756 1,990,756 ----------- ----------- ----------- ----------- Total $23,050,000 $22,985,648 $22,985,648 $22,985,648 =========== =========== =========== =========== (A) Marketable securities are included in cash and cash equivalents on the balance sheet. Cash of $638,258 is also included in this catagory. BALCOR PENSION INVESTORS - V (An Illinois Limited Partnership) SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION for the years ended December 31, 1993, 1992 and 1991 Column A Column B Item Charged to Costs and Expenses 1993 1992 1991 Maintenance and repairs $2,430,025 $1,142,678 $ 527,451 Real estate taxes 918,190 632,507 727,245

1993 ITEM 3. LEGAL PROCEEDINGS There are various legal and regulatory proceedings pending against the Company and its affiliates. While it is not feasible to predict or determine the outcome of these proceedings, the Company's management believes that the outcome will not have a material adverse effect on the Company's financial position. Mountain Fuel, as a result of acquiring Questar Pipeline's gas purchase contracts, is responsible for any judgment rendered against Questar Pipeline in a lawsuit that was tried before a jury. The jury awarded an independent producer compensatory damages of approximately $6,100,000 and punitive damages of $200,000 on his claims involving take-or-pay, tax reimbursement, contract breach, and tortious interference with a contract. A judgment will not be entered until the parties have an opportunity to determine appropriate volumes and Questar Pipeline can submit motions for judgment notwithstanding the verdict. The producer's counterclaims originally exceeded $57,000,000, but were reduced to less than $10,000,000, when the presiding judge dismissed with prejudice some of the claims prior to the jury trial. Mountain Fuel expects that any amounts arising from the breach of contract claims will be included in its gas balancing account and recovered in its rates for natural gas sales service. As a result of its former ownership of Entrada and Wasatch Chemical Company, Mountain Fuel has been named as a "potentially responsible party" for contaminants located on property owned by Entrada in Salt Lake City, Utah. Questar and Entrada have also been named as potentially responsible parties. (Entrada and the Company are both direct, wholly owned subsidiaries of Questar; prior to October 2, 1984, Mountain Fuel was the parent of Entrada.) The property, known as the Wasatch Chemical property, was the location of chemical operations conducted by Entrada's Wasatch Chemical division, which ceased operation in 1978. A portion of the property is included on the national priorities list, commonly known as the "Superfund" list. In September of 1992, a consent order governing clean-up activities was formally entered by the federal district court judge presiding over the underlying litigation involving the property. This consent order was agreed to by Questar, Entrada, the Company, the Utah Department of Health and the Environmental Protection Agency. Entrada has obtained approval for a specific design using an in situ vitrification procedure to clean up the Wasatch Chemical property and expects the in situ process to begin prior to year- end. The clean-up procedure may take as long as three years. Entrada has accounted for all costs spent on the environmental claims and has also accounted for all settlement proceeds, accruals and insurance claims. It has received cash settlements, which together with accruals and insurance receivables, should be sufficient for future clean-up costs. Mountain Fuel has consistently maintained that Entrada should be responsible for any liability imposed on the Questar group as a result of actions involving Wasatch Chemical. The Company has not paid any and does not expect to pay any costs associated with the clean-up activities for the property. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS During the fourth quarter of 1993, Mountain Fuel did not submit any matters to a vote of security holders. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S EQUITY AND RELATED STOCKHOLDER MATTERS The Company's outstanding shares of common stock, $2.50 par value, are owned by Questar. Information concerning the dividends paid on such stock and the ability to pay dividends is reported in the Statements of Common Shareholder's Equity and the Notes to Financial Statements included in Item 8. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS Following is a summary of revenues and operating information for the Company's operations: Natural gas volumes sold to residential and commercial customers increased 16% in 1993 following a 10% decrease in 1992. Temperatures were 5% colder than normal in 1993 and 10% warmer than normal in 1992. The number of customers increased 3.4% in 1993 and 3.2% in 1992 because of expanding population and construction in Mountain Fuel's service area. Natural gas deliveries to industrial customers increased 5% in 1993 and 7% in 1992, due to increased usage by metals, mining and petroleum customers. These customers are using more natural gas because of expanded operations and environmental concerns. The Company's industrial customers have not switched to residual fuel oil with the decline in oil prices because gas prices have been competitive and sufficient fuel oil is not readily available. Mountain Fuel assumed the responsibility for purchasing its own gas supplies on September 1, 1993, when Questar Pipeline began operating in accordance with FERC Order No. 636. Questar Pipeline transferred its gas purchase contracts to Mountain Fuel. The majority of these contracts are priced using a current natural gas market value. Mountain Fuel also acquired an inventory of working gas to meet customer requirements. Mountain Fuel has reserved transportation capacity on Questar Pipeline's system of approximately 800,000 decatherms per day and pays an annual demand charge of approximately $49 million for this reservation. Mountain Fuel releases excess capacity to its industrial transportation or other customers and receives a credit from Questar Pipeline for the released-capacity revenues and a portion of Questar Pipeline's interruptible-transportation revenues. Mountain Fuel reached a settlement of its Wyoming general rate case in July 1993, with the new rates effective August 1, 1993. The settlement approved an annualized increase in rates of $721,000, including recovery of costs attributable to FERC Order No. 636 and higher federal income tax rates. In April 1993, Mountain Fuel filed a general rate case with the Public Service Commission of Utah (PSCU). The original rate increase request was revised to $10.3 million based on September 30, 1993 results and included a 12.1% rate of return on equity. Hearings on the case were held in November 1993 and a rate order was received in January 1994. The PSCU rate order granted Mountain Fuel a $1.6 million decrease in general rates and a $2.1 million increase in costs allowed through the purchased-gas adjustment account for a net increase in rates of $500,000. The PSCU allowed a return on equity of 11%, required Mountain Fuel to reduce rates over a five-year period for unbilled revenues, and disallowed rate coverage for certain incentive compensation and advertising costs. Mountain Fuel requested a rehearing of the PSCU order for the allowed return on equity and the treatment of unbilled revenues, and the PSCU granted a rehearing on these issues. Natural gas purchases increased 6% in 1993 and decreased 14% in 1992. These changes were consistent with changes in volumes sold to residential and commercial customers, which were primarily weather related. Operating and maintenance expenses increased 16% in 1993 and decreased 1% in 1992. The 1993 increase was due to more customers, expanded service territory, a reduction in the percentage of labor costs capitalized, and recording of postretirement medical and life insurance benefits on an accrual basis. The 1992 decrease was due to increased percentage of labor costs capitalized as a result of the system expansion projects which offset increased costs from a larger natural gas distribution service territory and inflation. Depreciation and amortization expense increased 12% in 1993 and 8% in 1992 due to capital expenditure programs and higher natural gas production. The Company adopted the provisions of SFAS No. 106 on Employer's Accounting for Postretirement Benefits Other than Pensions effective January 1, 1993. This statement requires the Company to expense the costs of postretirement benefits, principally health-care benefits, over the service life of employees using an accrual method. Questar is amortizing the transition obligation over a 20-year period. Total cost of postretirement benefits other than pensions under SFAS No. 106 was $3,350,000 in 1993 compared with the costs based on cash payments to retirees totaling $876,000 in 1992 and $464,000 in 1991. The impact of SFAS No. 106 on the Company's future net income will be mitigated by recovery of these costs from customers. Both the PSCU and the PSCW allowed Mountain Fuel to recover future SFAS No. 106 costs in the 1993 rate cases if the amounts are funded in an external trust. The Financial Accounting Standards Board (FASB) has issued SFAS No. 112, Accounting for Postemployment Benefits. This statement requires the Company to recognize the liability for postemployment benefits when employees become eligible for such benefits. Postemployment benefits are paid to former employees after employment has been terminated but before retirement benefits are paid. The Company's principal liability under SFAS No. 112 is a long-term disability program. The Company is required to adopt SFAS No. 112 in the first quarter of 1994 and recognize a cumulative effect of a change in accounting method amounting to approximately $1,538,000. The Company may offset this amount with a regulatory asset depending on expected regulatory treatment and recovery of costs from customers. The effect on ongoing net income is not expected to be significant. The effective income tax rate was 23.5% in 1993, 24.2% in 1992 and 39.4% in 1991. The 1993 and 1992 rates were reduced by tight-sands gas production on Mountain Fuel-owned gas reserves amounting to $5,463,000 in 1993 and $4,281,000 in 1992. The 1993 federal income tax rate increased to 35%. The effect on the higher tax rate on deferred income taxes was recorded as income taxes recoverable from customers because the Company has adopted procedures with its regulatory commissions to include under-provided deferred taxes in customer rates on a systematic basis. Mountain Fuel is responsible for a judgment in a lawsuit involving the Company, Questar Pipeline and a gas producer. In March 1994, a jury awarded the gas producer damages of approximately $6.3 million on claims involving take-or-pay, tax reimbursement and breach of contract. Mountain Fuel expects that substantially all of the judgment will be included in its gas balancing account and recovered through customer rates. The judgment is not expected to have a significant impact on the Company's results of operations, financial position or liquidity. LIQUIDITY AND CAPITAL RESOURCES The majority of the Company's cash needs for capital expenditures and dividend payments has been met with cash from operations. Net cash from operating activities was $37,139,000 in 1993, $50,600,000 in 1992 and $54,655,000 in 1991. Inventories increased by $20,869,000 in 1993, primarily for gas stored underground. Changes in the purchased-gas adjustment account provided cash of $4,686,000 in 1993, $4,586,000 in 1992 and $16,662,000 in 1991. Following is a summary of capital expenditures for 1993, and a forecast of 1994 expenditures. Mountain Fuel's number of customers increased 18,075 during 1993 and 16,284 in 1992 due to population growth and building construction activity in its service area. The 1994 capital expenditures anticipate a similar level of customer growth. The Company funded 1993 capital expenditures with cash provided from operations and borrowings under short-term credit lines. The 1994 capital expenditures are expected to be financed with cash provided from operations, borrowings under Mountain Fuel's medium-term note program, equity investment from Questar and short-term credit arrangements. The Company has a short-term line-of-credit arrangement with a bank under which it may borrow up to $500,000, below the prime interest rate. The arrangements are renewable on an annual basis. At December 31, 1993, no amounts were borrowed under this arrangement. Questar loans funds to the Company under a short-term borrowing arrangement. Outstanding short-term notes payable to Questar totaled $57,800,000 and had an interest rate of 3.59% at December 31, 1993. During 1993, Mountain Fuel issued $91,000,000 of 15-year and 30-year medium-term notes at interest rates of 7.19% to 8.28%. Proceeds from these notes and $16,000,000 remaining from the 1992 issuances were used to redeem Mountain Fuel's $100,000,000 9 3/8% debentures and pay the associated refinancing costs. At December 31, 1993, Mountain Fuel had a registration statement filed with the Securities and Exchange Commission to issue an additional $17,000,000 of medium-term notes. The Company typically has negative net working capital at the end of the year because of short-term borrowings. These borrowings are seasonal and generally peak at the end of December because of cold-weather gas purchases. The assumption of gas-purchase contracts and the gas-supply purchase activity resulted in several changes to Mountain Fuel's working capital. Mountain Fuel acquired an inventory of gas stored underground to meet customer requirements. Accounts payable to unaffiliated parties increased while accounts payable to affiliates decreased because of direct purchases from gas producers. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The Company's financial statements are included in Part IV, Item 14, herein. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Mountain Fuel has not changed its independent auditors or had any disagreements with them concerning accounting matters and financial statement disclosures within the last 24 months. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information concerning the Company's directors and executive officers is located in the following chart: Business Experience and Positions Held Name Age With the Company and Affiliates Robert H. Bischoff 72 Director, May 1982; Director, Questar, May 1984; Chairman of Board, Key Bank of Utah (commercial bank), through December 31, 1993; Director, Deseret News Publishing Company; Trustee, Intermountain Health Care, Inc. (through April 1994). M. E. Benefield 54 Vice President, Gas Supply, May 1992; Vice President, Planning and Corporate Development, Questar (March 1989 to May 1992.) R. D. Cash 51 Director, May 1977; Chairman of the Board, May 1985; Director, President and Chief Executive Officer, Questar, May 1984; Chairman of the Board, Questar, May 1985. Director, Zions First National Bank and Zions Bancorporation; Trustee, Southern Utah University. W. F. Edwards 48 Vice President and Chief Financial Officer, May 1984; Senior Vice President and Chief Financial Officer, Questar, February 1989; Vice President and Chief Financial Officer, Questar, May 1984 to February 1989. Susan Glasmann 46 Vice President, Marketing, February 1994; General Manager, Marketing, April 1991 to February 1994; Manager, Corporate Communications, Questar, October 1989 to April 1991. Robert E. Kadlec 60 Director, March 1987; Director, Questar, March 1987; President and Chief Executive Officer, BC Gas Inc. (Vancouver, British Columbia); Director, BC Gas Inc., Trans Mountain Pipe Line Company Ltd., Bank of Montreal, and British Pacific Properties Ltd. and affiliated companies. B. Z. Kastler 73 Director, May 1969; Senior Director, Questar, May 1991; Director, Questar, May 1984 to May 1991; Consultant, January 1984 to December 1988; Chairman of the Board, May 1976 to May 1985. Dixie L. Leavitt 64 Director, May 1987; Director, Questar, May 1987; Chairman of the Board, Leavitt Group Agency Association (a group of approximately 42 separate insurance agencies); Director, Zions First National Bank. Gary G. Michael 53 Director, February 1994; Director, Questar, February 1994; Chairman and Chief Executive Officer, Albertson's; Director, Albertson's and member of Board of Directors of the Federal Reserve Bank of San Francisco. D. N. Rose 49 President and Chief Executive Officer, October 1984; Director, May 1984; Director, Questar, May 1984; Director, Key Bank of Utah; Trustee, Westminster College. G. H. Robinson 43 Vice President and Controller, April 1991; Vice President, Marketing, March 1985 to April 1991. Roy W. Simmons 78 Director, May 1968; Senior Director, Questar, May 1992; Director, Questar, May 1984 to May 1992; Chairman, Zions Bancorporation (commercial bank holding company) and Chairman, Zions First National Bank (commercial bank); Chief Executive Officer, Zions First National Bank to January 1989; Chief Executive Officer, Zions Bancorporation to January 1991; Director, Beneficial Life Insurance Company and Ellison Ranching Company. S. C. Yeager 46 Vice President, Customer Service, April 1991; Vice President, Retail Operations, March 1985 to April 1991. Except as otherwise indicated, the executive officers and directors have held the principal occupations described above for more than the past five years. There are no family relationships among the directors and executive officers of the Company. Directors of the Company are elected to serve three-year terms. Executive officers of the Company serve at the pleasure of the Board of Directors. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The following Summary Compensation Table lists annual and long-term compensation earned by Mr. D. N. Rose, the Company's President and Chief Executive Officer, and the other four most highly compensated officers during 1991, 1992, and 1993: 1/Amounts listed under this heading for 1993 include payments made in 1994 on 1993 target bonuses established under the Company's Annual Management Incentive Plan and cash payments made in 1993 on 1990 and 1991 target bonuses under such plan. They include the Company's portion of the amounts paid to Mr. Cash under Questar's Annual Management Incentive Plan for the same years and the Company's portion of the amounts paid to Mr. Benefield in 1992 as well as the payments made in 1993 and 1994 by the Company. Bonus payments reported for prior years are handled in a similar fashion. 2/Amounts under this heading include the value (as of the grant date) of any restricted shares of Questar's common stock used in 1993 and 1994, in lieu of cash, as partial payment of bonuses earned under the Company's 1992 and 1993 Annual Management Incentive Plans and the Company's allocated portion of the value of restricted shares granted to Mr. Cash under Questar's 1992 and 1993 Annual Management Incentive Plans. All shares of restricted stock vest in two equal, annual installments with the first installment occurring on the first anniversary of the grant date. Dividends are paid on the restricted shares at the same rate dividends are paid on other shares of Questar's common stock. As of year-end 1993, Messrs. Rose, Cash, Benefield, Robinson and Yeager owned 1,086; 2,891; 603; 446; and 446 shares of restricted stock, respectively. 3/Mountain Fuel's executive officers are granted nonqualified stock options to purchase shares of Questar's common stock under Questar's Long-Term Stock Incentive Plan. 4/Amounts listed under this heading include employer matching and nonmatching contributions to the Employee Stock Purchase Plan, matching "contributions" to the Deferred Share Plan, and directors' fees. The figures opposite Mr. Rose's name include $12,228 in contributions to the Employee Stock Purchase Plan for 1993, $10,499 for 1992 and $10,000 for 1991. They also include directors' fees amounting to $5,200 for 1993, $5,600 for 1992, and $4,600 for 1991 and matching "contributions" to the Deferred Share Plan of $1,358 for 1993, $903 for 1992, and $355 for 1991. The figures opposite Mr. Cash's name include the Company's allocated portion of the matching and nonmatching contributions to the Employee Stock Purchase Plan of $5,124 for 1993, $4,511 for 1992, and $4,365 for 1991. They also include directors' fees amounting to $5,200 for 1993, $5,600 for 1992, and $4,600 for 1991 and the Company's allocated portion of "contributions" to the Deferred Share Plan of $6,399 for 1993, $5,154 for 1992, and $4,439 for 1991. The figures opposite the names of Messrs. Benefield, Robinson, and Yeager include the matching and nonmatching contributions made by the Company to the Employee Stock Purchase Plan for their respective accounts. 5/Mr. Cash also serves as an executive officer of Questar and other affiliated companies. The base salary shown for Mr. Cash is the combination of the amount directly paid by the Company and the amount allocated to the Company. 6/Mr. Benefield did not become an executive officer of the Company until May 19, 1992. The base salary information reported for him in 1992 includes the amount that the Company paid directly and the amount allocated to the Company when Mr. Benefield served as an officer of Questar. The following table lists information concerning the nonqualified stock options to purchase shares of Questar's common stock that were granted to Mountain Fuel's five highest paid officers during 1993 under Questar's Long-Term Stock Incentive Plan. No stock appreciation rights were granted during 1992. 1/These nonqualified stock options vest in four annual, equal installments, with the first installment exercisable as of August 8, 1993. Participants can use cash or previously-owned shares as consideration for option shares. Participants can also elect to use newly-acquired shares to satisfy the minimum tax withholding obligation or previously-owned shares to satisfy either the minimum tax withholding obligation or maximum tax payment obligation. Options expire when a participant terminates his employment, unless termination is caused by an approved retirement, death, or disability. Options can be exercised for three months following a participant's approved retirement and 12 months following a participant's death or disability. 2/When calculating the present value of options granted in 1993, Questar used the Black-Scholes option pricing model. Questar assumed a volatility of .179, a risk free interest rate of 6.26 percent, a dividend yield of 5.00 percent and assumed that the shares would be exercised evenly throughout the four- year vesting schedule. The following table lists information concerning the nonqualified stock options to purchase shares of Questar's common stock that were exercised by the officers named above during 1993 and the total options and their value held by each at year-end 1993: 1/Stock appreciation rights (SARs) have not been granted since February of 1989. At year-end 1993, there were no SARs outstanding. 2/The "value" is calculated by subtracting the fair market value of the shares purchased on the date of exercise minus the option price. The value is equal to the amount of ordinary income recognized by each officer. The current value of the shares may be higher or lower than the aggregate value reported in the table. Retirement Plan Company employees (including executive officers) participate in the employee benefit plans of Questar. The Company has agreed to pay its share of the costs associated with the plans that are described below. Questar maintains a noncontributory Retirement Plan that is funded actuarially and does not involve specific contributions for any one individual. The following table lists the estimated annual benefits payable under the Retirement Plan as of December 31, 1993, and, if necessary, the Supplemental Executive Retirement Plan (described below). The benefits shown are based on earnings and years of service reaching normal retirement age of 65 in 1993 and do not include Social Security benefits. Benefits under the Retirement Plan are not reduced or offset by Social Security benefits. Questar's Retirement Plan, as of January 1, 1989, has a "step rate/excess" benefit formula. The formula provides for a basic benefit that is calculated by multiplying the employee's final average earnings by a specified base benefit factor and by subsequently multiplying such sum by the employee's years of service (up to a maximum of 25). This basic benefit is increased for each year of service in excess of 25 and is reduced for retirement prior to age 62. Employees also receive a supplemental benefit calculated by multiplying the difference between the employee's final average earnings and his "covered compensation" by a supplemental factor that varies by age. (The term covered compensation refers to the 35-year average Social Security wage base tied to year of an employee's birth.) Employees who retire prior to age 62 also receive a temporary supplement that is tied to years of service until they are eligible to receive Social Security benefits. The "final average earnings" (average annual earnings for the last three years) for purposes of calculating retirement benefits for the executive officers named above in the table as of December 31, 1993, is as follows: $247,024 for Mr. Rose; $157,253 for Mr. Benefield; $146,629 for Mr. Robinson; and $146,129 for Mr. Yeager. (No figure is given for Mr. Cash because his final average earnings for purposes of the Retirement Plan would include compensation paid by the Company's affiliates.) The years of credited service for the individuals listed in the compensation table are: 18 years for Mr. Cash; 25 years for Mr. Rose; 16 years for Mr. Benefield; 20 years for Mr. Robinson; and 18 years for Mr. Yeager. The Company also participates in Questar's Executive Incentive Retirement Plan (the EIRP). Under the terms of this nonqualified plan, a participant will receive monthly payments upon retirement until death equal to 10 percent of the highest average monthly compensation (excluding incentive compensation) paid to the officer during any period of 36 consecutive months of employment. The plan also provides for a family benefit in the event of the death of an officer. Although not required to do so, Questar and its affiliates have purchased life insurance on the life of each participant, with Questar named as owner and beneficiary. The covered officers have no rights under or to such insurance policies. All of the Company's officers listed in the compensation table have been nominated to participate in the plan, have satisfied the 15 years of service requirement and have a vested right to receive benefits under the EIRP. The annual benefits payable to the named officers under this plan as of December 31, 1993, are as follows: Mr. Rose, $19,065; Mr. Benefield, $12,823; and Messrs. Robinson and Yeager, $12,155. (No figure is given for Mr. Cash because his compensation for purposes of calculating benefits under the EIRP would include compensation paid by the Company's affiliates.) Any benefits payable under the SERP are offset against payments for the EIRP. Consequently, an officer would not receive any benefits for the SERP unless his benefit under the EIRP was less than the difference between what he could be paid under Questar's Retirement Plan at the date of retirement and what he had earned under such plan absent federal tax limitations. Given this relationship between the two nonqualified plans, the amounts listed in the table above do not include benefits payable under the EIRP. Executive Severance Compensation Plan Questar has an Executive Severance Compensation Plan that covers the Company's executive officers. Under this plan, participants, following a change in control of Questar, are eligible to receive compensation equal to up to two years' salary and miscellaneous benefits upon a voluntary or involuntary termination of their employment, provided that they have continued working or agree to continue working for six months following a potential change in control of Questar. This plan was adopted in 1983 by Mountain Fuel, was assumed by Questar as of October 2, 1984, and was amended and restated effective January 1, 1986. The amended plan also contains a provision that limits compensation and benefits payable under the plan to amounts that can be deducted under Section 280G of the Internal Revenue Code of 1986. The dollar amounts payable to the Company's executive officers (based on current salaries paid by the Company) in the event of termination of employment following a change in control of Questar are as follows: $422,000 to Mr.Rose; $280,800 to Mr. Benefield; and $268,000 each to Messrs. Yeager and Robinson. (The amount payable to Mr. Cash is not given since such amount is based on each officer's total salary.) The Company's executive officers would also receive certain supplemental retirement benefits, welfare benefits, and cash bonuses. Under the plan, a change in control is defined to include any change in control required to be reported under Item 6(e) of Schedule 14A of the Securities Exchange Act of 1934, as amended. A change in control is also deemed to occur once any person becomes the beneficial owner, directly or indirectly, of securities representing 20 percent or more of Questar's outstanding shares of common stock. Directors' Fees All directors receive an annual fee of $3,600 payable in 12 monthly installments and fees of $400 for each meeting of the Board of Directors that they attend. The Company has a Deferred Compensation Plan for Directors under which directors can elect to defer all or any portion of the fees received for service as directors until their retirement from such service and can choose to have the deferred amounts earn interest as if invested in long-term certificates of deposit or be accounted for with "phantom shares" of Questar's common stock. Upon retirement, the phantom shares of stock are "converted" to their fair market cash equivalent. During 1993, several directors of the Company chose to defer receipt of all or a portion of the compensation earned by them for their service. (Any shares of phantom stock credited to directors are not included in the number of shares listed opposite their names below.) ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The Company is a direct, wholly owned subsidiary of Questar. The following table sets forth information, as of December 31, 1993, with respect to each person known or believed by Questar to be the beneficial owner of 5 percent or more of its common stock: Shares and Name and Nature of Address of Beneficial Percent Beneficial Owner Ownership of Class First Security Bank of Utah 4,169,225 10.38 N.A., 79 South Main Street Trustee for Salt Lake City, Utah 84111 Company Employee Benefit Plans and Bank 1 The Equitable Companies Incorporated 2,493,225 6.21 787 Seventh Avenue Parent Holding New York, New York 10019 Company for Insurance Company and Investment Advisor Subsidiaries 2 1/Of this total, First Security beneficially owns 4,077,906 shares in its role as trustee of employee benefit plans sponsored by Questar or a subsidiary of Questar. Participating employees control the voting of 4,071,927 shares. 2/In an initial Schedule 13G dated as of December 31, 1993, and filed on behalf of a group, The Equitable Companies Incorporated reported sole voting power for 2,337,325 shares, shared voting power for 117,700 shares and sole dispositive power for 2,493,225 shares. The following table sets forth information, as of March 1, 1994, concerning the shares of Questar's common stock beneficially owned by each of the Company's named executive officers and directors and by the Company's executive officers and directors as a group: 1/The Company's executive officers own shares through their participation in Questar's Employee Investment Plan. The number of shares owned through this plan as of December 31, 1993, is as follows for the named officers: Mr. Benefield, 3,722 shares; Mr. Cash, 26,318 shares; Mr. Robinson, 6,234 shares; Mr. Rose, 13,990 shares; and Mr. Yeager, 6,829 shares. 2/The Company's executive officers have been granted nonqualified stock options under Questar's Stock Option Plan and Long-Term Stock Incentive Plan. The number of shares listed opposite the named officers attributable to vested options as of March 1, 1994, is as follows: Mr. Cash, 16,873 shares; Mr. Rose, 12,700 shares; and Mr. Yeager, 4,500 shares. 3/The Company's executive officers acquired restricted shares of Questar's common stock in partial payment of bonuses earned in the 1993 bonus plans. The number of restricted shares beneficially owned by each of the named officers as of March 1, 1994, is as follows: Mr. Benefield, 845 shares; Mr. Cash, 4,279 shares; Mr. Robinson, 738 shares; Mr. Rose, 1,766 shares; and Mr. Yeager, 738 shares. 4/Unless otherwise listed, the percentage of shares owned is less than .1 percent. The percentages of beneficial ownership have been calculated in accordance with Rule 13d-3(d)(1) under the Securities Exchange Act of 1934, as amended. 5/Messrs. Bischoff, Hawkins, Kadlec, and Leavitt, as nonemployee voting directors of Questar, have been granted nonqualified stock options to purchase shares of Questar's common stock as follows: Mr. Bischoff, 5,200 shares; Mr. Hawkins, 3,500 shares; Mr. Kadlec, 12,650 shares; and Mr. Leavitt, 9,100 shares. These shares are included in the numbers listed opposite their respective names. 6/Mr. Cash is the Chairman of the Board of Trustees of the Questar Corporation Educational Foundation and the Questar Corporation Arts Foundation, two nonprofit corporations that own an aggregate of 39,282 shares of Questar's common stock. As the Chairman, Mr. Cash has voting control for such shares, but disclaims any beneficial ownership of them. 7/Of the total shares reported for Mr. Cash, 3,270 shares are owned jointly with his wife and 4,549 are controlled by him as custodian for his son. Messrs. Leavitt and Yeager own their shares of record with their respective wives. 8/The total number of shares reported for this group includes vested options to purchase 102,648 shares of Questar's common stock. Committee Interlocks and Insider Participation The Company itself has no formal "Compensation Committee." Questar's Board of Directors has a Management Performance Committee that makes recommendations to the Company's Board of Directors concerning base salary and bonus payments. (Questar's Board approves all stock options.) Messrs. Cash and Rose, as directors and officers of the Company, are formally excused from all discussions by the Company's Board involving their compensation. Mr. Kastler, a retired employee and officer, is a director of the Company and does participate in these discussions. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS There are no relationships or transactions involving the Company's directors and executive officers. As described above, there are significant business relationships between the Company and its affiliates, particularly Wexpro and Questar Pipeline. Questar, the Company's parent, also provides certain administrative services, e.g., personnel, legal, public relations, financial, tax, and audit to the Company and other members of the consolidated group. The costs of performing such services are allocated to the Company. Questar Service, another affiliate, provides data processing and communication services for the Company; the charges for such services are based on cost of service plus a specified return on assets. See Note I to the financial statements for additional information concerning transactions between the Company and its affiliates. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a)(1)(2) Financial Statements and Financial Statement Schedules. The financial statements and schedules identified in the List of Financial Statements and Financial Statement Schedules are filed as part of this report. (3) Exhibits. The following is a list of exhibits required to be filed as a part of this report in Item 14(c). Exhibit No. Exhibit 3.1.* Restated Consolidated Articles of Incorporation dated August 15, 1980. (Exhibit No. 4(a) to Registration Statement No. 2-70087, filed December 1, 1980.) 3.2.* Certificate of Amendment to Restated Consolidated Articles of Incorporation dated May 13, 1982. (Exhibit No. 3(b) to Form 10-K Annual Report for 1982.) 3.3.* Certificate of Amendment to Restated Consolidated Articles of Incorporation dated May 10, 1983. (Included in Exhibit No. 4.1. to Registration Statement No. 2-84713, filed June 23, 1983.) 3.4.* Certificate of Amendment to Restated Consolidated Articles of Incorporation dated August 16, 1983. (Exhibit No. 3(a) to Form 8 Report amending the Company's Form 10-Q Report for Quarter Ended September 30, 1983.) 3.5.* Certificate of Amendment to Restated Consolidated Articles of Incorporation dated October 26, 1984. (Exhibit No. 3.5. to Form 10-K Annual Report for 1984.) 3.6.* Certificate of Amendment to Restated Consolidated Articles of Incorporation dated May 13, 1985. (Exhibit No. 3.1. to Form 10-Q Report for Quarter Ended June 30, 1985.) 3.7.* Articles of Amendment to Restated Consolidated Articles of Incorporation dated February 10, 1988. (Exhibit No. 3.7. to Form 10-K Annual Report for 1987.) 3.8.* Bylaws (as amended effective August 11, 1992). (Exhibit No. 3.8. to Form 10-K Annual Report for 1992.) 4.* Indenture dated as of May 1, 1992, between the Company and Citibank, as trustee, for the Company's Debt Securities. (Exhibit No. 4. to Form 10-Q Report for Quarter Ended June 30, 1992.) 10.1.* Stipulations and Agreement, dated October 14, 1981, executed by Mountain Fuel Supply Company; Wexpro Company; the Utah Department of Business Regulations, Division of Public Utilities; the Utah Committee of Consumer Services; and the staff of the Public Service Commission of Wyoming. (Exhibit No. 10(a) to Form 10-K Annual Report for 1981.) 10.7.* Data Processing Services Agreement effective July 1, 1985, between Questar Service Corporation and Mountain Fuel Supply Company. (Exhibit 10.7. to Form 10-K Annual Report for 1988.) 10.8.*1 Mountain Fuel Supply Company Annual Management Incentive Plan as amended and restated effective February 11, 1992. (Exhibit No. 10.8. to Form 10-K Annual Report for 1991.) 10.9.*1 Mountain Fuel Supply Company Window Period Supplemental Executive Retirement Plan effective January 24, 1991. (Exhibit No. 10.9. to Form 10-K Annual Report for 1990.) 12. Statement of Ratio of Earnings to Fixed Charges. 24. Consent of Independent Auditors. 25. Power of Attorney. *Exhibits so marked have been filed with the Securities and Exchange Commission as part of the referenced filing and are incorporated herein by reference. 1 Exhibits so marked are management contracts or compensation plans or arrangements. (b) Mountain Fuel did not file any Current Reports on Form 8- K during the last quarter of 1993. ANNUAL REPORT ON FORM 10-K ITEM 8. ITEM 14 (a) (1) and (2), (c) and (d) LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA FINANCIAL STATEMENT SCHEDULES YEAR ENDED DECEMBER 31, 1993 MOUNTAIN FUEL SUPPLY COMPANY SALT LAKE CITY, UTAH FORM 10-K--ITEM 14 (a) (1) and (2) MOUNTAIN FUEL SUPPLY COMPANY LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES The following financial statements of Mountain Fuel Supply Company are included in Item 8: Statements of income -- Years ended December 31, 1993, 1992 and 1991 Balance sheets -- December 31, 1993 and 1992 Statements of common shareholder's equity -- Years ended December 31, 1993, 1992 and 1991 Statements of cash flows -- Years ended December 31, 1993, 1992 and 1991 Notes to financial statements The following financial statement schedules of Mountain Fuel Supply Company are included in Item 14(d): Schedule II -- Amounts receivable from related parties and underwriters, promoters, and employees other than related parties Schedule V -- Property, plant and equipment Schedule VI -- Accumulated depreciation, depletion and amortization of property, plant and equipment Schedule X -- Supplementary income statement information All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and therefore have been omitted. Report of Independent Auditors Board of Directors Mountain Fuel Supply Company We have audited the accompanying balance sheets of Mountain Fuel Supply Company as of December 31, 1993 and 1992, and the related statements of income, common shareholder's equity, and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules 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 financial statements referred to above present fairly, in all material respects, the financial position of Mountain Fuel Supply Company at December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note H to the financial statements, in 1993 Mountain Fuel Supply changed its method of accounting for postretirement benefits other than pensions. ERNST & YOUNG Salt Lake City, Utah February 11, 1993 MOUNTAIN FUEL SUPPLY COMPANY STATEMENTS OF INCOME See notes to financial statements. MOUNTAIN FUEL SUPPLY COMPANY BALANCE SHEETS ASSETS See notes to financial statements. MOUNTAIN FUEL SUPPLY COMPANY STATEMENTS OF COMMON SHAREHOLDER'S EQUITY See notes to financial statements. MOUNTAIN FUEL SUPPLY COMPANY STATEMENTS OF CASH FLOWS See notes to financial statements. MOUNTAIN FUEL SUPPLY COMPANY NOTES TO FINANCIAL STATEMENTS Note A - Summary of Accounting Policies Mountain Fuel Supply Company (the Company or Mountain Fuel) is a wholly-owned subsidiary of Questar Corporation (Questar). Business and Regulation: The Company's business consists of natural gas distribution operations for industrial, residential and commercial customers. Mountain Fuel is regulated by the Public Service Commission of Utah (PSCU) and the Public Service Commission of Wyoming (PSCW). These regulatory agencies establish rates for the sale and transportation of natural gas. The regulatory agencies also regulate, among other things, the extension and enlargement or abandonment of jurisdictional natural gas facilities. Regulation is intended to permit the recovery, through rates, of the cost of service including, a rate of return on investment. The financial statements are presented in accordance with regulatory requirements. Methods of allocating costs to time periods, in order to match revenues and expenses, may differ from those of nonregulated businesses because of cost allocation methods used in establishing rates. Purchased-Gas Adjustments: The Company accounts for purchased-gas costs in accordance with procedures authorized by the PSCU and PSCW whereby purchased-gas costs that are different from those provided for in the present rates are accumulated and recovered or credited through future rate changes. Credit Risk: The Company's primary market area is the Rocky Mountain region of the United States. The Company's exposure to credit risk may be impacted by the concentration of customers in this region due to changes in economic or other conditions. The Company's customers include individuals and numerous industries that may be impacted differently by changing conditions. The Company believes that it has adequately reserved for potential credit-related losses. Property, Plant and Equipment: Property, plant and equipment are stated at cost. The provision for depreciation and amortization is based upon rates which will amortize costs of assets over their estimated useful lives. The costs of natural gas distribution property, plant and equipment, excluding gas wells, are amortized using the straight-line method. The costs of gas wells were amortized using the unit-of-production method at $.18 per Mcf of natural gas production during 1993. Historically, the Company used the successful efforts method to account for costs incurred for exploration and development of gas reserves; however, the Company has not incurred any such costs during the last three years. Income Taxes: On January 1, 1992, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 109. The deferred tax balance at December 31, 1993, represents the temporary differences between book and taxable income multiplied by the effective tax rates. These temporary differences relate primarily to depreciation, unbilled revenues and purchased-gas adjustments. The Company uses the deferral method to account for investment tax credits as required by regulatory commissions. See Note F. Reacquisition of Debt: Gains and losses on the reacquisition of debt are deferred and amortized as debt expense over the life of the replacement debt in order to match regulatory treatment. Allowance for Funds Used During Construction: The Company capitalizes the cost of capital during the construction period of plant and equipment using a method required by regulatory authorities. This amounted to $528,000 in 1993, $588,000 in 1992 and $527,000 in 1991. Note B - Cash and Short-Term Investments Short-term investments at December 31, 1993 and 1992, valued at cost (approximates market), amounted to $1,379,000 and $4,336,000, respectively. Short-term investments consisted of Euro-time deposits and repurchase agreements with maturities of three months or less. Note C - Debt The Company has a short-term line-of-credit arrangement with a bank under which it may borrow up to $500,000, below the prime interest rate. The arrangements are renewable on an annual basis. At December 31, 1993, no amounts were borrowed under this arrangement. Questar loans funds to the Company under a short-term borrowing arrangement. Outstanding short-term notes payable to Questar totaled $57,800,000 and had an interest rate of 3.59% at December 31, 1993. The details of long-term debt at December 31, were as follows: During 1993, Mountain Fuel issued $91,000,000 of 15-year and 30-year medium-term notes at interest rates of 7.19% to 8.28%. Proceeds from these notes and $16,000,000 remaining from the 1992 issuances were used to redeem Mountain Fuel's $100,000,000 9 3/8% debentures and pay the associated refinancing costs. At December 31, 1993, Mountain Fuel had a registration statement filed with the Securities and Exchange Commission to issue an additional $17,000,000 of medium-term notes. There are no maturities of long-term debt for the five years following December 31, 1993 nor long-term debt provisions restricting the payment of dividends. Cash paid for interest was $14,698,000 in 1993, $15,970,000 in 1992 and $14,969,000 in 1991. Note D - Redeemable Cumulative Preferred Stock The Company has authorized 4,000,000 shares of nonvoting redeemable cumulative preferred stock with no par value. The two current outstanding issues of stock have a stated and redemption value of $100 per share. Redemption requirements for the five years following December 31, 1993, are as follows: Note E - Estimated Fair Values of Financial Instruments The carrying amounts and estimated fair values of the Company's financial instruments were as follows: The Company used the following methods and assumptions in estimating fair values: (1) Cash and short-term investments - the carrying amount approximates fair value; (2) Short-term loans - the carrying amount approximates fair value; (3) Long-term debt - the fair value of the medium-term notes is based on the discounted present value of cash flows using the Company's current borrowing rates; (4) Redeemable cumulative preferred stock - the fair value is based on the discounted present value of cash flows using current preferred stock rates. Note F - Income Taxes The Company's operations are consolidated with those of Questar and its subsidiaries for income tax purposes. The income tax arrangement between the Company and Questar provides that amounts paid to or received from Questar are substantially the same as would be paid or received by the Company if it filed a separate return except that the Company is paid for tax benefits used in the consolidated tax return even if such benefits would not have been usable had the Company filed a separate return. Effective January 1, 1992, the Company changed its method of accounting for income taxes from the deferred method to the liability method required by SFAS No. 109, Accounting for Income Taxes. The Company did not restate prior years' financial statements. The application of the new rules did not have a significant impact on the 1992 net income. The Company records cumulative increases in deferred taxes as income taxes recoverable from customers. The Company has adopted procedures with its regulatory commissions to include under-provided deferred taxes in customer rates on a systematic basis. The amount of income taxes recoverable from customers was higher in 1993 due to an increase in the federal income tax rate. The components of income taxes were as follows: The difference between income tax expense and the tax computed by applying the statutory federal income tax rate to income before income taxes is explained as follows: Significant components of the Company's deferred tax liabilities and assets were as follows: The Company recorded a deferred tax asset of $4,035,000 for alternative minimum tax paid and production credits recognized but not yet realized on the tax return. The Company expects to realize this deferred tax asset within the next several years. Cash paid for income taxes was $8,631,000 in 1993, $6,805,000 in 1992 and $18,072,000 in 1991. Note G - Rate Matters, Litigation and Commitments On September 1, 1993, Questar Pipeline began operating in compliance with Federal Energy Regulatory Commission (FERC) Order No. 636. The order unbundled the sale-for-resale service from the transportation, gathering and storage services provided by natural gas pipelines. Questar Pipeline eliminated its merchant function. That activity was assumed by Mountain Fuel along with the gas-purchase contracts. In its order approving Questar Pipeline's Order No. 636 implementation plan, the FERC accepted Questar Pipeline's plan for the assignment of gas-purchase contracts to Mountain Fuel. Mountain Fuel filed a general rate case for its Utah operations in April 1993. The revised amount of deficiency requested in the case was $10.3 million, including a 12.1% return on equity. In January 1994, the PSCU issued a rate order granting Mountain Fuel a $1.6 million decrease in general rates and a $2.1 million increase in costs allowed through the purchase-gas adjustment account for a net increase in rates of $500,000. The PSCU allowed a return on equity of 11%, required Mountain Fuel to reduce rates over a five-year period for unbilled revenues, and disallowed rate coverage for certain incentive compensation and advertising costs. Mountain Fuel requested a rehearing of the PSCU order for the allowed return on equity and the treatment of unbilled revenues and the PSCU granted a rehearing on these issues. In 1993, Mountain Fuel began accruing gas distribution revenues for gas delivered to residential and commercial customers but not billed at the end of the year. The impact of these accruals on the income statement has been deferred in accordance with a rate order received from the PSCU. This rate order reduces customer rates by $2,011,000 per year over the five-year period from 1994 through 1998. Mountain Fuel will recognize the unbilled revenues and the associated gas costs over this same five-year period to offset the reduction in rates. In July 1993, the PSCW issued an order in Mountain Fuel's general rate case for Wyoming operations. The order approved a stipulation that had been negotiated by the Company and the PSCW's staff which allowed for an increase in general rates of $721,000 including recovery of costs attributable to FERC Order No. 636 and higher federal income tax rates. Many of Mountain Fuel's gas-purchase contracts include take-or-pay provisions that obligate it, on an annual basis, to take delivery of at least a specified percentage of volumes producible from wells or pay for such volumes. The contracts allow for the subsequent delivery of the gas within a specified period. Other gas-purchase contracts include provisions that obligate Mountain Fuel to schedule a specific volume for delivery on a daily or monthly basis. All gas-purchase contracts were transferred from Questar Pipeline to Mountain Fuel in 1993. Purchases of natural gas under gas-purchase contracts subsequent to the transfer of contracts from Questar Pipeline in September 1993 totalled $38,529,000. Following is a summary of projected purchase commitments under gas-purchase contracts with terms of one year or more. Prices under these contracts are based on the current market price. These commitments will change as a result of future negotiations with sellers. The Company has received notice that it may be partially liable in several environmental clean-up actions on sites that involve numerous other parties. Management believes that the Company's responsibility for remediation will be minor and that any potential liability will not be significant to the results of operations or its financial position. Mountain Fuel is responsible for a judgment in a lawsuit involving the Company, Questar Pipeline and a gas producer. In March 1994, a jury awarded the gas producer damages of approximately $6.3 million on claims involving take-or-pay, tax reimbursement and breach of contract. Mountain Fuel expects that substantially all of the judgment will be included in its gas balancing account and recovered through customer rates. The judgment is not expected to have a significant impact on the Company's results of operations, financial position or liquidity. There are various legal proceedings against the Company. While it is not currently possible to predict or determine the outcome of these proceedings, it is the opinion of management that the outcome will not have a material adverse effect on the Company's results of operations, financial position or liquidity. Note H - Employee Benefits Substantially all Company employees are covered by Questar's defined benefit pension plan. Benefits are generally based on years of service and the employee's 36-month period of highest earnings during the ten years preceding retirement. It is Questar's policy to make contributions to the plan at least sufficient to meet the minimum funding requirements of applicable laws and regulations. Plan assets consist principally of equity securities and corporate and U.S. government debt obligations. Pension cost was $3,251,000 in 1993, $2,991,000 in 1992 and $2,835,000 in 1991. The Company's portion of plan assets and benefit obligations is not determinable because the plan assets are not segregated or restricted to meet the Company's pension obligations. If the Company were to withdraw from the pension plan, the pension obligation for the Company's employees would be retained by the pension plan. At December 31, 1993, Questar's fair value of plan assets exceeded the accumulated benefit obligation. The Company participates in Questar's Employee Investment Plan, which allows the majority of employees to purchase Questar stock or other investments with payroll deductions. The Company makes contributions to the plan of approximately 75% of the employee's purchases. The Company's expense and contribution to the plan was $1,167,000 in 1993, $1,194,000 in 1992 and $1,405,000 in 1991. The Company participates in a Questar program that pays a portion of the health-care costs and all the life insurance costs for retired employees. Effective January 1, 1992, this program was changed for employees retiring after January 1, 1993, to link the health-care benefit to years of service and to limit the Company's monthly health-care contribution per individual to 170% of the 1992 contribution. Questar's policy is to fund amounts allowable for tax deduction under the Internal Revenue Code. Plan assets consist of equity securities, corporate and U.S. government debt obligation, and insurance company general accounts. The Company adopted the provisions of SFAS No. 106 on Employer's Accounting for Postretirement Benefits Other than Pensions effective January 1, 1993. This statement requires the Company to expense the costs of postretirement benefits, principally health-care benefits, over the service life of employees using an accrual method. Questar is amortizing the transition obligation over a 20-year period. Total cost of postretirement benefits other than pensions under SFAS No. 106 was $3,350,000 in 1993 compared with the costs based on cash payments to retirees totaling $876,000 in 1992 and $464,000 in 1991. The impact of SFAS No. 106 on the Company's future net income will be mitigated by recovery of these costs from customers. Both the PSCU and the PSCW allowed Mountain Fuel to recover future SFAS No. 106 costs in the 1993 rate cases if the amounts are funded in an external trust. The Company's portion of plan assets and benefit obligations related to postretirement medical and life insurance benefits is not determinable because the plan assets are not segregated or restricted to meet the Company's obligations. The Financial Accounting Standards Board (FASB) has issued SFAS No. 112, Accounting for Postemployment Benefits. This statement requires the Company to recognize the liability for postemployment benefits when employees become eligible for such benefits. Postemployment benefits are paid to former employees after employment has been terminated but before retirement benefits are paid. The Company's principal liability under SFAS No. 112 is a long-term disability program. The Company is required to adopt SFAS No. 112 in the first quarter of 1994 and recognize a cumulative effect of a change in accounting method amounting to approximately $1,538,000. The Company may offset this amount with a regulatory asset depending on expected regulatory treatment and recovery of costs from customers. The effect on ongoing net income is not expected to be significant. Note I - Related Party Transactions The Company receives a portion of Wexpro's income from oil operations after recovery of Wexpro's operating expenses and a return on investment. This amount, which is included in revenues, was $1,028,000 in 1993, $3,389,000 in 1992 and $4,190,000 in 1991. The Company paid Wexpro for the operation of Company-owned gas properties. These costs are included in natural gas purchases and amounted to $49,595,000 in 1993, $43,324,000 in 1992 and $33,783,000 in 1991. The Company purchased gas from Questar Pipeline amounting to $81,813,000 in 1993, $135,779,000 in 1992 and $174,359,000 in 1991. The Company did not purchase gas from Questar Pipeline subsequent to September 1, 1993 when Questar Pipeline began operating in accordance with FERC Order No. 636. Also included in natural gas purchases are amounts paid to Questar Pipeline for the transportation and gathering of Company-owned gas and purchased gas. These costs were $38,862,000 in 1993, $31,808,000 in 1992 and $18,389,000 in 1991. The Company paid $4,131,000 to Questar Pipeline for storage services subsequent to the implementation of FERC Order No. 636. Mountain Fuel has reserved transportation capacity on Questar Pipeline's system of approximately 800,000 decatherms per day and pays an annual demand charge of approximately $49 million for this reservation. Mountain Fuel releases excess capacity to its industrial transportation or other customers and receives a credit from Questar Pipeline for the released-capacity revenues and a portion of Questar Pipeline's interruptible-transportation revenues. Questar Service Corporation is an affiliated company that provides data processing and communication services to Mountain Fuel. The Company paid Questar Service $14,847,000 in 1993, $12,437,000 in 1992 and $11,530,000 in 1991. Questar charges the Company for certain administrative functions amounting to $5,609,000 in 1993, $5,517,000 in 1992 and $5,597,000 in 1991. These costs are included in operating and maintenance expenses and are allocated based on each affiliated company's proportional share of revenues; property, plant and equipment; and labor costs. Management believes that the allocation method is reasonable. Note J - Oil and Gas Producing Activities (Unaudited) The following information discusses the Company's oil and gas producing activities. All of the properties are cost-of-service properties with the return on investment established by state regulatory agencies. The Company has not incurred any costs for oil and gas producing activities for the three years ended December 31, 1993. Wexpro develops and produces gas reserves owned by the Company. See Note I for the amounts paid by the Company to Wexpro. Estimated Quantities of Proved Oil and Gas Reserves: The following estimates were made by Questar's reservoir engineers. Reserve estimates are based on a complex and highly interpretive process which is subject to continuous revision as additional production and development drilling information becomes available. The quantities are based on existing economic and operating conditions using current prices and operating costs. All oil and gas reserves reported are located in the United States. The Company does not have any long-term supply contracts with foreign governments or reserves of equity investees. No estimates are available for proved undeveloped reserves that may exist. SCHEDULE II - AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES MOUNTAIN FUEL SUPPLY COMPANY SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT MOUNTAIN FUEL SUPPLY COMPANY NOTE A - Other changes consist of transfers to or from affiliated companies. NOTE B - The annual provisions for depreciation have been computed using the straight-line method at 3% to 33 1/3% per year (average of 3.9% in 1993). SCHEDULE V I- ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT MOUNTAIN FUEL SUPPLY COMPANY NOTE A - Other changes consist of transfers to or from affiliated companies. NOTE B - The annual provisions for depreciation have been computed using the straight-line method at 3% to 33 1\3% per year (average of 3.8% in 1993). SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION MOUNTAIN FUEL SUPPLY COMPANY The Company has no depreciation and amortization of intangibles assets. Amounts for advertising costs are not presented as such amounts are less than 1% of total revenues. 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, on the 28th day of March, 1994. MOUNTAIN FUEL SUPPLY COMPANY (Registrant) By /s/ D. N. Rose D. N. Rose President and Chief Executive 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. /s/ D. N. Rose President and Chief Executive D. N. Rose Officer; Director (Principal Executive Officer) /s/ W. F. Edwards Vice President and Chief Financial W. F. Edwards Officer (Principal Financial Officer) /s/ G. H. Robinson Vice President and Controller G. H. Robinson (Principal Accounting Officer) *Robert H. Bischoff Director *R. D. Cash Chairman of the Board *W. Whitley Hawkins Director *Robert E. Kadlec Director *B. Z. Kastler Director *Dixie L. Leavitt Director *Gary G. Michael Director *D. N. Rose Director *Roy W. Simmons Director March 28, 1994 *By /s/ D. N. Rose Date D. N. Rose, Attorney in Fact EXHIBIT INDEX Sequential Exhibit Page Number Number Exhibit 3.1.* Restated Consolidated Articles of Incorporation dated August 15, 1980. (Exhibit No. 4(a) to Registration Statement No. 2-70087, filed December 1, 1980.) 3.2.* Certificate of Amendment to Restated Consolidated Articles of Incorporation dated May 13, 1982. (Exhibit No. 3(b) to Form 10-K Annual Report for 1982.) 3.3.* Certificate of Amendment to Restated Consolidated Articles of Incorporation dated May 10, 1983. (Included in Exhibit No. 4.1. to Registration Statement No. 2- 84713, filed June 23, 1983.) 3.4.* Certificate of Amendment to Restated Consolidated Articles of Incorporation dated August 16, 1983. (Exhibit No. 3(a) to Form 8 Report amending the Company's Form 10-Q Report for Quarter Ended September 30, 1983.) 3.5.* Certificate of Amendment to Restated Consolidated Articles of Incorporation dated October 26, 1984. (Exhibit No. 3.5. to Form 10-K Annual Report for 1984.) 3.6.* Certificate of Amendment to Restated Consolidated Articles of Incorporation dated May 13, 1985. (Exhibit No. 3.1. to Form 10-Q Report for Quarter Ended June 30, 1985.) 3.7.* Articles of Amendment to Restated Consolidated Articles of Incorporation dated February 10, 1988. (Exhibit No. 3.7. to Form 10-K Annual Report for 1987.) 3.8.* Bylaws (as amended effective August 11, 1992). (Exhibit No. 3.8. to Form 10-K Annual Report for 1992.) 4.* Indenture dated as of May 1, 1992, between the Company and Citibank, as trustee, for the Company's Debt Securities. (Exhibit No. 4. to Form 10-Q Report for Quarter Ended June 30, 1992.) 10.1.* Stipulations and Agreement, dated October 14, 1981, executed by Mountain Fuel Supply Company; Wexpro Company; the Utah Department of Business Regulations, Division of Public Utilities; the Utah Committee of Consumer Services; and the staff of the Public Service Commission of Wyoming. (Exhibit No. 10(a) to Form 10-K Annual Report for 1981.) 10.7.* Data Processing Services Agreement effective July 1, 1985, between Questar Service Corporation and Mountain Fuel Supply Company. (Exhibit 10.7. to Form 10-K Annual Report for 1988.) 10.8.* 1 Mountain Fuel Supply Company Annual Management Incentive Plan as amended and restated effective February 11, 1992. (Exhibit No. 10.8. to Form 10-K Annual Report for 1991.) 10.9.* 1 Mountain Fuel Supply Company Window Period Supplemental Executive Retirement Plan effective January 24, 1991. (Exhibit No. 10.9. to Form 10-K Annual Report for 1990.) 12. Statement of Ratio of Earnings to Fixed Charges. 24. Consent of Independent Auditors. 25. Power of Attorney. * Exhibits so marked have been filed with the Securities and Exchange Commission as part of the referenced filing and are incorporated herein by reference. 1 Exhibits so marked are management contracts or compensation plans or arrangements.

1993 ITEM 1. BUSINESS THE CORPORATION First National Bank Corp. (the "Corporation") is a bank holding company under the Bank Holding Company Act of 1956, as amended (the "Bank Holding Company Act"). As a bank holding company, the Corporation is subject to regulation by the Federal Reserve Board. The Corporation was organized on December 17, 1986, under the laws of the State of Dela- ware, and acquired First National Bank in Macomb County (formerly named First National Bank in Mount Clemens) (the "Bank"), effective April 30, 1987. The Corporation organized Bankers Fund Life Insurance Company (the "Insurance Company"), effective January 9, 1987. The Corporation exists primarily for the purpose of holding all the stock of its subsidiaries, the Bank and the Insurance Company, and of such other subsidiaries as it may acquire or establish. The Corporation's principal source of operating funds is expected to be dividends from the Bank. The expenses of the Corporation are generally paid using funds derived from dividends paid to the Corporation by the Bank. THE BANK The Bank is a national banking association which has been in operation since 1926 under the laws of the United States of America, pursuant to a charter issued by the Office of the Comptroller of the Currency. The Bank is a member of the Federal Reserve System, and its deposits are insured to the maximum extent provided by the Federal Deposit Insurance Corporation. The Bank, through its main office at 49 Macomb Place, Mount Clemens, Michigan and through its branch offices provides a wide variety of commercial banking services to individuals, businesses, governmental units, financial institutions, and other institutions. Its services include accepting time, demand and savings deposits, including regular checking accounts, NOW accounts, money market certificates, and fixed rate certificates of deposit. In addition, the Bank makes secured and unsecured commercial, construction, mortgage and consumer loans; finances commercial transactions, and provides safe deposit facilities. Each location has an automated teller machine ("ATM") which participates in the Network 1 system, a regional shared network; the Cashstream system, an eastern United States regional network; the Cash Station system, a midwest regional network; and the Cirrus system, a nationwide network. In addition to the foregoing services, the Bank provides its customers with extended banking hours, and a system to perform certain transactions by telephone or personal computer. The Bank does not have trust powers, but it provides trust services via a correspondent bank relationship. THE INSURANCE COMPANY The Insurance Company is incorporated under the laws of the State of Arizona. It is subject to regulation by the Arizona Corporation Commission and the Arizona Department of Insurance. Since substantially all of its business is conducted in the State of Michigan, it is re- quired to qualify as a foreign corporation, doing business in the State of Michigan. EFFECT OF GOVERNMENT MONETARY POLICIES The earnings of the Corporation are affected by domestic economic conditions and the monetary and fiscal policies of the United States government and its agencies. The Federal Reserve Board's monetary poli- cies have had, and will likely continue to have, an important impact on the operating results of commercial banks through its power to implement national monetary policy in order to, among other things, curb inflation or combat a recession. The policies of the Federal Reserve Board have a major effect FIRST NATIONAL BANK CORP. FORM 10-K (continued) upon the levels of bank loans, investments and deposits through its open market operations in United States government securities, and through its regulation of, among other things, the discount rate on borrowings of member banks and the reserve requirements against member bank deposits. It is not possible to predict the nature and impact of future changes in monetary and fiscal policies. REGULATION AND SUPERVISION The Corporation, as a bank holding company under the Bank Holding Company Act, is required to file with the Federal Reserve Board an annual report and such additional information as the Federal Reserve Board may require pursuant to the Bank Holding Company Act, and is subject to examination by the Federal Reserve Board. The Bank Holding Company Act limits the activities which may be engaged in by the Corporation and its subsidiaries to those of banking and the management of banking organizations, and to certain non-banking activities, including those activities which the Federal Reserve Board may find, by order or regulation, to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. The Federal Reserve Board is empowered to differentiate between activities by a bank holding company, or a subsidiary thereof, and activities commenced by acquisition of a going concern. With respect to non-banking activities, the Federal Reserve Board has, by regulation, determined that certain non-banking activities are closely related to banking within the meaning of the Bank Holding Company Act. These activities include, among other things, operating a mortgage company, finance company, credit card company or factoring company; performing certain data processing operations; providing certain investment and financial advice; acting as an insurance agent for certain types of credit related insurance; leasing property on a full-payout, nonoperating basis; and, subject to certain limitations, providing discount securities brokerage services for customers. The Corporation has organized the Insurance Company for the purpose of engaging in the credit life, accident, and health reinsurance business. The Corporation has no current plans to engage in other non-banking activities. The Bank is subject to certain restrictions imposed by federal law on any extension of credit to the Corporation, or any of its subsidiaries, on investments in stock or other securities thereof, and on the taking of such stock or securities as collateral for loans to any borrower. Federal law prevents the Corporation from borrowing from the Bank unless the loans are secured in designated amounts. With respect to the acquisition of banking organizations, the Corporation is required to obtain the prior approval of the Federal Reserve Board before it can acquire all or substantially all of the assets of any bank, or acquire ownership or control of any voting shares of any bank, if, after such acquisition, it will own or control more than 5% of the voting shares of such bank. The Bank Holding Company Act does not permit the Federal Reserve Board to approve the acquisition by the Corporation, or any subsidiary, of any voting shares of, or interest in, or all or substantially all of the assets of any bank located outside the State of Michigan, unless such acquisition is specifically authorized by the laws of the state in which such bank is located. Certain states within the same geographic region have enacted reciprocal legislation, allowing interstate acquisitions of and by banking organizations. The Bank is required to maintain a noninterest bearing deposit (reserve balance) with the Federal Reserve Bank, based on a percentage of the Bank's deposits. During 1993 and 1992, the average reserve balances were approximately $2,717,000 and $2,069,000, respectively. EMPLOYEES As of December 31, 1993, the Corporation and the Bank employed 244 persons (full-time equivalent). FIRST NATIONAL BANK CORP. FORM 10-K (continued) COMPETITION All phases of the business of the Bank are highly competitive. The Bank competes with numerous financial institutions, including other commercial banks, in the Macomb County and Greater Detroit area. The Bank, along with other commercial banks, competes with respect to its lending activities, and competes in attracting demand deposits, with savings banks, savings and loan associations, insurance companies, small loan companies, credit unions and with the issuers of commercial paper and other securities, such as shares in various mutual funds. Many of these institutions are substantially larger and have greater financial resources than the Bank. Interstate banking legislation has further increased competition within the financial services industry. The competitive factors among financial institutions can be classified into two categories; competitive rates and competitive services. With the advent of deregulation, rates have become more competitive, especially in the area of time deposits. From a service standpoint, financial institutions compete against each other in types of services. The Bank is generally competitive with other financial institutions in its primary service area with respect to interest rates paid on time and savings deposits, charges on deposit accounts and interest rates charged on loans. With respect to services, the Bank offers extended banking hours, personal checking services, a network of automated teller machines, and telephone banking services. Pursuant to federal regulations, the Bank is limited in the amount that it may lend to a single borrower. As of December 31, 1993, and December 31, 1992, the legal lending limits were approximately $5,568,000 and $4,918,000, respectively. ADDITIONAL STATISTICAL INFORMATION The majority of the consolidated statistical information for the Corporation is shown under the captions "Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Selected Quarterly Financial Information," on pages 29 through 34 and page 35, respectively, of the Annual Report of the Corporation for the year ended December 31, 1993, and is incorporated by reference herein. The following discussion contains additional statistical information for the Corporation. FIRST NATIONAL BANK CORP. FORM 10-K (continued) SECURITY PORTFOLIO The following table shows the composition of the security portfolio as of the dates indicated: Loan and Lease Portfolio The following table details the composition of the loan and lease portfolio as of the dates indicated: FIRST NATIONAL BANK CORP. FORM 10-K (continued) Residential real estate loans are generally for owner occupied, one to four family homes, which are secured by mortgages. The majority of these loans have a fixed interest rate. The increase in commercial loans during the 1989 to 1993 period came mostly from variable rate loans secured by commercial mortgages. In 1990, a large portion of the increase also came from fixed rate loans secured by commercial mortgages; and, in 1993, variable rate lines of credit contributed significantly to the increase. A large portion of the Bank's commercial mortgages are working capital loans, in which the Bank takes real estate as security on the loan. The decrease in installment loans in 1992 and 1993 was due primar- ily to the changing nature of the economy, as automobile and boat pur- chases (and therefore lending) have slowed, and consumers have tended to reduce their levels of debt. 1991's decrease was due to the Bank's sale of its credit card portfolio. The increase in installment loans in 1990 was primarily from "equity" lines of credit. The Bank has no material foreign or agricultural loans, and no material loans to energy producing customers. The following table shows the maturity distribution, classified according to fixed or variable interest rates, for the Bank's commercial loan portfolio at December 31, 1993. ANALYSIS OF NONPERFORMING LOANS The following table details the aggregate amount of nonaccrual loans and loans past due 90 days or more (but still accruing) as of the dates indicated: FIRST NATIONAL BANK CORP. FORM 10-K (continued) Loans are placed on a nonaccrual basis when, in the opinion of management, uncertainty exists as to the ultimate collection of princi- pal and interest. For the year ended December 31, 1993, $77,000 would have been recorded in interest income for loans in nonaccrual status at December 31, 1993, assuming they had been current in accordance with the original terms of the loan agreements. Interest received on such loans is credited directly to income. Interest income of $5,000 was collected and included in net income for the year ended December 31, 1993, for loans in nonaccrual status at December 31, 1993. Included in the nonaccrual category at December 31 were loans totaling $622,000 to a commercial borrower that was experiencing cash flow problems. The loans matured in 1992, and no principal or interest payments had been received since early 1993. Unpaid interest was $55,- 000 as of December 31, 1993. The loans were secured by a commercial property of the borrower. The Bank foreclosed on the collateral, and the property was sold in January, 1994. The entire principal amount was recovered in the sale; however, no interest was received. Another fore- closed property of the same borrower is being carried in other real estate at its estimated net realizable value of $300,000 at December 31, 1993. The Corporation charged off a total of $635,000 in 1993 related to this borrower's loans and ORE properties. Further losses, if any, are not expected to have a material effect on the Corporation's operat- ing results, liquidity, or capital resources. At December 31, 1993, there were no significant loans which are not disclosed above, where known information about possible credit prob- lems of borrowers causes management to have serious doubts as to the ability of the borrower to comply with present loan repayment terms and which, in management's judgment, may result in disclosure of such loans in the discussion above. Furthermore, management is not aware of any potential problem loans, except for those described above, which could have a material effect on the Corporation's operating results, liquidi- ty, or capital resources. Management is not aware of any other factors that would cause future net loan charge-offs, in total and by loan category, to signifi- cantly differ from those experienced in the past. At December 31, 1993, the Corporation's leverage ratio (Tier I capital to total assets) was 7.68%. Regulatory agencies require a con- solidated bank holding company to maintain a minimum leverage ratio of 3.00%. FIRST NATIONAL BANK CORP. FORM 10-K (continued) ALLOWANCE FOR LOAN AND LEASE LOSSES The following table summarizes loan balances at the end of each period and daily averages; changes in the allowance for loan and lease losses arising from loans charged off and recoveries on loans previously charged off, by loan category; additions to the allowance which have been charged to expense; and selected ratios. FIRST NATIONAL BANK CORP. FORM 10-K (continued) In each accounting period, the allowance for loan and lease losses is adjusted by management to the amount necessary to maintain the allow- ance at adequate levels. Through its internal loan review department, management has attempted to allocate specific portions of the allowance for loan losses based on specifically identifiable problem loans. Mana- gement's evaluation of the allowance is further based on consideration of actual loss experience, the present and prospective financial condi- tion of borrowers, industry concentrations within the portfolio and general economic conditions. Management believes that the present al- lowance is adequate, based on the broad range of considerations listed above. The primary risk element considered by management with respect to each installment and residential real estate loan is lack of timely payment. Management has a reporting system that monitors past due loans and has adopted policies to pursue its creditor's rights in order to preserve the Bank's position. The primary risk elements with respect to commercial loans are the financial condition of the borrower, the suffi- ciency of collateral, and lack of timely payment. Management has a policy of requesting and reviewing annual financial statements from its commercial loan customers and periodically reviews existence of collat- eral and its value. As evidenced by the table above, in 1993, the pro- vision for loan and lease losses decreased by $450,000, to $825,000, compared with a decrease of $600,000, to $1,275,000 in 1992. The prima- ry reason for the decrease was the continued improvement in the local economy, and lower levels of nonperforming loans throughout the year. Although management of the Bank believes that the allowance for loan and lease losses is adequate to absorb losses as they arise, there can be no assurance that the Bank will not sustain losses in any given period which could be substantial in relation to the size of the allow- ance for loan and lease losses. RETURN ON EQUITY AND ASSETS The following table contains selected ratios for the years indi- cated: ANALYSIS OF CHANGES IN NET INTEREST INCOME The components of fully tax-equivalent net interest income, along with the average daily balances of the earning assets and interest bear- ing liabilities, and the average rates earned and paid thereon, for each of the three years in the period ended December 31, 1993, are presented on page 31 of the Annual Report of the Corporation, for the year ended December 31, 1993, and are incorporated by reference herein. FIRST NATIONAL BANK CORP. FORM 10-K (continued) ITEM 2. ITEM 2. PROPERTIES The Bank leases its main office in the downtown business district of Mount Clemens. The executive offices of the Corporation are located in the Corporation - owned Financial Center, in Clinton Township. The Bank operates 16 branches located in Macomb County, 12 of which are owned and 4 of which are leased. ITEM 3. ITEM 3. LEGAL PROCEEDINGS As a depository of funds, the Bank is occasionally named as a defendant in lawsuits (such as garnishment proceedings) involving claims to the ownership of funds in particular accounts. All such litigation is incidental to the Bank's business. The Corporation's management believes that no litigation is threa- tened or pending in which the Corporation, or any of its subsidiaries, is likely to experience loss or exposure which would materially affect the Corporation's equity, financial position, or liquidity as presented herein. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. PART II ITEM 5. ITEM 5. MARKET FOR THE CORPORATION'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The information shown under the caption "Consolidated Financial Highlights" on page 1 and "Stockholder Information" on page 36 of the Annual Report of the Corporation, for the year ended December 31, 1993, is incorporated by reference herein. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The information detailed under the captions "Selected Financial Data" and "Selected Quarterly Financial Information" on pages 28 and 35, respectively, of the Annual Report of the Corporation, for the year ended December 31, 1993, is incorporated by reference herein. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION The information shown under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 29 through 34 of the Annual Report of the Corporation, for the year ended December 31, 1993, is incorporated by reference herein. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information presented under the captions "Consolidated Balance Sheets," "Consolidated Statements of Income," "Consolidated Statements of Changes in Stockholders' Equity," "Consolidated Statements of Cash Flow," "Notes to Consolidated Financial Statements," "Independent Audi- tors' Report," and "Selected Quarterly Financial Information" on pages 10 through 27 and page 35 of the Annual Report of the Corporation, for the year ended December 31, 1993, is incorporated by reference herein. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. FIRST NATIONAL BANK CORP. FORM 10-K (continued) PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information listed under the captions "Election of Directors" on pages 1 and 2, "Information about Directors and Nominees as Directors" on pages 3 and 4, and "Compliance with Section 16(a) of the Securities Exchange Act of 1934" on page 8 of the definitive Proxy Statement of the Corporation dated March 23, 1994, filed with the Securities and Exchange Commission pursuant to Regulation 14A, is incorporated by reference herein. EXECUTIVE OFFICERS The following is a list of the executive officers of the Corpora- tion, together with their ages, their present positions, and the posi- tions that they have held with the Corporation and the Bank during the past five years. Each of the executive officers of the Corporation has been employed as an officer or employee of the Corporation or the Bank for more than the past five years. Executive officers of the Corpora- tion are elected annually by the Corporation's Board of Directors to serve for the ensuing year and until their successors are elected and qualified. FIRST NATIONAL BANK CORP. FORM 10-K (continued) ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information detailed under the captions "Board of Directors Meetings and Committees" on pages 4 and 5, "Compensation Committee Interlocks and Insider Participation" on page 5, "Report of the Compensation and Executive Compensation Committee," on pages 5 and 6, "Summary Compensation Table" on page 6, "Options granted in 1993", Aggregated Stock Option Exercises in 1993 and Year End Option Values", and "Supplemental Executive Retirement Plan" on page 7 of the definitive Proxy Statement of the Corporation dated March 23, 1994, filed with the Securities and Exchange Commission pursuant to Regulation 14A, is incorporated by reference herein. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information summarized under the caption "Certain transactions" on page 7 of the definitive proxy statement of the Corporation dated March 23, 1994, filed with the Securities and Exchange Commission pursuant to Regulation 14A, is incorporated by reference herein. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information listed under the caption "Certain Transactions" on page 7 of the definitive proxy statement of the Corporation dated March 23, 1994, filed with the Securities and Exchange Commission pursuant to Regulation 14A, is incorporated by reference herein. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) The following documents are filed as a part of this Report: (*) Refers to page number(s) of Annual Report of the Corporation for the year ended December 31, 1993 at which the named item is located, and from which it is incorporated by reference into this Report. FIRST NATIONAL BANK CORP. FORM 10-K (continued) 2.Schedules: All schedules are omitted because they are inapplicable, not required, or the information is included in the financial statements or notes thereto. 3.Exhibits: FIRST NATIONAL BANK CORP. FORM 10-K (continued) (b) Reports on Form 8-K The Corporation has not filed any reports on Form 8-K during the last quarter of the period covered by this Report. FIRST NATIONAL BANK CORP. FORM 10-K (continued) SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securi- ties Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized in the Charter Township of Clinton, State of Michigan, on the 23rd day of March, 1994. FIRST NATIONAL BANK CORP. S/ ARIE GULDEMOND ------------------------ Arie Guldemond, Chairman S/ HAROLD W. ALLMACHER -------------------------------------- Harold W. Allmacher, Vice Chairman, President and Chief Executive Officer (Principle Executive Officer) S/ RICHARD J. MILLER ------------------------------------------ Richard J. Miller, Treasurer (Principle Financial and Accounting Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following Directors, in the capacities indicated on March 23, 1994. S/ RAYMOND M. CONTESTI S/ DAVID A. MCKINNON - ----------------------------- --------------------------- Raymond M. Contesti, Director David A. McKinnon, Director S/ JAMES T. CRESSWELL - ----------------------------- --------------------------- James T. Cresswell, Director Robert D. Morrison, Director S/ CELESTINA GILES S/ JOHN J. MULSO - ----------------------------- --------------------------- Celestina Giles, Director John J. Mulso, Director S/ FRANK E. JEANNETTE S/ GLEN D. SCHMIDT - ----------------------------- --------------------------- Frank E. Jeannette, Director Glen D. Schmidt, Director FIRST NATIONAL BANK CORP. FORM 10-K (continued) EXHIBIT INDEX The following constitute the exhibits to the Annual Report on Form 10-K of the Corporation for the fiscal year ended December 31, 1993: FIRST NATIONAL BANK CORP. FORM 10-K (continued)

1993 ITEM 1. BUSINESS. ------------------ General ------- Green Tree Financial Corporation ("Green Tree" or "the Company") originates conditional sales contracts for manufactured homes, home improvements and special products. The Company's insurance agencies also market physical damage and term life insurance relating to the customers' contracts it services, and acts as servicer on manufactured housing contracts originated by other lenders. Through its principal offices in Saint Paul, Minnesota and 43 regional service centers throughout the United States, Green Tree serves all 50 states. The Company finances both new and previously owned manufactured homes, and originates conventional contracts as well as contracts insured by the Department of Housing and Urban Development's Federal Housing Administration ("FHA") and contracts partially guaranteed by the Department of Veterans' Affairs ("VA"). The Company's home improvement loans are financed either on a conventional basis or insured through the FHA Title I program. In April 1993, the Company was approved as a seller and servicer of mortgages for the Federal National Mortgage Association ("FNMA"). The Company believes this new program may improve its flexibility in serving the home improvement lending market. The Company's special products contracts have historically consisted primarily of conventional contracts originated through established motorcycle dealers. In early 1993, the Company began to expand the types of special products it finances to include snowmobiles, personal watercraft, all-terrain vehicles, and trailers for recreational activities, such as horse, boat and snowmobile trailers. While the Company believes its special products will augment its overall growth, it currently does not expect special products to represent a substantial component of the Company's overall business in the foreseeable future. Green Tree pools and securitizes the contracts it originates, retaining the servicing on the contracts, and issues and sells asset-backed securities through public offerings and private placements. Substantially all FHA and VA manufactured housing contracts are converted into pass-through certificates ("GNMA certificates") guaranteed by the Government National Mortgage Association ("GNMA"), a wholly owned corporate instrumentality of the United States within the Department of Housing and Urban Development. The GNMA certificates, which are secured by the FHA and VA contracts, are then sold in the secondary market. Conventional contracts are pooled and such pools are structured into asset-backed securities which are sold in the public securities markets. The Company also pools FHA-insured and conventional home improvement contracts for sale in the secondary market. In servicing contracts, the Company collects payments from the borrower and remits principal and interest payments to the holder of the contract or investor certificate secured by the contracts. The Company was incorporated as Green Tree Acceptance, Inc. under the laws of the State of Minnesota in 1975. In 1992, the Company changed its name to Green Tree Financial Corporation. The Company's principal executive offices are located at 1100 Landmark Towers, 345 St. Peter Street, Saint Paul, Minnesota 55102-1639, and its telephone number is (612) 293-3400. Unless the context otherwise requires, "Green Tree" or "the Company" means Green Tree Financial Corporation and its subsidiaries. Purchase and Origination of Contracts ------------------------------------- Conditional sales contracts are the typical means of financing the purchase of manufactured homes ("MH") and special products ("SP"), and can also be used to finance home improvements ("HI") to existing single-family homes. A "contract" or "conditional sales contract" refers to an agreement evidencing a monetary obligation and providing security for the obligation. MH contracts grant the owner of the contract a security interest in the related manufactured home (and any other personal property described therein), and SP contracts grant a security interest in the related special product. For HI contracts, a mortgage or deed of trust on the single- family home to which the improvements relate serves as security for the payment obligation under the contract (except for unsecured contracts which may be offered on loans of $10,000 or less). All contracts that the Company originates directly or indirectly are written on forms provided by the Company and are originated on an individually approved basis in accordance with Company underwriting guidelines. Manufactured Housing -------------------- "Manufactured housing" or "manufactured home" is a structure, transportable in one or more sections, which is designed to be a dwelling with or without a permanent foundation. Since most manufactured homes are never moved once the home has reached the homesite, the wheels and axles are removable and have not been designed for continuous use. Manufactured housing does not include either modular housing (which typically involves more sections, greater assembly and a separate means of transporting the sections) or recreational vehicles ("RV's") (which are either self-propelled vehicles or units towed by passenger vehicles). Conditional sales contracts for manufactured home purchases may be financed on a conventional basis, insured by the FHA or partially guaranteed by the VA. With respect to manufactured housing, the relative volume of conventional, FHA and VA contracts originated by the Company depends on customer and dealer preferences as well as prevailing market conditions. Over the last five years, the percentage of FHA and VA contracts in the Company's manufactured home contract portfolio has ranged from 29% to 39%, and at December 31, 1993, such contracts constituted 29% of the Company's portfolio, of which approximately 94% were FHA contracts. Conventional and VA contracts are generally subject to minimum down payments of approximately 5% of the amount financed, while FHA contracts may require a minimum of 10% for down payment. Manufactured housing contract terms may be for 7 to 25 years. Through its regional service centers, the Company originates MH contracts through dealers located throughout the United States. The Company's regional personnel contact dealers located in their region and explain the Company's available financing plans, terms, prevailing rates, and credit and financing policies. If the dealer wishes to utilize the Company's available customer financing, the dealer must make an application for dealer approval. Upon satisfactory results of the Company's investigation of the dealer's creditworthiness and general business reputation, the Company and the dealer execute a dealer agreement. The Company also originates manufactured housing loan agreements directly with customers following the same general procedures for approval as it does with originations through dealers. For the year ended December 31, 1993, the Company's manufactured housing contract originations consisted of 87% originated through dealers, and 13% directly originated by the Company. The dealer or customer submits the customer's credit application and purchase order to one of the Company's service centers where the Company's personnel conduct an analysis of the creditworthiness of the proposed buyer. The analysis includes a review of the applicant's paying habits, length and likelihood of continued employment, and certain other factors. If the application meets the Company's guidelines and credit is approved, the Company agrees to fund the contract. For manufactured housing contracts, the Company uses a proprietary automated credit scoring system which was initially implemented in 1987 and subsequently refined and statistically re-validated. It is a statistically based scoring system which quantifies responses using variables obtained from customers' credit applications. As of December 31, 1993, this credit scoring system has been used in making credit determinations on approximately 1,140,000 applications. The Company believes the use of this proprietary credit scoring system has contributed to the reduction in the number of repossessions incurred as a percentage of the Company's servicing portfolio. In 1993, the manufactured housing market's shipments rose to approximately 254,000 units, a 21% increase over 1992. The Company has benefitted from the increase in the market's shipments and has increased its market share of contracts for new manufactured homes without compromising its credit standards. Competition to finance manufactured home purchases continues to be strong, and there can be no assurance that such competition will not intensify in the future. Significant decreases in consumer demand for manufactured housing, or significant increases in competition, could have an adverse effect on the Company's financial position and results of operations. Home Improvement and Special Products Through its centralized operations in Saint Paul, Minnesota, the Company arranges to originate contracts through home improvement contractors and special products dealers. The Company's available financing plans, terms, prevailing rates, and credit and financing policies are explained to the contractors and dealers. If they wish to utilize the Company's available customer financing, the contractor/dealer ("dealer") must make an application for approval. Upon satisfactory results of the Company's investigation of the dealer's creditworthiness and general business reputation, the Company and the dealer execute a dealer agreement. The Company occasionally originates home improvement loans directly. The growth in the Company's home improvement originations during the year ended December 31, 1993 is attributable primarily to the centralization of its home improvement business, the addition of business development managers throughout the United States and the implementation of a conventional home improvement lending program in September 1992. Prior to September 1992, the Company only financed home improvement contracts insured through the FHA Title I program. This focused organizational structure has enabled the Company to provide quality financial services to its expanding base of customers. The Company's home improvement contracts are generally secured by first, second or, to a lesser extent, third mortgages on single-family homes. For the year ended December 31, 1993, over 99% of the Company's home improvement contracts were originated through contractors. In April 1993, the Company was approved as a seller and servicer of secondary mortgages for FNMA. The Company believes this program may improve the Company's flexibility in serving the home improvement lending market, and expects to begin utilizing this program in 1994. The contractor, dealer or customer submits the customer's credit application and purchase order to the Company's home improvement office where personnel conduct an analysis of the creditworthiness of the proposed buyer. The analysis includes factors similar to that of a MH application. In the case of home improvement financing, the Company agrees to fund the contract if the application meets the Company's underwriting guidelines for credit approval (and applicable FHA regulations if FHA insured) and if stipulated funding guidelines are met. As to special products, the Company agrees to fund the contract once credit is approved and the customer accepts delivery of the unit. For home improvement contracts, the Company has developed a credit scoring system which was initially implemented in June 1993. This scoring system is similar to the system the Company uses in MH financing. The volume of contracts originated by the Company during the past five years and certain other information for each of those years, are indicated below: The Company believes that, in addition to an individual analysis of each contract, it is important to achieve a geographic dispersion of contracts in order to reduce the impact of regional economic conditions on the overall performance of the Company's portfolio. Accordingly, the Company seeks to maintain a portfolio of contracts dispersed throughout the United States. At December 31, 1993, no state accounted for more than 10% of all contracts serviced by the Company. In 1993, the Company originated manufactured housing contracts through over 3,000 active dealers, with no single MH dealer accounting for more than one percent of the total number of MH contracts originated by the Company. Likewise, in its home improvement business, the Company originated contracts through approximately 1,400 active contractors, and in its special products business, the Company originated contracts through approximately 600 active dealers. No single contractor or dealer accounted for more than three percent of the total number of HI or SP contracts originated by the Company. Pooling, Disposition and Related Sales Structures of Contracts -------------------------------------------------------------- The Company pools contracts for sale to investors, generally on a quarterly or more frequent basis. It is the Company's policy to sell substantially all of the contracts it originates or purchases. Conventional manufactured housing contracts are generally sold through asset-backed securities. FHA- insured and VA-guaranteed manufactured housing contracts are converted into GNMA certificates. The GNMA certificates, which are secured by the FHA and VA contracts, are then sold in the secondary market. The GNMA certificates provide for payment by the Company to registered holders of the certificates of monthly principal and interest, as well as the "pass- through" of any principal prepayments on the contracts. The Company also pools FHA-insured and conventional home improvement contracts for sale in the secondary market. Special products loans have also been pooled and sold to investors, although the Company chose to inventory its 1993 special products production. In 1994, the Company also securitized a significant portion of its excess servicing rights receivable in the form of net interest margin certificates. Principal and interest payments made by borrowers on the manufactured housing contracts securing each GNMA certificate are the source of funds for payments due on the GNMA certificates. The Company is required to advance its own funds in order to make timely payment of all amounts due on the GNMA certificates if, due to defaults or delinquencies on contracts, the payments received by the Company on the contracts securing such certificates are less than the amounts due on the certificates. If the Company was unable to make payments on the GNMA certificates as they became due, it would promptly notify GNMA and request GNMA to make such payments and, upon such notification and request, GNMA would make such payments directly to the registered holders of the certificates and would seek reimbursement from the Company, FHA or the VA as appropriate. The GNMA certificates are secured by manufactured housing contracts which are either FHA-insured or VA-guaranteed. For FHA manufactured housing contracts, the maximum amount of insurance benefits paid by FHA is equal to approximately 90% of the net unpaid principal and uncollected interest earned to the date of default on the contract, subject to certain adjustments, less the greater of the actual net sales price or FHA appraisal of the home. The amounts reimbursable by FHA are further limited to an aggregate amount representing reserves FHA has established. These reserves, which approximated $134.4 million at December 31, 1993, are based on the Company's origination and loss experience, and the Company is required to make scheduled premium payments to maintain the benefit of the reserve. If losses on FHA-insured contracts exceed the established reserve, the Company would not be reimbursed by FHA but would still be required to make payments on the GNMA certificates. For VA manufactured housing contracts, the maximum guarantee that may be issued is the lesser of: (1) the lesser of $20,000 or 40% of the principal amount of the contract, or (2) the maximum amount of guarantee entitlement available to the veteran (which may range from $20,000 to zero). Conventional manufactured housing, home improvement and special products contracts are pooled and sold by the Company through securitized asset sales which have been either single class or senior/subordinated pass- through structures. Certain senior/ subordinated structures retain a portion of the Company's excess servicing spread as additional credit enhancement or stipulate accelerated principal repayments to subordinated certificateholders. The Company reflects the cash flows unique to each transaction when measuring the net gains on contract sales. Under these structures, the Company has provided a bank letter of credit, surety bond, cash or a corporate guarantee to cover specified losses. Customer principal and interest payments are deposited to separate bank accounts as received by the Company and are held for monthly distribution to the certificateholders. The Company establishes reserves for estimated losses on the contracts comprising each pool. Upon a default under a contract and liquidation of the underlying collateral, any net losses are charged against the reserves that have been established. The dollar amount of potential contractual recourse to the Company exceeds the amount established by the Company as an "allowance for losses on contracts sold with recourse." The Company establishes an allowance for expected losses under the recourse provisions with investors/owners and calculates that allowance on the basis of historical experience as well as management's best estimate of future credit losses likely to be incurred. The underlying assets of the net interest margin certificates are the residual interest, guarantee fees, excess servicing fees, and GNMA excess spread related to certain pools of manufactured housing contracts sold by the Company. The net interest margin certificates issued by the Company in March, 1994 represent approximately 78% of the estimated present value of these assets. The Company has retained the remaining 22%, which is subordinate to the net interest margin certificates. The certificates will be payable from the cash flows of these assets, which are subject to prepayment and loan loss risk. "Contracts sold" represents the face amount of the contracts sold but not necessarily settled during the same year. Information on contracts sold is as follows: (a) Includes $533,159,000 of contracts purchased from the RTC. (b) Includes $52,108,000 of contracts purchased from other originators, but does not include $87,515,000 of contracts sold pursuant to a joint venture agreement with Merrill Lynch Mortgage Capital, Inc. The Company services all of the contracts that it originates or purchases from other originators, collecting loan payments, taxes and insurance payments, where applicable, and other payments from borrowers and remitting principal and interest payments to the holders of the asset-backed securities or of the GNMA certificates. The following table shows the composition of the Company's servicing portfolio at December 31 for the years indicated on contracts it originated. During 1990 and 1991, the Company acquired servicing on manufactured housing contracts originated by other lenders. The Company did not acquire servicing on manufactured housing contracts originated by other lenders during 1992 or 1993, and does not expect to acquire such servicing in the near future. The Company has no loss risk on these contracts and charges a service fee based on principal outstanding. The following table shows the composition of this servicing portfolio at December 31 for the years indicated. A contract is considered delinquent by the Company if any payment of $25 or more is past-due 30 days or more. Delinquent contracts are subject to acceleration, and repossession or foreclosure of the underlying collateral. Losses associated with such actions are charged against applicable reserves upon disposition of the collateral. The following table provides certain information with respect to the delinquency and loss experience of contracts the Company originated. (a) As a percentage of the total number of contracts serviced at period end (other than contracts already in repossession). (b) As a percentage of the average number of contracts serviced during the period. (c) As a percentage of the average principal amount of contracts serviced during the period. Annual net repossession losses represent the loss amount at the time the repossession is sold, and has not been reduced for amounts subsequently recovered from either customers or investors. (d) As a percentage of the total number of contracts serviced at period end. Insurance --------- Through certain subsidiaries, the Company markets physical damage insurance on manufactured homes and special products which collateralize contracts serviced by the Company and markets term life insurance to its MH and HI customers. In addition, the Company owns Green Tree Life Insurance Company, a life and disability reinsurance company, and Consolidated Casualty Insurance Company, a property and casualty reinsurance company, which function as reinsurers for policies written by selected other insurers covering individuals whose contracts are serviced by the Company. The following table provides certain information with respect to net written premiums (gross premiums on new or renewal policies issued less cancellations of previous policies) on policies written by the Company. The Company acts as an agent with respect to the sale of such policies and, in some cases, the Company also acts as reinsurer of such policies. Regulation ---------- The Company's operations are subject to supervision by state authorities (typically state banking, consumer credit and insurance authorities) that generally require that the Company be licensed to conduct its business. In many states, issuance of licenses is dependent upon a finding of public convenience, and of financial responsibility, character and fitness of the applicant. The Company is generally subject to state regulations, examinations and reporting requirements, and licenses are revocable for cause. Contracts insured under the FHA manufactured home and home improvement lending programs are subject to compliance with detailed federal regulations governing originations, servicing, and payment of contract insurance proceeds from the FHA to cover a portion of losses due to default and repossessions or foreclosures. These lending regulations were amended in November 1991 to add additional requirements such as equity requirements for home improvement contracts of over $15,000 and a pre-underwriting customer interview to verify the credit application for both programs. These changes have had the effect of making program compliance more burdensome for the Company, dealers and contractors. The FHA is presently studying other aspects of the program, and there are no assurances that future regulatory changes will not occur. Other governmental programs such as FNMA and VA also contain similar detailed regulations governing loan origination and servicing responsibilities. The FHA increased the maximum loan amounts for Title I manufactured home loans effective for credit applications completed and received after August 30, 1993. The maximum loan amounts have been increased to $48,600 for manufactured home loans, $16,200 for manufactured home lot loans and $64,800 for land-and-home loans. This represents a 20% increase over previously established maximum loan amounts. The FHA Title I maximum for single-family home improvement loans is $25,000. The Federal Consumer Credit Protection Act ("FCCPA") requires a written statement showing the annual percentage rate of finance charges, and requires that other information be presented to debtors when consumer credit contracts are executed. The Fair Credit Reporting Act requires certain disclosures to applicants for credit concerning information that is used as a basis for denial of credit. The Federal Equal Credit Opportunity Act prohibits discrimination against applicants with respect to any aspect of a credit transaction on the basis of sex, race, color, religion, national origin, age, marital status, derivation of income from a public assistance program, or the good faith exercise of a right under the FCCPA, of which it is a part. By virtue of a Federal Trade Commission rule, conditional sales contracts must contain a provision that the holder of the contract is subject to all claims and defenses which the debtor could assert against the seller, but the debtor's recovery under such provisions cannot exceed the amount paid under the contract. The Company is also required to comply with other federal disclosure laws for certain of its lending programs. The combination land-and-home program complies with the federal Real Estate Settlement and Procedures Act. In addition, the Company complies with the reporting requirements of the Home Mortgage Disclosure Act for its manufactured home and home improvement contracts. The construction of manufactured housing is subject to compliance with governmental regulation. Changes in such regulations may occur from time to time and such changes may affect the cost of manufactured housing. The Company cannot predict whether any regulatory changes will occur or what impact such future changes would have on the manufactured housing industry. The Company is subject to state usury laws. Generally, state law has been preempted by federal law with respect to certain manufactured home and home improvement contracts, although individual states are permitted to enact legislation superseding federal law. To be eligible for the federal preemption, the manufactured home or home improvement contract form must comply with certain consumer protection provisions. A few states have elected to override federal law, but have established maximum rates that either fluctuate with changes in prevailing rates or are high enough so that, to date, no state's maximum interest rate has precluded the Company from continuing business in that state. Competition and Other Factors ----------------------------- The Company is affected by consumer demand for manufactured housing, home improvements, special products and its insurance products. Consumer demand, in turn, is partially influenced by regional trends, economic conditions and personal preferences. The Company competes with banks, savings and loan associations, finance companies, finance subsidiaries of certain manufacturing companies, credit unions and others seeking to purchase contracts. Prevailing interest rates are typically affected by economic conditions. Changes in rates, however, generally do not inhibit the Company's ability to compete, although from time to time in particular geographic areas, local competition may choose to offer more favorable rates. The Company competes by offering superior service, prompt credit review, and a variety of financing programs. The Company's business is generally subject to seasonal trends, reflecting the general pattern of sales of manufactured housing and site-built homes. Sales typically peak during the spring and summer seasons and decline to lower levels from mid-November through January. Employees --------- As of December 31, 1993, the Company had 1,645 full-time and 208 part-time employees, and considers its employee relations to be satisfactory. None of the employees are represented by a union. ITEM 2. ITEM 2. PROPERTIES. -------------------- At December 31, 1993, the Company operated 40 manufactured housing regional service centers located in 34 states. The Company plans to open three additional regional servicing centers in 1994. Such offices are leased, typically for a term of three years, and range in size from 1,600 to 10,500 square feet to accommodate a staff of approximately 8 to 46 employees. In February 1994, the Company's home improvement division entered into a lease for its main office in Saint Paul, Minnesota. The lease is for a term of five years and consists of 77,000 square feet to accommodate their staff of approximately 230 employees. (See Note I of Notes to Consolidated Financial Statements for annual rental obligations.) In January 1993, the Company purchased the remaining commercial floors of the building which houses its corporate offices. (See Note D of Notes to Consolidated Financial Statements.) ITEM 3. ITEM 3. LEGAL PROCEEDINGS. --------------------------- Reference is made to Note I, Litigation, of Notes to Consolidated Financial Statements contained in Item 8 hereof. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. ------------------------------------------------------------- None. PART II ------- ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED -------------------------------------------------------------- STOCKHOLDER MATTERS. -------------------- The Company's Common Stock is traded on the New York and Pacific Stock Exchanges under the symbol "GNT." The following table sets forth, for the periods indicated, the range of the high and low sale prices. The above stock prices, as well as all other share and per share amounts referenced in this Annual Report on Form 10-K, have been restated to reflect a two-for-one stock split effected in the form of a stock dividend during January 1993. On February 28, 1994, the Company had approximately 453 shareholders of record of its Common Stock including the nominee of The Depository Trust Company which held approximately 32,296,314 shares of Common Stock. The Company has paid cash dividends since December 1986. The 1993 quarterly dividend rate through the third quarter was $0.08125 per share. In September 1993, the Board of Directors approved an increase in the quarterly dividend rate to $0.09375 per share effective December 1993. The payment of future dividends will depend on the Company's financial condition, prospects and such other factors as the Board of Directors may deem relevant. Under certain debt agreements, the Company is subject to restrictions limiting the payment of dividends and Common Stock repurchases. At December 31, 1993, under the most restrictive agreement, such payments were limited to $43,585,000, which represents 50% of consolidated net earnings for the most recently concluded four fiscal quarter periods less dividends paid and prepayment of subordinated debt during such period. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. --------------------------------- (a) Before extraordinary loss relating to the debt exchange in 1992. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS. ---------------------------------------------- Introduction ------------ The Company originates conditional sales contracts for manufactured homes ("MH"), home improvements ("HI") and special products ("SP") (primarily motorcycles to date). In early 1993, the Company began to expand the types of special products it finances to include snowmobiles, personal watercraft, all- terrain vehicles, and trailers for recreational activities, such as horse, boat and snowmobile trailers. The Company also markets physical damage and term life insurance relating to the customers' contracts it services, and acts as servicer on manufactured housing contracts originated by other lenders. The Company records "net gains on contract sales" at the time of sale of its contracts and defers service income, recognizing it as servicing is performed. The Company's net gains on contract sales are an amount equal to the present value of the expected excess servicing rights receivable to be collected during the term of the contracts, plus or minus any premiums or discounts realized on the sale of the contracts and less any selling expenses. "Excess servicing rights receivable" represents cash expected to be received by the Company over the life of the contracts. Excess servicing rights receivable is calculated by aggregating the contractual payments to be received pursuant to the contracts and subtracting: (i) the estimated amount to be remitted to the investors/owners of the contracts, (ii) the estimated amount that will not be collected as a result of prepayments, (iii) the estimated amount to be remitted for FHA insurance and other credit enhancement fees and (iv) the estimated amount that represents deferred service income. Deferred service income represents the amount that will be earned by the Company for servicing the contracts. Concurrently with recognizing such gains, the Company also records the present value of excess servicing rights as an asset on the Company's balance sheet. The excess servicing rights receivable is calculated using prepayment, default, and interest rate assumptions that the Company believes market participants would use for similar instruments. The excess servicing rights receivable has not been reduced for expected losses under recourse provisions of the sales, but such rights are subordinated to the rights of investors/owners of the contracts. The Company believes that the excess servicing rights receivable recognized at the time of sale does not exceed the amount that would be received if it were sold in the marketplace. The Company records the amount to be remitted to the investors/owners of the contracts for the activity related to the current month, payable the next month, as "investor payable" and it is shown separately as a liability on the Company's balance sheet. The Company establishes an allowance for expected losses under the recourse provisions with investors/owners of contracts or investor certificates and calculates that allowance on the basis of historical experience and management's best estimate of future credit losses likely to be incurred. The amount of this provision is reviewed quarterly and adjustments are made if actual experience or other factors indicate management's estimate of losses should be revised. The Company retains a substantial amount of risk of default on the loan portfolios that it sells. The Company has provided the investors/owners of pools of contracts with a variety of additional forms of credit enhancements. These credit enhancements have included letters of credit, corporate guarantees and surety bonds that provide limited recourse to the Company, and letters of credit that if drawn, are entitled to reimbursement only from the future excess cash flows of the underlying transactions. Furthermore, certain securitized sales structures use cash reserve funds and certain cash flows from the underlying pool of contracts as the credit enhancement. The Company believes that its allowance for losses on contracts sold with recourse is adequate and consistent with current economic conditions as well as historical default and loss experiences of the Company's entire loan portfolio. The outstanding security balances of contracts at December 31, 1993 were $1,793,908,000 of GNMA certificates and $4,713,012,000 related to securitized transactions, including whole loan sales. The allowance for losses on contracts sold with recourse is shown separately as a liability. For contracts sold prior to October 1, 1992, the allowance has been recorded on a nondiscounted basis. For contracts sold subsequent to September 30, 1992, the allowance has been discounted using an interest rate equivalent to the risk-free market rate for securities with a duration similar to that estimated for the underlying contracts based on guidance issued by the Financial Accounting Standards Board's Emerging Issues Task Force in "EITF Issue 92-2". The Company's expectations used in calculating its excess servicing rights receivable and allowance for losses on contracts sold with recourse are subject to volatility that could materially affect operating results. Prepayments resulting from obligor mobility, general and regional economic conditions, and prevailing interest rates, as well as actual losses incurred, may vary from the performance the Company projects. The Company recognizes the impact of adverse prepayment and loss experience by recording a charge to earnings immediately. The Company reflects favorable portfolio experience prospectively as realized. During March 1994, the Company concluded its first public sale of a significant portion of its excess servicing rights receivable. The sale was in the form of senior/subordinated net interest margin certificates whereby the senior certificates were issued by a trust, supported by the cash flows from previous manufactured housing securitizations and GNMA sales, whose only assets are the cash flows derived from certain excess servicing rights and the proceeds therefrom. The subordinated certificates were retained by the Company. The effect of this transaction was to monetize a significant portion of the Company's excess servicing rights receivable and to begin to establish a public market for such net interest margin certificates. Results of operations --------------------- The following table shows, for the periods indicated, the percentage relationships to income of certain income and expense items and the percentage changes in such items from period to period. Net gains on contract sales, when netted with the Company's provision for losses on contract sales, increased 66.3% in 1993 as the dollar volume of contracts originated and sold rose over 1992. During the year ended December 31, 1993, total contract sales increased $474,274,000, or 25.3%. Also contributing to the increase in net gains on contract sales for both 1993 and 1992 was an increase in the average contract size and term due to a shift in manufactured home sales to more expensive multi-section homes versus single-wide homes. These increases for 1993 were partially offset by decreased interest rate spreads on contracts sold and an increase in prepayment reserves as a result of falling interest rates and the ongoing evaluation of the Company's prepayment projections based on year-to-date activity. The increase in net gains on contract sales in 1992 is a reflection of the higher percentage of conventional versus GNMA contracts sold. In addition, during the first quarter of 1992, the Company purchased portfolios from the Resolution Trust Corporation ("RTC") which resulted in gains at the time of sale primarily due to purchase discounts. The gain on RTC contract sales was substantially offset by recourse liabilities assumed at the same time which were included in the provision for losses on contracts sales (see below). For 1991, net gains on contract sales reflects increased interest rate spreads on contracts sold and the impact of securitization of portfolios purchased from other originators at discounts. Prevailing interest rates are typically affected by economic conditions. Changes in interest rates generally do not inhibit the Company's ability to compete, although from time to time, in particular geographic areas, local competition may be able to offer more favorable rates. Because of the size of the excess servicing spread (which enables the Company to absorb changes in interest rates) and the relatively short period of time between origination of contracts and sale by the Company of such contracts, the Company's ability to sell contracts is generally not affected by gradual changes in interest rates, although the amount of earnings may be affected. Average excess servicing spreads were 3.8%, 4.8% and 4.5% for 1993, 1992 and 1991, respectively. Excess servicing spreads decreased during 1993 as the rates on the contracts originated by the Company declined faster than the rates on the Company's sales of securitized loans. Excess servicing spreads increased during 1992 as the rates on contracts purchased, primarily from the RTC, were higher than the rates on the contracts originated by the Company during 1992. Excluding the contracts purchased from the RTC, the servicing spread was 4.1% for 1992, which is reflective of interest rate movements during the year and interest rates at the time of sale. Excess servicing spreads increased during 1991 as the rates on contracts originated by the Company declined more slowly than the rates on the Company's sales of securitized loans. In addition, the inclusion of seasoned portfolios in the Company's securitized program reduced the expected lives of contracts sold, further contributing to the increased spreads. Traditionally, changes in interest rates have less of an impact on the Company's prepayment level as compared to conventional housing prepayment levels. The changes in the interest rate environment, however, did cause an increase in prepayments on the portfolio underlying the Company's excess servicing rights receivable during 1993 and 1992. The weighted average customer interest rate on the underlying portfolio of the Company decreased during 1993 and 1992 due to lower rates on originations for those years. A lower interest rate portfolio should add even greater prepayment stability to the Company's portfolio. The 26.8% decrease in the provision for losses on contract sales for 1993 is a result of the increased provision for losses incurred in 1992 for the recourse liabilities assumed as a result of the RTC repurchase and as a result of discounting the provision for losses on contracts sold during all of 1993 compared to just one quarter in 1992. The decrease in the provision also reflects the shift in manufactured home sales to more expensive multi-section homes and land-and-home sales from single-wide homes, as well as the continued use of the Company's proprietary credit scoring system and the resulting improvement in loan performance. The 40.8% increase in the provision for losses on contract sales for 1992 reflects the effect of the RTC repurchase as well as the higher dollar volume of contracts sold including a higher percentage of conventional versus GNMA contracts sold. The Company's provision for losses on contract sales increased by 134.6% from 1990 to 1991 as a result of an increase in contract sales of $105,829,000, additional losses incurred in 1991 as a result of the unexpected length and severity of the recession, additional provisions for the expected impact of a continuing recession, as well as additions for anticipated losses on portfolios purchased at a discount from other originators which the Company estimates will perform less favorably than the Company's originated product. The Company feels that its credit underwriting standards and servicing procedures will stabilize its loss experience. A very important factor in the reduction of the Company's credit risk is the geographic dispersion of the portfolio. At December 31, 1993, no state accounted for more than 10% of all contracts serviced by the Company. The Company continually monitors its dispersion of contracts as economic downturns are more severely felt in certain geographic areas than others. Interest income is realized from contracts held for sale, cash deposits and amortization of the present value discount established for the excess servicing rights receivable. Interest income grew 45.2% during 1993 due to interest earned on the increased dollar amount of contracts held for sale during 1993 compared to 1992, and due to an increase in the amortization of present value discount on the Company's increasing excess servicing rights receivable. Interest income grew during 1992 and 1991 primarily due to increases in the amortization of present value discount on the excess servicing rights receivable. The increase in service income of 6.8% during 1993 and 4.9% during 1992 resulted from the increase in the Company's growing servicing portfolio. The Company's average servicing portfolio grew 20.3% during 1993 and 12.2% during 1992. Offsetting this increase in revenue was a decline in servicing revenue on contracts originated by others. The average unpaid principal balance of contracts being serviced for others during 1993 and 1992 decreased 23.0% and 19.8%, respectively. The Company expects this decline in outside servicing to continue in the future. Servicing income in 1991 included additional amortization of deferred service income as a result of increasing the rate at which such income is deferred to reflect 44 basis points over the entire portfolio, higher fees collected under outside servicing agreements and growth in the Company's servicing portfolio. Commissions and other income, which represents commissions earned on new insurance policies written and renewals on existing policies, as well as other income from late fees, grew during 1993, 1992 and 1991 as a result of the increase in the Company's contract originations and servicing portfolio. Excluding a nonrecurring loss in the third quarter of 1991, commissions and other income increased 12.7% in 1992. The Company's interest expense increased 14.0% in 1993 as a result of the higher amount of average outstanding borrowings supporting the Company's increased contract inventory levels. The increase was, however, partially offset by lower credit facility borrowing rates and the lower effective interest rate on the Company's senior subordinated debt as a result of the Company's debt exchange in April 1992. Interest expense decreased 8.4% during 1992 primarily as a result of the April 1992 debt exchange which reduced the blended effective cost of the Company's publicly held subordinated debt from 13.1% to 10.8%. In addition, average interest rates on the Company's line of credit borrowings decreased substantially from 1991, although the average amount outstanding rose. Interest expense declined in 1991 due to the cancellation of long-term debt related to the office building the Company previously owned, and a decline in short-term borrowing rates. While the dollar amount of cost of servicing has increased over the past three years, the cost of servicing as a percentage of contracts serviced remained relatively constant during 1991 and 1992 , and decreased modestly in 1993. General and administrative expenses rose 49.7% during 1993, however, as a percentage of revenue, these expenses have remained consistent with the previous two years. The dollar growth is due primarily to an increase in personnel and other origination costs related to the significant growth in the number of contracts the Company has originated during the year. The number of contracts originated during 1993 increased 81.6% over 1992. The increase in general and administrative costs during 1992 and 1991 are related to the centralization and growth in the Company's home improvement division and the growth in manufactured home loan originations. The Company continues to actively manage and control these expenses, although increases are expected as the volume of business grows. During the third quarter of 1993, the Company took a one-time charge to earnings of $4,685,000 as a result of the August enactment of the new federal corporate income tax rate. The charge reflects the increase in the federal corporate income tax rate on the Company's deferred tax liability and increased the Company's effective tax rate during the year to 41.9%. Going forward, the Company's effective tax rate is expected to be 40%, compared to 39% in 1992 and 38.5% in 1991. The Company is affected by consumer demand for manufactured housing, home improvements, special products and its insurance products. Consumer demand, in turn, is partially influenced by regional trends, economic conditions and personal preferences. The Company can make no prediction about any particular geographic area in which it does business. These regional effects, however, are mitigated by the national geographic dispersion of the Company's servicing portfolio. Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," does not affect the Company as the Company does not provide postretirement benefits other than its pension plans. Inflation has not had a material effect on the Company's income or earnings over the past three fiscal years. Capital resources and liquidity ------------------------------- Green Tree's business requires continued access to the capital markets for the purchase, warehousing and sale of contracts. To satisfy these needs, the Company employs a variety of capital resources. Historically, the most important liquidity source for the Company has been its ability to sell contracts in the secondary markets through loan securitizations and sales of GNMA certificates. Under certain securitized sales structures, bank letters of credit, surety bonds, cash deposits or other equivalent collateral are provided by the Company as credit enhancements. Certain senior/subordinated structures retain a portion of the Company's excess servicing spread as additional credit enhancement or for accelerated principal repayments to subordinated certificateholders. The Company analyzes the cash flows unique to each transaction, as well as the marketability and earnings potential of such transactions when choosing the appropriate structure for each securitized loan sale. In addition, the structure of each securitized sale depends, to a great extent, on conditions of the fixed income markets at the time of sale, as well as cost considerations, availability and effectiveness of the various enhancement methods. During 1993, the Company utilized a combination of senior/subordinated structures and corporate guarantees in its manufactured home asset securitizations, and did not utilize any outside sources of credit enhancement to effect its sales. The home improvement loan sales in 1993 were enhanced with a cash deposit. During March 1994, the Company added another liquidity source as it completed its first public sale of a significant portion of its excess servicing rights receivable. Net proceeds to the Company from the sale are expected to be approximately $493,000,000 and will be used to pay down short-term debt and fund the Company's future growth. In February 1992, the Company replaced letters of credit and cash deposits held as credit enhancements for certain existing securitized transactions with financial guaranty insurance policies issued by a credit bond insurer for an annual fee approximately equal to the Company's cost of maintaining the letters of credit and cash deposits. The financial guaranty insurance polices are noncancelable for the lives of the securitized transactions. The effect of this transaction was to make available to the Company previously restricted cash deposits approximating $20 million. In addition, the Company's outstanding letters of credit were reduced by approximately $62 million. Servicing fees and net interest payments collected, which is the Company's principal source of cash, increased in each of the last three years. These increases are a result of the increased amount of servicing spread collected as the Company's servicing portfolio continues to grow. With the completion of the sale of net interest margin certificates in March 1994, the Company will show an increase in servicing fees and net interest payments collected for the first quarter of 1994. Thereafter, servicing fees and net interest payments collected will consist of servicing fees collected only from the net interest margin certificates, plus servicing fees and net interest payments on all existing HI and SP securitizations, and all future securitizations in which the Company does not sell the related excess servicing rights. After the first quarter of 1994, repossession losses net of recoveries will likewise only consist of losses on existing HI and SP securitizations, plus losses on future securitizations, and losses on the first five MH securitizations (1987 through the first quarter of 1988), as such losses have been excluded from the net interest margin certificate sale. Net principal payments collected have been positive in each of the last three years as a result of an increase in the contract principal payments collected by the Company as of the end of each year but not yet remitted to the investors/owners of the contracts. These increases are a result of customer payoffs and the growth of the Company's servicing portfolio. The significant increase in net principal payments collected in 1992 compared to 1991 occurred in conjunction with the purchase and resale of the contracts from the RTC in which the Company recouped approximately $18,000,000 of previously advanced principal. The Company expects net principal payments collected to decrease in 1994 as payoffs are expected to stabilize. Accelerated principal repayments to subordinated certificateholders ("defeasance payments") increased during 1993 and 1992. Defeasance structures were used on the Company's securitized sales in the fourth quarter of 1990 through the second quarter of 1992. Generally, defeasance payments will decline as the securitization balances on these securitized loan sales decrease. Net cash used for operating activities increased in 1993 due largely to the increase in dollar volume of contracts held for sale. This increase in contract inventory was a result of the Company's decision not to securitize any SP loans, any HI loans after the second quarter, and through increases in MH production. Although the Company purchased more contracts than it sold, resulting in a usage of cash, this usage was offset by positive cash flows from other operating items, including an increase in servicing and net payments collected, an increase in interest on contracts and GNMA certificates held for sale, and a reduction in repossession losses. During 1992, the additional servicing fees and net interest and principal payments collected, as well as the reduction in net cash deposits provided, contributed to the Company's positive cash flows from operating activities. These increased operating cash flows in 1992 were offset by repossession losses net of recoveries which increased 57% in 1992 over 1991 as a result of management's action to reduce the Company's aged repossession inventory levels and poor economic conditions in California. Negative cash flows from operating activities in 1991 were primarily due to cash deposits that the Company was required to provide as credit enhancements for newly issued and existing securitized sales. To a lesser extent, 1993, 1992 and 1991 cash flows from operating activities were also reduced by income taxes paid. The Company expects it will use its remaining net operating loss carryforward during 1994 and 1995, and accordingly will be paying additional taxes on its taxable income thereafter. Net cash used for investing activities for the year ended December 31, 1993 included the purchase of certain floors of the building where its corporate offices are located. The positive cash flows from investing activities in 1991 are a result of the sale of GNMA certificates previously held for investment and the sale of other assets. Net cash provided by financing activities was positive in 1993 and 1991 as borrowings on credit facilities and proceeds from the issuance of common stock and debt exceeded debt repayments and dividends, while in 1992, debt repayments, dividends and other financing activities exceeded borrowings. The Company has a $60 million bank warehousing credit agreement for the purpose of financing its manufactured home, home improvement and motorcycle contract production under which $58,725,000 was available, subject to the availability of appropriate collateral, at December 31, 1993. This agreement expires November 30, 1994. In addition, the Company currently has $950 million in master repurchase agreements with various investment banking firms for the purpose of financing its contract production. At December 31, 1993, the Company had $765,535,000 available under these master repurchase agreements, subject to the availability of appropriate collateral. These agreements expire during 1994, however, the Company believes, based on discussions with the lenders, that these agreements will be renewed. At December 31, 1993, the Company also had $21,171,000 of notes payable outstanding through a GNMA reverse repurchase agreement. These notes were collateralized by GNMA certificates. In September 1993, the Company completed a 2,500,000 share common stock offering, and sold an additional 375,000 shares to cover over-allotments. The net proceeds of approximately $138,000,000 were used to finance the Company's continued growth in its manufactured home, home improvement and special products contract inventory, to temporarily reduce notes payable under the Company's borrowing agreements, and for other general corporate purposes. During the first quarter of 1992, the Company completed a 6,000,000 share common stock offering, and in April 1992, the Company sold an additional 614,800 shares to cover over-allotments. The net proceeds of approximately $115,000,000 were used to purchase and retire all of the Company's outstanding preferred stock (which had a liquidation value of $143,495,000) for $102,000,000 as part of the settlement of litigation between the Company and the RTC, and for general corporate purposes. The preferred stock had a $9,300,000 annual cash dividend requirement which terminated upon its repurchase. In September 1992, the Securities and Exchange Commission declared effective the Company's $250 million shelf registration which enables the Company to offer, from time to time, medium-term notes with maturities in excess of nine months. The notes may bear interest at fixed or floating rates. In October 1992, the Company sold $12 million of 7.55% notes due 1999. In April 1993, the Company sold $14,650,000 of medium-term notes. The notes were issued at varying rates (6.69% to 7.62%) with terms ranging from 5 to 10 years. The proceeds from the issuance of these notes were used to pay down the Company's notes payable. The issuance of these notes lengthened the Company's debt maturity schedule at an interest rate which the Company believes to be favorable. In April 1992, the Company completed an exchange offer related to its 8 1/4% Senior Subordinated Debentures due 1995 (the "Debentures"). Of the $287,500,000 of Debentures, $267,254,000 were tendered and accepted for exchange by the Company for its new 10 1/4% Senior Subordinated Notes due 2002. The result of the exchange was to reduce the blended effective cost of the Company's outstanding subordinated debt from 13.1% to 10.8%. An extraordinary charge of $17,457,000 was recognized in the second quarter as a result of the exchange. The extraordinary charge resulted from the accelerated write-down of the original issue discount and deferred debt expense, net of income taxes of $11,161,000, relating to the Debentures exchanged. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. ----------------------------------------------------- GREEN TREE FINANCIAL CORPORATION AND SUBSIDIARIES FINANCIAL STATEMENTS FURNISHED PURSUANT TO THE REQUIREMENTS OF FORM 10-K AND INDEPENDENT AUDITORS' REPORT ------------------------------------- YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 -------------------------------------------- INDEPENDENT AUDITORS' REPORT The Board of Directors and Shareholders Green Tree Financial Corporation Saint Paul, Minnesota: We have audited the accompanying consolidated balance sheets of Green Tree Financial Corporation and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, stockholders' equity and cash flows for each of the years in the three-year period ended December 31, 1993 and the financial statement schedules listed in the Index at Item 14(a)(2). These consolidated financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules 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 Green Tree Financial Corporation and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1993 in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, information set forth therein. KPMG Peat Marwick Minneapolis, Minnesota March 22, 1994 GREEN TREE FINANCIAL CORPORATION AND SUBSIDIARIES ------------------------------------------------- CONSOLIDATED BALANCE SHEETS --------------------------- See notes to consolidated financial statements. GREEN TREE FINANCIAL CORPORATION AND SUBSIDIARIES ------------------------------------------------- CONSOLIDATED STATEMENTS OF OPERATIONS ------------------------------------- See notes to consolidated financial statements. GREEN TREE FINANCIAL CORPORATION AND SUBSIDIARIES ------------------------------------------------- CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY ----------------------------------------------- See notes to consolidated financial statements. GREEN TREE FINANCIAL CORPORATION AND SUBSIDIARIES ------------------------------------------------- CONSOLIDATED STATEMENTS OF CASH FLOWS ------------------------------------- GREEN TREE FINANCIAL CORPORATION AND SUBSIDIARIES ------------------------------------------------- CONSOLIDATED STATEMENTS OF CASH FLOWS ------------------------------------- See notes to consolidated financial statements. GREEN TREE FINANCIAL CORPORATION AND SUBSIDIARIES ------------------------------------------------- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ------------------------------------------ YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 -------------------------------------------- A. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of consolidation --------------------------- The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All material intercompany profits, transactions and balances have been eliminated. Contract sales -------------- The Company originates directly, or indirectly through dealers, conditional sales contracts. It typically sells the contracts at or near par to investors with servicing retained (the Company retains a participation in cash flows from the loans). The present value of expected cash flows from this participation which exceeds normal servicing fees is recorded at the time of sale as "excess servicing rights receivable." The excess servicing rights receivable is calculated using prepayment, default and interest rate assumptions that the Company believes market participants would use for similar instruments but is not reduced for expected losses under recourse provisions of the sales. The Company believes that the excess servicing rights receivable recognized at the time of sale does not exceed the amount that would be received if it were sold in the marketplace. The allowance for losses on contracts sold with recourse is shown separately as a liability on the Company's balance sheet. For contracts sold prior to October 1, 1992, the allowance is shown on a nondiscounted basis. For contracts sold after September 30, 1992, the allowance has been discounted using an interest rate equivalent to the risk-free market rate for securities with a duration similar to that estimated for the underlying contracts based on guidance issued by the Financial Accounting Standards Board's Emerging Issues Task Force ("EITF") in "EITF Issue 92-2." In determining expected cash flows, management considers economic conditions at the date of sale. In subsequent periods, these estimates are revised as necessary using the original discount rate and any losses arising from adverse prepayment and loss experience are recognized by recording a charge to earnings immediately. Favorable experience is recognized prospectively as realized. Interest payments received on the contracts, less interest payments paid to investors, is reported on the consolidated statements of cash flows as "servicing fees and net interest payments collected." Principal payments received on the contracts, less non-defeasance principal payments paid to investors is reported as "net principal payments collected" on the consolidated statements of cash flows. Interest income and service income are recognized by systematically amortizing the present value discount and deferred service income, respectively. The Company defers service income at an annual rate of 0.44%. The Company discounts cash flows on sales at the rate it believes a purchaser would require as a rate of return. The cash flows are discounted to present value using discount rates which averaged approximately 9.3% in 1993, 9.6% in 1992 and 9.5% in 1991. The Company has developed its assumptions based on experience with its own portfolio, available market data and consultation with its investment bankers. The Company believes that the assumptions used in estimating cash flows are similar to that which would be used by an outside investor. Depreciation ------------ Property, furniture and fixtures are carried at cost and are depreciated over their estimated useful lives on a straight-line basis. Deferred debt expenses ---------------------- Expenses associated with the issuance of long-term debt are amortized on a straight-line basis over the term of the debt. Amortization was $389,000 in 1993, $494,000 in 1992 and $838,000 in 1991. Earnings per common and common equivalent share ----------------------------------------------- Earnings per common and common equivalent share are computed by dividing net earnings less preferred dividends ($1,995,000 in 1992 and $9,310,000 in 1991) by the weighted average number of shares of Common Stock and Common Stock equivalents outstanding during each year. Common Stock equivalents consist of the dilutive effect of Common Stock which may be issued upon exercise of stock options. All share and per-share amounts have been restated to reflect the two-for-one stock split the Company effected in January 1993. Earnings per share and fully diluted earnings per share are substantially the same. Cash and cash equivalents ------------------------- For purposes of the statements of cash flows, the Company considers all highly liquid temporary investments purchased with a maturity of three months or less to be cash equivalents. These temporary investments are held in United States Treasury Funds or bank money market accounts. At December 31, 1993 and 1992, cash of approximately $140,528,000 and $107,117,000, respectively, was held in trust for subsequent payment to investors. In addition, cash of approximately $2,404,000 and $2,525,000 was restricted and held by the Company's subsidiaries pursuant to master repurchase agreements and government requirements at December 31, 1993 and 1992, respectively. Other investments ----------------- Other investments consist of highly liquid investments with original maturities of more than three months. Other investments are held in United States Treasury Bills, United States Government Bonds, corporate bonds and certificates of deposit, and are stated at cost plus accrued interest, which approximates market value. At December 31, 1993 and 1992, investments of approximately $17,865,000 and $12,275,000, respectively, were held in trust for policy and claim reserves for the Company's insurance subsidiaries. In addition, investments of approximately $1,151,000 and $1,229,000 were restricted and held by the Company's subsidiaries pursuant to a master repurchase agreement and government requirements at December 31, 1993 and 1992, respectively. Allowance for losses -------------------- Recourse of investors against the Company is governed by the agreements between the investor and the Company (Note F). The allowance for losses on contracts sold with recourse represents the Company's best estimate of future credit losses likely to be incurred over the entire life of the contracts, pursuant to recourse provided to investors. Reclassifications ----------------- Certain reclassifications have been made to the December 31, 1992 and 1991 financial statements to conform to the classifications used in the December 31, 1993 financial statements. These reclassifications had no effect on net earnings or stockholders' equity as previously reported. B. EXCESS SERVICING RIGHTS RECEIVABLE Excess servicing rights receivable consists of: The carrying value of excess servicing rights receivable is analyzed quarterly to determine the impact of prepayments, if any. The adjustments required as a result of adverse prepayment activity, net of refinancings, were approximately $22,000,000 and $14,000,000 in 1993 and 1992, respectively. During the years ended December 31, 1993, 1992 and 1991, the Company sold $213,368,000, $268,916,000 and $499,780,000, respectively, of GNMA guaranteed certificates secured by FHA-insured and VA-guaranteed contracts. At December 31, 1993 and 1992, the outstanding principal balance on GNMA certificates issued by the Company was $1,793,908,000 and $1,893,363,000, respectively. During the years ended December 31, 1993, 1992 and 1991, the Company sold $2,132,472,000, $1,602,650,000 and $638,886,000, respectively, of contracts in various securitized transactions and in sales to private investors. At December 31, 1993 and 1992, the outstanding principal balance on all conventional securitized and private investor sales was $4,713,012,000 and $3,272,988,000, respectively. C. CONTRACTS, GNMA CERTIFICATES AND COLLATERAL Contracts, GNMA certificates and collateral consist of: The aggregate method is used in determining the lower of cost or market value of contracts held for sale and contracts held as collateral. See fair value disclosure of financial instruments in Note H. Potential losses on the liquidation of the collateral are included in determining the allowance for losses on contracts sold with recourse (Notes F and H). Included in other accounts receivable as of December 31, 1993 and 1992 was approximately $34,055,000 and $24,687,000, respectively, of GNMA certificates which were sold during 1993 and 1992 for settlement in January 1994 and 1993, respectively. These GNMA certificates along with contracts held for sale are used in full or in part as collateral on the Company's warehousing credit agreement and master repurchase agreements (Note E). D. PROPERTY, FURNITURE AND FIXTURES Property, furniture and fixtures consist of: In January 1993, the Company purchased the remaining commercial floors of the building where its corporate offices are located. The total purchase price was $5,800,000. Depreciation expense for 1993, 1992 and 1991 was $2,482,000, $1,668,000 and $1,579,000, respectively. E. DEBT The Company has a $60 million bank warehousing credit agreement under which $58,725,000 was available, subject to the availability of appropriate collateral, at December 31, 1993, and borrowings under this agreement were $1,275,000. This committed facility is to be used for financing the Company's manufactured home, home improvement and motorcycle contract production and expires November 30, 1994. The agreement provides for interest at variable rates (4.31% at December 31, 1993) and certain fee provisions, the costs of which are included in interest expense. The borrowings are collateralized by manufactured housing, home improvement and motorcycle contracts totaling $1,417,000 as of December 31, 1993. The credit agreement contains certain restrictive covenants which include maintaining minimum net worth (as defined in the agreement) and a debt to net worth ratio not to exceed 5 to 1. In addition, the Company currently has $950 million in master repurchase agreements with various investment banking firms for the purpose of financing its contract production. At December 31, 1993, the amount available, subject to the availability of appropriate collateral, was $765,535,000. The borrowings of $184,465,000 under these agreements were collateralized by $207,810,000 of manufactured housing, home improvement and special products contracts at December 31, 1993. The rates under these agreements ranged from 3.44% to 4.66% at December 31, 1993. These agreements expire during 1994, however, the Company believes, based on discussions with the lenders, that these agreements will be renewed. At December 31, 1993, the Company also had $21,171,000 of notes payable outstanding through a GNMA reverse repurchase agreement. The rate under this agreement was 3.63% at December 31, 1993 and was collateralized by $22,286,000 of GNMA certificates. Debt is as follows: The Company has on file a shelf registration to issue up to $250 million of senior notes with maturities in excess of nine months. The notes may bear interest at fixed or floating rates. The senior notes outstanding at December 31, 1993 bear interest at a weighted average rate of 7.27% and have maturities ranging from 1998 to 2003. Interest on these notes is payable semi-annually. The 8 1/4% senior subordinated debentures due 1995 (the "Debentures") were issued in connection with a public offering in June 1985. The effective interest rate on the Debentures is 13.1% and interest is payable semi- annually. In April 1992, the Company completed an offer to exchange a new issue of 10 1/4% Senior Subordinated Notes due June 1, 2002 (the "Notes") for its outstanding Debentures. Of the Company's $287,500,000 of Debentures, $267,254,000 were tendered and accepted for exchange by the Company for its new Notes. The effective interest rate on the Notes is 10.8%. The Company must maintain a net worth of $80,000,000 or will be required, through the operation of a sinking fund, to redeem $25,000,000 on such contingent sinking fund payment date. Interest is payable semi- annually. An extraordinary charge of $17,457,000 was recognized in the second quarter of 1992 as a result of the exchange. The extraordinary charge resulted from the accelerated write-down of the original issue discount and deferred debt expense, net of income taxes of $11,161,000, relating to the Debentures exchanged. In May 1993, the Company retired the subordinate note at a 5% discount. At December 31, 1993, aggregate maturities of debt other than notes payable for the following five years were $28,246,000, payable as follows: $20,246,000 in 1995 and $8,000,000 in 1998. F. ALLOWANCE FOR LOSSES ON CONTRACTS SOLD WITH RECOURSE The Company sells GNMA guaranteed certificates which are secured by FHA- insured and VA-guaranteed contracts. The majority of credit losses incurred on these contracts are covered by FHA insurance or VA guarantees with the remainder borne by the Company. The Company establishes an allowance for expected losses under the recourse provisions with investors/owners and calculates that allowance on the basis of historical experience and management's best estimate of future credit losses likely to be incurred. For contracts sold prior to October 1, 1992, the allowance is shown on a nondiscounted basis. For contracts sold after September 30, 1992, the allowance has been discounted using an interest rate equivalent to the risk-free market rate for securities with a duration similar to that estimated for the underlying contracts. The amount of this provision is reviewed quarterly and adjustments are made if actual experience or other factors indicate management's estimate of losses should be revised. The Company retains substantial amounts of risk of default on the loan portfolios that it sells. The Company has provided the investors/owners of pools of contracts with a variety of additional forms of credit enhancements. These credit enhancements have included letters of credit and surety bonds that provided limited recourse to the Company, and letters of credit that, if drawn, are entitled to reimbursement only from the future excess cash flows of the underlying transactions. Furthermore, certain securitized sales structures use cash reserve funds and certain cash flows from the underlying pool of contracts as the credit enhancement. At December 31, 1993 and 1992, the Company had bank letters of credit and surety bonds outstanding of $141,052,000 and $161,344,000, respectively. Cash deposits held in interest bearing accounts totaled $124,817,000 and $117,067,000, and contracts pledged aggregated $9,716,000 and $9,654,000 at December 31, 1993 and 1992, respectively, and are maintained as part of credit enhancement features under certain sales structures. Allowances are provided for the Company's best estimate of future credit losses likely to be incurred over the entire life of the contracts. Estimated losses are based on an analysis of the underlying loans and do not reflect the maximum recourse provided to investors. The following table presents an analysis of the allowance for losses on contracts sold with recourse for 1993, 1992 and 1991. G. STOCKHOLDERS' EQUITY Common Stock ------------ In September 1993, the Company completed a 2,500,000 share Common Stock offering, and sold an additional 375,000 shares to cover over-allotments. The net proceeds of approximately $138,000,000 were used to finance the Company's continued growth in its manufactured home, home improvement and special products contract inventory, to temporarily reduce certain borrowings under the Company's bank warehousing agreement and master repurchase agreements and for other general corporate purposes. During the first quarter of 1992, the Company completed a 6,000,000 share Common Stock offering and in April 1992, the Company sold an additional 614,800 shares to cover over-allotments. The net proceeds of approximately $115,000,000 were used to purchase and retire all of the Company's outstanding Preferred Stock discussed below, and for general corporate purposes. In December 1992, the Board of Directors declared a two-for-one stock split, in the form of a stock dividend, payable on January 31, 1993 to shareholders of record as of January 15, 1993. All references in the consolidated financial statements and notes with regard to number of shares, stock options and related prices, and per-share amounts have been restated to give retroactive effect to the stock split. Preferred Stock --------------- During 1992, the Company repurchased 50,012 shares of its Preferred Series B Stock, 712,562 shares of its Preferred Series C Stock and 672,376 shares of its Preferred Series D Stock which represented all of the Company's outstanding Preferred Stock. These shares, which had a liquidation value of $100 per share, or $143,495,000, were repurchased and retired for $102,000,000 as part of the settlement of litigation between the Company and the Resolution Trust Corporation (the "RTC"). The Preferred Stock had a $9,300,000 annual cash dividend requirement which terminated upon its repurchase. In connection with the issuance of the rights discussed below, the Company authorized shares of Junior Preferred Stock. If issued, the stock will be nonredeemable. Each share of Junior Preferred Stock will have a minimum cumulative, preferential quarterly dividend rate of $25 per share, but will be entitled to an aggregate dividend of 100 times the dividend declared on the Common Stock. In the event of liquidation, the holders of the Junior Preferred Stock will receive a minimum preferred liquidation payment of $100 per share, but will be entitled to receive an aggregate liquidation payment equal to 100 times the payment made per share of Common Stock. Each share of Junior Preferred Stock will have 100 votes, voting together with the Common Stock. In the event of any merger, consolidation or other transaction in which Common Stock is exchanged, each share of Junior Preferred Stock will be entitled to receive 100 times the amount received per share of Common Stock. At December 31, 1993, there were no shares of Junior Preferred Stock outstanding. Rights ------ In October 1985, the Company issued one Preferred Stock purchase right for each share of Common Stock and amended the rights in August 1990. The rights become exercisable if a person or group either acquires or makes an offer to acquire 20% or more of Green Tree's Common Stock (10% in the case of an "adverse person" designated by the Board of Directors). If the rights become exercisable, a holder will be entitled to purchase for the exercise price ($125) the number of shares of Common Stock that could be purchased at a price per share equal to one-half of the then-current market price per share of Common Stock. If the Company is involved in a merger or other business combination, the rights will be modified so as to entitle a holder to buy a number of shares of Common Stock of the acquiring company having a market value of twice the exercise price of each right. The rights may be redeemed upon approval of a majority of the independent directors of the Company for $.10 per right at any time prior to the tenth day after a public announcement that a person or group has acquired beneficially 20% or more of Green Tree's Common Stock. Stock option plans ------------------ Under the terms of two previous stock option plans, a total of 6,065,880 shares of Green Tree's Common Stock were initially reserved for grant to eligible employees and directors. A summary of stock activity related to these stock option plans is as follows: As of December 31, 1993, all of the outstanding options were exercisable. No additional options will be granted under these plans. In 1988, the Company's shareholders approved three new stock option plans: an employee stock option plan, a key executive plan and an outside director plan. In 1992, the Board of Directors approved a new supplemental stock option plan for its outside directors. The number of shares reserved under those plans is 8,200,000. A summary of the three stock option plans is as follows: Of the 1,460,884 options outstanding at December 31, 1993, 1,408,884 options related to the employee stock option plan, and 52,000 options related to the outside director plan. The director options and 832,227 shares of certain employee options were exercisable as of December 31, 1993. Options for 5,525,450 shares were available for future grant. The option price per share represents the market value of the Company's stock on the date of grant except for those options issued pursuant to an employment agreement and certain options granted in 1993. The option price per share on the options related to the employment agreement represents the market value of the stock on the date of the employment agreement. The option price per share on 85,000 options granted in 1993 represents 50% of the market value of the Company's stock on the date of grant. Dividends --------- During 1993, 1992 and 1991 the Company declared and paid dividends of $.34, $.31 and $.30 per share, respectively, on its Common Stock. Under certain debt agreements, the Company is subject to restrictions limiting the payment of dividends and common stock repurchases. At December 31, 1993, under the most restrictive agreement, such payments were limited to $43,585,000, which represents 50% of consolidated net earnings for the most recently concluded four fiscal quarter period less dividends paid and prepayment of subordinated debt during such period. H. FAIR VALUE DISCLOSURE OF FINANCIAL INSTRUMENTS Statement of Financial Accounting Standards No. 107 ("FAS 107"), "Disclosures about Fair Value of Financial Instruments," requires that the Company disclose the estimated fair values of its financial instruments. Fair value estimates, methods and assumptions are set forth below for the Company's financial instruments. Cash and cash equivalents, cash deposits and other investments --------------------------------------------------------------- The carrying amount of cash and cash equivalents, cash deposits and other investments approximates fair value because they generally mature in 90 days or less and do not present unanticipated credit concerns. Excess servicing rights receivable ---------------------------------- Excess servicing rights receivable is calculated using prepayment, default and interest rate assumptions that the Company believes market participants would use for similar instruments at the time of sale. Projected performance is monitored on an ongoing basis. However, the Company does not change the underlying rate at which future estimated cash flows are discounted once the initial sale has been recorded. As such, the fair value of excess servicing rights receivable primarily includes consideration of an appropriate discount rate to be applied to the financial instrument as a whole. The Company has consulted with investment bankers and obtained an estimate of a market discount rate. Utilizing this market discount rate, and such other assumptions as the Company believes market participants would use for similar instruments, the Company has estimated the fair value of its excess servicing rights receivable to approximate its carrying value. Contracts held for sale and as collateral ----------------------------------------- Contracts held for sale and as collateral are generally recent originations which will be sold during the following quarter. The Company does not charge origination fees or points and, as such, its contracts have origination rates generally in excess of rates on the securities into which they will be pooled. Since these contracts have not been converted into securitized pools, the Company estimates the fair value to be the carrying amount plus the cost of origination. Collateral in process of liquidation ------------------------------------ Collateral in the process of liquidation is valued on an individual unit basis after inspection of such collateral. The difference between carrying amount and fair value is carried as a liability by the Company in the allowance for losses on contracts sold with recourse. Other contracts held -------------------- Pursuant to investor sale agreements, certain contracts are repurchased by the Company as a result of delinquency before they are repossessed, and are included in other contracts held. The loss has been estimated on an aggregate basis, and is included on the balance sheet in allowance for losses on contracts sold with recourse. Notes payable ------------- Notes payable consists of amounts payable under the Company's warehouse line or repurchase agreements and, given its short-term nature, is at a rate which approximates market. As such, fair value approximates the carrying amount. Senior notes ------------ The fair value of the Company's senior notes is estimated based on the quoted market price of similar issues or on the current rates offered to the Company for debt of a similar maturity. Senior subordinated notes and debentures ---------------------------------------- The Company's senior subordinated notes and debentures are valued at quoted market prices. The carrying amounts and estimated fair values of the Company's financial assets and liabilities are as follows: Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instrument. The estimates do not reflect any premium or discount that could result from offering for sale at one time the Company's entire holdings of a particular financial instrument. Fair value estimates are based on judgments regarding future loss and prepayment experience, current economic conditions, specific risk characteristics and other factors. Changes in assumptions could significantly affect the estimates. Fair value estimates are based on existing on- and off-balance sheet financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. For example, the Company has a regional branch network with significant dealer relationships and a proprietary credit scoring system, both of which contribute heavily to the Company's ongoing profitability and neither of which is considered a financial instrument. I. COMMITMENTS AND CONTINGENCIES Lease commitments ----------------- At December 31, 1993, aggregate minimum rental commitments under noncancelable leases having terms of more than one year were $11,453,000, payable $3,558,000 (1994), $2,771,000 (1995), $2,055,000 (1996), $1,850,000 (1997) and $1,219,000 (1998). Total rental expense for the years ended December 31, 1993, 1992 and 1991 was $4,449,000, $4,955,000 and $4,402,000, respectively. These leases are for office facilities and equipment, and many contain either clauses for cost of living increases and/or options to renew or terminate the lease. Litigation ---------- Shareholder Class Action In December 1988, a Green Tree shareholder commenced an action in the U.S. District Court in Minnesota against the Company and certain of its present and former officers and directors alleging violations of Sections 10(b) and 20 of the Securities Exchange Act of 1934, as amended. Several additional shareholders were joined as party plaintiffs in the case, which was certified as a class action in July 1990. The class consists of shareholders of the Company who purchased Common Stock from May 20, 1985 through March 28, 1989. In March 1994, the Company reached an agreement to settle the action. The settlement, which is subject to court approval, will not have a material impact on the Company's financial condition or results of operation. General The nature of the Company's business is such that it is routinely a party or subject to other items of pending or threatened litigation. Although the ultimate outcome of certain of these matters cannot be predicted, management of the Company believes, based upon information currently available and the advice of counsel, that the resolution of these routine matters will not result in any material adverse effect on its consolidated financial condition. J. BENEFIT PLANS The Company has a qualified noncontributory defined benefit pension plan covering substantially all of its employees over 21 years of age. The plan's benefits are based on years of service and the employee's compensation. The plan is funded annually based on the maximum amount that can be deducted for federal income tax purposes. The assets of the plan are primarily invested in common stock, corporate bonds and cash equivalents. As of December 31, 1993 and 1992, net assets available for plan benefits were $5,242,000 and $4,056,000, and the accumulated benefit obligation was $4,305,000 and $3,484,000, respectively. As of December 31, 1993 and 1992, the projected benefit obligation of the plan was $8,169,000 and $6,973,000, respectively. In addition, the Company maintains a nonqualified pension plan for certain key employees as designated by the Board of Directors. This plan is not currently funded and the projected benefit obligation at December 31, 1993 and 1992 was $9,158,000 and $5,741,000, respectively. Total pension expense for the plans in 1993, 1992 and 1991 was $2,340,000, $1,619,000 and $1,347,000, respectively. In July 1992, the Company's Board of Directors approved a 401(k) Retirement Savings Plan available to all eligible employees. The plan commenced on October 1, 1992. To be eligible for the plan, the employee must be at least 21 years of age and have completed one year of employment at Green Tree during which the employee worked at least 1,000 hours. Eligible employees may contribute to the plan up to 10% of their earnings with a maximum of $8,994 for 1993 based on the Internal Revenue Service annual contribution limit. The Company will match 50% of the employee contributions for an amount up to 6% of each employee's earnings. Contributions are invested at the direction of the employee in one or more funds. Company contributions generally vest after three years, although contributions for those employees already having three years of service vest immediately. Company contributions to the plan were $575,000 and $208,000 in 1993 and 1992, respectively. Income taxes consist of the following: For the year ended December 31, 1992, a current tax benefit of $11,161,000 is included in the extraordinary loss from the Company's debt exchange so that net tax expense was $35,173,000. Deferred income taxes are provided for temporary differences between pretax income for financial reporting purposes and taxable income. The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 1993 and 1992 are presented below. At December 31, 1993, the Company has net operating loss carryforwards for federal income tax purposes of approximately $60,000,000 which are available to offset future federal taxable income and expire no earlier than 2001. A reconciliation of the statutory federal income tax rate to the Company's effective tax rate is as follows: L. SUBSEQUENT EVENT In March 1994, the Company sold, through a public transaction, approximately $508,000,000 of securitized Net Interest Margin Certificates ("the Certificates"). The Certificates represent 78% of the estimated present value of future cash flows from certain pools of manufactured housing contracts sold by the Company between 1978 and 1993. The estimated present value of these future cash flows are recorded on the Company's December 31, 1993 balance sheet as part of "Excess servicing rights receivable," "Contracts, GNMA certificates and collateral" and "Allowance for losses on contracts sold with recourse." The remaining 22% equity interest will be held by the Company and recorded as part of excess servicing rights receivable. The following unaudited pro forma balance sheet assumes the transaction closed on December 31, 1993 and the proceeds were used to provide a 4% cash deposit, pay off outstanding notes payable, and invest the remainder in cash and cash equivalents. QUARTERLY RESULTS OF OPERATIONS (unaudited) ------------------------------------------------- ITEM 9. ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURES. - --------------------------------------------------------------- None. PART III -------- ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. ------------------------------------------------------------- Pursuant to General Instruction G(3), reference is made to the information contained in the Company's definitive proxy statement for its 1994 Annual Meeting of Shareholders which will be filed with the Securities and Exchange Commission on or before May 1, 1994. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. --------------------------------- Pursuant to General Instruction G(3), reference is made to the information contained in the Company's definitive proxy statement for its 1994 Annual Meeting of Shareholders which will be filed with the Securities and Exchange Commission on or before May 1, 1994. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND ------------------------------------------------------------ MANAGEMENT. ----------- Pursuant to General Instruction G(3), reference is made to the information contained in the Company's definitive proxy statement for its 1994 Annual Meeting of Shareholders which will be filed with the Securities and Exchange Commission on or before May 1, 1994. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. --------------------------------------------------------- Reference is made to Note I of Notes to Consolidated Financial Statements contained in Item 8 hereof. PART IV ------- ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON ---------------------------------------------------------------- FORM 8-K. --------- (a)(l) Financial statements The following consolidated financial statements of Green Tree Financial Corporation and subsidiaries are included in Part II, Item 8 of this report: Page(s) ------- Independent Auditors' Report 28 Consolidated Balance Sheets - December 31, 1993 and 1992 29 Consolidated Statements of Operations - years ended December 31, 1993, 1992 and 1991 30 Consolidated Statements of Stockholders' Equity - years ended December 31, 1993, 1992 and 1991 31 Consolidated Statements of Cash Flows - years ended December 31, 1993, 1992 and 1991 32-33 Notes to Consolidated Financial Statements 34-50 (2) Financial statement schedules The following consolidated financial statement schedules of Green Tree Financial Corporation and subsidiaries are included in Part IV of this report: Schedule II - Amounts receivable from related parties 58 Schedule VIII - Valuation and qualifying accounts 59 Schedule IX - Short-term borrowings 60 Schedules other than those listed above are omitted because of the absence of the conditions under which they are required or because the information required is included in the consolidated financial statements or noted thereto. (3) Exhibits Exhibit No. ------- 3(a) Articles of Incorporation (incorporated by reference to Company's Registration Statement on Form S-4; File No. 33-42249). 3(b) Bylaws (incorporated by reference to Company's Registration Statement on Form S-4; File No. 33-42249). 4(a) Amended and Restated Rights Agreement dated as of August 16, 1990 relating to amendments to the Company's Shareholders Rights Plan originally adopted on October 9, 1985 (incorporated by reference to the Company's quarterly report on Form 10-Q for the quarter ended September 30, 1990; File No. 0-11652). 4(b) Indenture dated as of June 1, 1985 relating to $287,500,000 of 8 1/4% Senior Subordinated Debentures due June 1, 1995 (incorporated by reference to the Company's Registration Statement on Form S-4; File No. 33-42249). 4(c) Indenture dated as of March 15, 1992 relating to $287,500,000 of 10 1/4% Senior Subordinated Notes due June 1, 2002 (incorporated by reference to the Company's Registration Statement on Form S-4; File No. 33-42249). 4(d) Indenture dated as of September 1, 1992 relating to $250,000,000 of Medium-Term Notes, Series A, Due Nine Months or More From Date of Issue (incorporated by reference to the Company's Registration Statement on Form S-3; File No. 33-51804). 10(a) Company's Key Executive Bonus Program (incorporated by reference to the Company's Registration Statement on Form S-1; File No. 2-82880). 10(b) Nonqualified Option Plan dated May 19, 1984 (incorporated by reference to the Company's Registration Statement on Form S-2; File No. 2-85303). 10(c) Employment Agreement, dated April 20, 1991 between the Company and Lawrence M. Coss (incorporated by reference to the Company's Registration Statement on Form S-4; File No. 33-42249). 10(d) Green Tree Financial Corporation 1987 Stock Option Plan (incorporated by reference to the Company's Registration Statement on Form S-4; File No. 33-42249). 10(e) Green Tree Financial Corporation Key Executive Stock Bonus Plan (incorporated by reference to the Company's Registration Statement on Form S-4; File No. 33-42249). 10(f) 1987 Supplemental Stock Option Plan (incorporated by reference to the Company's Registration Statement on Form S-4; File No. 33-42249). 10(g) Master Repurchase Agreement dated as of August 1, 1990 between Green Tree Finance Corp.-Three and Merrill Lynch Mortgage Capital Inc. (incorporated by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1990; File No. 0-11652). 10(h) Warehousing Credit Agreement dated as of November 30, 1990 among Green Tree Financial Corporation and certain banks and First Bank National Association, Administrative Agent (incorporated by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1990; File No. 0-11652); as amended by a Consent and Third Amendment to Warehousing Credit Agreement dated November 27, 1991 (incorporated by reference to the Company's Registration Statement on Form S-4; File No. 33-42249); as amended by a Consent to Warehousing Credit Agreement dated February 13, 1992 (incorporated by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1991; File No. 0-11652); as amended by Fourth Amendment to Warehousing Credit Agreement dated November 30,1992 (incorporated by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1992; File No. 0-11652). 10(i) Master Repurchase Agreement dated as of May 17, 1991 between Green Tree Finance Corp.-Four and First Boston Mortgage Capital Corp. (incorporated by reference to the Company's Registration Statement on Form S-4; File No. 33- 42249). 10(j) Insurance and Indemnity Agreement dated as of February 13, 1992 among Green Tree Financial Corporation, MaHCS Guaranty Corporation and Financial Security Assurance Inc. (incorporated by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1991; File No. 0-11652). 10(k) Master Repurchase Agreement dated as of October 15, 1992 between Green Tree Finance Corp.-Five and Lehman Commercial Paper, Inc. (incorporated by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1992; File No. 0-11652). 10(l) 401(k) Plan Trust Agreement effective as of October 1, 1992 (incorporated by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1992; File No. 0-11652). 10(m) Green Tree Financial Corporation 1992 Supplemental Stock Option Plan (filed herewith). 11(a) Computation of Primary Earnings Per Share (filed herewith). 11(b) Computation of Fully Diluted Earnings per Share (filed herewith). 12 Computation of Ratio of Earnings to Fixed Charges (filed herewith). 22 Subsidiaries of the Registrant (filed herewith). 24 Consent of KPMG Peat Marwick (filed herewith). 25 Powers of Attorney (filed herewith). PURSUANT TO ITEM 601(b)(4) OF REGULATION S-K, THERE HAS BEEN EXCLUDED FROM THE EXHIBITS FILED PURSUANT TO THIS REPORT, INSTRUMENTS DEFINING THE RIGHTS OF HOLDERS OF LONG-TERM DEBT OF THE COMPANY WHERE THE TOTAL AMOUNT OF THE SECURITIES AUTHORIZED UNDER SUCH INSTRUMENTS DOES NOT EXCEED TEN PERCENT OF THE TOTAL ASSETS OF THE COMPANY. THE COMPANY HEREBY AGREES TO FURNISH A COPY OF ANY SUCH INSTRUMENTS TO THE COMMISSION UPON REQUEST. (b) Reports on Form 8-K None. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Green Tree Financial Corporation has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. GREEN TREE FINANCIAL CORPORATION By: /s/Lawrence M. Coss By: /s/John W. Brink ----------------------- --------------------------- Lawrence M. Coss John W. Brink Chairman, President and Executive Vice President, Chief Executive Officer Treasurer and Chief (principal executive Financial Officer officer) (principal financial officer) By: /s/Robley D. Evans --------------------------- Robley D. Evans Vice President and Controller (principal accounting officer) Dated: March 28, 1994 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 dates indicated: /s/Lawrence M. Coss ------------------------------- Lawrence M. Coss, Director March 28, 1994 /s/Richard G. Evans ------------------------------- Richard G. Evans, Director March 28, 1994 /s/Robert D. Potts ------------------------------- Robert D. Potts, Director March 28, 1994 By: /s/Richard G. Evans --------------------------- Richard G. Evans, Attorney-in-Fact C. Thomas May, Jr., Director ) Dated: March 28, 1994 ) W. Max McGee, Director ) ) Robert S. Nickoloff, Director ) ) Kenneth S. Roberts, Director ) GREEN TREE FINANCIAL CORPORATION AND SUBSIDIARIES ------------------------------------------------- SCHEDULE II - AMOUNTS RECEIVABLE FROM RELATED PARTIES ----------------------------------------------------- The above notes were executed by certain officers and directors of the Company to purchase Company stock or as personal loans. The stock certificates were held as collateral as long as the loans were outstanding. The notes were due on demand and carried an interest rate of prime plus 1/2% on personal loans, and on the stock loans, the greater of 6% or the Internal Revenue Service applicable federal rate for officer borrowings. No notes were executed during 1993. GREEN TREE FINANCIAL CORPORATION AND SUBSIDIARIES ------------------------------------------------- SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS ------------------------------------------------- Notes: (a) Amortization and discount. (b) Amounts charged off. GREEN TREE FINANCIAL CORPORATION AND SUBSIDIARIES ------------------------------------------------- SCHEDULE IX - SHORT-TERM BORROWINGS ----------------------------------- Notes: (1) These notes represent borrowings under committed lines of credit for contract financing. The calculations of the weighted average interest rates include commitment and usage fees on borrowings. (2) Average amount outstanding during the period was computed by totaling the daily outstanding balances and dividing the sum by the number of days in the period. (3) Weighted average interest rate during the period was computed by dividing the interest expense for the year by the average daily amount of outstanding borrowings. GREEN TREE FINANCIAL CORPORATION Securities and Exchange Commission Form 10-K (For the Fiscal Year Ended December 31, 1993) EXHIBIT INDEX Exhibit No. Exhibit Page No. ----------- ------- -------- 10(m) 1992 Supplemental Stock Option Plan 62-66 11(a) Computation of Primary Earnings Per Share 67 11(b) Computation of Fully Diluted Earnings Per Share 68 12 Computation of Ratio of Earnings to Fixed Charges 69 22 Subsidiaries of Registrant 70-71 24 Consent of KPMG Peat Marwick 72 25 Powers of Attorney 73 Exhibit 10(m). -------------- GREEN TREE ACCEPTANCE, INC. 1992 SUPPLEMENTAL STOCK OPTION PLAN 1. Purpose of Plan. --------------- This Plan shall be known as the "Green Tree Acceptance, Inc. 1992 Supplemental Stock Option Plan" and is hereinafter referred to as the "Plan." The purpose of the Plan is to attract and retain the services of experienced and knowledgeable non-employee directors of Green Tree Acceptance, Inc. (the "Company") and to provide additional incentive for such directors to increase their interest in the Company's long term success and progress. Options granted under this Plan shall be non- qualified stock options which do not qualify as Incentive Stock Options within the meaning of Section 422A of the Internal Revenue Code of 1986, as amended (the "Code"). 2. Stock Subject to Plan. --------------------- Subject to the provisions of Section 11 hereof, the stock to be subject to options under the Plan (the "Shares") shall be the Company's authorized Common Stock, par value $0.01 per share (the "Common Stock"). Such shares will be authorized but unissued shares. Subject to adjustment as provided in Section 11 hereof, the maximum number of shares on which options may be exercised under this Plan shall be 50,000 shares. If an option under the Plan expires, or for any reason is terminated or unexercised with respect to any Shares, such Shares shall again be available for options thereafter granted during the term of the Plan. 3. Administration of Plan. ---------------------- The Plan shall be administered by the Board of Directors of the Company. The Board of Directors shall have plenary authority in its discretion, but subject to the express provisions of this Plan, to interpret the Plan, to prescribe, amend, and rescind rules and regulations relating to the Plan, and to make all other determinations necessary or advisable for the administration of the Plan. The Board of Directors' determinations on the foregoing matters shall be final and conclusive. 4. Eligibility. ----------- An "Eligible Director" shall be a director of the Company who is not otherwise an employee of the Company or any subsidiary of the Company; provided, however, that so long as any director of the Company is serving as a representative of another organization and any options issued to such director under the Plan are required to be remitted to such organization, such director shall not be deemed to be an Eligible Director for purposes of the Plan. 5. Grant of Options. ---------------- Upon approval of the Plan by the Board of Directors, but subject to approval of the Plan by the stockholders of the Company pursuant to Section 14 hereof, each Eligible Director who completes a full fiscal quarter of service as a director of the Company after December 31, 1992 shall automatically be granted on the last business day of each such quarter an option to acquire 500 Shares under the Plan. 6. Price. ----- The option price for all options granted under the Plan shall be the fair market value of the Shares covered by the option at the time the option is granted. For the purpose of the preceding sentence and for all other valuation purposes under the Plan, the "fair market value" of the Common Stock as of any date shall be (i) the closing price of the Common Stock on such date, as reported on the consolidated reporting system for the New York Stock Exchange or such other national securities exchange as is then the primary exchange for trading in the Common Stock, or (ii) if the Common Stock is not then listed on a national securities exchange, the last sale price or highest closing bid price (whichever is applicable) as reported on the National Association of Securities Dealers Automated Quotation System. If, on the date of determination of fair market value, the Common Stock is not publicly traded, the Board of Directors shall make a good faith attempt to determine the fair market value of the Common Stock as required by this Section 6 and in connection therewith shall take such action as it deems necessary or advisable. 7. Term. ---- Each option and all rights and obligations thereunder shall, subject to the provisions of Section 9 herein, expire ten (10) years from the date of granting of the option. 8. Exercise of Option. ------------------ (a) Options granted under the Plan shall not be exercisable for a period of six months after the date of grant, or until stockholder approval of the Plan has been obtained, whichever occurs later, but thereafter will be exercisable in full at any time or from time to time during the term of the option, subject to the provisions of Section 9 hereof. (b) The exercise of any option granted hereunder shall only be effective at such time as counsel to the Company shall have determined that the issuance and delivery of Common Stock pursuant to such exercise will not violate any state or federal securities or other laws. An optionee desiring to exercise an option may be required by the Company, as a condition of the effectiveness of any exercise of an option granted hereunder, to agree in writing that all Common Stock to be acquired pursuant to such exercise shall be held for his or her own account without a view to any further distribution thereof, that the certificates for such shares shall bear an appropriate legend to that effect and that such shares will not be transferred or disposed of except in compliance with applicable federal and state securities laws. (c) An optionee electing to exercise an option shall give written notice to the Company of such election and of the number of Shares subject to such exercise. The full purchase price of such Shares shall be tendered with such notice of exercise. Payment shall be made to the Company either (i) in cash (including check, bank draft or money order), or (ii) by delivering shares of Common Stock already owned by the optionee having a fair market value equal to the full purchase price of the Shares, or (iii) by any combination of cash and such shares; provided, however, that an optionee shall not be entitled to tender shares of Common Stock pursuant to successive, substantially simultaneous exercises of options granted under this or any other stock option plan of the Company. For purposes of the preceding sentence, the "fair market value" of such tendered shares shall be determined as provided in Section 6 herein as of the date of exercise. Until such person has been issued the Shares subject to such exercise, he or she shall possess no rights as a stockholder with respect to such Shares. 9. Effect of Termination of Directorship or Death or Disability. ------------------------------------------------------------ (a) In the event that an optionee shall cease to be a director of the Company for any reason other than removal for cause due to his or her serious misconduct or his or her death or disability, such optionee shall have the right to exercise the option at any time within seven months after such termination of directorship to the extent of the full number of Shares he or she was entitled to purchase under the option on the date of termination, subject to the condition that no option shall be exercisable after the expiration of the term of the option. (b) In the event that an optionee shall be removed for cause as a director of the Company by reason of his or her serious misconduct during the course of his or her service as a director of the Company, the option shall be terminated as of the date of the misconduct. (c) If the optionee shall die while serving as a director of the Company or within three months after termination of his or her directorship for any reason other than removal for cause due to his or her serious misconduct, or become disabled (as determined by the Board of Directors in its sole discretion) while serving as a director of the Company and such optionee shall not have fully exercised the option, such option may be exercised at any time within twelve months after his or her death or disability by the personal representatives, administrators, or, if applicable, guardian, of the optionee or by any person or persons to whom the option is transferred by will or the applicable laws of descent and distribution, to the extent of the full number of shares he or she was entitled to purchase under the option on the date of death, disability, or termination of directorship, if earlier, and subject to the condition that no option shall be exercisable after the expiration of the term of the option. 10. Non-Transferability. ------------------- No option granted under the Plan shall be transferable by the optionee, otherwise than by will or the laws of descent and distribution as provided in Section 9(c) herein. Except as provided in Section 9(c) herein with respect to disability of the optionee, during the lifetime of an optionee the option shall be exercisable only by such optionee. 11. Dilution or Other Adjustments. ----------------------------- If there shall be any change in the Common Stock through merger, consolidation, reorganization, recapitalization, stock dividend (of whatever amount), stock split or other change in the corporate structure, appropriate adjustments in the Plan and outstanding options shall be made by the Board of Directors. In the event of any such changes, adjustments shall include, where appropriate, changes in the aggregate number of shares subject to the Plan, the number of shares and the price per share subject to outstanding options in order to prevent dilution or enlargement of option rights. 12. Amendment or Discontinuance of Plan. ----------------------------------- The Board of Directors may amend or discontinue the Plan at any time. However, subject to the provisions of Section 11 no amendment of the Plan shall, without stockholder approval: (i) increase the maximum number of Shares with respect to which options may be granted under the Plan as provided in Section 2 hereof, (ii) modify the eligibility requirements for participation in the Plan as provided in Section 4 hereof, or (iii) change the date of grant or exercise price of, or the number of Shares subject to, options granted or to be granted to Eligible Directors, as provided in Sections 5 and 6 hereof. The Board of Directors shall not alter or impair any option theretofore granted under the Plan without the consent of the holder of the option. Notwithstanding any other provision of the Plan or any option, without the approval of stockholders of the Company, no such amendment shall be made that, absent such approval, would cause the exemptions of Rule 16b-3 to become unavailable with respect to the options hereunder or with respect to the ability of the Eligible Directors to satisfy the disinterested person requirements of Rule 16b-3 in administering any other stock-based compensation plan of the Company (this limitation on amendments to the Plan shall include, without limitation, a prohibition on any contemplated amendment within six months of any prior amendment, other than to comport with changes in the Code, the Employee Retirement Income Security Act, or the rules thereunder). 13. Time of Granting. ---------------- Nothing contained in the Plan or in any resolution adopted or to be adopted by the Board of Directors or by the stockholders of the Company, and no action taken by the Board of Directors (other than the execution and delivery of an option), shall constitute the granting of an option hereunder. 14. Effective Date and Termination of Plan. -------------------------------------- (a) The Plan was approved by the Board of Directors on March 10, 1992 and shall be approved by the stockholders of the Company within twelve (12) months thereafter. The effective date of the Plan shall be the date of stockholder approval. (b) Unless the Plan shall have been discontinued as provided in Section 12 hereof, the Plan shall terminate on December 31, 1997. No option may be granted after such termination, but termination of the Plan shall not, without the consent of the optionee, alter or impair any rights or obligations under any option theretofore granted. Exhibit 11.(a) -------------- GREEN TREE FINANCIAL CORPORATION AND SUBSIDIARIES ------------------------------------------------- COMPUTATION OF PRIMARY EARNINGS PER SHARE ----------------------------------------- Exhibit 11.(b) -------------- GREEN TREE FINANCIAL CORPORATION AND SUBSIDIARIES ------------------------------------------------- COMPUTATION OF FULLY DILUTED EARNINGS PER SHARE ----------------------------------------------- Exhibit 12. ----------- GREEN TREE FINANCIAL CORPORATION AND SUBSIDIARIES ------------------------------------------------- COMPUTATION OF RATIO OF EARNINGS TO FIXED CHARGES ------------------------------------------------- (1) For purposes of computing the ratios, earnings consist of earnings before income taxes plus fixed charges. Exhibit 22. ----------- GREEN TREE FINANCIAL CORPORATION SUBSIDIARIES The following is a list of the Company's subsidiaries which are all owned 100% by Green Tree Financial Corporation who is the ultimate or immediate parent: STATE OF NAME OF SUBSIDIARY INCORPORATION ------------------ ------------- Green Tree Financial Corp.- Kentucky Delaware Green Tree Financial Corp.- Louisiana Delaware Green Tree Financial Corp. - Mississippi Delaware Green Tree Financial Corp.- North Carolina Delaware Green Tree Financial Corp.- Ohio Delaware Green Tree Financial Corp.- Texas Delaware Green Tree Credit Corp. New York Green Tree Consumer Discount Company Pennsylvania Consolidated Acceptance Corporation Nevada Rice Park Properties Corporation Minnesota Woodgate Consolidated Incorporated Texas Woodgate Utilities Incorporated Texas Woodgate Place Owners Association Texas Green Tree Finance Corp.-One Minnesota Green Tree Finance Corp.-Two Minnesota Green Tree Finance Corp.-Three Minnesota Green Tree Finance Corp.-Four Minnesota Green Tree Finance Corp.-Five Minnesota Green Tree Agency, Inc. Minnesota Green Tree Agency of Montana, Inc. Montana Green Tree Agency of Nevada, Inc. Nevada GTA Agency, Inc. New York STATE OF NAME OF SUBSIDIARY INCORPORATION ------------------ ------------- Crum-Reed General Agency, Inc. Texas Green Tree Life Insurance Company Arizona Consolidated Casualty Insurance Company Arizona Green Tree Guaranty Corporation Minnesota Green Tree Vehicles Guaranty Corporation Minnesota MaHCS Guaranty Corporation Delaware Green Tree Manufactured Housing Net Interest Margin Finance Corp. I Delaware Green Tree Manufactured Housing Net Interest Margin Finance Corp. II Delaware Exhibit 24 ---------- CONSENT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS --------------------------------------------------- The Board of Directors Green Tree Financial Corporation: We consent to incorporation by reference of our report dated March 22, 1994, relating to the consolidated balance sheets of Green Tree Financial Corporation and subsidiaries as of December 31, 1993 and 1992 and the related consolidated statements of operations, stockholders' equity and cash flows for each of the years in the three-year period ended December 31, 1993, which report appears in the December 31, 1993 Form 10-K of Green Tree Financial Corporation, and in the following Registration Statements of Green Tree Financial Corporation: No. 33- 26498 on Form S-8/S-3, No. 2-88293 on Form S-8, No. 33-51804 on Form S-3 and No. 33-50527 on Form S-3/S-11. KPMG Peat Marwick Minneapolis, Minnesota March 22, 1994 Exhibit 25. ----------- POWER OF ATTORNEY KNOW ALL BY THESE PRESENTS, that each person whose signature appears below hereby constitutes and appoints Lawrence M. Coss and Richard G. Evans, and each or either one of them, his true and lawful attorney(s)-in- fact and agent(s), with full power of substitution and resubstitution for him and in his name, place, and stead, in any and all capacities, to sign the 1993 Annual Report on Form 10-K of Green Tree Financial Corporation, and any and all amendments thereto, and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorney(s)-in-fact and agent(s), and each of them, full power and authority to do and perform each and every act and thing requisite or necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorney(s)-in-fact and agent(s), or either of them, or his or their substitutes, may lawfully do or cause to be done by virtue hereof. SIGNATURE DATE --------- ---- /s/ C. Thomas May, Jr. ------------------------- February 22, 1994 C. Thomas May, Jr. /s/ W. Max McGee ------------------------- February 22, 1994 W. Max McGee /s/ Robert S. Nickoloff ------------------------- February 22, 1994 Robert S. Nickoloff /s/ Kenneth S. Roberts ------------------------- February 22, 1994 Kenneth S. Roberts

1993 ITEM 1. BUSINESS (a) General Development of Business The company has continued to conduct its business under the same corporate structure. There have been no material reclassifications, mergers, or consolidations of the company or its subsidiaries during the year. During 1990-1991, the company realigned and restructured its operations into three principal elements which were renamed in 1993; semiconductor equipment, electronics, and environmental services. There have been no acquisitions or dispositions of material amounts of assets other than in the ordinary course of business during 1993. (b) Financial Information about Industry Segments The company operates within three industry segments-semiconductor equipment, electronics, and environmental services. Financial information about industry segments is included in Note 10 to the consolidated financial statements contained in Part II, Item 8 of this annual report on Form 10-K. (c) Narrative Description of Business Semiconductor Equipment The Semiconductor Equipment Group manufactures semiconductor processing equipment, primarily chemical-vapor deposition (CVD) equipment. The company's atmospheric-pressure CVD equipment is used by semiconductor manufacturers worldwide in the production of memory devices (DRAMs) and microprocessors. Historically, the company's CVD systems have been used primarily for the deposition of interlevel-dielectric films--the first dielectric layer on a semiconductor wafer. The company's current principal product, the TEOS999 System, deposits both interlevel and intermetal layers of film on sub-half-micron geometries. The addition of the intermetal capability increased the potential market size for W-J's CVD equipment. The company's next-generation product, the WJ-1000 System, is designed for high-throughput CVD onto the 200-mm (8-inch) wafers currently entering production in major fabrication facilities in the U.S. and overseas. A variant of Watkins-Johnson's semiconductor-production tool is used for manufacturing flat-panel displays for personal-communication, computing and entertainment products. Semiconductor equipment products are primarily marketed through manufacturers' representatives and global distributor networks. Sales by the segment were 28% of consolidated sales in 1993, 21% in 1992 and 24% in 1991. Semiconductor equipment product customers are numerous. The majority of the segment's sales are to manufacturers of semiconductor integrated circuits. There are several domestic and international competitors and competition is intense. In meeting the competition, emphasis is placed on selling quality products having excellent reliability and performance and a strong customer support network. Electronics The Electronics Group manufactures turnkey systems, integrated subsystems and signal-processing components for a broad range of communications and defense applications. The group is serving new customers who have wireless-communication and "dual-use" requirements in addition to supplying sophisticated electronic products for defense-intelligence, missile-guidance and space-communications missions. Recent commercial contracts include high-fidelity W-J cellular receivers to monitor ongoing telephone traffic to ensure authorized use of the system, transponder subsystems to enable ship traffic to navigate treacherous waterways during inclement weather and signal-processing components for a wide range of wireless-communications products. Watkins-Johnson receivers, antennas and signal-analysis equipment are used by both commercial and military governmental agencies to perform range-monitoring, frequency-measurement, signal-localization and interference-analysis functions, often in complex, high-signal-density environments. Key missile programs, such as the Advanced Medium-Range Air-to-Air Missile (AMRAAM) and the High-speed Anti Radiation Missile (HARM) continue to represent a substantial portion of the group's core defense-electronics business. Electronics products are marketed through direct sales efforts and distributor networks. Sales by the electronics segment were 70% of consolidated sales in 1993, 76% in 1992 and 72% in 1991. The majority of the segment sales is made to government agencies and to customers engaged in defense contracting. The principal customer for such sales is the U.S. Department of Defense. Sales contracts with the government are customarily subject to terms and conditions which provide for renegotiation of profits or termination of the contract at the election of the government. The right to terminate for convenience has not had any significant effect on the company's financial position or results of operations. The electronics segment has numerous competitors which include both large diversified corporations and smaller specialty firms. Due to the various industries in which the company and its competitors operate, a competitive ranking cannot be reasonably established. However, the electronics segment is a leading supplier in several of its product markets. In meeting its competition the company offers quality products featuring excellent reliability and performance at competitive prices. Environmental Services W-J Environmental (WJE) specializes in hydrogeology and offers services from the remedial investigation of contaminated-water sites through the remedial action necessary to eliminate the environmental problem. The recent addition of an environmental engineering capability enabled WJE to design and install an innovative wastewater-minimization system which eliminates the discharge of heavy metals and cyanide into the public sewer system. This system is being marketed to manufacturers and governmental agencies charged with finding ways to cope with increasingly restrictive environmental regulations. The unit also markets its capabilities in chemistry, microbiology, geophysics, toxicology, risk assessment and data management to customers who do not require a full range of environmental services, but have a serious requirement for one or two areas of expertise which our new group can satisfy. Other Business Items Raw materials for the production of semiconductor equipment and electronics products are obtained from numerous suppliers. Dependence on any particular supplier is minimal. Business operations are not believed to be seasonal. Except for negotiated advance or progress payments from customers on long-term contracts in the defense-electronics business, there are no special working capital practices in any of the three segments. The company has been increasingly active in securing patents and licensing agreements to protect certain proprietary technologies and know-how resulting from its on-going research and development efforts. Although the company holds and has filings pending on numerous domestic and foreign patents and technology licenses for the manufacture and sale of various products, patents have not significantly affected the company's operations or financial performance. Management believes the company's competitive position is derived primarily from its core competence of engineering, manufacturing and understanding of its customers and markets. Total company backlog at December 31, 1993 was $222,628,000 compared to $207,827,000 at December 31, 1992. The percentage of backlog attributable to the semiconductor equipment and electronics segments were 22% and 77% respectively in 1993, compared to 9% and 89% in 1992. Approximately 86% of all backlog at year-end 1993 is expected to be shippable within 12 months compared to 83% at year-end 1992. Company-sponsored research and development expense was $27,163,000 in 1993, $27,210,000 in 1992, and $27,180,000 in 1991. Customer-sponsored research and development was estimated to be approximately $18,000,000 in 1993, $25,000,000 in 1992, and $15,000,000 in 1991. The company's employment on December 31, 1993 was 2,390. None of the company's employees is covered by a collective bargaining agreement. The company's relationship with its employees is good. Environmental issues are discussed in Note 8 to the consolidated financial statements contained in Part II, Item 8 of this annual report on Form 10-K. (d) Financial Information about Foreign and Domestic Operations and Export Sales. Company foreign operation assets and sales are less than ten percent of consolidated totals. Sales outside the United States accounted for 33% of the company's sales in 1993, 25% in 1992, and 30% in 1991. The inherent risks of foreign business are similar to those of domestic business but with the additional risks of foreign government instability and export license cancellation. A major portion of foreign product orders in the electronics segment requires export licensing by the Department of State prior to shipment. For international shipments of electronics and semiconductor equipment, the company purchases forward exchange contracts and/or obtains customer letters of credit to reduce foreign currency fluctuation and credit risks. For further information on foreign sales, see Note 7 and Note 10 to the consolidated financial statements contained in Part II, Item 8 of this annual report on Form 10-K. ITEM 2. ITEM 2. PROPERTIES Watkins-Johnson Company and subsidiaries conduct their main operations at plants in Palo Alto, Scotts Valley and San Jose, California and Gaithersburg, Maryland. Additional operations are conducted in Columbia, Maryland, and Windsor, England. The company has nine field offices in the United States and five offices overseas. As part of the company's cost reduction efforts, the 56,000 square-foot facility located in North Carolina was closed in 1991. At December 31, 1993 there were approximately 732,000 square feet of plant space in California, 225,000 square feet in Maryland, and 15,000 square feet in England. Approximately 90% of the company's plant space is occupied for the company's operations. The company is pursuing opportunities to realize the market value of its properties while ensuring efficient use of available space. The electronics segment utilizes substantially all of the above named facilities except for the Scotts Valley plant, which houses the semiconductor equipment segment. In addition, the environmental services division maintains leased field offices located in Palo Alto, California and Denver, Colorado. The Palo Alto and Columbia facilities are leased. Sales offices are also leased. The San Jose plant is held subject to a long-term mortgage. Information on long-term obligations is in Note 3 to the consolidated financial statements contained in Part II, item 8 of this annual report on Form 10-K. ITEM 3. ITEM 3. LEGAL PROCEEDINGS Information required under this item is contained in Note 6 and Note 8 to the consolidated financial statements contained in Part II, Item 8 of this annual report on Form 10-K. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS The company submitted no matters to a vote of the shareowners during the last quarter of the period covered by this report. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The company's common stock is principally traded on the New York and Pacific stock exchanges. At December 31, 1993 there were approximately 4,600 shareowners, which included holders of record and beneficial owners. The company expects that comparable cash dividends will continue in the future. DIVIDENDS AND STOCK PRICES 1993 QUARTERS 1ST 2ND 3RD 4TH ---------- ---------------------------------------------- Dividends Declared Per Share (in cents)................... 12 12 12 12 Stock Price (NYSE--in dollars). High 15-1/2 18-1/2 24-1/2 26-1/4 Low 12 12-3/4 17-1/4 19-3/8 1992 QUARTERS 1ST 2ND 3RD 4TH ---------- -------------------------------------------------- Dividends Declared Per Share (in cents)......................... 12 12 12 12 Stock Price (NYSE--in dollars)... High 12-5/8 12-1/8 10-7/8 15 Low 10-1/4 9-3/4 8-3/4 8-5/8 ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Financial Condition: The company's financial condition remains strong while operations continued to generate sufficient funds for growth. During 1993 cash and equivalents decreased slightly from $49 million to $45 million as a result of higher demands on working capital and increased business volume. The company continues to be in excellent position to pursue investment opportunities including additional product development, potential acquisitions and stock repurchase. The company had no significant commitments outstanding at the end of the year. Current Operations: Performance of the Semiconductor Equipment Group was excellent in 1993. Sales and profit rebounded strongly from the poor conditions of the last two years. Sales volume in the Asia/Pacific region and the U. S. increased substantially. During 1993 Semiconductor Equipment Group facilities were modified to improve production efficiency and capacity in keeping pace with delivery commitments. The Semiconductor Equipment Group's record backlog at year-end indicates that a similar level of business volume is likely to continue through the first half of 1994. Electronics Group sales were steady in 1993 while profits declined slightly. Lower margins were attributable to the disruption of operations resulting from the consolidation of a product line during the first half of 1993. Persistent pricing pressures from customers and competitors also contributed to the lower profitability. The Electronics Group is positioning itself to achieve a better balance between commercial and defense products. During 1993 the group was successful in capturing orders for high-end microwave components, RF receiver opportunities and other wireless communication products for commercial applications. It must be recognized that the semiconductor equipment business is cyclical and can change rapidly. Uncertainty increases significantly when projecting demand for semiconductor equipment products more than six months into the future. Over a longer horizon, uncertainty persists as to how changes in worldwide defense spending may affect sales of the company's Electronic Group products. Therefore, the performance and results of 1993 may not be indicative of future performance. Result of Operations: 1993 Compared to 1992 Semiconductor Equipment Group sales jumped 46% while Electronics Group sales remained flat. Margins improved significantly in the Semiconductor Equipment Group due to the higher volume and operational efficiencies. This more than offset the slight decline in profit margins experienced in the Electronics Group as explained above. As a result, the combined gross margin improved from 34% in 1992 to 35% in 1993. Selling and administrative expenses were higher as expected due to the increase in volume and expenses associated with the profitability of the company. In a percentage-of-sales comparison, selling and administrative expenses were favorable relative to 1992 but may increase in 1994 due to anticipated higher commissions and expenses associated with certain international sales. Research and development expenses decreased for the first three quarters of 1993 as activities eased from the intense levels experienced in 1992. In the fourth quarter 1993, Semiconductor Equipment Group began to reemphasize research and development activities to focus on the next generation of products to meet the time-to-market window. The higher level of research and development expenses incurred in the fourth quarter is expected to continue for at least the first half of 1994. All other nonoperating income and expenses were within expectations. Due to the combined effect of the above factors, 1993 net income of $11,596,000 more than doubled the 1992 income of $4,963,000 before the cumulative effect of an accounting change. A cumulative tax benefit of $5,438,000 was added to the 1992 year-end results due to the adoption of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes". 1992 Compared to 1991 Company sales decreased 5%, mostly attributable to the continued softness in semiconductor-equipment business while electronics sales were flat. The company was able to achieve a 34% gross margin and an inventory turnover rate of more than four times a year by maintaining minimum levels of inventory during 1992. Although 1992 gross margins improved from the 32% in 1991, all elements of cost were under substantial pressure because of the extremely competitive business environment. The decline in selling and administrative expenses was primarily attributable to the company's continual cost reduction efforts. Research and development expenses were maintained at 10% of sales to improve our competitive position in both the electronics and semiconductor equipment markets. Intense R&D efforts resulted in several acceptances by key customers of our TEOS-Ozone process, indicating increased order opportunities for the Semiconductor Equipment Group. As discussed below, certain nonrecurring provisions related to restructuring, environmental remediation and government claims adversely affected 1991 results. The provisions made in 1991 continued to appear adequate to meet the company's obligations. Interest income was higher in 1992 resulting from additional funds for investment. All other nonoperating income and expenses were within expectations. The company adopted provisions of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS 109) resulting in a cumulative tax benefit of $5,438,000. Income before the cumulative adjustment was $.66 per share in 1992 compared to a net loss of $2.98 per share in 1991. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA WATKINS-JOHNSON COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) YEAR ENDED DECEMBER 31 ----------------------------------- 1993 1992 1991 ------- -------- -------- Sales .......................... $286,290 $264,400 $277,540 ---------- ---------- ---------- Costs and expenses: Cost of goods sold ........... 184,749 173,816 188,275 Selling and administrative ... 57,452 55,648 60,180 Research and development ..... 27,163 27,210 27,180 Restructuring ................ 12,251 ---------- ---------- ---------- 269,364 256,674 287,886 ---------- ---------- ---------- Income (loss) from operations .. 16,926 7,726 (10,346) Other income (expense): Interest income .............. 1,497 1,422 1,056 Interest expense ............. (1,293) (1,497) (1,519) Other income (expense)--net .. (284) (438) (2,915) Environmental remediation .... (15,000) ---------- ---------- ---------- Income (loss) before Federal and foreign income taxes and cumulative effect of accounting change............. 16,846 7,213 (28,724) Federal and foreign income taxes . (5,250) (2,250) 6,325 ---------- ---------- ---------- Income (loss) before cumulative effect of accounting change .... 11,596 4,963 (22,399) Cumulative effect of change in accounting for income taxes .. 5,438 ---------- ---------- ---------- Net income (loss) ............ $ 11,596 $ 10,401 $ (22,399) ========== ========== ========== Per share amounts: Income (loss) before cumulative effect of accounting change .. $1.45 $ .66 $(2.98) Cumulative effect of change in accounting for income taxes .72 ---------- ---------- ---------- Net income (loss) ............ $1.45 $1.38 $(2.98) ========== ========== ========== Average common and equivalent shares......................... 7,999,000 7,551,000 7,527,000 See notes to consolidated financial statements. WATKINS-JOHNSON COMPANY AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) DECEMBER 31 ---------------------------------- 1993 1992 ---------- --------- ASSETS CURRENT ASSETS: Cash and equivalents ................ $ 45,040 $ 49,081 Receivables ......................... 73,971 55,562 Inventories:......................... Finished goods .................... 1,805 2,172 Work in process .................... 28,014 29,290 Raw materials and parts ............ 7,327 6,029 Deferred income taxes ............... 10,545 9,630 Other ............................... 2,072 1,479 ---------- --------- Total current assets .......... 168,774 153,243 ---------- --------- PROPERTY, PLANT AND EQUIPMENT: Land ................................ 4,130 4,130 Buildings and improvements .......... 31,250 28,881 Plant facilities, leased ............ 13,060 13,060 Machinery and equipment ............. 119,417 116,948 ---------- --------- 167,857 163,019 Accumulated depreciation and amortization ....................... (121,028) (115, 908) ---------- --------- Property, plant and equipment--net .. 46,829 47,111 ---------- --------- OTHER ASSETS: Deferred income taxes ............... 4,380 4,220 Other ............................... 645 1,516 ---------- --------- Total other assets ............. 5,025 5,736 ---------- --------- $ 220,628 $ 206,090 ========== ========== LIABILITIES AND SHAREOWNERS' EQUITY CURRENT LIABILITIES: Accounts payable .................... $ 13,243 $ 10,950 Accrued expenses .................... 10,619 10,605 Advances on contracts ............... 11,820 10,559 Provision for warranties and losses on contracts .......................... 5,984 6,964 Payroll and profit sharing .......... 13,217 11,693 Income taxes ........................ 5,394 1,620 ---------- --------- Total current liabilities ........... 60,277 52,391 ---------- --------- LONG-TERM OBLIGATIONS .......... 26,463 28,644 ---------- --------- SHAREOWNERS' EQUITY: Preferred stock, $1.00 par value-- authorized and unissued, 500,000 shares ............................. Common stock, no par value-- authorized, 45,000,000 shares; outstanding: 1993, 7,598,290 shares; 1992, 7,554,865 shares ..... 9,106 7,839 Retained earnings ................... 124,782 117,216 ---------- --------- Total shareowners' equity ..... 133,888 125,055 ---------- --------- $ 220,628 $ 206,090 ========== ========== See notes to consolidated financial statements. WATKINS-JOHNSON COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREOWNERS' EQUITY (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) COMMON STOCK TOTAL ----------------- RETAINED SHAREHOLDERS' SHARES DOLLARS EARNINGS EQUITY ---------- ------ ---------- ---------- Balance, January 1, 1991 ...... 7,519,645 $ 7,521 $136,454 $ 143,975 Net loss for 1991 .......... (22,399) (22, 399) Dividends declared--$.48 per share ...................... (3,614) (3,614) Sales under stock option plans 18,850 164 164 --------- ------ ---------- ------- Balance, December 31, 1991 ..... 7,538,495 7,685 110,441 118,126 Net income for 1992 .......... 10,401 10,401 Dividends declared--$.48 per share .................. (3,626) (3,626) Sales under stock option plans 16,370 154 154 --------- ------ --------- ------- Balance, December 31, 1992....... 7,554,865 7,839 117,216 125,055 Net income for 1993 ........... 11,596 11,596 Repurchase of common stock .... (32,000) (27) (399) (426) Dividends declared--$.48 per share (3,631) (3,631) Sales under stock option plans .. 75,425 1,294 1,294 --------- ------- -------- -------- Balance, December 31, 1993.......... 7,598,290 $ 9,106 $124,782 $133,888 ========= ======= ======== ======== See notes to consolidated financial statememts. WATKINS-JOHNSON COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollars in thousands) YEAR ENDED DECEMBER 31 ------------------------------------- 1993 1992 1991 --------- ---------- --------- OPERATING ACTIVITIES: Net income (loss) .................. $ 11,596 $ 10,401 $(22,399) Adjustments to reconcile net income (loss) to net cash provided by operating activities: Depreciation and amortization ..... 9,961 11,305 11,945 Write-down of assets related to restructuring ................... 8,785 Deferred tax provisions including accounting change ............... (1,075) (6,450) (3,660) Changes net of restructuring:...... Receivables .................... (18,409) 13,527 21,708 Inventories .................... 345 (2,218) 8,880 Other assets .................... (556) 4,438 (4,347) Accruals and payables .......... 8,878 1,318 (5,788) Advances on contracts ........... 1,261 (12,037) 5,803 Provision for warranties and losses on contracts ........... (980) 198 2,508 Environmental remediation ....... (1,676) (1,581) 15,000 -------- --------- -------- Net cash provided by operating activities.......... 9,345 18,901 38,435 -------- --------- -------- INVESTING ACTIVITIES: Additions of property, plant and equipment ......................... (9,714) (5,206) (9,889) Other .............................. 869 32 49 -------- ------- -------- Net cash used in investing activities.................... (8,845) (5,174) (9,840) -------- ------- -------- FINANCING ACTIVITIES: Net borrowings (repayments) under lines of credit..................... 204 (343) (371) Payments on long-term obligations ... (1,982) (974) (918) Proceeds from issuance of common stock............................... 1,294 154 164 Repurchase of common stock .......... (426) Dividends paid ..................... (3,631) (3,626) (4,517) -------- -------- ------- Net cash used in financing activities..................... (4,541) (4,789) (5,642) -------- -------- ------- Net increase (decrease) in cash and equivalents ......................... (4,041) 8,938 22,953 Cash and equivalents at beginning of year................................. 49,081 40,143 17,190 --------- ------- ------- Cash and equivalents at end of year .......................... $ 45,040 $49,081 $40,143 ========= ======== ======= Other cash flow information: Income taxes paid (refunded) . $ 3,808 $(2,638) $ 4,242 Interest expense paid .......... 1,324 1,522 1,503 See notes to consolidated financial statements. WATKINS-JOHNSON COMPANY AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation--The consolidated financial statements include those of the company and its subsidiaries after elimination of intercompany balances and transactions. Cash Equivalents--Cash equivalents consist principally of U.S. Treasury bills and commercial paper acquired with remaining maturity periods of ninety days or less and are stated at cost plus accrued interest which approximates market value. The company's investment guidelines limit holdings in commercial paper to $1,000,000 per issuer. Inventories--Inventories are stated at the lower of cost, using first-in, first-out and average-cost basis, or market. Cost of inventory items is based on purchase and production cost. Long-term contract costs and selling and administrative expenses are excluded from inventory. Progress payments are not netted against inventory. Property, Plant and Equipment--Property, plant and equipment are stated at cost. Leases which at inception assure the lessor full recovery of the fair market value of the property over the lease term are capitalized. Provision for depreciation and amortization is primarily based on the sum-of-the-years'-digits and declining-balance methods. Revenue Recognition--Revenue on fixed-price contracts other than long-term contracts is recorded upon shipment or completion of tasks as specified in the contract. Sales and allowable fees under cost-reimbursement contracts are recorded as costs are incurred. Long-term contract sales and cost of goods sold are recognized using the percentage-of-completion method based on the actual physical completion of work performed and the ratio of costs incurred to total estimated costs to complete the contract. Any anticipated losses on contracts are charged to earnings when identified. Income Taxes--In 1992 the company adopted Statement of Financial Accounting Standard No. 109, "Accounting for Income Taxes" (SFAS 109); previously the company had accounted for taxes under SFAS 96 (see Note 7). Under both SFAS 109 and 96, the consolidated statements of income include provisions (benefits) for deferred income taxes using the "liability" method for transactions that are reported in one period for financial accounting purposes and in another period for income tax purposes. State and local income taxes are included in selling and administrative expenses. Per Share Information--Beginning in 1993 net income per share is computed using the weighted average number of common and common equivalent shares (dilutive stock options) outstanding during the year. The difference between fully diluted earnings per share and primary earnings per share is not significant. Prior to 1993, the computation excluded outstanding stock options as their dilutive effect was not material. Reclassification--Certain amounts for 1992 and 1991 have been reclassified to conform to the 1993 presentation. 2. RECEIVABLES Receivables consist of the following (in thousands): 1993 1992 ---------- ---------- U.S. Government long-term contracts: Billed .............................. $ 2,936 $ 2,125 Unbilled ........................... 4,896 3,560 Commercial long-term contracts: Billed .............................. 3,818 2,416 Unbilled ........................... 11,917 10,367 ---------- ---------- Total long-term contract receivables .. 23,567 18,468 Other trade receivables ............... 50,404 37,094 ---------- ---------- Total receivables less allowance of $999 in 1993 and $982 in 1992 .... $73,971 $55,562 ========== ========== Unbilled receivables represent revenue recognized for long-term contracts not yet billable based on the terms of the contract. These amounts are billable upon shipment of the product, achievement of milestones, or completion of the contract. Unbilled receivables are expected to be billed and collected within one year. Receivables representing retainage not collectible within one year are not material. There are no significant billed or unbilled receivables subject to future negotiation. Government contracts have provisions for audit, price redetermination and other profit and cost limitations. Contracts may be terminated without prior notice at the Government's convenience. In the event of such termination, the company may be compensated for work performed, a reasonable allowance for profit, and commitments at the time of termination. The right to terminate for convenience has not had any significant effect on the company's financial position or results of operations. 3. LONG-TERM OBLIGATIONS AND LINES OF CREDIT Long-term obligations, excluding amounts due within one year, consist of (in thousands): 1993 1992 ---------- ---------- Mortgage ........................... $ 4,238 $ 5,508 Deferred compensation .............. 4,034 2,898 Environmental remediation .......... 10,257 11,933 Long-term leases ................... 7,934 8,305 ---------- ---------- Total ........................... $26,463 $28,644 ========== ========== The current portion of long-term obligations is included in current liabilities. The expected maturity amounts are as follows: 1994, $4,102,000; 1995, $1,873,000; 1996, $1,917,000; 1997, $1,964,000, 1998, $2,016,000. Mortgage--Primarily consists of a mortgage bearing 8-3/4% interest secured by the San Jose, California plant. The annual payments totaling $710,000 continue into the year 2003 and are payable in monthly installments. Based on the borrowing rates currently available to the company for loans with similar terms, the carrying value of the mortgage approximates fair value. Deferred Compensation--The company has deferred compensation plans covering selected members of management and key technical employees. The purpose is to reward and encourage talented employees to remain with the company. Environmental Remediation--As discussed in Note 8, the company is obligated to remediate groundwater contamination at the Scotts Valley and Palo Alto facilities. The portion expected to be paid within one year is included in current liabilities. Leases--Certain long-term leases for plant facilities are treated as capital leases for financial statement purposes. The leases expire during the years 1994 to 2014, however renewal options provide for lease extensions ranging from fifteen to thirty-five years at revised rental terms. The company also has noncancellable operating leases for plant facilities and equipment expiring through 1996. The leases may be renewed for various periods after the initial term. Payment obligations under these capitalized and operating leases as of December 31, 1993 are as follows (in thousands): CAPITAL OPERATING LEASES LEASES ---------- --------- Lease payments: 1994 .................... $ 1,156 $1,104 1995 .................... 848 839 1996 .................... 848 163 1997 .................... 848 36 1998 .................... 848 Remaining years ........ 16,568 ---------- --------- Total ...................... 21,116 $ 2,142 ========== Imputed interest ........... (12,811) --------- Present value of lease payments (current portion, $371) .. $ 8,305 ========= Rent expense for property and equipment relating to operating leases is as follows (in thousands): 1993 1992 1991 --------- --------- -------- Real property ................ $ 1,033 $ 1,188 $1,234 Equipment .................... 865 830 929 -------- -------- ------- Total ................. $ 1,898 $ 2,018 $2,163 ======== ======== ======= Lines of Credit--The company has arranged with certain banks to provide unsecured revolving lines of credit totaling $23,500,000. These agreements are generally renegotiated on an annual basis. No material compensating balances are required or maintained. Borrowings under these facilities generally bear interest at prime rate, which was 6 percent in 1993. The lines of credit were substantially unused during the year. The amount of outstanding letters of credit and other guarantees, which may reduce the company's available lines, totaled $4,230,000 at December 31, 1993. 4. SHAREOWNERS' EQUITY Stock Repurchase Program--The Board of Directors has authorized the company to repurchase a maximum of 1,500,000 shares of company stock. Approximately 936,000 shares have been repurchased through December 31, 1993. Common Share Purchase Rights--For each share of company common stock outstanding, one Common Share Purchase Right is attached. The Rights expire October 20, 1996, and may be redeemed by the company for $.01 per Right at any time prior to 15 days after an entity acquires 20% or more of the company's common stock. The Rights become exercisable if an entity acquires 20% or more of the company's outstanding common stock, or announces an offer which would result in such entity acquiring 30% or more of the company's common stock. When exercisable, the Rights trade separately from the common stock and entitle a holder to buy one share of the company's common stock for $160. If the company is subsequently involved in a merger or other business combination, each Right will entitle its holder to buy a number of shares of common stock of the surviving company having a market value of twice the $160 exercise price. The Rights also provide for protection against self-dealing transactions by a controlling shareowner. Stock Option Plans--The Employee Stock Option Plan provides for grants of nonqualifying and incentive stock options to certain key employees and officers. The options are granted at the market price on date of grant and expire at the tenth anniversary date. One-third of the options granted are exercisable in each of the third, fourth and fifth succeeding years. The Plan allows those employees who are subject to the insider trading restrictions certain limited rights to receive cash in the event of a change in control. Shares issued are net of retirement of shares used in payment for options exercised. In addition, the Plan permits the award of restricted stock rights subject to a fixed vesting schedule. The holder of vested restricted stock has certain dividend, voting, and other shareowner rights. No restricted stock awards have been made through December 31, 1993. The Nonemployee Directors Stock Option Plan provides for a fixed schedule of options to be granted through 1998. Options granted are exercisable similarly to the Employee Stock Option Plan. The total number of shares to be issued under this plan may not exceed 200,000 shares. Included in the tables below, 17,640 option shares were granted at $12.88 in 1993 and 19,080 option shares were granted at $10.00 in 1992. 1993 SHARES PRICE - ---------- ---------- ---------- Granted ...................... 449,640 $12.38 to $24.50 Exercised .................... 87,945 $13.00 to $21.00 Terminated .................. 154,167 At December 31: Outstanding ................ 1,869,412 $ 9.63 to $36.75 Exercisable ................ 1,058,700 Reserved for future grants . 1,657,230 1992 SHARES PRICE - ---------- ---------- ------------ Granted ...................... 556,080 $ 9.25 to $10.75 Exercised .................... 19,270 $ 8.88 to $10.17 Terminated .................. 161,524 At December 31: Outstanding ................ 1,661,884 $ 9.63 to $36.75 Exercisable ................ 711,046 Reserved for future grants . 1,952,703 5. RESTRUCTURING During 1991, the company took actions resulting in restructuring charges totaling $12,251,000 associated with the consolidation and closure of facilities. Such actions included reductions in work force and consolidation of product lines required to concentrate on core markets. Charges incurred were primarily related to severance pay and write-down of assets. 6. OTHER INCOME (EXPENSE)--NET In 1991 the company received and reviewed various audit reports and claims asserted by the Defense Contract Audit Agency (DCAA) for contracts completed in prior years. Although the company believes it has meritorious defenses, provisions totaling $2,500,000 were recorded for these claims in 1991. 7. INCOME TAXES In 1992 the company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS 109) which permits recognition of tax benefits for certain temporary differences that could not be recognized under SFAS 96. Under SFAS 109, deferred tax assets are recognized when management believes realization of future tax benefits of temporary differences is more likely than not. In estimating future tax consequences, SFAS 109 generally considers all expected future events other than enactments of changes in the tax law or rates, whereas SFAS 96 gave no recognition to future events other than the recovery of assets and settlement of liabilities at their carrying amounts. The cumulative effect of this accounting change increased deferred tax assets at January 1, 1992 and first quarter 1992 net income by $5,438,000 or 72 cents per share. As permitted by SFAS 109, the income tax provision for 1991 has not been restated. The provision (benefit) for Federal and foreign income taxes consists of the following (in thousands): 1993 1992 1991 ---------- ---------- ---------- Current .................. $ 6,325 $ 3,262 $ (2,665) Deferred ................. (1,075) (1,012) (3,660) ---------- ---------- ---------- Total ............. $ 5,250 $ 2,250 $ (6,325) ========== ========== ========== Deferred tax assets (liabilities) are comprised of the following at December 31 (in thousands): 1993 1992 1991 ---------- ---------- ---------- Capitalized leases ...................$ 675 $ 736 $ 786 Deferred compensation ................ 3,357 2,055 2,291 Loss accruals ....................... 5,423 5,919 4,762 Environmental remediation ............ 4,034 4,601 5,134 Uniform capitalization .............. 1,055 929 844 Vacation accrual ..................... 1,744 1,698 1,656 Unusable tax benefits under SFAS 96 .. (5,438) Other ................................ 454 211 20 ---------- ---------- --------- Gross deferred tax assets......... 16,742 16,149 10,055 ---------- ---------- --------- Depreciation ....................... (1,413) (1,910) (2,267) Other ............................... (404) (389) (388) ---------- ---------- --------- Gross deferred tax liabilities.... (1,817) (2,299) (2,655) ---------- ---------- --------- Net deferred tax asset .............. $14,925 $13,850 $ 7,400 ========== ========== ========== The differences between the effective income tax rate and the statutory Federal income tax rate are as follows: 1993 1992 1991 ---------- ---------- ---------- Statutory Federal tax rate ........... 35.0% 34.0% 34.0% FSC ............................... (7.4) (7.8) 3.5 Deferred tax changes ............. (14.7) Foreign subsidiary losses ........ 1.8 3.1 Other ............................. 1.8 1.9 (.8) ---------- ---------- ---------- Effective rate ..................... 31.2% 31.2% 22.0% ========== ========== ========== Deferred tax changes in 1991 resulted primarily from loss provisions for which no tax benefit was recognized under SFAS 96. Domestic state and local income taxes included in selling and administrative expenses totaled $1,257,000 in 1993, $640,000 in 1992, and $265,000 in 1991. Foreign operation amounts represent less than 5% of totals. The Omnibus Budget Reconciliation Act of 1993 (the Act) became effective on August 10, 1993. The provisions of the Act did not have a material effect on the company's deferred taxes or its results of operations. 8. ENVIRONMENTAL REMEDIATION AND OTHER CONTINGENCIES In 1991, the company completed negotiations with the Environmental Protection Agency (EPA) for a consent decree, which was subsequently lodged in U.S. District Court. The agreement requires the company to complete restoration and thereafter maintain the groundwater quality at the Scotts Valley Plant. In a separate action, the California Environmental Protection Agency issued a letter challenging the company's position that the source of subsurface contamination originated outside of company facilities in Palo Alto and directed the company to revise its remedial investigation/feasibility study. The state further directed the company to clean up certain contamination under the company facilities irrespective of the origin thereof; and to coordinate remedial efforts among the potential responsible parties cited in a 1988 regional remedial action order. The company recorded a provision totaling $15,000,000 for estimated costs to comply with the consent decree on the Scotts Valley Plant site and for estimated costs necessary to fully investigate, develop, and implement the remedial actions at the Palo Alto Plant site. The provision was not reduced by any potential recoveries from insurers or other responsible parties. The ultimate cost of restoring the sites cannot be predicted with certainty. Additional uncertainty exists with the Palo Alto site since the extent of the contamination and the respective share of each potential responsible party has not yet been conclusively determined. Technological advances and developments may also affect the future costs of the restoration efforts. Moreover, the company will continue to vigorously pursue recovery from its insurers and other responsible parties. The company believes adequate provisions have been taken to cover the expected expenditures associated with the known environmental actions at this time. In addition to the above environmental matters and pending government claims discussed in Note 6, the company is involved in various legal actions which arose in the ordinary course of its business activities. Except for the provisions noted above and in Note 6, the company believes the final resolution of these matters should not have a material impact on its results of operations and financial position. 9. EMPLOYEE BENEFIT PLANS Profit Sharing Investment Plan--The Watkins-Johnson Employees' Profit Sharing Investment Plan conforms to the requirements of ERISA and the Internal Revenue Code as a qualified defined contribution plan. The Plan covers substantially all employees and provides that the company's contribution equal 9% of the net pretax earnings and be funded each year. The amount charged to income was $1,945,000 in 1993, $906,000 in 1992, and $0 in 1991. Employee Stock Ownership Plan (ESOP)--To encourage employee participation and long-term ownership of company stock, an ESOP was implemented on January 1, 1991. The Board determines each year's contribution depending on the performance and financial condition of the company. The Board approved a contribution equal to 1% of eligible employee compensation for 1993, 1992, and 1991, which resulted in charges to income of $887,000, $900,000, and $910,000, respectively. The ESOP is a qualified defined contribution plan under the similar employment and regulatory requirements as the Profit Sharing Investment Plan. 10. BUSINESS SEGMENT REPORTING The company operates in three industry segments. Operations in the Electronics (formerly Defense) segment include the design, development, manufacture and sale of advanced electronic systems and devices for military, space, and commercial applications. Operations in the Semiconductor Equipment (formerly Commercial) segment involve the development, production, sales and service of chemical-vapor-deposition equipment for the manufacture of semiconductor products and flat-panel displays. The Environmental Services operations provide technical consulting services ranging from the exploration, development and utilization of groundwater resources to the detection and remediation of contaminated sites. The U.S. Government is a significant customer for the Electronics and Environmental Services segments. Hughes Aircraft Company is a significant customer for the Electronics segment. Sales to U.S. Government agencies and Hughes Aircraft Company totaled $63,000,000 and $41,000,000 in 1993; $70,000,000 and $28,000,000 in 1992; $71,000,000 and $25,000,000 in 1991, respectively. Corporate assets consist primarily of cash and equivalents. Intersegment sales were transferred based on negotiated prices. Sales by geographic area are as follows (in thousands): 1993 1992 1991 ---------- ---------- ---------- United States .................. $193,075 $199,611 $ 193,298 Export sales: Europe ....................... 20,830 12,266 14,704 Far East ..................... 44,970 26,548 42,143 Other ........................ 15,652 11,311 14,294 European foreign operations .. 11,763 14,664 13,101 ---------- ---------- ---------- Total ..................... $286,290 $264,400 $ 277,540 ========== ========== ========== Foreign operations' sales and identifiable assets are less than ten percent of consolidated totals. 11. QUARTERLY FINANCIAL DATA-UNAUDITED Unaudited quarterly financial data are as follows (in thousands, except per share amounts): YEAR ENDED DECEMBER 31 ------------------------------------------ 1993 QUARTERS 1ST 2ND 3RD 4TH - -------------- -------- ------- -------- -------- Sales ...........................$67,083 $68,216 $72,708 $78,283 Gross profit ................... 22,147 23,250 25,462 30,682 Net income ...................... 1,370 2,652 3,512 4,062 Net income per share ............ $.18 $.33 $.42 $.52 1992 QUARTERS 1ST 2ND 3RD 4TH - -------------- -------- ------- -------- -------- Sales .......................... $63,049 $66,984 $68,478 $65,889 Gross profit ................... 21,851 23,973 23,629 21,131 Net income ..................... 6,913(a) 754 1,368 1,366 Net income per share ........... $.92(a) $.10 $.18 $.18 - ---------- (a) The first quarter of 1992 includes a tax benefit of $5,438 or 72 cents per share due to the cumulative effect of an accounting change (see Note 7). REPORT OF MANAGEMENT The consolidated financial statements of Watkins-Johnson Company and subsidiaries were prepared by management, which is responsible for their integrity and objectivity. The statements were prepared in conformity with generally accepted accounting principles and, as such, include amounts that are based on the best judgments of management. The system of internal controls of the company is designed to provide reasonable assurance that assets are safeguarded and that transactions are executed in accordance with management's authorization and are reported properly. Perhaps the most important safeguard for shareowners is the company's emphasis in the selection, training and development of professional accounting managers to implement and oversee the proper application of its internal controls and the reporting of management's stewardship of corporate assets and maintenance of accounts in conformity with generally accepted accounting principles. Deloitte & Touche, independent auditors, are retained to provide an objective, independent review as to management's discharge of its responsibilities insofar as they relate to the fairness of reported operating results and financial position. They obtain and maintain an understanding of the company's accounting and financial controls, and conduct such tests and related procedures as they deem necessary to arrive at an opinion on the fairness of the financial statements. The Audit Committee of the Board of Directors, composed solely of Directors from outside the company, meets periodically, separately and jointly, with the independent auditors and representatives of management to review the work of each. The functions of the Audit Committee include recommending the engagement of the independent auditors, reviewing the scope and results of the audit and reviewing management's evaluation of the system of internal controls. W. Keith Kennedy Scott G. Buchanan President and Vice President and Chief Executive Officer Chief Financial Officer INDEPENDENT AUDITORS' REPORT The Shareowners and Board of Directors of Watkins-Johnson Company: We have audited the accompanying consolidated balance sheets of Watkins-Johnson Company and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, shareowners' equity, and cash flows for each of the three years in the period ended December 31, 1993. 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, such consolidated financial statements present fairly, in all materials respects, the financial position of Watkins-Johnson Company and subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. In 1992, the company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," as described in Note 7 to the consolidated financial statements. February 4, 1994 Deloitte & Touche San Francisco, California ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required by this item concerning the company's directors is shown under the caption "Election of Directors" in the company's definitive proxy statement filed with the Commission pursuant to Regulation 14A. The information relating to the company's executive officers is presented in Part I of this Form 10-K under the caption "Executive Officers of the Registrant". ITEM 11. ITEM 11. EXECUTIVE COMPENSATION See this caption in the definitive proxy statement which the company has filed with the Commission pursuant to Regulation 14A. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT This information is shown under the captions "Security Ownership of Certain Beneficial Owners & Management" in the company's definitive proxy statement filed with the Commission pursuant to Regulation 14A. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information concerning certain business relationships is shown under the caption "Executive Compensation" in the definitive proxy statement which the company has filed with the Commission pursuant to Regulation 14A. There were no transactions with management for which disclosure would be required by Item 404 of Regulation S-K. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K PAGE ---- (a)1. Consolidated Financial Statements Consolidated Statements of Operations For the Years Ended December 31, 1993, 1992 and 1991 7 Consolidated Balance Sheets December 31, 1993 and 1992 8 Consolidated Statements of Shareowners' Equity For the Years Ended December 31, 1993, 1992 and 1991 9 Consolidated Statements of Cash Flows For the Years Ended December 31, 1993, 1992 and 1991 10 Notes to Consolidated Financial Statements 11-18 Report of Management 19 Independent Auditors' Report 20 2. Financial Statement Schedules PAGE ---- Independent Auditors' Report........................................ 24 I Marketable Securities as of December 31, 1993................ 25 VIII Valuation and Qualifying Accounts and Reserves For the Years Ended December 31, 1993, 1992 and 1991......... 26 IX Short-Term Borrowings For the Years Ended December 31, 1993, 1992 and 1991.............................27 X Supplementary Income Statement Information For the Years Ended December 31, 1993, 1992 and 1991.................28 Schedules not listed above are omitted because of the absence of conditions under which they are required or because the required information is included in the financial statements or in the notes thereto. 3. Exhibits A list of the exhibits required to be filed as part of this report is set forth in the Exhibit Index, which immediately precedes such exhibits. The exhibits are numbered according to Item 601 of Regulation S-K. Exhibits incorporated by reference to a prior filing are designated by an asterisk. ---------- (b) No reports on Form 8-K were required to be filed during the last quarter of the period covered by this report. (c) The exhibits required to be filed by Item 601 of Regulation S-K are the same as Item 14(a)3 above. (d) Financial statement schedules not included herein have been omitted because of the absence of conditions under which they are required or because the required information is included in the financial statements or in the notes thereto. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this annual report to be signed on its behalf by the undersigned, thereunto duly authorized. WATKINS-JOHNSON COMPANY ----------------------------------------- (Registrant) Date: March 25, 1994 By /s/ DEAN A. WATKINS ------------------------------------- DEAN A. WATKINS CHAIRMAN OF THE BOARD INDEPENDENT AUDITORS' REPORT Watkins-Johnson Company: We have audited the consolidated financial statements of Watkins-Johnson Company and subsidiaries as of December 31, 1993 and 1992, and for each of the three years in the period ended December 31, 1993, and have issued our report thereon dated February 4, 1994, which report includes an explanatory paragraph as to an accounting change in 1992 to adopt Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," such consolidated financial statements and report are included in Item 8 of this annual report on Form 10-K. Our audits also included the consolidated financial statement schedules of Watkins-Johnson Company and subsidiaries, listed in Item 14. These consolidated financial statement schedules are the responsibility of the company's management. Our responsibility is to express an opinion based on our audits. In our opinion, such consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. February 4, 1994 Deloitte & Touche San Francisco, California Schedule VIII WATKINS-JOHNSON COMPANY AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS AND RESERVES FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 BALANCE AT CHARGED TO BALANCE AT BEGINNING COSTS AND END OF DESCRIPTION OF PERIOD EXPENSES DEDUCTIONS(1) PERIOD(2) - ---------- ---------- ---------- ------------- ---------- Allowance for doubtful accounts ....$982,244 $ 21,420 $ 4,666 $ 998,998 ========== ========== ======== ========== Allowance for doubtful accounts ....$965,989 $ 24,550 $ 8,295 $ 982,244 ========== ========== ======= ========== Allowance for doubtful accounts ....$617,772 $351,817 $ 3,600 $ 965,989 ========== ========== ======= ========= - ---------- (1) Write-off of uncollectible accounts. (2) Reduction to accounts receivable. SCHEDULE X WATKINS-JOHNSON COMPANY AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 CHARGED TO COSTS AND EXPENSES ------------------------------------- ITEM 1993 1992 1991 ---------- ---------- ---------- ---------- 1. Maintenance and repairs .............$3,788,406 $4,652,897 $6,553,973 2. Depreciation and amortization of intangible assets ..................... (1) (1) (1) 3. Taxes, other than payroll and income taxes .......................... (1) (1) (1) 4. Royalties ............................. (1) (1) (1) 5. Advertising costs ..................... (1) (1) (1) - ---------- (1) Expense did not exceed 1% of sales. EXHIBIT INDEX EXHIBIT NUMBER DESCRIPTION - ---------- ------------ 3-a ...... *Articles of Incorporation of Watkins-Johnson Company, as amended May 8, 1989. 3-b ...... *By-Laws of Watkins-Johnson Company, as amended April 27, 1989 (Exhibit 3-b to Form 10-K for 1980, Commission File No. 1-5631). 10........ Material Contracts: 10-a...... *Lease and Agreement between Lindco Properties Company and Watkins-Johnson Company commencing May 1, 1969 (Exhibit (b) I to Form 10-K for 1969, Commission File No. 2-22436). 10-b ..... *Lease and Agreement between Morrco Properties Company and Watkins-Johnson Company dated October 31, 1975 (Exhibit 2(c) to Form 10-K for 1976, Commission File No. 1-5631). 10-c...... *Lease and Agreement between Danac Real Estate Investment Corporation and Watkins-Johnson Company (Exhibit 6 to Form 10-K for 1972, Commission File No. 2-22436) and the amendments thereto (Exhibit 1(b) to Form 10-K for 1976, Commission File No. 1-5631). 10-d...... *Building and Loan Agreement and Deed of Trust Note between Danac Real Estate Investment Corporation and Watkins-Johnson Company (Exhibit 7 to Form 10-K for 1972, Commission File No. 2-22436). 10-e ..... *Promissory Note and Deed of Trust Agreement entered into between the New England Mutual Life Insurance Company and Watkins-Johnson Company dated May, 1978 (Exhibit 2 to Form 10-K for 1978, Commission File No. 1-5631). 10-f...... *Promissory Note and Deed of Trust entered into by the Wake County Industrial Facilities and Pollution Control Financing Authority, the NCNB National Bank of North Carolina and Watkins-Johnson Company dated December 28, 1984 (Exhibit 10-f to Form 10-K for 1984, Commission File No. 1-5631). 10-g .......*Deferred Compensation Plan effective November 29, 1979 (Exhibit 10-g to Form 10-K for 1984, Commission File No. 1-5631). 10-h .......*Key Top-Management Incentive Bonus Plan Summary (Exhibit 10-h to Form 10-K for 1985, Commission File No. 1-5631). 10-i .......*Employment Agreement Form, in effect for those employees listed in the company's definitive proxy statement filed with the Commission pursuant to Regulation 14A (Exhibit 10-i to Form 10-K for 1984, Commission File No. 1-5631). 10-j .......*Deferred Compensation Plan effective November 29, 1979 as amended March 31, 1986 (Exhibit 10-j to Form 10-K for 1986, Commission File No. 1-5631). 10-k .......*Lease and Agreement between Seagate Technology and Watkins-Johnson Company dated September 19, 1986 (Exhibit 10-k to Form 10-K for 1986, Commission File No. 1-5631). 10-k(1) ....*Termination of Lease and Agreement between Seagate Technology and Watkins-Johnson Company dated September 22, 1987 (Exhibit 10-k(1) to Form 10-K for 1987, Commission File No. 1-5631). 10-l .......*Severance Agreement Form, in effect for those employees listed in the company's definitive proxy statement filed with the Commission pursuant to Regulation 14A (Exhibit 10-l to Form 10-K for 1986, Commission File No. 1-5631). 10-m .......*Form of Rights Agreement between Watkins-Johnson Company and Bank of America National Trust and Savings Association (Exhibit 4 to the 1986 Third Quarter Form 10-Q, Commission File No. 1-5631). 10-n .......*Watkins-Johnson Company 1976 Stock Option Plan, as amended September 28, 1987 (Appendix A to the company's definitive proxy statement dated March 1, 1988 filed with the Commission pursuant to Regulation 14A). 10-o .......*Watkins-Johnson Company 1989 Stock Option Plan for nonemployee directors (Appendix A to the company's definitive proxy statement dated February 28, 1990 filed with the Commission pursuant to Regulation 14A). 10-p .......*Watkins-Johnson Company 1976 Stock Option Plan amended and renamed as the 1991 Stock Option and Incentive Plan (Appendix A to the company's definitive proxy statement dated February 28, 1991 filed with the Commission pursuant to Regulation 14A). 11 .........Statement re Computation of Per Share Earnings. 21 .........Subsidiaries of Watkins-Johnson Company. 23 .........Consent of Independent Auditors.

1993 ITEM 1. BUSINESS General Description of Business BFC Financial Corporation is a savings bank holding company operating principally through its approximately 48.17% owned subsidiary, BankAtlantic, A Federal Savings Bank ("BankAtlantic"). BFC Financial Corporation and its subsidiaries are collectively identified herein as the "Registrant", "BFC" or the "Company". The Company acquired control of BankAtlantic in 1987 for a total investment of approximately $43 million. From 1987 through June 1993, BFC increased its ownership in BankAtlantic and BankAtlantic was consolidated in BFC Financial Corporation's financial statements since October 1987. During November 1993, a public offering of 2,070,000 million shares of BankAtlantic common stock at a price of $13.50 per common share was consummated. Of the shares sold, 1,400,000 shares were sold by BFC Financial Corporation. Net proceeds to BFC Financial Corporation from the sale amounted to approximately $17.7 million. Upon the sale of the 2,070,000 shares, BFC Financial Corporation's ownership of BankAtlantic decreased from 77.83% to 48.17%. With the Company's ownership position less than 50%, BankAtlantic is no longer consolidated in BFC Financial Corporation's financial statements. BankAtlantic represented approximately 97% of the Company's consolidated assets when it was consolidated with the Company. Now based on the equity method of accounting for the Company's investment in BankAtlantic, the investment represents approximately 43% of the Company's consolidated assets. At September 30, 1993, BankAtlantic ranked seventh in size among all savings institutions headquartered in the State of Florida and first in size among all financial institutes headquartered in Broward County, Florida based on its total assets at such date. During March 1992, BFC, which was formerly known as BankAtlantic Financial Corporation changed its name to BFC Financial Corporation, to eliminate confusion with its subsidiary, BankAtlantic, A Federal Savings Bank. In addition to its investment in BankAtlantic, the Company owns and manages real estate. Since its inception in 1980, and prior to the acquisition of control of BankAtlantic, the Company's primary business was the organization, sale and management of real estate investment programs. Effective as of December 31, 1987, the Company ceased the organization and sale of new real estate investment programs, but continues to manage the real estate assets owned by its existing programs. Subsidiaries of the Company continue to serve as the corporate general partners of 4 public limited partnerships which file periodic reports with the Securities and Exchange Commission under the Securities Exchange Act of 1934, as amended (the "Exchange Act"). Subsidiaries of the Company also serve as corporate general partners of a number of private limited partnerships formed in prior years. The Company and/or its predecessors and affiliates have been engaged in real estate investment activities since 1972. Registrant was organized in its current corporate form in 1980 as the result of a statutory merger which consolidated I.R.E. Series I, Inc., I.R.E. Series II, Inc. and I.R.E. Series III, Inc. Such corporations were originally organized as limited partnerships sponsored by predecessors and affiliates of the Company. In March 1989, (the "1989 Exchange") the Company acquired all of the assets and liabilities of three affiliated public limited partnerships, I.R.E. Real Estate Fund, Ltd. - Series 21, I.R.E. Real Estate Fund, Ltd. - Series 23 and I.R.E. Real Estate Fund, Ltd.- Series 24 in exchange for approximately $30,000,000 in subordinated unsecured debentures which mature in 2009. In connection with the transaction, the Company acquired 14 real properties, 3 of which are still owned by the Company. In February 1991, the Company acquired all of the assets and liabilities of two affiliated public limited partnerships, I.R.E. Real Estate Fund, Ltd. - Series 25 and I.R.E. Real Estate Fund, Ltd. - Series 27 in exchange for approximately $9,308,000 in subordinated unsecured debentures which mature in 2011. In June 1991, the Company acquired all of the assets and liabilities of an affiliated public limited partnership, I.R.E. Real Estate Income Fund, Ltd., in exchange for approximately $6,057,000 in subordinated unsecured debentures that mature in 2011. In connection with these transactions, (the "1991 Exchange") the Company acquired 8 real properties, 4 of which are still owned by the Company. Numerous lawsuits were filed against the Company in connection with both the 1989 and 1991 Exchange offers and in December 1992, a jury returned a verdict for $8 million but extinguished approximately $16 million of subordinated debentures issued in connection with the 1989 Exchange. As discussed above, BFC sold 1.4 million BankAtlantic shares in November 1993. The proceeds from such sale provided BFC with the current resources necessary to allow it to attempt to negotiate settlements with respect to these lawsuits. In March 1994, a settlement agreement, with respect to the lawsuits against the Company pertaining to the 1991 Exchange, was entered into whereby BFC Financial Corporation will pay approximately eighty-one percent of the face amount of the outstanding debentures held by class members and the debentures will be canceled pursuant to the procedures outlined in the agreement. The settlement is subject to, among other things, court approval. (See Item 3. "Legal Proceedings" and "Liquidity and Capital Resources" in Managements Discussion and Analysis.) The Company is pursuing discussions with the remaining plaintiffs in litigation relating to the Exchange offers with a view to settling the ongoing litigation but there is no assurance that a settlement will be resolved. The Company is actively seeking buyers for all of the real property held by it with a view to selling the properties and reducing mortgage indebtedness. As indicated above, during 1987, the Company acquired a controlling interest in BankAtlantic and became a savings bank holding company. Although the Company's current ownership in BankAtlantic is less than 50%, the Company's principal business is still the business of the savings bank as conducted by BankAtlantic. Therefore, set forth below, as excerpted from BankAtlantic's 1993 Annual Report on Form 10-K, is a description of BankAtlantic's business. A description of the Company's real estate partnership program business and related real estate activities follows. The Business Of BankAtlantic General BankAtlantic is a federal savings bank headquartered in Ft. Lauderdale, Florida that provides traditional retail banking services, a full range of commercial banking products and related financial services directly and through subsidiary corporations. The principal business of BankAtlantic is attracting checking and savings deposits from the public and general business customers and using these deposits to originate commercial, mortgage and installment loans and to make other permitted investments such as mortgage-backed securities and tax certificates and other investment securities. BankAtlantic has attempted to shift its primary activities from those of a traditional savings and loan to those generally associated with commercial banking. In an effort to cause its loan portfolio to adjust more rapidly to market conditions, BankAtlantic has shifted its emphasis in lending from fixed-rate, long-term residential loans to shorter term and variable rate consumer and commercial loans and investments. BankAtlantic operates through 31 branch offices located in Dade, Broward and Palm Beach Counties in South Florida. Based on its consolidated assets at September 30, 1993, BankAtlantic is currently the largest independent financial institution headquartered in Broward County, Florida and seventh in size among all savings institutions headquartered in the State of Florida. BankAtlantic is regulated and examined by the Office of Thrift Supervision ("OTS") and its deposit accounts are insured up to applicable limits by the Federal Deposit Insurance Corporation ("FDIC"). BankAtlantic's revenues are derived principally from interest earned on loans, mortgage-backed securities and tax certificates and other investment securities. BankAtlantic's major expense items are interest paid on deposits and borrowings, the provision for loan losses and general and administrative expenses. Lending Activities General - BankAtlantic's lending activities are currently divided into three primary segments: residential real estate lending, commercial lending (consisting of commercial real estate and commercial business lending) and installment lending (primarily consisting of loans secured by second liens on residential real property, loans secured by automobiles and boats and unsecured signature loans). See "Regulation and Supervision" for a description of restrictions on BankAtlantic's lending activities. Commercial lending is currently BankAtlantic's main lending focus. Substantially all of BankAtlantic's commercial loans are made in or relate to Dade, Broward and Palm Beach Counties, Florida. BankAtlantic's residential real estate lending consists primarily of home mortgage loans secured by residential real estate located in Dade, Broward and Palm Beach Counties, Florida. Installment loans are primarily solicited through mass market advertising and through the distribution and display of advertising materials at branch offices. BankAtlantic's loan underwriting procedures are designed to assess both the borrower's ability to make principal and interest payments and the value of the collateral securing the loan. Employment and financial information is solicited from prospective borrowers, credit records are reviewed and the value of any collateral for the loan is analyzed. Loan information supplied by a prospective borrower is independently verified. Loan officers or other loan production personnel in a position to directly benefit monetarily through loan solicitation fees from individual loan transactions do not have approval authority and commercial and residential loans of $500,000 or more and installment loans of $100,000 or more, require the approval of BankAtlantic's Major Loan Committee. The Major Loan Committee consists of the Chairman of the Board, the Vice Chairman, the President, the Senior Executive Vice President, certain Executive Vice Presidents and certain other officers of BankAtlantic. Interest rates and origination fees charged on loans originated by BankAtlantic are generally competitive with other financial institutions and other mortgage originators in BankAtlantic's general market area under the provisions of the Community Reinvestment Act of 1977, as amended (the "CRA"). BankAtlantic has an affirmative obligation to serve the credit needs of the communities in which it operates, and management believes that BankAtlantic fulfills its obligations under the CRA. See "Regulation and Supervision--Community Reinvestment." Commercial Real Estate Loans - BankAtlantic's commercial real estate loans include permanent mortgage loans on commercial and industrial properties, construction loans secured by income producing properties (or for residential development and land acquisition) and development loans. BankAtlantic generally lends not more than 70% of the securing property's appraised value and requires borrowers to maintain, at BankAtlantic, appropriate escrow accounts for the secured property's real estate taxes and insurance. In making lending decisions, BankAtlantic generally considers, among other things, the overall quality of the loan, the credit of the borrower, the location of the real estate, the projected income stream of the property and the reputation and quality of management constructing or administering the property. No one factor is determinative and such factors may be accorded different weights in any particular lending decision. As a general rule, BankAtlantic also requires that these loans be guaranteed by one or more individuals who have made a significant equity investment in the property. Commercial real estate loans generally have shorter terms, adjust more rapidly to interest rate fluctuations and bear higher rates of interest than alternative investments. Income from this type of loan should be more responsive to changes in the general level of interest rates. However, construction and permanent commercial real estate lending is generally considered to have higher credit risk than single-family residential lending because repayment typically is dependent on the successful operation of the related real estate project and thus may be subject, to a greater extent, to adverse conditions in the real estate market or the economy, generally. Construction loans involve additional risks because loan funds are advanced based on the security of the project under construction, which is of uncertain value prior to completion, and because it is relatively difficult to evaluate accurately the total amount required to complete a project. Commercial Business Loans - BankAtlantic's corporate lending activities are generally directed to small to medium size companies located in Dade, Broward and Palm Beach Counties, Florida. BankAtlantic's corporate lending division makes both secured and unsecured loans, although the majority of such lending is done on a secured basis. The development of ongoing customer relationships with commercial borrowers is an important part of BankAtlantic's efforts to attract more low-interest and non-interest bearing demand deposits and to generate other fee-based, non-lending services. The average corporate loan is approximately $1 million and is generally secured by the receivables, inventory, equipment, and/or general corporate assets of the borrower. These loans are originated on both a line of credit basis, and on a fixed-term basis ranging from one to five years in duration. Commercial business loans generally have annual maturities and prime-based interest rates. However, commercial business loans generally have a higher degree of credit risk than residential loans because they are more likely to be adversely affected by unfavorable economic conditions. Residential Mortgage Loans - BankAtlantic's branch banking network is largely responsible for a majority of its residential loan originations. BankAtlantic originates fixed rate and adjustable rate mortgage ("ARM") loans with 15 and 30-year amortization periods; however, substantially all of these loans are sold to correspondents. Applicable regulations require that all loans in excess of 90% of appraised value be insured by private mortgage insurance. BankAtlantic's policy is to require private mortgage insurance on all residential loans with a loan to value ratio greater than 80%. In connection with residential loans insured by the Federal Housing Administration or guaranteed by the Veterans Administration, BankAtlantic may lend up to the maximum percentage of the appraised value acceptable to the insuring or guaranteeing agency. Appraised values are determined by on-site inspections conducted by qualified independent appraisers. BankAtlantic does not presently originate a significant amount of residential mortgage loans for its portfolio and follows regulatory and agency guidelines when it originates such loans for sale. Federal regulations permit savings institutions to originate and purchase mortgage loans secured by one- to-four family residences on which the payment amount, the loan terms, the principal balance or a combination thereof change periodically as a result of changes in interest rates. Pursuant to such regulations, changes in the interest rate must be based on the movement of an index that is beyond the control of the institution and must be agreed to by the institution and the borrower. Under such regulations, "ARMs" must specify the maximum interest rate which may be imposed during the term of the loan. One-to-four family residential loans generally are of a longer duration and bear lower rates of interest than commercial or installment loans; however, there is a lower credit risk associated with these types of loans. BankAtlantic generally does not purchase individual residential mortgage loans. Installment Loans - BankAtlantic significantly reduced its installment lending activities during early 1991 by eliminating indirect consumer loans (installment loans made by others and acquired by BankAtlantic) and significantly decreasing originations of direct installment loans (loans made directly to consumers rather than through dealers). However, during 1993, BankAtlantic has focused on originating installment loans directly through its branch network and slightly increased the volume of its direct installment lending during the latter part of the year. It is anticipated that volume of direct installment lending will increase in 1994 from 1993 levels. Federal savings institutions are authorized to make secured and unsecured consumer installment loans in an aggregate amount up to 35% of their assets. In addition, BankAtlantic has lending authority above this 35% limit for certain consumer loans, such as second mortgages, home improvement loans, mobile home loans and loans secured by savings accounts. Installment loans typically involve a higher degree of credit risk than one-to-four family residential loans secured by first mortgages, but they generally carry higher yields and have shorter terms to maturity. Second mortgage loans are secured by a junior lien on residential real property and are typically based on a maximum 80% loan-to-value ratio. Personal loans may be secured by various forms of collateral, both real and personal, or to a minimal extent, may be made on an unsecured basis. Such loans generally bear interest at floating rates with the exception of personal unsecured loans which bear interest at a fixed rate. Prior to 1991, BankAtlantic funded dealer reserves to dealers who originated consumer loans which were then purchased by BankAtlantic ("indirect consumer loans"). The risk of any amounts advanced to the dealer is primarily associated with loan performance but, secondarily, is dependent on the financial condition of the dealer. The dealer is generally responsible to BankAtlantic for the amount of the reserve only if a loan giving rise to the reserve becomes delinquent or is prepaid. However, the dealer's ability to refund any portion of the unearned reserve to BankAtlantic is subject to economic conditions, generally, and the financial condition of the dealer. A decline in economic conditions could adversely affect both the performance of the loans and the financial condition of the dealer. There is no assurance that BankAtlantic can successfully recover amounts advanced in the event it pursues the dealer for amounts due. See "Management's Discussion and Analysis of Results of Operations and Financial Condition" regarding recovery from BankAtlantic's fidelity bond carrier of certain amounts associated with certain indirect consumer loans. Loan Commitments - BankAtlantic issues commitments to make residential and commercial real estate loans and commercial business loans on specified terms which are conditioned upon the occurrence of stated events. Loan commitments are generally issued in connection with (i) the origination of loans for the financing of residential properties by prospective purchasers, (ii) construction or permanent loans secured by commercial and multi-unit residential income-producing properties and (iii) loans to corporate borrowers in connection with loans secured by corporate assets. The commitment procedure followed by BankAtlantic depends on the type of loan underlying the commitment. Residential loan commitments are generally limited to 30 days and are issued after the loan is approved. However, loan commitments may be extended based on the circumstances. BankAtlantic offers interest rate "locks" for periods of up to 150 days. BankAtlantic also issues short-term commitments on commercial real estate loans and commercial business loans. Short-term commitments generally remain open for no more than 90 days. BankAtlantic usually charges a commitment fee of 1% to 2% on short-term commitments relating to commercial real estate loans and commercial business loans. In most cases, half of the fee is payable upon the acceptance of the commitment and is non-refundable. If the loan is ultimately made, the remainder of the commitment fee is collected at closing. Loan Servicing Rights - BankAtlantic generally retains servicing rights on loans which it sells and has sought to purchase additional servicing rights from third parties. BankAtlantic derives fees for providing the servicing of mortgage loans, including, among other fees, assumption fees and late charges. The amount of revenue earned from loan servicing is dependent on the prepayments of the underlying loans. Generally, as interest rates fall, loan prepayments accelerate, resulting in lower net revenues earned on loan servicing rights. Conversely, as interest rates rise, loan prepayments decline, resulting in higher net revenues earned on loan servicing rights. Usury Limitations - The maximum rate of interest that BankAtlantic may charge for any particular loan transaction varies depending upon the purpose of the loan, the nature of the borrower, the security and other various factors set forth in Florida and federal interest rate laws. Under Florida law, BankAtlantic is not subject to any usury ceiling on loans secured by a first lien on residential real estate and certain other secured loans. Other types of loans are subject to Florida's statutory usury ceiling which is currently 18% per annum, although certain types of loans in excess of $500,000 may legally carry an interest rate of up to 25% per annum. Non-Performing and Classified Assets, Loan Delinquencies and Defaults - When a borrower fails to make a required payment on a loan, BankAtlantic attempts to have the deficiency cured by communicating with the borrower. In most cases, deficiencies are cured promptly. If the delinquency is not cured within 90 days, it is BankAtlantic's general policy to institute appropriate legal action to collect the loan, including foreclosing on any collateral securing the loan and obtaining a deficiency judgment against the borrower, if appropriate. Current regulations provide for the classification of loans and other assets considered by examiners to be of lesser quality as "special mention," "substandard," "doubtful" or "loss" assets. The special mention category applies to assets not warranting classification as substandard but possessing credit deficiencies or potential weaknesses necessitating management's close attention. Substandard assets have one or more defined weaknesses and are characterized by the distinct possibility that the insured institution will sustain some loss if the deficiencies are not corrected. Doubtful assets have the weaknesses of substandard assets with the additional characteristic that such weaknesses make collection of the loan or liquidation in full on the basis of currently existing facts, conditions and values, highly questionable or improbable. Assets classified as a loss are considered uncollectible and of such little value that their continued treatment as assets is not warranted. The asset classification regulations require insured institutions to classify their own assets and to establish prudent general allowances for loan losses. However, regulators have considerable discretion to review asset classifications and loss allowances of insured institutions, and, if a regulator concludes that the valuation allowances established by an institution are inadequate, the regulator may determine, subject to certain reviews, the need for, and extent of, any increase necessary in the institution's general allowance for loan losses. Management of BankAtlantic has identified certain assets as "Risk elements". These assets include: (i) loans accounted for on a non-accrual basis; (ii) loans not included in category (i), which are contractually 90 days or more past due as to interest or principal payments; (iii) assets acquired in settlement of loans; and (iv) restructured loans. Non-accrual loans are loans on which interest recognition has been suspended until realized because of doubts as to the borrower's ability to repay principal or interest. Restructured loans are loans on which the terms have been altered to provide a reduction or deferral of interest or principal because of a deterioration in the borrower's financial position. Such restructured loans may be removed from the restructured category based upon various factors, including a period of satisfactory loan performance under the revised terms. Allowance for Loan Losses - Management of BankAtlantic establishes allowances for loan losses in amounts which it believes are sufficient to provide for potential future losses. In establishing its allowance for loan losses, management considers past loss experience, present indicators such as delinquency rates, economic conditions, collateral values and the potential for loan losses in future periods. The evaluation of potential losses in BankAtlantic's loan portfolio includes a review of all loans for which full collectibility may not be reasonably assured. Increases in the allowance for loan losses are recorded when losses are both probable and estimable. In the case of loans in foreclosure or probable foreclosure, the estimated fair value of the underlying collateral, and such other factors which, in management's judgment, deserve recognition under existing economic conditions are considered in estimating loan losses. Investment Activities BankAtlantic maintains an investment portfolio consisting primarily of mortgage-backed securities and tax certificates. Additionally, BankAtlantic has purchased banker's acceptances, which have been classified as loans. Federal regulations limit the types and quality of instruments in which BankAtlantic may invest. Mortgage-backed securities are pools of residential loans which are made to consumers and then generally sold to governmental agencies, such as the Government National Mortgage Corporation ("GNMA"), the Federal National Mortgage Corporation ("FNMA") and the Federal Home Loan Mortgage Corporation ("FHLMC"). Mortgage-backed securities are either 15-30 year maturity, 5-7 year balloon maturity or ARMs. BankAtlantic generally invests in ARMs or 5-7 year balloon maturity mortgage-backed securities. Banker's acceptances are unconditional obligations of the issuing bank and are collateralized by various means, including inventory and receivables of borrowers of the issuing bank. BankAtlantic's portfolio also includes tax lien certificates issued by various counties in the State of Florida. Tax certificates represent a priority lien against real property for which assessed real estate taxes are delinquent. Although tax certificates have no stated maturity, the certificate holder has the right to collect the delinquent tax amount, plus interest, and can file for a deed to the underlying property if the delinquent tax amount is unpaid at the end of two years. If the certificate holder does not file for the deed within seven years, the certificate becomes null and void. BankAtlantic's experience with this type of investment has been favorable as rates earned are generally higher than many alternative investments, substantial repayment generally occurs over a two year period and losses to date, have been minimal. The primary risks BankAtlantic has experienced with tax certificates have related to the risk that additional funds may be required to purchase other certificates relating to the property, the risk that the liened property may be unusable and the risk that potential environmental concerns may make taking title to the property untenable. The OTS is reviewing the amount, and procedures utilized in the acquisition and administration of tax certificates by savings institutions. The purpose of such review is believed to be the establishment of specific regulatory guidelines and procedures so as to insure safety and soundness, generally. BankAtlantic has participated with the OTS in this review and, based upon current practices, BankAtlantic believes its procedures comply with applicable safety and soundness requirements. Additionally, the Southeast Regional Office of the OTS requested that BankAtlantic limit its purchases of tax certificates at 1993 tax certificate auctions to an aggregate amount not to exceed $85 million. Based on market conditions, BankAtlantic purchased only approximately $64 million in tax certificates at auctions in 1993. BankAtlantic is also aware that on November 17, 1992, the FDIC issued an Interpretive Letter stating its view that it constitutes an unsafe or unsound banking practice for a non-member commercial bank to invest in tax certificates. Although the FDIC currently has supervisory and examination jurisdiction with respect to thrifts such as BankAtlantic (see "Regulation and Supervision"), BankAtlantic is unaware of any similar statement published by the FDIC concerning investments in tax certificates by savings banks. BankAtlantic has been advised that the FDIC may be preparing or may have issued a memorandum or policy statement concerning tax certificates and has made a request under the Freedom of Information Act to obtain a copy of any such memorandum or policy statement. However, to date, the FDIC has not made any such memorandum or policy statement publicly available. If the FDIC or the OTS were to make a determination in the future that such investments are improper, either regulator could seek to impose restrictions or sanctions, prohibit or limit investments in tax certificates or require additional regulatory reserves with respect to these investments. For descriptions of BankAtlantic's investments in tax certificates and other investment securities, see Note 3 to the Consolidated Financial Statements. Based upon current discussions with the Southeast Regional Office of the OTS, BankAtlantic believes the OTS has completed its current review of tax certificate investments and has determined that savings institutions may continue to invest in tax certificates, subject to certain volume limitations and adherence to specific underwriting, asset classification and other procedural guidelines. BankAtlantic believes it is in a position to comply with OTS requirements and that compliance will not significantly change BankAtlantic's tax certificate investment activities or practices. For a discussion of regulatory limitations on BankAtlantic's investments, see "Regulation and Supervision." Sources of Funds General - Historically, deposits have been the principal source of BankAtlantic's funds for use in lending and for other general business purposes. Loan repayments, sales of securities, advances from the Federal Home Loan Bank ("FHLB") of Atlanta and other borrowings, including the issuance of subordinated debentures, and the use of repurchase agreements have been additional sources of funds. Loan amortization payments, deposit inflows and outflows are significantly influenced by general interest rates. Borrowings may be used by BankAtlantic on a short-term basis to compensate for reductions in normal sources of funds such as savings inflows, and to provide additional liquidity investments. On a long-term basis, borrowings may support expanded lending activities. Historically, BankAtlantic has borrowed primarily from the FHLB of Atlanta and through the use of repurchase agreements. Deposit Activities - BankAtlantic offers several types of deposit programs designed to attract both short-term and long-term funds from the general public by providing an assortment of accounts and rates. BankAtlantic believes that its product line is comparable to that offered by its competitors. BankAtlantic offers the following accounts: commercial and retail demand deposit accounts; regular passbook and statement savings accounts; money market accounts; fixed-rate, fixed-maturity certificates of deposit, ranging in maturity from 30 days to 8 years; variable-maturity jumbo certificates of deposit; and various NOW accounts. BankAtlantic also offers IRA and Keogh retirement accounts. BankAtlantic's deposit accounts are insured by the FDIC through the Savings Association Insurance Fund ("SAIF") up to a maximum of $100,000 for each insured depositor. BankAtlantic solicits deposits through advertisements in newspapers and magazines of general circulation and on radio and television in Dade, Broward and Palm Beach Counties, Florida. Most of its depositors are residents of these three counties at least part of the year. BankAtlantic does not hold any deposits obtained through brokers. Borrowings - BankAtlantic has utilized wholesale repurchase agreements as a means of obtaining funds and increasing yields on its investment portfolio. In a wholesale repurchase transaction, BankAtlantic sells a portion of its current investment portfolio (usually government and mortgage-backed securities) at a negotiated rate and agrees to repurchase the same or substantially identical assets on a specified date. Proceeds from such transactions are treated as secured borrowings pursuant to applicable regulations. See Note 14 to the Consolidated Financial Statements. BankAtlantic is a member of the FHLB and is authorized to apply for secured advances from the FHLB of Atlanta. See "Regulation and Supervision." BankAtlantic has used advances from the FHLB to repay other borrowings, meet deposit withdrawals and expand its lending and short-term investment activities. See Note 13 to the Consolidated Financial Statements. Competition Based on its total assets, at September 30, 1993, BankAtlantic ranked seventh in size among all savings institutions headquartered in the State of Florida and first in size among all financial institutions headquartered in Broward County, Florida. BankAtlantic has substantial competition in attracting and retaining deposits and in lending funds. The primary factors in competing for deposits are the range and quality of financial services offered, the ability to offer attractive rates and the availability of convenient office locations. There is direct competition for deposits from credit unions and commercial banks and other savings institutions. Additional significant competition for savings deposits comes from other investment alternatives, such as money market mutual funds and corporate and government securities. The primary factors in competing for loans are the range and quality of lending services offered, interest rates and loan origination fees. Competition for origination of real estate loans normally comes from other savings and financial institutions, commercial banks, mortgage bankers and insurance companies. Past legislative and regulatory action has increased competition between savings institutions and other financial institutions, such as commercial banks, by expanding the ranges of financial services that may be offered by savings institutions (e.g., interest bearing checking accounts, trust services and consumer and commercial lending authority), while reducing or eliminating the difference between thrift institutions and commercial banks with respect to long-term lending authority, taxation and maximum rates of interest that may be paid on savings deposits. Current and future regulatory requirements may adversely affect BankAtlantic's competitive position by restricting its operations. BankAtlantic's operating goal is to provide a broad range of financial services with a strong emphasis on customer service to individuals and businesses in South Florida. REGULATION AND SUPERVISION General BankAtlantic is a member of the FHLB system and its deposit accounts are insured up to applicable limits by the FDIC. BankAtlantic is subject to supervision, examination and regulation by the OTS and to a lesser extent by the FDIC as the insurer of its deposits. BankAtlantic must file reports with the OTS and the FDIC concerning its activities and financial condition, in addition to obtaining regulatory approvals prior to entering into certain transactions. There are periodic examinations by the OTS and the FDIC to examine BankAtlantic's compliance with various regulatory requirements. The regulatory structure also gives regulatory authorities extensive discretion in connection with their supervisory and enforcement policies with respect to the classification of non-performing and other assets and the establishment of adequate loan loss reserves for regulatory purposes. Additionally, as a company having a class of publicly held equity securities, BankAtlantic is subject to the reporting and other requirements of the Securities Exchange Act of 1934, as amended. Legislative Developments In recent years, measures have been taken to reform the thrift and banking industries and to strengthen the insurance funds for depository institutions. The most significant of these measures was the Financial Institution Reform, Recovery and Enforcement Act of 1989 ("FIRREA"), which has had a major impact on the operations and regulation of savings associations generally. In 1991, a comprehensive deposit insurance and banking reform plan, the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"), became law. Although FDICIA's primary purpose is to recapitalize the Bank Insurance Fund (the "BIF") of the FDIC, FDICIA also affects the supervision and regulation of all federally insured depository institutions, including federal savings banks such as BankAtlantic. The Financial Institutions Reform, Recovery and Enforcement Act of 1989 - FIRREA, enacted in response to concerns regarding the soundness of the thrift industry, brought about a significant regulatory restructuring, limited savings institutions' business activities and increased savings institutions' regulatory capital requirements. FIRREA abolished the FHLB Board and the Federal Savings and Loan Insurance Corporation ("FSLIC") and established the OTS as the primary federal regulator for savings institutions. Deposits at BankAtlantic are insured through the SAIF, a separate fund managed by the FDIC for institutions whose deposits were formerly insured by the FSLIC. Regulatory functions relating to deposit insurance are generally exercised by the FDIC. The Federal Deposit Insurance Corporation Improvement Act of 1991 - FDICIA authorizes the regulators to take prompt corrective action to solve the problems of critically undercapitalized institutions. As a result, banking regulators are required to take certain supervisory actions against undercapitalized institutions, the severity of which increases as an institution's level of capitalization decreases. Pursuant to FDICIA, federal banking agencies have established the levels at which an insured institution is considered to be "well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized" or "critically undercapitalized." See "Savings Institution Regulations--Prompt Regulatory Action" below for a discussion of the applicable capital levels. Based upon these established capital levels, BankAtlantic meets the definition of a "well capitalized" institution. FDICIA requires federal banking agencies to revise their risk-based capital requirements to include components for interest rate risk, concentration of credit risk and the risk of non-traditional activities. See "Savings Institution Regulations--Regulatory Capital" below for a discussion of the interest rate risk component in the risk-based capital requirement effective June 30, 1994. In addition, FDICIA requires each federal banking agency to establish standards relating to internal controls, information systems, and internal audit systems that are designed to assess the financial condition and management of the institution, loan documentation, credit underwriting, interest rate exposure, asset growth, and compensation, fees and benefits. FDICIA lowered the Qualified Thrift Lender ("QTL") investment percentage applicable to institutions insured by SAIF. See "Regulation and Supervision--Savings Institution Regulations--Qualified Thrift Lender--Insurance of Accounts." FDICIA further requires annual on-site full examinations of depository institutions, with certain exceptions, and annual reports on institutions' financial and management controls. Other proposals are currently being considered which could have a significant impact on BankAtlantic, including proposals, which would consolidate the regulatory agencies having authority over financial institutions. It is not yet clear which, if any, proposals will be adopted or the impact such proposals may have on BankAtlantic. Savings Institution Regulations Regulatory Capital - Both the OTS and the FDIC have promulgated regulations setting forth capital requirements applicable to savings institutions. The effect and interrelationship of these regulations are discussed below. Savings institutions must meet the OTS' specific capital standards which by law must be no less stringent than capital standards applicable to national banks with exceptions for risk-based capital requirements to reflect interest rate risk or other risk. Capital calculated pursuant to the OTS' regulations varies substantially from capital calculated pursuant to generally accepted accounting principles ("GAAP"). At December 31, 1993, BankAtlantic met all applicable capital requirements. The capital requirements are as follows: (a) The leverage limit requires savings institutions to maintain core capital of at least 3% of adjusted total assets. Adjusted total assets are calculated as GAAP total assets, minus intangible assets (except those included in core capital as described below). Core capital consists of common shareholders' equity, including retained earnings, noncumulative perpetual preferred stock and related surplus, less specified intangible assets (a percentage of purchased mortgage servicing rights ("PMSRs")). In addition, a portion of PMSRs may be included in core capital. Generally, an amount may be included in core capital equal to the lowest of (i) 90% of the fair market value of readily marketable PMSRs or (ii) the current amortized book value as determined under GAAP. However, the amount of PMSRs included in core capital is limited to a maximum of 50% of core capital. (b) Under the tangible capital requirement, savings institutions must maintain tangible capital in an amount not less than 1.5% of adjusted total assets. Tangible capital is defined in the same manner as core capital, except that all intangible assets, except PMSRs, must be deducted. The percentage of PMSRs which may be included in tangible capital is equal to the lesser of (a) 100% of the amount of tangible capital that exists before the deduction of any disallowed PMSRs or (b) the amount of PMSRs allowed to be included in core capital. (c) The risk-based standards of the OTS currently require maintenance of core capital equal to at least 4% of risk-weighted assets, and total capital equal to at least 8% of risk-weighted assets. Total capital includes core capital plus supplementary capital, but supplementary capital that may be included in computing total capital for this purpose may not exceed core capital. Supplementary capital includes cumulative perpetual preferred stock, allowable subordinated debt and general loan loss allowances, within specified limits. Such general loss allowances may not exceed 1.25% of risk-weighted assets. Additionally, investments in non-includable subsidiaries will be subject to a 100% exclusion from risk-based capital by July 1, 1994. Risk-weighted assets are determined by assigning to all assets designated risk weights ranging from 0% to 100%, based on the credit risk assumed to be associated with the particular asset. Generally, zero weight is assigned to risk-free assets, such as cash and unconditionally guaranteed United States government securities such as mortgage-backed securities issued or guaranteed by GNMA. A weight of 20% is assigned to, among other things, certain obligations of United States government-sponsored agencies (such as the FNMA and the FHLMC), stock of a FHLB and high quality mortgage-related securities. A weight of 50% is assigned to qualifying mortgage loans and certain other residential mortgage-related securities. A weight of 100% is assigned to consumer, commercial and other loans, repossessed assets and assets that are 90 days or more past due and all other assets not identified in the categories above. In addition to the capital requirements set forth in the OTS' regulations, the OTS has delegated to its Regional Directors the authority to establish higher individual minimum capital requirements for savings institutions based upon a determination that the institution's capital is or may become inadequate in view of its circumstances. For example, circumstances which may be considered by the Regional Directors are the institution: (i) receiving special supervisory attention; (ii) having or expected to have losses resulting in capital inadequacy; (iii) having a high degree of exposure to interest-rate, prepayment, credit or similar risks or a high proportion of off-balance sheet risk; (iv) having poor liquidity or cash flow; (v) growing, internally or through acquisitions, at such a rate that supervisory problems are presented that are not dealt with adequately by other OTS regulations; (vi) having potential adverse effects from the activities or condition of its affiliates or others with which it has significant business relationships, including concentrations of credit; (vii) having a portfolio reflecting weak credit quality; (viii) having inadequate underwriting policies or procedures for loans and investments; (ix) having a record of operational losses that exceeds the average of other, similarly situated savings institutions; (x) having management deficiencies; or (xi) having a poor record of supervisory compliance. In August 1993, the OTS adopted a final rule incorporating an interest-rate risk component into the risk-based capital regulation. Under the rule, an institution with a greater than "normal" level of interest-rate risk will be subject to a deduction of its interest-rate risk component from total capital for purposes of calculating the risk-based capital requirement. As a result, such an institution will be required to maintain additional capital in order to comply with the risk-based capital requirement. An institution with a greater than "normal" interest-rate risk is defined as an institution that would suffer a loss of net portfolio value exceeding 2.0% of the estimated market value of its assets in the event of a 200 basis point increase or decrease (with certain minor exceptions) in interest rates. The interest-rate risk component will be calculated, on a quarterly basis, as one-half of the difference between an institution's measured interest-rate risk and 2.0% multiplied by the market value of its assets. The rule also authorizes the director of the OTS, or his designee, to waive or defer an institution's interest-rate risk component on a case-by-case basis. The final rule is effective as of January 1, 1994, subject however to a two quarter "lag" time between the reporting date of the data used to calculate an institution's interest-rate risk and the effective date of each quarter's interest-rate risk component. Thus, an institution with greater than "normal" risk will not be subject to any deduction from total capital until July 1, 1994. Additionally, the Office of the Comptroller of the Currency (the "OCC"), which is the primary regulator for national banks, has adopted a final rule increasing the leverage ratio requirements for all but the most highly rated national banks. Pursuant to FIRREA, the OTS is required to issue capital standards for savings institutions that are no less stringent than those applicable to national banks. Accordingly, savings institutions must maintain a leverage ratio (defined as the ratio of core capital to adjusted total assets) of between 4% and 5%. The OTS indicated in the final rule that it intended to lower the leverage ratio requirement (in its prompt corrective action regulation) to 3.0% from the current level of 4.0%, on July 1, 1994. If this rule and the interest rate component discussed above were in effect at December 31, 1993, BankAtlantic believes it would be in full compliance with the new rules and would have risk-based capital substantially in excess of applicable risk-based capital requirements. The OTS also issued a final rule, effective March 1, 1994, which excludes core deposit intangibles ("CDIs") in the determination of regulatory capital. As BankAtlantic's CDIs have been fully amortized at December 31, 1993, BankAtlantic is not currently effected by this exclusion from capital. Insurance of Accounts - BankAtlantic's deposits are insured by the SAIF up to $100,000 for each insured account holder, the maximum amount currently permitted by law. Pursuant to the FDICIA, the FDIC adopted transitional regulations implementing risk-based insurance premiums that became effective on January 1, 1993. Under these regulations, institutions are divided into groups based on criteria consistent with those established pursuant to the prompt regulatory action provisions of the FDICIA (see "Savings Institution Regulations -- Prompt Regulatory Action" below). Each of these groups is further divided into three subgroups, based on a subjective evaluation of supervisory risk to the insurance fund posed by the institution. Insurance premiums range from 23 to 31 basis points, with well capitalized institutions in the highest supervisory subgroup paying 23 basis points and undercapitalized institutions in the lowest supervisory subgroup paying 31 basis points. As an insurer, the FDIC issues regulations and conducts examinations of its insured members. Insurance of deposits by the SAIF may be terminated by the FDIC, after notice and hearing, upon a finding that an institution has engaged in unsafe and unsound practices, is in an unsafe and unsound condition to continue operations, or has violated any applicable law, regulation, rule, order or condition imposed by the OTS or the FDIC. When conditions warrant, the FDIC may impose less severe sanctions as an alternative to termination of insurance. BankAtlantic's management does not know of any present condition pursuant to which the FDIC would seek to impose sanctions on BankAtlantic or terminate insurance of its deposits. Prompt Regulatory Action - The OTS and other federal banking regulators have established capital levels for institutions to implement the "prompt regulatory action" provisions of the FDICIA. Capital levels have been established for which an insured institution will be categorized as well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized or critically undercapitalized. The FDICIA requires federal banking regulators, including the OTS, to take prompt corrective action to solve the problems of those institutions that fail to satisfy their applicable minimum capital requirements. The level of regulatory scrutiny and restrictions imposed become increasingly severe as an institution's capital level falls. A "well capitalized" institution must have risk-based capital of 10% or more, core capital of 5% or more and Tier 1 risk-based capital (based on the ratio of core capital to risk-weighted assets) of 6% or more and may not be subject to any written agreement, order, capital directive or prompt corrective action directive issued by the OTS to meet and maintain a specific capital level for a specific capital measure. An institution will be categorized as: "adequately capitalized" if it has total risk-based capital of 8% or more, Tier 1 risk-based capital of 4% or more and core capital of 4% or more; "undercapitalized" if it has total risk-based capital of less than 8%, Tier 1 risk-based capital of less than 4% or core capital of less than 4%; "significantly undercapitalized" if it has total risk-based capital of less than 6%, Tier 1 risk-based capital of less than 3% or core capital of less than 3%; and "critically undercapitalized" if it has tangible capital of less than 2%. Any savings institution that fails its regulatory capital requirement is subject to enforcement action by the OTS or the FDIC. BankAtlantic meets the capital requirements of a well capitalized institution as defined above. An undercapitalized institution is required to submit an acceptable capital restoration plan to its appropriate federal banking agency. The plan must specify (i) the steps the institution will take to become adequately capitalized, (ii) the capital levels to be attained each year, (iii) how the institution will comply with any regulatory sanctions then in effect against the institution and (iv) the types and levels of activities in which the institution will engage. The banking agency may not accept a capital restoration plan unless the agency determines, among other things, that the plan is based on realistic assumptions, and is likely to succeed in restoring the institution's capital and would not appreciably increase the risk to which the institution is exposed. Under FDICIA, an insured depository institution cannot make a capital distribution (as broadly defined to include, among other things, dividends, redemptions and other repurchases of stock), or pay management fees to any person that controls the institution, if thereafter it would be undercapitalized. The appropriate federal banking agency, however, may (after consultation with the FDIC) permit an insured depository institution to repurchase, redeem, retire or otherwise acquire its shares if such action (i) is taken in connection with the issuance of additional shares or obligations in at least an equivalent amount and (ii) will reduce the institution's financial obligations or otherwise improve its financial condition. An undercapitalized institution is generally prohibited from increasing its average total assets. An undercapitalized institution is also generally prohibited from making any acquisitions, establishing any branches or engaging in any new line of business except in accordance with an accepted capital restoration plan or with the approval of the FDIC. In addition, the appropriate federal banking agency is given authority with respect to any undercapitalized depository institution to take any of the actions it is required to or may take with respect to a significantly undercapitalized institution as described below if it determines "that those actions are necessary to carry out the purpose" of FDICIA. FDICIA provides that the appropriate federal regulatory agency must require an insured depository institution that (i) is significantly undercapitalized or (ii) is undercapitalized and either fails to submit an acceptable capital restoration plan within the time period allowed by regulation or fails in any material respect to implement a capital restoration plan accepted by the appropriate federal banking agency, to take one or more of the following actions: (i) sell enough shares, including voting shares, to become adequately capitalized; (ii) merge with (or be sold to) another institution (or holding company), but only if grounds exist for appointing a conservator or receiver; (iii) restrict certain transactions with banking affiliates as if the "sister bank" exception to the requirements of Section 23A of the Federal Reserve Act ("FRA") did not exist; (iv) otherwise restrict transactions with bank or non-bank affiliates; (v) restrict interest rates that the institution pays on deposits to "prevailing rates" in the institution's "region;" (vi) restrict asset growth or reduce total assets; (vii) alter, reduce or terminate activities; (viii) hold a new election of directors; (ix) dismiss any director or senior officer who held office for more than 180 days immediately before the institution became undercapitalized; provided that in requiring dismissal of a director or senior officer, the agency must comply with certain procedural requirements, including the opportunity for an appeal in which the director or officer will have the burden of proving his or her value to the institution; (x) employ "qualified" senior officers; (xi) cease accepting deposits from correspondent depository institutions; (xii) divest certain non-depository affiliates which pose a danger to the institution; (xiii) be divested by a parent holding company; and (xiv) take any other action which the agency determines would better carry out the purposes of the prompt corrective action provisions. In addition to the foregoing sanctions, without the prior approval of the appropriate federal banking agency, a significantly undercapitalized institution may not pay any bonus to any senior officer or increase the rate of compensation for such an officer without regulatory approval. Furthermore, in the case of an undercapitalized institution that has failed to submit or implement an acceptable capital restoration plan, the appropriate federal banking agency cannot approve any such bonus. Not later than 90 days after an institution becomes critically undercapitalized, the appropriate federal banking agency for the institution must appoint a receiver or, with the concurrence of the FDIC, a conservator, unless the agency, with the concurrence of the FDIC, determines that the purposes of the prompt corrective action provisions would be better served by another cause of action. The FDICIA requires that any alternative determination be "documented" and reassessed on a periodic basis. Notwithstanding the foregoing, a receiver must be appointed after 270 days unless the FDIC determines that the institution has positive net worth, is in compliance with a capital plan, is profitable or has a sustainable upward trend in earnings and is reducing its ratio of non-performing loans to total loans and the head of the appropriate federal banking agency and the chairperson of the FDIC certify that the institution is viable and not expected to fail. The FDIC is required, by regulation or order, to "restrict the activities" of such critically undercapitalized institutions. The restrictions must include prohibitions on the institution's doing any of the following without prior approval of the FDIC: entering into any material transactions not in the usual course of business, extending credit for any highly leveraged transaction, engaging in any "covered transaction" (as defined in Section 23A of the FRA) with an affiliate, paying "excessive compensation or bonuses," and paying interest on "new or renewed liabilities" that would increase the institution's average cost of funds to a level significantly exceeding prevailing rates in the market. Appointment of Receiver or Conservator - The grounds for appointment of a conservator or receiver for a savings institution include the following events: (i) "substantially insufficient capital;" (ii) incurrence or likely incurrence of losses that will substantially deplete all of the institution's capital in the absence of reasonable prospects for replenishing that capital without federal assistance; (iii) a violation of law or regulation that is likely to weaken the institution's condition; (iv) assets insufficient for the satisfaction of its obligations; (v) substantial dissipation of assets or earnings; (vi) unsafe and unsound condition; (vii) willful violation of cease and desist orders; (viii) concealment of information; (ix) inability to meet obligations in the normal course of business; (x) violations of law; (xi) consent by resolution of the institution's board of directors or shareholders; (xii) cessation of insured status; (xiii) under-capitalization; and (xiv) other capital problems. Supervisory Agreement - On April 16, 1991, BankAtlantic voluntarily entered into a Supervisory Agreement with the OTS. The Supervisory Agreement required BankAtlantic to implement additional policies and reporting procedures relating to the internal operations of BankAtlantic within specified time frames, and to particularly address concerns relating to classified assets, general valuation allowances and the policies, procedures, information reporting and guidelines in the consumer loan department. On March 16, 1994, the OTS notified BankAtlantic that it had been released from the Supervisory Agreement, BankAtlantic's management does not believe that the Agreement had any material impact on BankAtlantic's business or operations. Restrictions on Dividends and Other Capital Distributions - Current regulations applicable to the payment of cash dividends by savings institutions impose limits on capital distributions based on an institution's regulatory capital levels and net income. An institution that meets or exceeds all of its fully phased-in capital requirements (both before and after giving effect to the distribution) and is not in need of more than normal supervision would be a "Tier 1 association." A Tier 1 association may make capital distributions during a calendar year up to the greater of (i) 100% of net income for the current calendar year plus 50% of its capital surplus or (ii) 75% of its net income over the most recent four quarters. Any additional capital distributions would require prior regulatory approval. An institution that meets the minimum regulatory capital requirements but does not meet the fully phased-in capital requirements would be a "Tier 2 association," which may make capital distributions of between 25% and 75% of its net income over the most recent four-quarter period, depending on the institution's risk-based capital level. A "Tier 3 association" is defined as an institution that does not meet all of the minimum regulatory capital requirements and therefore may not make any capital distributions without the prior approval of the OTS. Savings institutions must provide the OTS with at least 30 days written notice before making any capital distributions. All such capital distributions are also subject to the OTS' right to object to a distribution on safety and soundness grounds. The FHLB System - BankAtlantic is a member of the FHLB system, which consists of 12 regional FHLBs governed and regulated by the Federal Housing Finance Board ("FHFB"). The FHLBs provide a central credit facility for member institutions. BankAtlantic, as a member of the FHLB of Atlanta, is required to acquire and hold shares of capital stock in the FHLB of Atlanta in an amount at least equal to the greater of 1% of the aggregate principal amount of its unpaid residential mortgage loans, home purchase contracts and similar obligations as of the close of each calendar year, or 5% of its borrowings from the FHLB of Atlanta (including advances and letters of credit issued by the FHLB on BankAtlantic's behalf). BankAtlantic is currently in compliance with this requirement. Each FHLB makes loans (advances) to members in accordance with policies and procedures established by the board of directors of the FHLB. These policies and procedures are subject to the regulation and oversight of the FHFB. The FHLB Act establishes collateral requirements for advances from the FHLB. First, all advances from the FHLB must be fully secured by sufficient collateral as determined by the FHLB of Atlanta. The FHLB Act prescribes eligible collateral as first mortgage loans less than 90 days delinquent or securities evidencing interests therein, securities (including mortgage-backed securities) issued, insured or guaranteed by the federal government or any agency thereof, deposits with the FHLB and, to a limited extent, real estate with readily ascertainable value in which a perfected security interest may be obtained. All long-term advances are required to provide funds for residential home financing. The FHLB of Atlanta has established standards of community service that members must meet to maintain access to long-term advances. Fees and Assessments of the OTS - The OTS has adopted regulations to assess fees on savings institutions to fund the operations of the OTS. The regulations provide for the OTS' assessments to be made based on the total consolidated assets of a savings institution as shown on its most recent report to the agency. Troubled savings institutions (generally, those operating in conservatorship or with the lowest two (of five) supervisory subgroup ratings) are to be assessed at a rate 50% higher than similarly sized thrifts that are not experiencing problems. Investment Activities - As a federally-chartered savings bank, BankAtlantic is subject to various restrictions and prohibitions with respect to its investment activities. These restrictions and prohibitions are set forth in the Home Owner's Loan Act ("HOLA") and in the rules of the OTS and include dollar amount limitations and procedural limitations. BankAtlantic is in compliance with these restrictions. Under the Federal Deposit Insurance Act ("FDIA"), a savings institution is required to provide 30 days' prior notice to the FDIC and the OTS of its desire to establish or acquire a new subsidiary or conduct any new activity through a subsidiary. The institution is also required to conduct the activities of the subsidiary in accordance with the OTS' orders and regulations. The Director of the OTS has the power to force divestiture of any subsidiary or the termination of any activity it determines is a serious threat to the safety, soundness or stability of the savings institution or is otherwise inconsistent with sound banking principles. Additionally, the FDIC is authorized to determine whether any specific activity poses a threat to the SAIF and to prohibit any member of the SAIF from engaging directly in the activity, even if it is an activity that is permissible for a federally-chartered savings institution or for a subsidiary of a state-chartered savings institution. Safety and Soundness - The FDIA authorizes the appropriate federal agency (in the case of BankAtlantic, the OTS) to prescribe, for all federally insured depository institutions, operational, managerial and compensation standards for internal controls, information systems, loan documentation, credit underwriting, interest rate exposure, asset growth and compensation and benefits for bank officers, employees, directors and principal shareholders. The statute further empowers the OTS to set standards for any other facet of institution operations not specifically covered in this list. The OTS is required to prescribe asset quality, earnings and stock valuation standards specifying: (i) a maximum ratio of classified assets to capital; (ii) minimum earnings sufficient to absorb losses without impairing capital; (iii) to the extent feasible, a minimum ratio of market value to book value for publicly traded shares of the institution; and (iv) such other standards relating to asset quality, earnings and valuation as the OTS deems appropriate. An institution failing to meet these standards must file a plan to bring the institution into compliance and have the plan approved by the OTS. Continued non-compliance allows the OTS to prohibit growth, require higher capital, restrict interest rates paid on deposits or take any other appropriate action. Loans to One Borrower - Generally, a savings institution's total loans and extensions of credit to one borrower or related group of borrowers, outstanding at one time and not fully secured by readily marketable collateral, may not exceed 15% of the institutions' unimpaired capital and surplus. Except as set forth below for certain highly rated securities, an institution's investment in commercial paper and corporate debt securities of any one issuer or related entity must be aggregated "loans" for purposes of the immediately preceding sentence. Savings institutions may invest, in addition to the 15% general limitation, up to 10% of unimpaired capital and surplus in commercial paper of one issuer rated by two nationally recognized rating services in the highest category, or in corporate debt securities rated in one of the two highest categories by at least one such service. A savings institution may also lend up to 10% of unimpaired capital and surplus, if the loan is fully secured by readily marketable collateral which is defined to include certain securities and bullion, but generally does not include real estate. A savings institution which meets its fully phased-in capital requirements may make loans to one borrower to develop domestic residential housing units, up to the lesser of $30,000,000 or 25% of the savings institution's unimpaired capital and surplus if certain other conditions are satisfied. These loans are an alternative to the 15% limitation and not in addition to that limitation. At December 31, 1993, BankAtlantic was in compliance with the loans to one borrower limitations. Qualified Thrift Lender ("QTL") - BankAtlantic, like all other savings institutions, is required to meet the QTL test for, among other things, future eligibility for advances from the FHLB. The QTL test requires that a savings institution's qualified thrift investments equal or exceed 65% of the savings institution's portfolio assets calculated on a monthly average basis in nine out of every twelve months. For the purposes of the QTL test, portfolio assets are total assets less intangibles, properties used to conduct business and liquid assets (up to 10% of total assets). The following assets are included as qualified thrift investments without limit: (i) domestic residential housing or manufactured housing loans; (ii) home equity loans and mortgage-backed securities secured by residential housing or manufactured housing loans; and (iii) certain obligations of the FDIC and other related entities. Other qualifying assets which may be included up to an aggregate of 20% of portfolio assets are: (i) 50% of originated residential mortgage loans sold within 90 days of origination; (ii) investments in debt or equity securities of service corporations that derive at least 80% of their gross revenues from housing-related activities; (iii) 200% of certain loans to and investments in low-cost, one-to-four family housing; (iv) 200% of loans for residential real property, churches, nursing homes, schools and small businesses in areas where credit needs of low-to-moderate income families are not met; (v) other loans for churches, schools, nursing homes and hospitals; and (vi) consumer and education loans up to 10% of total portfolio assets. Any savings institution that fails to meet the QTL test must convert to a commercial bank charter or limit its future investments and activities to those permitted for both savings institutions and national banks. Additionally, any such savings institution that does not convert to a commercial bank charter will be ineligible to receive future advances from the FHLB and, beginning three years after the loss of QTL status, will be required to repay all outstanding advances from the FHLB and dispose of or discontinue all preexisting investments and activities not permitted for both savings institutions and national banks. If an institution converts to a commercial bank charter, it will remain insured by the SAIF until December 31, 1993, or until the FDIC permits it to transfer to BIF, if later. Generally, a transfer to BIF is not permitted until August 1994. If any institution that fails the QTL test and is subject to these restrictions on activities and advances and is controlled by a holding company, then, within one year after the failure, the holding company must register as a bank holding company and will be subject to all restrictions on bank holding companies. At December 31, 1993, BankAtlantic was in compliance with current QTL requirements. Transaction with Affiliates - As a federally chartered savings institution, BankAtlantic is subject to the OTS' regulations relating to transactions with affiliates, including officers and directors. BankAtlantic is subject to substantially similar restrictions regarding affiliate transactions as those imposed on member banks under Sections 22(g), 22(h), 23A, and 23B of the FRA. Sections 22(g) and 22(h) establish restrictions on loans to directors, controlling shareholders and their related companies and certain officers. Section 22(g) provides that no institution may extend credit to an executive officer unless (i) the bank would be authorized to make such extension of credit to borrowers other than its officers, (ii) the extension of credit is on terms not more favorable than those afforded to other borrowers, (iii) the officer has submitted a detailed current financial statement and (iv) the extension of credit is on the condition that it shall become due and payable on demand at any time that the officer is indebted to any other bank or banks on account of extensions of credit in any one of the following three categories, respectively, in an aggregate amount greater than the amount of credit of the same category that could be extended to the officer by the institution: (a) an extension of credit secured by a first lien on a dwelling which is expected to be owned by the officer and used by the officer as his or her residence; (b) an extension of credit to finance the education of the children of the officer; or (c) for any other purpose prescribed by the OTS. Section 22(g) also imposes reporting requirements on both the officers to whom it applies and on the institution. Section 22(h) requires that loans to directors, controlling shareholders and their related companies and certain officers be made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with other persons and that those loans do not involve more than the normal risk of repayment or present other unfavorable features. Section 23A limits transactions with any one affiliate to 10% of the institution's capital and surplus (including supervisory goodwill to the extent that it may be included in core capital through July 1, 1995) and limits aggregate affiliate transactions to 20% of such capital and surplus. Sections 23A and 23B provide that a loan transaction with an affiliate generally must be collateralized (other than by a low-quality asset or by securities issued by an affiliate) and that all covered transactions as well as the sale of assets, the payment of money or the providing of services by a savings institution to an affiliate must be on terms and conditions that are substantially the same, or at least as favorable to the savings institution, as those prevailing for comparable non-affiliated transactions. A covered transaction is defined as a loan to an affiliate, the purchase of securities issued by an affiliate, the purchase of assets from an affiliate (with some exceptions), the acceptance of securities issued by an affiliate as collateral for a loan or the issuance of a guarantee, acceptance or letter of credit on behalf of an affiliate. The OTS regulations clarify that transactions between either a thrift or a thrift subsidiary and an unaffiliated person that benefit an affiliate are considered covered transactions. A savings institution may make loans to or otherwise extend credit to an affiliate only if the affiliate is engaged solely in activities permissible for bank holding companies. In addition, no savings institution may purchase the securities of any affiliate other than the shares of a subsidiary. The Director of the OTS may further restrict these transactions in the interest of safety and soundness. At December 31, 1993, BankAtlantic was in compliance with the restrictions regarding affiliate transactions. Subordinated Debentures - Insured institutions may increase their regulatory risk-based capital by selling subordinated debentures only with the prior written approval of the OTS. Applicable regulations also prohibit the inclusion in regulatory risk-based capital of subordinated debentures which have an original maturity of less than seven years and restrict the timing of sinking fund payments with respect to such securities. Pursuant to FIRREA, maturing capital instruments issued on or before November 7, 1989 includable as regulatory capital must be amortized pursuant to a schedule that permits 100% to be included when the years to maturity are greater than or equal to seven, and decreases by approximately one-seventh each year thereafter. Subordinated debentures issued after November 7, 1989 may, subject to regulatory approval prior to inclusion, be includable in regulatory capital, but such inclusion is limited based on one of two elections to be chosen by the issuing institution. The institution may elect to phase capital inclusion out on a straight-line basis over the last five years to maturity of the instrument, or may elect to limit the inclusion of the subordinated debt with less than seven years to maturity to 20% of the institution's capital. The OTS is permitted to determine the treatment of subordinated debentures if an institution is in receivership. At December 31, 1993, all of BankAtlantic's subordinated debentures had been redeemed. Liquidity Requirements of the OTS - The OTS' regulations currently require all member savings institutions to maintain an average daily balance of liquid assets (cash, certain time deposits, banker's acceptances, specified United States government, state or federal agency obligations and other corporate debt obligations and commercial paper) equal to 5% of the sum of the average daily balance during the preceding calendar month of net withdrawable accounts and short-term borrowings payable in one year or less. The liquidity requirement may vary from time to time (between 4% and 10%) depending upon economic conditions and savings flows of all savings institutions. All savings institutions are also required to maintain an average daily balance of short-term liquid assets (generally having maturities of 12 months or less) equal to at least 1% of the average daily balance of net withdrawable accounts and current borrowings. Monetary penalties may be imposed by the OTS for failure to meet liquidity requirements. At December 31, 1993 BankAtlantic was in compliance with all applicable liquidity requirements. The Federal Reserve System - BankAtlantic is subject to certain regulations promulgated by the Federal Reserve Board (the "FRB"). Pursuant to such regulations, savings institutions are required to maintain non-interest bearing reserves against their transaction accounts (which include deposit accounts that may be accessed by writing checks) and non-personal time deposits. The FRB has authority to adjust reserve percentages and to impose in specified circumstances emergency and supplemental reserves in excess of the percentage limitations otherwise prescribed. The balances maintained to meet the reserve requirements imposed by the FRB may be used to satisfy liquidity requirements which may be imposed by the OTS. In addition, FRB regulations limit the periods within which depository institutions must provide availability for and pay interest on deposits to transaction accounts. Depository institutions are required to disclose their check holding policies and any changes to those policies in writing to customers. BankAtlantic believes that it is in compliance with all such FRB regulations. Community Reinvestment - Under the CRA, as implemented by OTS regulations, a savings institution has a continuing and affirmative obligation consistent with its safe and sound operation to help meet the credit needs of its entire community, including low- and moderate-income neighborhoods. CRA does not establish specific lending requirements or programs for financial institutions nor does it limit an institution's discretion to develop the types of products and services that it believes are best suited to its particular community, consistent with CRA. CRA requires the OTS, in connection with its examination of a savings institution, to assess the institution's record of meeting the credit needs of its community and to take such record into account in its evaluation of certain applications by such institution. Effective July 1, 1990, the CRA, as amended by FIRREA, requires public disclosure of an institution's CRA rating and requires that the OTS provide a written evaluation of an institution's CRA performance utilizing a four-tiered descriptive rating system. The four ratings are "outstanding record of meeting community credit needs", "satisfactory record of meeting community credit needs", "needs to improve record of meeting community credit needs" and "substantial non-compliance in meeting community credit needs." An institution's CRA rating is taken into account in determining whether to grant charters, branches and other deposit facilities, relocations, mergers, consolidations and acquisitions. Poor CRA performance may be the basis for denying an application. BankAtlantic received a "satisfactory record of meeting community credit needs" during its most recent OTS examination. Holding Company Regulation - By virtue of its ownership of approximately 48.17% of the Common Stock, BFC Financial Corporation ("BFC") is a savings institution holding company subject to the regulatory oversight of the OTS. As such, BFC is required to register and file reports with the OTS and is subject to regulation and examination by the OTS. In addition, the OTS has enforcement authority over BFC and its non-savings institution subsidiaries. Among other things, this authority permits the OTS to restrict or prohibit activities that are determined to be a serious risk to the subsidiary savings institution. As an insured institution and a subsidiary of a savings institution holding company, BankAtlantic is subject to restrictions in its dealings with BFC and any other companies that are "affiliates" of BFC under the HOLA, and certain provisions of the FRA that are made applicable to savings institutions by FIRREA and OTS regulations. As a result of FIRREA, a savings institution's transactions with its affiliates are subject to limitations set forth in the HOLA and OTS regulations, which incorporate Section 23A, 23B, 22(g) and 22(h) of the FRA and Regulation O adopted by the FRB. Under Section 23A, an "affiliate" of an institution is defined generally as (i) any company that controls the institution and any other company that is controlled by the company that controls the institution, (ii) any company that is controlled by the shareholders who control the institution or any company that controls the institution or (iii) any company that is determined by regulation or order to have a relationship with the institution (or any subsidiary or affiliate of the institution) such that "covered transactions" with the company may be affected by the relationship to the detriment of the institution. "Control" is determined to exist if a percentage stock ownership test is met or if there is control over the election of directors or the management or policies of the company or institution. "Covered transactions" generally include loans or extensions of credit to an affiliate, purchases of securities issued by an affiliate, purchases of assets from an affiliate) (except as may be exempted by order or regulation), and certain other transactions. See "Transaction with Affiliates" above for a general discussion of the restrictions on dealing with affiliates. Further, BankAtlantic is currently considering the formation of a holding company which would own 100% of BankAtlantic's common stock. Any such formation will be subject to shareholder approval and will involve the exchange of BankAtlantic shares for shares in the new entity. If approved, a shareholder's proportionate ownership position in the new entity would be equal to the proportionate interest previously held in BankAtlantic. BFC has indicated that it would vote in favor of this type of shareholder proposal. Capital Maintenance Agreement Pursuant to an agreement entered into on May 10, 1989 between BFC, its affiliates and BankAtlantic's primary regulator, BFC is obligated to infuse additional capital into BankAtlantic in the event that BankAtlantic's net capital (as defined) falls below the lesser of the industry's minimum capital requirement (as defined) or 6% of BankAtlantic's assets. This obligation will expire ten years from the date of the agreement, or at such earlier time as BankAtlantic's net capital exceeds its fully phased-in capital requirement (as defined) for a period of two consecutive years. BankAtlantic's capital has exceeded its fully phased-in capital requirement since December 31, 1992. New Accounting Standards and Policies During May 1993, the Financial Accounting Standards Board approved two new accounting standards. Financial Accounting Standards No. 114--Accounting by Creditors for Impairment of a Loan ("FAS 114"), and Financial Accounting Standards No. 115--Accounting for Certain Investments in Debt and Equity Securities ("FAS 115"). FAS 114 addresses the collectibility of both contractual interest and contractual principal of all receivables when assessing the need for a loss accrual. This standard requires that unpaid loans be measured at the present value of expected cash flows by discounting those cash flows at the loan's effective interest rate. FAS 114 must be adopted by 1995, prospectively. If BankAtlantic implemented FAS 114 at December 31, 1993, its effect would be immaterial. BankAtlantic intends to adopt FAS 114 in 1995. In a related matter, in August 1993, the OTS issued Regulatory Bulletin 31 "Classification of Assets", which incorporates the OTS policy on the classification of troubled, collateral-dependent loans. Effective September 1993, OTS' policy for troubled, collateral-dependent loans (where proceeds for repayment can be expected to come only from the operation and sale of the collateral) is as follows: (a) For a troubled, collateral-dependent loan where, based on current information and events, it is probable that the lender will be unable to collect all amounts due (both principal and interest), any excess of the recorded investment in the loan over its "value" should be classified Loss, and the remainder should generally be classified Substandard. (b) For a troubled, collateral-dependent loan, the "value" is either (1) the present value of the expected future cash flows, discounted at the loan's effective interest rate, based on the original contractual terms ("loan-rate present value"); (2) the loan's observable market price; or (3) the fair value of the collateral. (c) For a troubled, collateral-dependent loan, it is probable that the lender will be unable to collect all amounts due when the expected future cash flows, on an undiscounted basis, from the operation and sale of the collateral over a period of time not to exceed the intermediate term (e.g., five years) are less than the principal and interest payments due according to the contractual terms of the loan agreement. The term "all amounts due" is based on the original contractual terms, except as discussed below. (d) For a troubled, collateral-dependent loan (whether or not restructured) where, based on current information it is probable, but not reasonably assured, that the lender will be able to collect all amounts due (both principal and interest), any excess of the recorded investment in the loan over its value should be classified Doubtful, and the remainder should generally be classified Substandard. An exception to this policy is for a loan that was restructured in a troubled debt restructuring involving a modification of terms prior to December 31, 1993. For loans restructured before December 31, 1993, the evaluation for probability of collection may be based on the collectibility of principal and interest under the restructured contractual terms. For all restructured loans, including loans modified before and after December 31, 1993, that become impaired after modification, the measurement of value is based on the same standard discussed above: (1) the present value of the expected future cash flows discounted at the loan's original contractual interest rate; (2) the loan's observable market price; or (3) the fair value of the collateral, if the loan is collateral dependent. OTS does not allow savings institutions to use general valuation allowances to cover any amount considered to be a Loss under the above policy; however, specific valuation allowances may be used in lieu of charge-offs. BankAtlantic experienced no material write-downs as the result of complying with Regulatory Bulletin 31. FAS 115 addresses the valuation and recording of debt securities as held-to-maturity, trading and available for sale. Under this standard, only debt securities that BankAtlantic has the positive intent and ability to hold to maturity would be classified as held to maturity and reported at amortized cost. All others would be reported at fair value. FAS 115 must be adopted by January 1,1994, prospectively. If FAS 115 were effective at December 31, 1993, BankAtlantic does not believe that it would be required to reclassify its debt securities. The effect of implementation increased stockholders' equity by approximately $2.7 million on January 1, 1994. However, BankAtlantic believes that implementation of FAS 115 may result in the volatility of capital amounts reported over time and could in the future negatively impact the institution's regulatory capital position. FEDERAL AND STATE TAXATION For federal income tax purposes, BankAtlantic reports its income and expenses on the accrual method of accounting. Savings institutions that meet certain definitional tests and other conditions prescribed by the Internal Revenue Code of 1986 (the "Code"), relating primarily to the composition of their assets and the nature of their business activities are, within certain limitations, permitted to establish, and deduct additions to, reserves for bad debts in amounts in excess of those which would otherwise be allowable on the basis of actual loss experience. A qualifying savings institution may elect annually, and is not bound by such election in any subsequent year, one of the following two methods for computing additions to its bad debt reserves for losses on "qualifying real property loans" (generally, loans secured by interests in improved real property): (i) the experience method or (ii) the percentage of taxable income method. BankAtlantic has utilized both the percentage of taxable income method and the experience method in computing the tax-deductible addition to its bad debt reserves. Additions to the reserve for losses on non-qualifying loans, however, must be computed under the experience method and reduce the current year's addition to the reserve for losses on qualifying real property loans, unless that addition also is determined under the experience method. The sum of the addition to each reserve for each year is BankAtlantic's annual bad debt deduction. If the percentage of BankAtlantic's specified qualifying assets (generally, loans secured by residential real estate or deposits, banker's acceptances, educational loans, cash, government obligations and certain certificates of deposit) were to fall below 60% of its total assets, BankAtlantic would not be eligible to claim further bad debt reserve deductions, and would recapture into income all previously accumulated bad debt reserves. As of December 31, 1993, BankAtlantic's qualifying assets were in excess of 60% of total assets. The experience method allows a savings institution to deduct the greater of an amount based upon a six-year moving average of loan losses or an amount determined with respect to its bad debt reserve for the "base year". The "base year" is, for these purposes, the last taxable year beginning before 1988. For the past four taxable years, BankAtlantic has utilized the experience method. Under the percentage of taxable income method, the bad debt deduction equals 8% of taxable income determined without regard to that deduction and with certain adjustments. The percentage bad debt deduction thus computed is reduced by the amount permitted as a deduction for the addition to the reserve for losses on non-qualifying loans, which must be computed under the experience method. The availability of the percentage of taxable income method permits qualifying savings institutions to be taxed at a lower maximum effective federal income tax rate than that applicable to corporations generally. The effective maximum marginal federal income tax rate applicable to a qualifying savings institution (exclusive of the alternative minimum tax), assuming the maximum percentage bad debt deduction, is approximately 32.2%. The percentage of taxable income method is available only to the extent that amounts accumulated in reserves for losses on qualifying real property loans do not exceed 6% of such loans at year-end. Use of this method is further limited to the greater of (i) the amount which, when added to the amount computed for the addition to the reserve for losses on non-qualifying loans, equals the amount by which 12% of savings deposits or withdrawable accounts of depositors at year-end exceeds the sum of surplus, undivided profits and reserves at the beginning of the year or (ii) the amount determined under the experience method. None of these limitations would have restricted the deduction for the addition to the reserve for bad debts available to BankAtlantic for 1993. BankAtlantic's reserve for bad debts included $6.6 million, for which no deferred income taxes have been provided at December 31, 1993. To the extent that (i) a savings institution's reserve for losses on qualifying real property loans exceeds the amount that would have been allowed under the experience method and (ii) it makes distributions to shareholders that are considered to result in withdrawals from that excess bad debt reserve, then the amounts withdrawn will be included in its taxable income. The amount considered to be withdrawn by a distribution will be the amount of the distribution plus the amount necessary to pay the tax with respect to the withdrawal. Dividends paid out of the savings institution's current or accumulated earnings and profits, as calculated for federal income tax purposes, will not be considered to result in withdrawals from its bad debt reserves. The Internal Revenue Service has examined the consolidated federal income tax returns of BankAtlantic through calendar year 1988. In February 1992, FAS 109, Accounting for Income Taxes, was issued, and it significantly changes the method of accounting for deferred income taxes. The standard requires the use of the asset and liability method in accounting for income taxes and eliminates, on a prospective basis, the former exception for the provision of deferred income taxes on thrift bad debt reserves. BankAtlantic implemented, on a prospective basis, FAS 109 on January 1, 1993, and there was no cumulative effect adjustment required upon implementation. New Tax Legislation - The Omnibus Budget Reconciliation Act of 1993 (the "Omnibus Act") was passed by Congress and signed into law by the President during August, 1993. The Omnibus Act increased the maximum federal income tax rate applicable to BankAtlantic from 34% to 35% retroactive to January 1, 1993. The effect of the Omnibus Act on BankAtlantic at the date of enactment was to increase the income tax provision by approximately $175,000. BankAtlantic may also be impacted by other provisions of the Omnibus Act either directly as a consequence of additional provisions applicable to it or indirectly as a consequence of their impact on BankAtlantic's borrowers or the economy in general. Florida Franchise Tax - The State of Florida imposes a corporate franchise tax on savings and loan institutions at the rate of 5.5% on taxable income as determined for Florida franchise tax purposes, in lieu of the Florida corporate income tax. Taxable income for this purpose is based on federal taxable income in excess of $5,000 as adjusted by certain items. A credit is available against up to 65% of the franchise tax otherwise due for certain intangible taxes imposed by the State of Florida. The corporate franchise tax, exclusive of this credit availability, is substantially equivalent to the Florida corporate income tax. Real Estate and Other Activities As discussed in "General Description of Business", the Company prior to its investment in BankAtlantic had been primarily engaged in the real estate business. From 1981 through 1987, eleven public real estate partnerships were formed for which the Company provided property management, for fees, and administrative and accounting services, for cost reimbursements. In March 1989, February 1991 and June 1991, the assets and liabilities of six partnerships were exchanged for subordinated debentures of the Company. Three other partnerships have been or are in the process of being liquidated. It is the Company's intent to liquidate the assets acquired in the Exchanges and at December 31, 1993 only seven of the twenty-two properties acquired in the 1989 and 1991 Exchanges remain. In addition to its investment in BankAtlantic and unrelated to the public limited partnership programs and its property management activities noted in the paragraphs above, the Company holds mortgage notes receivable of approximately $9.1 million which were received in connection with the sale of properties previously owned by the Company. Holding Company Regulation - As the holder of approximately 48.2% of BankAtlantic's Common Stock, BFC is a non-diversified savings and loan holding company within the meaning of the National Housing Act of 1934, as amended. As such, BFC is registered with and is subject to examination and supervision by the OTS as well as subject to certain reporting requirements. As an FDIC- insured subsidiary of a savings bank holding company, BankAtlantic is subject to certain restrictions in dealing with BFC and with other persons affiliated with BFC. Employees At December 31, 1993, BankAtlantic employed approximately 603 full-time (with an additional 19 employees on leave of absence) and 20 part-time employees. In addition to the above BFC Financial Corporation employed 5 full-time and 1 part-time employee. Management believes that its relations with its employees are satisfactory. The employee benefits offered by the Company are considered by management to be generally competitive with employee benefits provided by other major employers in Florida. The Company's employees are not represented by any collective bargaining group. ITEM 2. ITEM 2. Properties BankAtlantic's principal and executive offices are located at 1750 East Sunrise Boulevard, Fort Lauderdale, Florida 33304. In addition to its principal office, BankAtlantic currently conducts business at 30 branch offices located in Dade, Broward and Palm Beach Counties, Florida. BankAtlantic owns the land and building on which its executive offices are located and also owns 20 of the branch offices. BankAtlantic leases either the land, the building or both in connection with the operation of its 10 other branch offices. BankAtlantic has seven leased branch office sites in Broward County, with lease expiration dates ranging from 1994 to 1998; two leased branch office sites in Dade County, with lease expiration dates ranging from 1995 to 2003; and one leased branch office in Palm Beach County, with a lease expiring in 1999. BankAtlantic also maintains a ground lease for a drive-in facility in Broward County which expires in 1999. At December 31, 1993, the aggregate net book value of premises and equipment, including leasehold improvements and equipment, was $37.4 million. Other Properties Held By the Company at December 31, 1993 Prior to January 31, 1994, BFC's principal executive offices of approximately 6,200 square feet of office space was located at 1320 South Dixie Highway, Coral Gables, Florida. The space was leased pursuant to a lease expiring upon the giving of six (6) months written notice to landlord and was utilized by the Company and its affiliates other than BankAtlantic. Effective January 31, 1994, BFC relocated its offices to approximately 1,500 square feet located in BankAtlantic's executive offices. The space is leased pursuant to a lease with BankAtlantic on terms no less favorable than could be obtained from an independent third party, expiring December 20, 1994. The commercial properties listed below are not utilized by the Company but are held by the Company as investments. All are zoned for their current uses. Lease terms do not include options. Land Approximately subject to an Springfield, Massachusetts 5 acres estate for years expiring in Land and Restaurant Building 5,000 square subject to a Galesburg, Illinois foot building net lease expiring in 1995 Clinton Plaza Shopping 129,575 square owned, subject Center, Knoxville, TN feet leasable to a ground lease IBM Executive Office 48,050 square owned Building, Kingsport, TN feet leasable Delray Industrial Park 134,237 square owned Delray Beach, FL feet leasable Burlington Manufacturers Outlet Center 277,965 square owned Burlington, NC feet leasable Pinebrook Square 285,365 square owned Charlotte, NC feet leasable Professional Towers 128,125 square owned Louisville, KY feet leasable Lennar Medical Professional Center 75,584 square owned Miami, FL feet leasable ITEM 3. ITEM 3. LEGAL PROCEEDINGS The following is a description of certain lawsuits to which the Company is a party. Timothy J. Chelling vs. BFC Financial Corporation, Alan B. Levan, I.R.E. Advisors Series 21, Corp. and First Equity Corporation, U.S. District Court, Southern District of Florida Case No. 89-1850-Civ Nesbitt. John D. Purcell and Debra A. Purcell vs. BFC Financial Corporation, Alan B. Levan, Scott Kranz, Frank Grieco, I.R.E. Advisors Series 23, Corp. and First Equity Corporation, U.S. District Court, Southern District of Florida, Case No. 89-1284- Civ-Ryskamp. William A. Smith and Else M. Smith vs. BFC Financial Corporation, Alan B. Levan and I.R.E. Advisors Series 24, Corp. and First Equity Corporation, U.S. District Court, Southern District of Florida, Case No. 89-1605- Civ-Marcus. These actions were filed by the plaintiffs as class actions during September 1989, June 1989 and August 1989, respectively. The actions arose out of an Exchange Offer made by the Company to the limited partners of I.R.E. Real Estate Fund, Ltd. - Series 21, I.R.E. Real Estate Fund, Ltd. - Series 23, and I.R.E. Real Estate Fund, Ltd. - Series 24. The plaintiffs, who were limited partners of the above named partnerships who did not consent to the Exchange Offer, brought this action purportedly on behalf of all limited partners that did not consent to the Exchange Offer. The Exchange Offer was made through the solicitation of consents pursuant to a Proxy Statement/Prospectus dated February 14, 1989 and was approved by the holders of a majority of the limited partnership interests of each of the Partnerships in March 1989. Messrs. Levan, Grieco and Kranz served as individual general partners of each of the Partnerships, and Mr. Levan is the President and a director of the Company. The plaintiffs alleged that the Proxy Statement/Prospectus contained material misstatements and omissions, that defendants violated the federal securities laws in connection with the offer and Exchange, that the Exchange breached the respective Limited Partners Agreement and that the defendants violated the Florida Limited Partnership statute in effectuating the Exchange. The complaint also alleged that the defendant general partners violated their fiduciary duties to the plaintiffs. In a memorandum opinion and order dated December 17, 1991, the Court granted the defendant's motion for summary judgement and denied the plaintiff's motion for summary judgement, ruling that the Exchange did not violate the partnership agreements or the Florida partnership statute. In July 1992, the Court granted summary judgment in favor of the defendants and dismissed the plaintiffs' claims for breach of fiduciary duty. Subsequently, the court entered summary judgment in favor of the defendants on all claims of misrepresentations or omissions except with respect to the statement in the Proxy Statement/Prospectus to the effect that BFC, Alan Levan and the Managing General Partners believed the Exchange transaction was fair. The case on that issue was tried in December 1992, and the jury returned a verdict in the amount of $8 million but extinguished approximately $16 million of debentures held by the plaintiffs. BFC Financial Corporation would record a pre-tax gain of approximately $6 million from the reduction in its debt resulting from the verdict, but it nonetheless believes that the verdict was not supported by the evidence at trial. Based on the verdict, BFC Financial Corporation would record a pre-tax gain of approximately $6 million from the extinguishment of the $16 million of outstanding debt. No amounts have been reflected in the financial statements because the judgement amount was less that the Company's carrying amount of the debentures and related accrued interest and because the Company intends to appeal the verdict. The court denied plaintiffs' motion for prejudgment interest as to Series 21 and Series 23 and awarded prejudgment interest to plaintiffs in Series 24 to be calculated to run from March 31, 1989 through December 18, 1992, the date of entry of final judgment, at the rate of 3.54%. The plaintiffs appealed the court's denial for prejudgment interest in Series 21 and Series 23. The Company also appealed the judgment as well as the court's denial of various post-trial motions filed by the Company. Pursuant to the request of the Eleventh Circuit Court of Appeals, the parties submitted briefs regarding the issue of whether the Eleventh Circuit has jurisdiction to hear the appeal. In February 1994, the Eleventh Circuit Court dismissed the appeal for lack of jurisdiction. In September 1993, the court granted the Company's motion to stay of the execution of the final judgment pending appeal and to allow alternative form of security. In December 1993, the Company filed with the district court a motion to correct the judgment to reflect the cancellation of the outstanding debentures, which motion is still pending. Arthur Arrighi, et al. vs. KPMG Peat Marwick, BFC Financial Corporation; Alan B. Levan; Frank V. Grieco; Glen Gilbert; Al DiBenedetto; BankAtlantic, A Federal Savings Bank; Georgeson & Company, Inc.,; First Equity Corporation of Florida; I.R.E. Advisors Series 25, Corp.; I.R.E. Advisors Series 27, Corp.; I.R.E. Income Advisors, Corp.; and National Realty Consultants, in the United States District Court for the District of New Jersey, Case No. 92-1206-CDR. This case was filed on March 20, 1992 by more than 2,000 former limited partners in Series 25, Series 27 and Income Fund. The complaint alleged that BFC and certain other defendants developed a fraudulent scheme commencing in 1972 to sell the plaintiffs limited partnership units with the undisclosed goal of later taking over the assets of the partnerships in exchange for securities in a new entity in which the defendant Alan B. Levan would be a major shareholder. The complaint further alleged that the defendants made material misrepresentations and omissions in connection with the sale of the original limited partnership units in the 1980s and in connection with the 1991 Exchange, and fraudulently tallied the votes in connection with the 1991 Exchange and Solicitation of Consents described above. On March 2, 1994, the parties entered into an agreement to settle this action pursuant to which BFC will pay approximately eighty-one percent (81%) of the face amount of the outstanding debentures held by plaintiffs and the debentures will be canceled pursuant to the procedures outlined in the agreement. The settlement is subject to, among other things, court approval. Upon effectiveness, the settlement of this action will be dismissed with prejudice and the parties will exchange releases. Marjory Meador, Shirley B. Daniels, Robert A. and Ruby L. Avans, and Dr. and Mrs. Czerny, individually and on behalf of all others similarly situated, Plaintiffs, vs. BFC Financial Corporation; BankAtlantic, A Federal Savings Bank; Alan B. Levan; I.R.E. Advisors Series 21, Corp.; I.R.E. Advisors Series 23, Corp.; I.R.E. Advisors Series 24, Corp.; I.R.E. Advisors Series 25, Corp.; I.R.E. Advisors Series 27, Corp.; I.R.E. Income Advisors Corp.; and First Equity Corporation of Florida; Defendants, in the Circuit Court of the Seventeenth Judicial Circuit in and for Broward County, Florida, Case No. 91- 29892 (CA-17). This action was filed as a class action during October 1991 and is brought on behalf of all persons who were limited partners in (a) I.R.E. Real Estate Fund, Ltd. - Series 21, I.R.E. Real Estate Fund, Ltd. - Series 23, or I.R.E. Real Estate Fund, Ltd. -Series 24 on the effective date of the 1989 Exchange Transaction not otherwise included in the action by limited partners who voted against the Exchange; or (b) were limited partners in I.R.E. Real Estate Fund, Ltd. - Series 25, I.R.E. Real Estate Fund, Ltd. - Series 27 or I.R.E. Real Estate Income Fund, Ltd. on the effective dates of the 1991 Exchange Transactions. The action alleges breach of the limited partnership agreements, breach of fiduciary duty, aiding and abetting a breach of fiduciary duty by BFC Financial Corporation and BankAtlantic, and negligent misrepresentation by all defendants. The action seeks damages in an unstated amount, imposition of a constructive trust on the assets of the exchanging partnerships, attorney's fees, costs and such other relief as the courts may deem appropriate. Plaintiffs have voluntarily dismissed all claims which arose out of or related to the 1991 Exchange. Shirley B. Daniels, Robert S. and Ruby L. Avans, and Dr. and Mrs. Czerny, individually and on behalf of all others similarly situated, Plaintiffs, vs. BFC Financial Corporation; BankAtlantic, A Federal Savings Bank; Alan B. Levan; I.R.E. Advisors Series 25, Corp.; I.R.E. Advisors Series 27, Corp.; I.R.E. Income Advisors Corp.; First Equity Corporation of Florida, Defendants, in the United States District Court for the Southern District of Florida, Fort Lauderdale Division, Case No. 92-6588-Civ-King. On January 18, 1991, BFC issued a prospectus and solicitation of consents in which it offered to exchange up to $17 million in subordinated unsecured debentures for all of the assets and liabilities of I.R.E. Real Estate Fund, Ltd.- ("Series 25"), I.R.E. Real Estate Fund, Ltd.- ("Series 27"), I.R.E. Real Estate ("Income Fund") and I.R.E. Pension Investors, Ltd the ("1991 Exchange"). The 1991 Exchange was approved by a majority of the limited partners in all of the partnerships except I.R.E. Pension Investors, Ltd. The Exchange subsequently was effectuated without I.R.E. Pension Investors, Ltd. In December 1992, plaintiffs filed an amended complaint, the result of which is to enlarge the class to all limited partners in the 1991 Exchange. Plaintiffs allege that the defendants orchestrated the Exchange for their own benefit and caused the issuance of the Exchange Offer and Solicitation of Consents, which contained materially misleading statements and omissions. The complaint contains counts against BFC for violations of the Securities Act and the Exchange Act. Plaintiffs also allege that Alan Levan and the managing general partners breached the limited partnership agreements, breached fiduciary duties and that BFC and BankAtlantic aided and abetted these alleged breach of fiduciary duties, that Alan Levan, the managing general partners, BFC and BankAtlantic committed fraud in connection with the 1991 Exchange and made certain negligent misrepresentations to the plaintiffs. The complaint seeks damages and prejudgment interest in an unspecified amount, attorneys' fees and costs. The defendants have filed an answer and affirmative defenses to the amended complaint. On March 2, 1994, the parties entered into an agreement to settle this action pursuant to which BFC will pay approximately eighty-one percent (81%) of the face amount of the outstanding debentures held by plaintiffs and the debentures will be canceled pursuant to the procedures outlined in the agreement. The settlement is subject to, among other things, court approval. Upon effectiveness, the settlement of this action will be dismissed with prejudice and the parties will exchange releases. Cheryl and Wayne Hubbell, et al., vs. I.R.E. Advisors Series 26, Corp. et al., in the California Superior Court in Los Angeles, California, Case No. BC049913. This action was filed as a class action during March 1992 on behalf of all purchasers of I.R.E. Real Estate Fund, Ltd. - Series 25, I.R.E. Real Estate Fund, Ltd. - Series 26, I.R.E. Real Estate Fund, Ltd. - Series 27, I.R.E. Real Estate Growth Fund, Ltd. - Series 28 and I.R.E. Real Estate Income Fund, Ltd. against the managing and individual general partners of the above named partnerships and the officers and directors of those entities. The plaintiffs allege that the offering materials distributed in connection with the promotions of these limited partnerships contained misrepresentations of material fact and that the defendants misrepresented and concealed material facts from the plaintiffs during the time the partnerships were in existence. The complaint asserts two causes of action for fraud, one of which is based on a claim for intentional misrepresentation and concealment and one of which is based on a claim of negligent misrepresentation. The complaint also contains a claim for breach of fiduciary duty. The complaint seeks unspecified compensatory and punitive damages, attorneys' fees and costs. Plaintiffs filed an amended complaint, which the Court dismissed in February 1993 pursuant to a motion to dismiss filed by the Defendants. Plaintiffs thereafter filed a second amended complaint in February 1993. which was also dismissed. Plaintiffs filed a third amended complaint which defendants answered in April 1993. Management intends to vigorously defend this action. Martha Hess, et. al., on behalf of themselves and all others similarly situated, v. Gordon, Boula, Financial Concepts, Ltd., KFB Securities, Inc., et al. In the Circuit Court of Cook County, Illinois. On or about May 20, 1988, an individual investor filed the above referenced action against two individual defendants, who allegedly sold securities without being registered as securities brokers, two corporations organized and controlled by such individuals, and against approximately sixteen publicly offered limited partnerships, including two partnerships that the Company acquired the assets and liabilities of in the 1991 Exchange transaction, (the "predecessor partnerships") interests in which were sold by the individual and corporate defendants. Plaintiff alleged that the sale of limited partnership interests in the predecessor partnerships (among other affiliated and unaffiliated partnerships) by persons and corporations not registered as securities brokers under the Illinois Securities Act constitutes a violation of such Act, and that the Plaintiff, and all others who purchased securities through the individual or corporate defendants, should be permitted to rescind their purchases and recover their principal plus 10% interest per year, less any amounts received. The predecessor partnerships' securities were properly registered in Illinois and the basis of the action relates solely to the alleged failure of the Broker Dealer to be properly registered. In November 1988, Plaintiff's class action claims were dismissed by the Court. Amended complaints, including additional named plaintiffs, were filed subsequent to the dismissal of the class action claims. Motions to dismiss were filed on behalf of the predecessor partnerships and the other co-defendants. In December 1989, the Court ordered that the predecessor partnerships and the other co-defendants rescind sales of any plaintiff that brought suit within three years of the date of sale. Under the Court's order of December 1989, one of the predecessor partnerships rescinded sales of $41,500 of units. Plaintiffs appealed, among other items, the Court's order with respect to plaintiffs that brought suit after three years of the date of sale In February 1993, the Appellate court ruled that the statute of limitations was tolled during the pendency of the class action claims. Therefore, those investors that brought suit within 3.6 years and potentially 4 years from the date of sale may be entitled to rescission. The Company and the other co- defendants sought leave to appeal before the Illinois Supreme Court and on October 6, 1993, the leave to appeal was denied. Plaintiff's claims are now pending in Circuit Court. Plaintiffs have indicated that they will file amended complaints against the predecessor partnerships and other co- defendants. The amended complaints will include both individual and class claims. The individual and corporate defendants sold a total of $1,890,500 of limited partnership interests in the predecessor partnerships. Limited partners holding approximately $1,042,800 of limited partnership interests have filed an action for recision. Under the appellate decision, if recision was made to all limited partners that filed an action, refunds, at March 31, 1993, (including interest payments thereon) would amount to approximately $1,800,000. A provision for such amount has been made in the accompanying financial statements. Short vs. Eden United, Inc., et al. in the Marion County Superior Court, State of Indiana. Civil Division Case No. S382 0011. In January, 1982, an individual filed suit against a subsidiary of the Company, Eden United, Inc. ("Eden"), seeking return of an earnest money deposit held by an escrow agent and liquidated damages in the amount of $85,000 as a result of the failure to close the purchase and sale of an apartment complex in Indianapolis, Indiana. Eden was to have purchased the apartment complex from a third party and then immediately resell it to plaintiff. The third party was named as a co-defendant and such third party has also filed a cross claim against Eden, seeking to recover the earnest money deposit. In September 1983, Plaintiff filed an amended complaint, naming additional subsidiaries of the Company and certain officers of the Company as additional defendants. The amended complaint sought unspecified damages based upon alleged fraud and interference with contract. In interrogatory answers served in September 1987, Plaintiff stated for the first time that he was seeking damages in the form of lost profits in the amount of approximately $6,350,000. The case went to trial during October 1988. On April 26, 1989, the Court entered a judgement against Eden, the Company and certain additional subsidiaries of the Company jointly and severally in the sum of $85,000 for liquidated damages with interest accruing at 8% per annum from September 1, 1981, normal compensatory damages of $1.00, and punitive damages in the sum of $100,000. The judgement also rewards the Plaintiff the return of his $85,000 escrow deposit, and awards the third party $85,000 in damages plus interest accruing from September 14, 1981 against Eden. The Company has charged expense for the above amounts. Both Short and the Company appealed the judgement and in June 1991, the appellate court reversed the trial court's decision on the issue of compensatory damages, determined that Short maybe entitled to an award of compensatory damages and remanded the case to the trial court to determine the amount of compensatory damages to be awarded. The Indiana Supreme Court denied review. A hearing on remand was held on February 3, 1993. On February 25, 1994, the court on remand awarded plaintiff a judgment in the amount of $85,000 for liquidated damages for breach of contract jointly and severally from the subsidiary, the Registrant and certain named affiliates, plus prejudgment interest of $52,108 through May 1, 1989, plus post-judgment interest of 10% per annum thereafter until paid. Additionally, plaintiff was awarded a judgment against the defendants in the amount of $2,570,000 for tortious interference, plus prejudgment interest of $469,400 through May 1, 1989, plus post-judgment interest of 10% per annum thereafter until paid. The Registrant which was advised of the courts decision on March 2, 1994 intends to appeal the trial court's order. Scott Kranz and Investment Management Group, Inc. vs. Alan B. Levan, BFC Financial Corporation, I.R.E. Investments, Inc., Frank V. Grieco, I.R.E. Advisors Series 23, Corp., I.R.E. Advisors Series 24, Corp., I.R.E. Advisors Series 25, Corp., I.R.E. Advisors Series 26, Corp., and I.R.E. Real Estate Institutional Corp., in the Eleventh Judicial Circuit in and for Dade County, Florida, Case No. 85-08751 (the "employment case"), Scott G. Kranz in the name of I.R.E. Realty Advisory Group, Inc., vs I.R.E. Realty Advisory Group, Inc. et al in the Eleventh Judicial Circuit in and for Dade County, Florida, Case No. 84-40012 (CA25) (the "appraisal case"). On March 5, 1985 Scott Kranz and Investment Management Group, Inc. filed suit seeking damages in excess of $1,800,000 and punitive damages of at least $10,000,000 plus costs. Investment Management Group, Inc. ("IMG") is a real estate development corporation of which Scott Kranz is the President. Until his termination on August 1, 1984, Scott Kranz was associated with Registrant and/or various of its affiliates either individually or through IMG. The Complaint alleges that Alan B. Levan, acting on his own behalf and on behalf of Registrant and certain unnamed affiliates and in combination with one or more unnamed defendants wrongfully caused the termination of certain contractual relationships between the Company and Scott Kranz and IMG and of Scott Kranz as general partner of five publicly registered real estate limited partnerships. On October 29, 1984, Scott G. Kranz, a 10% shareholder of I.R.E. Realty Advisory Group, Inc. ("RAG"), of which Registrant is a 50% shareholder, filed suit in the name of RAG seeking a declaration of the rights and liabilities of the parties in relation to a merger effective August 21, 1984 by and among Gables Advisors, Inc., I.R.E. Real Estate Funds, Inc. and RAG. Plaintiff seeks damages in the amount of the fair market value of his shares in RAG as of the day before the merger. He further claims punitive damages, attorneys fees and costs. On January 30, 1985, plaintiff amended his complaint, to add claims of breach of statutory duty and willful failure to submit the merger transactions to a vote at a meeting of shareholders, in addition to a claim for punitive damages. On June 17, 1985, Plaintiff again amended his complaint adding a claim of constructive fraud. In March 1986, Plaintiff's motion for summary judgement was denied. On January 21, 1987, the Court ordered this action consolidated for trial with the action described immediately above. Defendants denied Plaintiff's claims and filed a counterclaim. The defendants also filed a motion to strike all of Kranz's and IMG's pleadings in both cases and to enter a default judgement against Kranz and IMG for gross and continuing violations of discovery orders. By order dated June 26, 1990, the judge struck all of the pleadings filed by Kranz and IMG including both of their complaints and both of their answers to the Company's counterclaims. On February 12, 1991, the trial judge entered final judgement in favor of the individual defendants, Alan Levan and Frank Grieco, specifically reserving jurisdiction for further proceedings as to the corporate entities to enter final judgement against the plaintiffs on the complaint. Kranz and IMG appealed the judgement in favor of the individual defendants and the judgement was affirmed. The corporate defendants have filed a motion for entry of judgment against Kranz and IMG and requesting damages and attorney's fees. Joseph Roma vs. I.R.E. Advisors Series 29, Corp., et al., in the Circuit Court of Cook County, Illinois, County Department, Chancery Division, Case No. 91CH2429. - This action was filed as a class action during March 1991. The action, brought on behalf of investors in I.R.E. Real Estate Fund, Ltd. - Series 29 ("Series 29"), alleged fraud and fraudulent inducement, breach of fiduciary duty, negligent misrepresentation and violations of the Blue Sky Laws by defendants relating to their promotion, marketing, control and management of Series 29, a public limited partnership. The action sought rescission of the investments, contracts and agreements relating to investments in Series 29, damages in an unstated amount and other relief as the court deemed appropriate. This action was dismissed by the court. Plaintiffs appealed such dismissal and in February 1994, the Appellate Court affirmed the dismissal in favor of all defendants. John F. Weaver, Trustee for the Bankruptcy Estate of Milton A. Turner vs. I.R.E. Real Estate Investments, Inc., in the United States Bankruptcy Court for the Eastern District of Tennessee, Case No. 3-89-01210. - On July 25, 1991, an action was filed by John Weaver alleging that the conveyance of Turner's equity of $1,642,001 under a wrap note to I.R.E. Real Estate Investments, Inc. (successor to I.R.E. Real Estate Fund, Ltd. - Series 23) in connection with the sale of property by Series 23 to Turner was a fraudulent conveyance, as defined, in that Turner conveyed an asset, namely the cancellation of a wrap note and wrap trust, without fair consideration while insolvent. The trial on the complaint to avoid fraudulent conveyance was heard before the Bankruptcy Court in May 1993. Judgment was entered in favor of BFC and the complaint was dismissed. No appeal was taken from the judgment and it is now final. Alan B. Levan and BFC Financial Corporation v. Capital Cities/ABC, Inc. and William H. Wilson, in the United States District Court for the Southern District of Florida, Case No. 92-325-Civ-Atkins. On November 29, 1991, The ABC television program 20/20 broadcast a story about Alan B. Levan and BFC which purportedly depicted some securities transactions in which they were involved. The story contained numerous false and defamatory statements about the Company and Mr. Levan and, February 7, 1992, a defamation lawsuit was filed on behalf of the Company and Mr. Levan against Capital Cities/ABC, Inc. and William H. Wilson, the producer of the broadcast. In July 1993, a magistrate recommended that summary judgment be entered against Mr. Levan on their defamation claims. Objections to and an appeal from that recommendation were filed with the presiding judge. Such appeal remains pending. On March 21, 1988, an action captioned Elliot Borkson, et al. vs. Alan Levan, Jack Abdo and BankAtlantic, Case No. 88-12063, was filed by a group of approximately 54 shareholders of BankAtlantic in the Circuit Court of the Eleventh Judicial Circuit in and for Dade County, Florida. The complaint alleges that Messrs. Levan and Abdo breached their fiduciary duties as directors of BankAtlantic by disregarding the rights of minority shareholders under a certain option agreement between BFC and a third party dated April 9, 1986, by taking actions to depress the value of BankAtlantic's stock, by denying access to BankAtlantic's books and records and by allegedly wasting corporate assets. BankAtlantic is a nominal party to the proceeding. Plaintiffs seek punitive damages of $10.0 million, compensatory damages, attorneys' fees, costs and injunctive relief. Discovery is proceeding and the defendants are vigorously defending the action. No trial date has been set. Counsel has obtained a letter from counsel for plaintiffs in which counsel for plaintiffs conclude that there is insufficient evidence to maintain the claim against the defendants. This matter has been set for jury trial during the two-week period commencing June 6, 1994. Elliot Borkson, et al vs. BFC Financial Corporation. Circuit Court of the 11th Judicial Circuit in and for Dade County Florida. Case No. 88-11171 (CA 10). In March 1988, a group of approximately 54 shareholders of BankAtlantic filed a class action suit against Registrant alleging Registrant had breached its agreement, contained in an option agreement ("the Pearce Agreement") pursuant to which Registrant had purchased shares of BankAtlantic, to offer to acquire all of the remaining outstanding shares of BankAtlantic at a price equal to the greater of (i) $18 per share or (ii) an amount per share which, in the opinion of an investment banking firm of recognized national standing, is fair to the stockholders of BankAtlantic. Such obligation was subject to receipt of all required regulatory approvals and was relieved if there occurred a material adverse change in financial conditions affecting the savings and loan industry. Plaintiffs seek to recover compensatory damages arising from Registrant's alleged breach of contract, costs, interest and attorneys fees. In April 1988, BankAtlantic joined in a motion to stay the proceedings pending resolution of a similar action filed in Pennsylvania and transferred to the United States District Court for the Southern District of Florida. The stay with respect to the proceedings remains in effect. Marvin E. Blum, et al vs. BFC Financial Corporation; Alan B. Levan and Jack Abdo. Case No. 88-6277, U.S. District Court for the Southern District of Florida. This litigation was commenced on February 11, 1988, by International Apparel Associates as a class action against BFC Financial Corporation and Alan Levan. Subsequently, the Borkson plaintiffs and their counsel were substituted for International Apparel, with Dr. Marvin Blum being designated as the class representative. Jack Abdo was also added as a party defendant. The plaintiff class was certified by the district court as "all persons, other than defendants, and their affiliates, officers, and members of their immediate family who owned shares of BankAtlantic common stock on February 6, 1988, or their successors in interest". The Second Amended Complaint, upon which this action is presently based, asserts a claim for breach of contract and a claim for violation of Section 10(b) of the Securities Exchange Act of 1934. Plaintiffs allege that they, as minority shareholders of BankAtlantic, A Federal Savings Bank, are third party beneficiaries of an option agreement between BFC Financial Corporation and Dr. Pearce requiring BFC Financial Corporation to offer to purchase all their shares of BankAtlantic subject to certain conditions. Plaintiffs claim that none of the conditions set forth in the Pearce Agreement arose to excuse BFC Financial Corporation from offering to buy the shares; defendants claim that those conditions did in fact occur and that BFC Financial Corporation did not, therefore, have any obligation to offer to purchase the shares. Plaintiffs also allege that defendants made certain misrepresentations regarding their intentions to perform pursuant to the Pearce agreement, which defendants deny. Settlement negotiations, which had been progressing, have terminated. The plaintiffs have requested that this matter be rescheduled for trial. Pretrial conference has been conducted, however, no trial date has been set. During 1989 and 1991, the Company exchanged subordinated debentures for the assets and liabilities of certain affiliated partnerships. While, to the Company's knowledge, no formal order of investigation is pending, the Securities and Exchange Commission ("SEC") has advised the Company that it is currently reviewing the transactions. Following is a description of additional legal proceedings in which the Company's significant subsidiary, BankAtlantic, is a party: Caroline Berger, on behalf of herself and all others similarly situated vs. Joseph Giarizzo, Ron Scott, Leon Martin, Paul Tedaldy, Sal Giarizzo, James Gansky, Harbor Crest Assocs. Ltd., Queens Window Systems Ltd., Dartmouth Plan Inc., Wendover Funding, Inc., Midwest Federal Savings Bank, Sterling Resources Ltd., Bencharge Credit Service of New York, Inc., Skopbank, David Beyer, Jeffrey Beyer, BankAtlantic, National City Bank of Akron, Suburban Equity Corp., Oxford Home Equity Loan Co., National Westminster Bank, Embanque Capital Corp., Chrysler First, Capital Resources Corp., Green Point Savings, United States District Court, Eastern District of New York, CV-90-2500, Platt, C.J. This action was originally filed on July 13, 1990 by the plaintiff, Caroline Berger ("Berger"), in her individual capacity, against Joseph Giarizzo, Harbor Crest Associates, Ltd., Queens Window Systems Ltd., Dartmouth Plan, Inc., Wendover Funding Inc., Midwest Federal Savings Bank, Sterling Resources Ltd., Bencharge Credit Service of New York Inc., SkopBank, David Beyer and Jeffrey Beyer. The original complaint asserted a variety of state and federal causes of action. The plaintiff, Berger, is allegedly suing on behalf of herself and all others similarly situated. Berger asserts that she was defrauded by Dartmouth Plan Inc., Midwest Federal Savings Bank and by Harbor Crest, a home improvement contractor affiliated with Dartmouth. The plaintiff maintains that Dartmouth and Harbor Crest operated a scheme pursuant to which Harbor Crest would identify individuals on small incomes with little or no education and sell them home improvements at substantially marked up prices. The plaintiff also maintains that the home improvements were provided in a shoddy and unprofessional manner and that the requirements of the truth in lending laws were not met. In related matters, BankAtlantic is represented by counsel in connection with a suit filed by the New Jersey Attorney General has filed suit against Sterling and certain contractors originating Sterling paper (some of which was subsequently sold to BankAtlantic). In that action, the New Jersey Attorney General seeks civil remedies against the contractor and Sterling and seeks to cancel or modify the mortgage loans. These are some of the same Sterling loans discussed above. The New Jersey Attorney General staff has stated that some of the New Jersey customers have better claims than others and have asked BankAtlantic to recommend a procedure for independent evaluation of any claims relating to these loans. On June 15, 1992, BankAtlantic sent the New Jersey Attorney General a written recommendation regarding the procedures that should be utilized to evaluate the claims relating to the Sterling loans held by BankAtlantic on a case-by-case basis. The New Jersey Attorney General is in the process of reviewing and revising the suggested procedures. In an action entitled BankAtlantic, A Federal Savings Bank, a federally chartered savings bank vs. National Union Fire Insurance Co. of Pittsburgh, Pennsylvania, a Pennsylvania corporation, United States District Court, Southern District of Florida, 91-2940-CIV-MORENO, BankAtlantic and National Union entered into a Covenant Not To Execute (the "Covenant"). Pursuant to the Covenant, BankAtlantic will continue to pursue its litigation against National Union but has agreed to limit execution on any judgment obtained against National Union to $18 million. Further, BankAtlantic agreed to join certain third parties as defendants in the action. Pursuant to the Covenant, National Union paid BankAtlantic approximately $6.1 million on execution of the Covenant, and agreed to pay an additional $3 million, which was paid when due on November 1993, and approximately $2.9 million on November 1, 1994. Further, National Union agreed to reimburse BankAtlantic for additional losses (as defined) incurred by it in connection with the Subject Portfolio, if any, provided that in no event will National Union be obligated to pay BankAtlantic in the aggregate more than $18 million. In the event of recovery by BankAtlantic of damages against third party wrongdoers, BankAtlantic will be entitled to retain such amounts until such amounts plus any payments received from National Union equal $22 million. Thereafter National Union will be entitled to any such recoveries to the extent of its payments to BankAtlantic. On July 21, 1987, a foreclosure action captioned Atlantic Federal Savings and Loan Association of Fort Lauderdale and BankAtlantic Development Corporation vs. Promenade at Inverrary, et. al., Case No. 87-19998CM, was filed in the Circuit Court of the Seventeenth Judicial Circuit in and for Broward County, Florida, against Promenade at Inverrary. On November 27, 1991, the state court judge entered a final judgment in favor of BankAtlantic and BankAtlantic Development Corporation for $11,957,820.73 and against the Kozich defendants on their counterclaims. BankAtlantic, and two other financial institutions (a junior mortgagee who challenged the priority of certain of one of the other institution's mortgages on the borrower's properties) were ordered to attend mediation shortly before a November 1992 trial date. At mediation, a settlement was reached whereby the other institution agreed to sell certain of its mortgages at a discount and assign them to BankAtlantic, dismiss its defenses to the second amended complaint so that BankAtlantic could proceed to complete the foreclosure without the necessity of trial and dismiss the appeals it had taken in both the state and bankruptcy courts. In exchange for BankAtlantic's payment of a nominal sum, the other institution agreed to dismiss its challenge to the priority of one of the other institution's mortgages and thereby release its mortgages from the properties. The trial court entered an order allowing BankAtlantic to credit the bid at the foreclosure sale for the amount of the junior mortgages that were assigned to it from the other institution. The Bankruptcy Court has released the five Kozich properties from bankruptcy and the trustee turned the properties over to a management company selected by BankAtlantic until the foreclosure case was completed in 1993. BankAtlantic now owns the properties and is seeking to dispose of the subject properties. An action to recover $750,000 captioned BankAtlantic, A Federal Savings Bank, f/k/a Atlantic Federal Savings and Loan Association of Fort Lauderdale, vs. Jetborne International, Inc., a Delaware corporation, Allen Blattner, individually and Benjamin Friedman, individually, was filed on April 28, 1989, in the Circuit Court of the Eleventh Judicial Circuit in and for Dade County, Florida; Case No. 89-18792 CA 16, for breach of three separate promissory notes for $250,000 each executed by Allen Blattner, individually. As disclosed previously on Form 10K, BankAtlantic also sought to enforce a guarantee executed by Jetborne International of all three promissory notes. On September 12, 1991, judgement was entered in favor of BankAtlantic and against all defendants. Judgments against Jetborne and Allen Blattner were in the amount of $706,800 and $769,282, respectively. On December 12, 1991 an involuntary bankruptcy petition was filed against Jetborne. Jetborne did not contest the bankruptcy filing and converted to a voluntary proceeding. BankAtlantic is pursuing its claim as a creditor in the bankruptcy proceeding on the judgment against Allen Blattner. Jetborne has filed a Plan of Reorganization in its bankruptcy case which was confirmed in 1993. BankAtlantic has reached an agreement as to the treatment of BankAtlantic's claim. Jetborne paid BankAtlantic $100,000 in the first quarter of 1994 and the remainder of BankAtlantic's claim is to be paid in full over a period of approximately five years. On July 2, 1990, an action entitled BankAtlantic, A Federal Savings Bank, f/k/a Atlantic Federal Savings and Loan Association of Fort Lauderdale vs. Aircraft Modular Products, Inc., Case No. 90-31870 CA19, was filed in the Circuit Court of the Eleventh Judicial Circuit in and for Dade County, Florida by BankAtlantic seeking to enforce a guaranty. This case is related to BankAtlantic vs. Jetborne et. al. described above. The defendant, Aircraft Modular Products, Inc., is a subsidiary of Jetborne International. The guaranty executed by Jetborne of Allen Blattner's indebtedness also includes "subsidiaries". As part of the preliminary settlement reached between BankAtlantic and Jetborne as described above, BankAtlantic released its claims against Aircraft Modular Products, Inc. and its indebtedness is to be satisfied in full under Jetborne's Plan of Reorganization, and BankAtlantic was released by Aircraft Modular Products from any claim. BankAtlantic is also a defendant in various other legal proceedings arising in the ordinary course of its business. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. PART II ITEM 5. ITEM 5. MARKET PRICE OF AND DIVIDENDS ON THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS a) The following table sets forth the high bid and low offer prices on the NASD OTC Bulletin Board of Registrant's common stock for the last three quarters of 1993, as reported to the Registrant by the National Quotation Bureau, and the quarter end market price for the year 1992 and the first quarter of 1993, as reported on the pink sheets. Year: High Low Quarter Market Price Bid Offer ------- ------------ ----- ----- 1992: 1st Quarter .50 2nd Quarter .75 3rd Quarter .75 4th Quarter 2.00 1993: 1st Quarter 2.25 2nd Quarter 3.00 2.25 3rd Quarter 5.00 2.00 4th Quarter 5.00 3.00 b) The approximate number of shareholders of record of common stock as of March 18, 1994 was 1,350. c) No dividends have been paid by Registrant since its inception. There are no restrictions on the payment of dividends by Registrant except that no dividends may be paid to the holders of any equity securities of the Company while any deferred interest on the Company's Exchange debentures remains unpaid. Since December 31, 1991, the Company has deferred the interest payments relating to the debentures issued in both the 1989 Exchange and the 1991 Exchange, amounting to a total of approximately $12.1 million. Additionally, as noted in Part I, Item I under "Business - Regulation - Dividend Restrictions," there are restrictions on the payment of dividends by BankAtlantic. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA ITEM 7. ITEM 7. BFC FINANCIAL CORPORATION'S MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS General - The Company became a savings bank holding company during 1987 by acquiring a controlling interest in BankAtlantic, A Federal Savings Bank ("BankAtlantic"). The Company's ownership interest in BankAtlantic has been recorded by the purchase method of accounting. On November 12, 1993, BankAtlantic closed a public offering of 1.8 million common shares. Of the 1.8 million shares sold, 400,000 shares were sold by BankAtlantic and 1.4 million by the Company. On November 10, 1993, the underwriters exercised the option to purchase 270,000 additional shares of BankAtlantic's common stock. Upon the sale of the 2,070,000 shares of BankAtlantic, the company's ownership of BankAtlantic was reduced to 48.17%. Because of the decrease in ownership, the Company's investment, commencing in 1993 is carried on the equity method rather than consolidated. Therefore, the discussion in management's discussion and analysis of financial condition and results of operations which follows relates to the changes of BFC Financial Corporation and subsidiaries excluding BankAtlantic. The following table presents comparative information for 1992 and 1991 as if BankAtlantic was carried on the equity basis for those periods also. For information relating to changes affecting BankAtlantic for 1993 and 1992, see management's discussion and analysis of financial condition and results of operations of BankAtlantic, A Federal Savings Bank and Subsidiaries, included elsewhere herein. See note 2 of notes to consolidated financial statements for a discussion of the Company's investment in BankAtlantic. 1993 1992 1991 ------------------------------ Interest income: Interest and fees on loans 767 913 1,534 Interest and dividends on tax certificates and other investment securities 299 257 181 ------------------------------ 1,066 1,170 1,715 ------------------------------ Interest expense: Interest on exchange debentures 6,031 5,163 4,199 Interest-other 3,032 4,309 4,828 ------------------------------ 9,063 9,472 9,027 ------------------------------ Net interest (expense) (7,997) (8,302) (7,312) ------------------------------ Non-interest income: Equity in earnings of BankAtlantic before accounting for income taxes and extraordinary items 10,764 12,683 (6,926) Gain on sale of BankAtlantic common stock 1,050 - - Earnings on real estate operations 1,647 3,200 3,326 Other 318 335 441 ------------------------------ 13,779 16,218 (3,159) ------------------------------ Non-interest expense: Employee compensation and benefits 1,453 1,416 2,257 Occupancy and equipment 331 159 213 Provision for litigation 4,034 1,800 - Foreclosed asset activity, net - 67 - Write down of real estate acquired in debenture exchanges - 89 3,353 Other 1,267 1,828 1,415 ------------------------------ 7,085 5,359 7,238 ------------------------------ Income (loss) before cumulative effect of change on accounting for income taxes and extraordinary item (1,303) 2,557 (17,709) Extraordinary item - BankAtlantic - - 350 Cumulative effect of change in accounting for income taxes (501) - - ------------------------------ Net income (loss) (1,804) 2,557 (17,359) ============================== In addition to its investment in BankAtlantic, the Company owns and manages real estate. Since its inception in 1980 and prior to the acquisition of control of BankAtlantic in 1987, the Company's primary business was the organization, sale and management of real estate investment programs. Effective as of December 31, 1987, the Company ceased the organization and sale of new real estate investment programs, but continues to manage the real estate assets owned by its existing programs. At December 31, 1993, subsidiaries of the Company continue to serve as the corporate general partners of 4 public limited partnerships which file periodic reports with the Securities and Exchange Commission under the Securities Exchange Act of 1934, as amended. Subsidiaries of the Company also serve as corporate general partners of a number of private limited partnerships formed in prior years. In March 1989, the Company acquired all of the assets and liabilities of three affiliated public limited partnerships, I.R.E. Real Estate Fund, Ltd. - Series 21, I.R.E. Real Estate Fund, Ltd. - Series 23 and I.R.E. Real Estate Fund, Ltd. - Series 24 in exchange for approximately $30,000,000 in subordinated unsecured debentures which mature in 2009 (the "1989 Exchange"). In connection with the transaction, the Company acquired 14 real properties, 3 of which are still owned by the Company. In February 1991, the Company acquired all of the assets and liabilities of two affiliated public limited partnerships, I.R.E. Real Estate Fund, Ltd. - Series 25 and I.R.E. Real Estate Fund, Ltd. - Series 27 in exchange for approximately $9,308,000 in subordinated unsecured debentures which mature in 2011 (the "1991 Exchange"). In June 1991, the Company acquired all of the assets and liabilities of an affiliated public limited partnership, I.R.E. Real Estate Income Fund, Ltd., in exchange for approximately $6,057,000 in subordinated unsecured debentures that mature in 2011. In connection with these transactions, the Company acquired 8 real properties, 4 of which are still owned by the Company. The Company is actively seeking buyers for the properties held by it with a view to selling the properties and reducing mortgage indebtedness. See note 2 of notes to consolidated financial statements for more information on these transactions. Litigation has been brought against the Company relating to both the 1989 and 1991 Exchange transactions. In December 1992, a jury returned a verdict in favor of the plaintiffs for approximately $8 million but extinguished approximately $16 million of subordinated debt. In March 1994, the Company entered into an agreement to settle litigation relating to the 1991 exchange transaction. See "Legal Proceedings". Net loss amounted to approximately $1.8 million in 1993 and net earnings amounted to approximately $2.6 million in 1992 as compared to a net loss of approximately $17.4 million in 1991. A major component in each of the above amounts related to the Company's ownership position in BankAtlantic. Operations for 1993 included a charge aggregating $501,000 from the cumulative effect of a change in accounting for income taxes. Operations for 1991 include extraordinary gain of $350,000 (the 1991 extraordinary gain of $350,000 related to BankAtlantic). During 1993 and 1992, the Company recorded net earnings from BankAtlantic of approximately $10.8 and 12.7 million and during 1991 the Company recorded a net loss from BankAtlantic of approximately $6,576,000 after the extraordinary item. Exclusive of the Company's ownership of BankAtlantic, the Company and its other subsidiaries generated net losses in 1993, 1992 and 1991 of $12.6 million. $10.1 million, and $10.8 million, respectively. Approximately $6,031,000, $5,163,000, and $4,199,000 of 1993, 1992 and 1991 operations related to interest expense on the debentures issued in the Exchange transactions described above. Approximately $4.0 million of 1993 operations related to a provision for the Short litigation and approximately $1.8 million of 1992 operations related to a provision arising from an appellate court decision in connection with the Hess litigation. (See Item 3. "Legal Proceedings.") Approximately $3,353,000 of 1991 operations resulted from the write-down of real estate owned, of which $2,882,000 related to properties acquired in the 1989 Exchange and $471,000 related to an apartment complex acquired in October 1990 through foreclosure. In addition to its investment in BankAtlantic, the Company's other primary sources of revenues are from the net interest earnings on its mortgage note receivables, fees received for property management services rendered to affiliated public limited partnerships and operation of the properties acquired in the 1989 and 1991 Exchange transactions. Results of Operations - The Company reported a net loss of approximately $1.8 million for the year ended December 31, 1993, as compared to net earnings of $2.6 million for the year ended December 31, 1992 and a net loss of $17.4 million for the year ended December 31, 1991. The 1993 net loss included a $501,000 charge due to the cumulative effect of a change in accounting for income taxes. (See note 18 of notes to consolidated financial statements.) Operations for the fourth quarter and year 1993 included the gain on the sale of 1.4 million shares of BankAtlantic common stock as discussed further in note 2 of notes to consolidated financial statements. The 1992 net income included a $548,000 net extraordinary gain during the fourth quarter, net of minority interest of $208,000, for the utilization of state net operating loss carryforwards from BankAtlantic. Net Interest Expense - BFC net interest expense decreased by $305,000 for the year ended December 31, 1993 as compared with the same period in 1992 primarily due to a decrease in interest expense, partially offset with by decrease in interest income. The decrease in interest expense for the year ended December 31, 1993 as compared to the same period in 1992 was primarily due to a reduction in interest expense - other. This decrease was offset with an increase in interest payable on the Exchange debentures. Other interest expense decreased for the year ended December 31, 1993 as compared to the 1992 and 1991 periods primarily due to the elimination of mortgage debt principally related to the sale of two properties acquired in the 1991 Exchange, the foreclosure of one property during the first quarter of 1993, acquired in the 1989 Exchange and other reductions in borrowing. Interest on the Exchange debentures increased for the year ended December 31, 1993 as compared to the same period in 1992 due to the accrual of interest on the previously deferred interest relating to the debentures issued in both 1989 and 1991 exchange transactions. Interest on Exchange debentures for 1992 increased as compared to 1991 because 1992 reflects a full year of interest on both the 1989 and 1991 Exchange debentures as compared to 1991 which includes only ten months relating to the February 1991 Exchange transaction and six months relating to the June 1991 Exchange transaction. Non-Interest Income - Non-interest income decreased approximately $2.4 million for the year ended December 31, 1993 as compared to 1992 primarily due to the decline in equity in earnings of BankAtlantic of approximately $1.9 million caused by BFC's decreased ownership of BankAtlantic resulting from the November 1993 sale of 1,400,000 shares of BankAtlantic common stock, a decline in earnings from real estate operations and a decline in non-interest income, other. Partially offsetting these declines was a gain of $1.1 million relating to the sale of BankAtlantic common stock. On November 12, 1993, BankAtlantic closed a public offering of 1.8 million common shares at a price of $13.50 per common share. Of the 1.8 million shares sold, 400,000 shares were sold by BankAtlantic and 1.4 million were sold by BFC. Net proceeds to BFC from the sale on the 1.4 million shares was approximately $17.7 million and a net cost of approximately $16.6 million, including purchase accounting of $1.4 million, was recorded on the sale of BankAtlantic common stock, resulting in a net gain of approximately $1.1 million on the sale. In connection with the public offering, BankAtlantic granted the underwriters a 30 day option to purchase up to 270,000 additional shares of common stock to cover over - allotments. On November 10, 1993, the underwriters exercised this option to purchase the 270,000 shares. Upon the sale of 2,070,000 shares, BFC's ownership of BankAtlantic decreased from 77.83% to 48.17%. The decrease of BFC's ownership in BankAtlantic investment in common stock resulted in the deconsolidation of the Company's assets and business operations for the year 1993 and the $10.8 million in equity in earnings of BankAtlantic was separately accounted for in the consolidated financial statements for the year ended December 31, 1993. Earnings on Real Estate Operations - Earnings on real estate operations include earnings from the 1989 and 1991 Exchange properties and BFC deferred profit recognition on sales of real estate by the Company and its subsidiaries other than BankAtlantic (excluding the 1989 and 1991 Exchange properties). Earnings on real estate operations for the years ended December 31, 1993, 1992, and 1991 amounted to $1.6 million, $3.2 million, and $3.3 million, respectively. The decrease in earnings on real estate operations for the year ended December 31, 1993 as compared to the same periods in 1992 and 1991 was primarily due to the disposal of properties acquired in the 1991 Exchange transaction and an increase in legal fees associated with litigation relating to the Exchanges. Non-Interest Income-Other - The decrease of non-interest income, other for the year ended December 31, 1992 as compared to the same period in 1991 was primarily due to reduction of property management fee income due to the sale of properties acquired in the 1989 and 1991 Exchanges. Non-Interest Expense -The increase in non-interest expense for the year ended December 31, 1993 as compared to the same period in 1992 was primarily due to an increase in the provision for litigation and an increase in occupancy and equipment expense. This increase was offset with a decrease in other non- interest expense. Provision for Litigation - The 1993 provision for litigation was due to a $4.0 million provision in connection with the court decision in the Short vs. Eden United, Inc. litigation and the $1.8 million 1992 provision was attributable to an appellate court decision in the Hess litigation. (See Item 3, "Legal Proceedings".) Occupancy and Equipment - Occupancy and equipment expense increased in 1993 compared to 1992 primarily due to the accrual of expenses in connection with the relocation of the Company's offices. Non-interest expense, other decreased primarily due to a loss in 1992 relating to the pay-off of a mortgage receivable at a discount, the write down in 1992 of a mortgage receivable, the write-off of some receivables from affiliated partnerships and legal fees incurred in 1992 in connection with the Exchange litigation. Financial Condition - BFC's total assets at December 31, 1993, and at December 31, 1992, were $87.5 million and $1.3 billion, respectively. The majority of the difference at December 31, 1993 as compared to December 31, 1992 is due to the deconsolidation in 1993 of BankAtlantic. The decrease of $2.0 million and $1.8 million in real estate acquired in the 1989 and 1991 Exchange transactions and mortgage payables and other borrowings, respectively, was attributable to the sale of properties acquired in the 1991 Exchange and the foreclosure of a property acquired in the 1989 Exchange. Purchase Accounting - The acquisition of BankAtlantic has been accounted for as a purchase and accordingly, the assets and liabilities acquired have been revalued to reflect market values at the dates of acquisition. The discounts and premiums arising as a result of such revaluation are generally being accreted or amortized (i.e. added into income or deducted from income), net of tax, using the level yield or interest method over the remaining life of the assets and liabilities. The net impact of such accretion, amortization and other purchase accounting adjustments for 1993 was to decrease net loss by approximately $191,000, increase net earnings during 1992 by approximately $807,000, and increase net loss during 1991 by approximately $792,000. Liquidity and Capital Resources - In connection with certain litigation related to the 1989 Exchange transaction (See Item 3. "Litigation", Timothy J. Chelling vs. BFC Financial Corporation, et.al.), in December 1992, a jury found that BFC Financial Corporation's issuance of debentures was unfair to investors. The jury found that those limited partners who did not vote in favor of the transaction are entitled to receive $8 million, rather than the approximately $16 million of subordinated debentures which were issued to them as a consequence of the Exchange. Based on the verdict, the Company would record a pre-tax gain from the reduction of its debt of approximately $6 million, but it nonetheless believes the verdict was not supported by the evidence at trial. Accordingly, the Company intends to appeal the verdict and the gain is not reflected in the financial statements. The court denied plaintiffs' motion for prejudgment interest as to Series 21 and Series 23 and awarded prejudgment interest to plaintiffs in Series 24 to be calculated to run from March 31, 1989 through December 18, 1992, the date of entry of final judgment, at the rate of 3.54%. In connection with the stay of the judgment without a bond and to secure the final judgment during the pendency of the appeal, BFC agreed to place shares of the BankAtlantic Common Stock owned by it into an escrow or collateral account for the benefit of the plaintiffs. Initially 800,000 shares have been delivered pursuant to the agreement but additional shares will be delivered in the event that the market value of the 800,000 shares delivered falls below $10 million. In connection with the litigation related to the purchase and sale of an apartment complex in Indiana (See item 3. "Litigation ", Short vs Eden United, Inc., et.al.), on February 25, 1994, the court on remand awarded plaintiff a judgment totaling approximately $4.5 million, including interest. The Company intends to appeal the trial court's order and may have to post a bond during the appeal process. The Company had accrued approximately $400,000 in prior years and based upon this order, at December 31, 1993, accrues an additional $4.1 million bringing to a total of $4.5 million the provision for this litigation in the financial statements. In connection with other litigation against the Company relating to the 1991 Exchange transaction (See item 3. "Litigation ", Arthur Arrighi, et.al. and Shirley B. Daniels, Robert and Ruby Avans, et.al.), on March 2, 1994, the parties entered into an agreement to settle these actions pursuant to which BFC will pay approximately eighty-one percent (81%) of the face amount of the outstanding debentures held by plaintiffs and the debentures will be canceled pursuant to the procedures outlined in the agreement. The settlement is subject to, among other things, court approval. Upon effectiveness, the settlement of this action will be dismissed with prejudice and the parties will exchange releases. On November 12, 1993, a public offering of 1.8 million BankAtlantic common shares at a price of $13.50 per common share was closed. Of the 1.8 million shares sold, 400,000 shares were sold by BankAtlantic and 1.4 million shares were sold by BFC. Net proceeds to BFC and BankAtlantic from the sale was approximately $17.7 million and $4.6 million, respectively. In connection with the public offering, BankAtlantic granted the underwriters a 30 day option to purchase up to 270,000 additional shares of common stock to cover over-allotments. On November 10, 1993, the underwriters exercised this option to purchase the 270,000 shares, with a settlement date of November 18, 1993. The additional net proceeds to BankAtlantic will be approximately $3.4 million. Upon the sale of the 2,070,000 shares, BFC's ownership of BankAtlantic decreased from 77.83% to 48.17%. Proceeds from such sales will be utilized to fund the Exchange II settlements. The Company, during March 1993 placed $12.5 million in an escrow account to fund the settlement. In addition to the litigation discussed above, an appellate court has entered an order reversing a lower court decision in favor of the Company and its affiliates which related to the sale of units in two partnerships which participated in the 1991 Exchange transaction. (See Item 3. "Litigation", Martha Hess, et.al. vs Gordon, Boula, et.al.) The effect of this decision, which the Company intends to appeal, is to create a potential liability of approximately $1.8 million. Such amount was accrued at December 31, 1992. There is no requirement for a bond in connection with the appeal of this matter. The Company's ability to meet its obligations and to pay interest on its Exchange debentures is substantially dependent on the earnings and regulatory capital position of BankAtlantic. However, pursuant to the terms of the debentures issued in the 1989 and 1991 Exchange transactions, the Company may elect to defer interest payments on its subordinated debentures if management of the Company determines in its discretion that the payment of interest would impair the operations of the Company. Such deferral does not create a default. Since December 31, 1991, the Company has deferred interest payments amounting to approximately $12 million. The Company, not considering BankAtlantic, has sufficient current liquidity to meet its normal operating expenses, but it is not anticipated that it will make current payments of interest on the Exchange debentures until at least such time as the issues relating to the $8 million judgment discussed above and the other litigation discussed in Item 3. "Litigation" have been resolved. Pursuant to an agreement entered into on May 10, 1989 between BFC, its affiliates and BankAtlantic's primary regulator, BFC is obligated to infuse additional capital into BankAtlantic in the event that BankAtlantic's net capital (as defined) falls below the lesser of the industry's minimum capital requirement (as defined) or six percent of BankAtlantic's assets. However, there is no assurance that BFC will be in a position to infuse additional capital in the event it is called upon to do so. This obligation will expire ten years from the date of the agreement, or at such earlier time as BankAtlantic's net capital exceeds its fully phased-in capital requirement (as defined) for a period of two consecutive years. BankAtlantic's net capital exceeded its fully phased in capital requirement at December 31, 1993. Effective June 30, 1993, the Company exercised its warrants which were held to purchase 1,126,327 shares of BankAtlantic's common stock by tendering approximately $2.0 million of BankAtlantic subordinated debentures, including accrued interest. The purchase increased BFC's ownership percentage of BankAtlantic's common stock to 77.83%. On November 1993, BFC decreased its ownership percentage of BankAtlantic's common stock to 48.17% primarily due to the sale of 1.4 million shares of BankAtlantic common stock. An OTS regulation, effective August 1, 1990, limits all capital distributions made by savings institutions, including cash dividends, by permitting only certain institutions that meet specified capital levels to make capital distributions without prior OTS approval. The regulation established a three- tiered system, with the greatest flexibility afforded to well-capitalized institutions. An institution that meets all of its fully phased-in capital requirements and is not in need of more than normal supervision would be a "Tier 1 Institution". An institution that meets its minimum regulatory capital requirements but does not meet its fully phased-in capital requirements would be a "Tier 2 Institution". An institution that does not meet all of its minimum regulatory capital requirements would be "Tier 3 Institution". A Tier 1 Institution may, after prior notice but without the approval of the OTS, make capital distributions during a calendar year up to 100% of net income earned to date during the current calendar year plus 50% of its capital surplus ("surplus" being the amount of capital over its fully phased-in capital requirement). Any additional capital distributions would require prior regulatory approval. A Tier 2 Institution may, after prior notice but without the approval of the OTS, make capital distributions of between 50% and 75% of its net income over the most recent four-quarter period (less any dividends previously paid during such four-quarter period) depending on how close the institution is to its fully phased-in risk-based capital requirement. A Tier 3 Institution would not be authorized to make any capital distributions without the prior approval of the OTS. Notwithstanding the provision described above, the OTS also reserves the right to object to the payment of a dividend on safety and soundness grounds. In August and December 1993, BankAtlantic declared cash dividends of $0.06 per share, payable September 1993 and January 1994, respectively, to its common stockholders. A 15% common stock dividend was declared in May, 1993. In March 1994, the Board of Directors declared a cash dividend of $0.06 per share, payable in April 1994 to its common stockholders. BankAtlantic presently meets all required and fully phased-in capital requirements and has had operating income in the prior eight quarters. BankAtlantic has indicated that it expects to continue dividend payments on its non-cumulative preferred stock. Future cash dividends on common and preferred stock will be subject to declaration by BankAtlantic's Board of Directors, in its discretion, to additional regulatory notice or approval, and continued compliance with capital requirements. See note 29 of the Notes to the Consolidated Financial Statements. Cash Flows - A summary of the Company's consolidated cash flows follows (in thousands): December 31, --------------------------------------- 1993 1992 1991 ---- ---- ---- Net cash provided (used) by: Operating activities $ (523) 17,638 23,415 Investing activities 1,384 139,627 405,103 Financing activities (932) (164,465) (435,814) ------- ------- ------- Decrease in cash and due from depository institutions $ (71) (7,200) (7,296) ======= ======= ======= The changes in cash flow used or provided in operating activities are affected by the changes in operations, which are discussed elsewhere herein, and by certain other adjustments. These adjustments include additions to operating cash flows for non-operating charges such as depreciation and the provision for loan losses and write downs of assets. Cash flow of operating activities is also adjusted to reflect the use or the providing of cash for increases and decreases respectively, in operating assets and decreases or increases, respectively, of operating liabilities. Accordingly, the changes in cash flow of operating activities in the periods indicated above has been impacted not only by the changes in operations during the periods but also by these other adjustments. The primary sources of funds to the Company for the year ended December 31, 1993 was the proceeds received of approximately $17.7 million from the sale of BankAtlantic's common stock, revenues from property operations, collections on mortgage receivables and the dividend from BankAtlantic. These funds, excluding the proceeds from the sale of BankAtlantic common stock, were primarily utilized for operating expenses at the properties, capital improvements at the properties, mortgage payables on the properties and general and administrative expenses. The proceeds from the sale of BankAtlantic common stock will be utilized to fund the Exchange II settlements. Investing activities for the years ended December 31, 1993 included proceeds from the sale of BankAtlantic common stock of approximately $17.7 million and December 31, 1992, and 1991, included proceeds from the sale of real estate acquired in the 1991 and 1989 Exchange transactions of $5.6 million, and $7.6 million, respectively. The other major portions of the cash flows indicated above for financing and investing activities relate to BankAtlantic for the year ended December 31, 1992 and 1991. Impact of Inflation - The financial statements and related financial data and notes presented herein have been prepared in accordance with GAAP, which require the measurement of financial position and operating results in terms of historical dollars, without considering changes in the relative purchasing power of money over time due to inflation. Virtually all of the assets and liabilities of BankAtlantic are monetary in nature. As a result, interest rates have a more significant impact on BankAtlantic's performance than the effects of general price levels. Although interest rates generally move in the same direction as inflation, the magnitude of such changes varies. The possible effect of fluctuating interest rates is discussed more fully under BankAtlantic's section of managements discussion and analysis of financial condition and results of operations entitled "Interest Rate Sensitivity". BFC does not believe that inflation has had any material impact on the Company, however, economic conditions generally have had an adverse effect on the values and operations of its real estate assets. ITEM 8. ITEM 8. INDEX TO FINANCIAL STATEMENTS Independent Auditors' Report Financial Statements: Consolidated Statements of Financial Condition - December 31, 1993 and Consolidated Statements of Operations - For each of the Years in the Three Year Period ended December 31, 1993 Consolidated Statements of Stockholders' Equity (Deficit) - For each of the Years in the Three Year Period ended December 31, 1993 Consolidated Statements of Cash Flows - For each of the Years in the Three Year Period ended December 31, 1993 Notes to Consolidated Financial Statements Independent Auditors' Report The Board of Directors BFC Financial Corporation: We have audited the accompanying consolidated statements of financial condition of BFC Financial Corporation and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, stockholders equity (deficit) and cash flows for each of the years in the three year period ended December 31, 1993. These consolidated 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 BFC Financial Corporation and subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed in note 25 to the consolidated financial statements, BFC Financial Corporation is a defendant in various lawsuits, the ultimate outcome of which cannot be presently determined. The consolidated financial statements do not include any adjustments that might result from these uncertainties. As discussed in notes 1 and 2 to the consolidated financial statements, in 1993, BFC Financial Corporation sold certain of its investment in the outstanding common stock of BankAtlantic, A Federal Savings Bank ("the Bank") and, as a result, no longer controlled a majority voting interest in the Bank as of December 31, 1993. As a result, the Company utilized the equity method of accounting for its investment in the Bank in 1993 and accordingly, financial position, results of operations and cash flows were not consolidated as in 1992 and 1991. As discussed in note 18 to the consolidated financial statements, the Company changed its method of accounting for income taxes in 1993 to adopt the provisions of the Financial Accounting Standards Board's SFAS No. 109, "Accounting for Income Taxes". KPMG PEAT MARWICK Fort Lauderdale, Florida March 30, 1994 BFC FINANCIAL CORPORATION Consolidated Statements of Financial Condition December 31, 1993 and December 31, 1992 (in thousands, except share data) ASSETS --------- 1993 1992 --------- --------- Cash and due from depository institutions $ 78 31,357 Tax certificates and other investment securities, net (at cost which approximates market value) 20,644 125,047 Investment in BankAtlantic, a Federal Savings Bank 36,436 - Loans receivable (net of unearned discount of $1,733 in 1992) 9,179 574,882 Loans originated for resale - 7,641 Less: allowance for loan losses - (16,500) ---------- ---------- Total loans receivable, net 9,179 566,023 ---------- ---------- Mortgage-backed securities (approximate market value $353,984 in 1992) - 349,531 Mortgage-backed securities available for sale (approximate market value of $145,011 in 1992) - 137,355 Accrued interest receivable 8 22,196 Real estate owned - 14,997 Real estate acquired in debenture exchange, net 18,315 20,330 Office properties and equipment, net 28 36,032 Federal Home Loan Bank stock at cost, which approximates market value ($924 in 1992 available for sale) - 8,366 Investment in and advances to joint ventures - 1,217 Excess cost over fair value of net assets acquired, net - 1,925 Dealer reserves, net - 4,533 Other assets 2,807 21,556 ---------- ---------- Total assets $ 87,495 1,340,465 ========== ========== (Continued) LIABILITIES AND STOCKHOLDERS' DEFICIT --------------------------------------------------- 1993 1992 --------- --------- Deposits $ - 1,108,115 Advances from Federal Home Loan Bank - 66,100 Securities sold under agreements to repurchase - 21,532 Capital notes and other subordinated debentures - 7,928 Exchange debentures, net 35,651 38,996 Mortgages payable and other borrowings 30,367 32,168 Drafts payable - 1,246 Advances by borrowers for taxes and insurance - 9,193 Deferred interest on the exchange debentures 12,049 6,126 Other liabilities 8,602 22,527 Deferred income taxes 2,038 2,380 ---------- ---------- Total liabilities 88,707 1,316,311 Commitments and contingencies Minority interest - 16,258 Preferred stock of BankAtlantic - 7,036 Redeemable common stock (353,478 shares) (redemption amount $299 in 1993 and $655 in 1992) 5,776 5,776 Stockholders' deficit: Preferred stock of $.01 par value; authorized 10,000,000 shares; none issued - - Special class A common stock of $.01 par value; authorized 20,000,000 shares; none issued - - Common stock of $.01 par value; authorized 20,000,000 shares; issued 2,351,021 in 1993 and 1992 17 17 Additional paid-in capital 15,264 15,532 Accumulated deficit (21,989) (20,185) Less: treasury stock (45,339 shares for 1993 and 1992) (280) (280) ---------- ---------- Total stockholders' deficit (6,988) (4,916) ---------- ---------- Total liabilities and stockholders' deficit $ 87,495 1,340,465 ========== ========== See accompanying notes to consolidated financial statements. BFC FINANCIAL CORPORATION AND SUBSIDIARIES Consolidated Statement of Operations For each of the years in the three year period ended December 31, 1993 (in thousands, except per share data) 1993 1992 1991 --------- --------- --------- Interest income: Interest and fees on loans $ 767 63,181 91,200 Interest on mortgage-backed securities - 37,170 35,173 Interest on mortgage-backed securities available for sale - 642 1,172 Interest and dividends on tax certificates and other investment securities 299 17,320 20,518 ---------- ---------- ---------- Total interest income 1,066 118,313 148,063 ---------- ---------- ---------- Interest expense: Interest on deposits - 47,393 83,227 Interest on advances from FHLB - 3,697 3,587 Interest on securities sold under agreements to repurchase - 2,881 1,671 Interest on capital notes and other subordinated debentures - 1,440 2,020 Interest on exchange debentures 6,031 5,163 4,199 Interest - other 3,032 4,309 5,240 ---------- ---------- ---------- Total interest expense 9,063 64,883 99,944 ---------- ---------- ---------- Net interest income (expense) (7,997) 53,430 48,119 Provision for loan losses - 6,650 17,540 ---------- ---------- ---------- Net interest income (expense) after provision for loan losses (7,997) 46,780 30,579 ---------- ---------- ---------- Non-interest income: Loan servicing and other loan fees - 3,189 4,344 Gain on sales of loans - 976 330 Gain on sales of mortgage-backed securities - 8,116 748 Gain on sales of investment securities - 143 85 Equity in earnings of BankAtlantic 10,764 - - Gain on sale of BankAtlantic common stock 1,050 Earnings on real estate operations 1,647 3,200 3,384 Non interest income - other 318 7,672 9,063 ---------- ---------- ---------- Total non-interest income 13,779 23,296 17,954 ---------- ---------- ---------- (Continued) Non-interest expenses: Employee compensation and benefits 1,453 20,618 26,319 Occupancy and equipment 331 8,747 10,629 Federal insurance premium - 2,772 3,281 Advertising and promotion - 480 1,143 (Income) loss from joint venture investments - 245 (2,335) Foreclosed asset activity, net - 4,390 9,451 Write-down of real estate acquired in debenture exchanges - 89 2,882 (Recovery) write-down of dealer reserve - (2,739) 2,739 Provision for branch consolidation - 2,085 Provision for litigation 4,034 1,800 - Minority interest in BankAtlantic - 3,964 (2,977) Non interest expenses - other 1,267 18,500 17,901 ---------- ---------- ---------- Total non-interest expenses 7,085 58,866 71,118 ---------- ---------- ---------- Income (loss) before cumulative effect of change in accounting for income taxes, income taxes and extraordinary items (1,303) 11,210 (22,585) Provision (benefit) for income taxes - 9,201 (4,876) ---------- ---------- ---------- Income (loss) before cumulative effect of change in accounting for income taxes and extraordinary items (1,303) 2,009 (17,709) Cumulative effect of change in accounting for income taxes (501) - - Extraordinary items: Gain on early retirement of capital notes net of applicable income taxes of $340 and minority interest of $197 - - 350 Utilization of state net operating loss carryforwards, net of minority interest of $208,000 - 548 - ---------- ---------- ---------- Net income (loss) $ (1,804) 2,557 (17,359) ========== ========== ========== Earnings (loss) per share: Net earnings (loss) before cumulative effect of change in accounting for income taxes and extraordinary items $ (1.18) 0.78 (10.71) Cumulative effect of change in accounting for income taxes (0.29) - - Extraordinary items - 0.32 .20 ---------- ---------- ---------- Net earnings (loss) per share $ (1.47) 1.10 (10.51) ========== ========== ========== Weighted average number of shares outstanding 1,702 1,702 1,718 ========== ========== ========== See accompanying notes to consolidated financial statements. BFC FINANCIAL CORPORATION Consolidated Statements of Stockholders' Equity (Deficit) For each of the years in the three year period ended December 31, 1993 (in thousands, except share data) Addi- tional Accu- Trea- Common Paid-in mulated sury Stock Capital Deficit Stock Total -------- -------- -------- -------- -------- Balance at December 31, 1990 18 15,584 (5,383) (280) 9,939 Purchase of treasury stock - - - (53) (53) Retirement of treasury stock (1) (52) - 53 - Net (loss) - - (17,359) - (17,359) -------- -------- -------- -------- -------- Balance at December 31, 1991 17 15,532 (22,742) (280) (7,473) Net income - - 2,557 - 2,557 -------- -------- -------- -------- -------- Balance at December 31, 1992 17 15,532 (20,185) (280) (4,916) Effect of issuance of BankAtlantic's common stock to BankAtlantic minority shareholders - (268) - - (268) Net (loss) - - (1,804) - (1,804) -------- -------- -------- -------- -------- Balance at December 31, 1993 17 15,264 (21,989) (280) (6,988) ======== ======== ======== ======== ======== See accompanying notes to consolidated financial statements. Consolidated Statements of Cash Flows For each of the years in the three year period ended December 31, 1993 (In thousands) 1993 1992 1991 --------- --------- --------- Operating activities: Income (loss) before extraordinary items and cumulative effect of change in accounting for income taxes $ (1,303) 2,009 (17,709) Adjustments to reconcile income (loss) before extraordinary items and cumulative effect of change in accounting for income taxes to net cash provided (used) by operating activities: Equity in earnings of BankAtlantic (10,764) - - Provision for loan losses - 6,650 17,540 Provision for declines in real estate owned - 3,916 10,626 FHLB stock dividends - (498) (618) Depreciation 1,658 4,998 4,920 Amortization of purchased servicing rights - 2,573 1,274 Increase (decrease) in deferred income taxes - 1,775 (4,480) Utilization of net operating loss carryforwards before minority interest - 756 - Net accretion of securities - (456) (243) Net amortization of deferred loan origination fees - (41) (40) Accretion on exchange debentures and mortgage payables 285 505 783 Tax effect of real estate acquired in debenture exchange (92) (136) (189) Amortization of discount on loans receivable (70) (107) (321) Loss (gain) on sales of real estate owned - (602) 59 Proceeds from loans originated for sale - 37,030 15,279 Origination of loans for sale - (39,888) (18,756) Write-off of office properties and equipment - 600 461 Loss of mortgage receivables - 408 17 Gain on sales of loans - (976) (330) Gain on sales of mortgage-backed securities available for sale - (8,116) (748) Gain on sale of BankAtlantic common stock (1,050) - - Gain on sales of investment securities - (143) (85) Loss (gain) on sales of office properties and equipment - 71 (7) Loss (income) from joint venture operations - 245 (2,335) Decrease in drafts payable - (9,410) (1,403) Decrease in accrued interest receivable - 2,257 4,615 Increase in exchange debentures deferred interest 5,923 4,985 1,140 Increase (decrease) in other liabilities 354 (1,444) 4,163 Decrease (increase) in other assets 502 (4,236) 3,522 Minority interest of BankAtlantic - 3,964 (2,977) (Continued) 1993 1992 1991 --------- --------- --------- Purchase accounting adjustments: Amortization of excess cost over fair value of net assets acquired - 320 238 Amortization of intangible assets - - 296 Amortization (accretion) of purchase accounting adjustments, net - 1,263 (986) Amortization of dealer reserve - 6,406 5,491 Write-down of dealer reserve - - 2,739 Prepayments of dealer reserve - - (1,417) Provision for tax certificates losses - 1,160 811 Provision for branch consolidation - - 2,085 Provision for litigation 4,034 1,800 - ---------- ---------- ---------- Net cash (used) provided by operating activities $ (523) 17,638 23,415 ---------- ---------- ---------- Investing activities: Cash received in debenture exchange $ - - 4,613 Sales of real estate acquired in debenture exchanges - 5,563 7,598 Proceeds from the sale of BankAtlantic common stock 17,691 - - Increase in BankAtlantic investment in common stock (1,971) - - Dividends received from BankAtlantic investment in common stock 271 - - Proceeds from sales of investment securities - 2,137 30,235 Purchase of tax certificates and other investment securities (14,245) (129,415) (123,451) Proceeds from redemption and maturities of tax certificates and other investment securities - 111,070 118,447 Loan sales - - - Loans purchased - - (2,182) Principal reduction on loans 252 299,347 298,462 Loans originated - (136,179) (122,511) Proceeds from sales of mortgage-backed securities available for sale - 155,243 70,903 Mortgage-backed securities purchased - (271,041) (98,587) Principal collected on mortgage-backed securities - 95,266 56,634 Proceeds from sales of real estate owned - 12,589 2,937 Purchases and additional investments in real estate owned - - (1,374) Additions to office properties and equipment (32) (748) (1,037) Sales of office equipment - 105 525 Advances to joint ventures - (26) (2,690) Repayments of advances to joint ventures - 77 12,929 Investments in joint ventures - - (115) Cash distributions from joint ventures - - 561 FHLB stock sales - 142 3,071 FHLB stock purchased - (65) - Improvements to real estate acquired in debenture exchanges (582) (606) (1,094) (Continued) 1993 1992 1991 --------- --------- --------- Servicing rights purchased - (3,832) (3,457) Settlement of amount due from broker - - 154,686 ---------- ---------- ---------- Net cash provided by investing activities $ 1,384 139,627 405,103 ---------- ---------- ---------- Financing activities: Net decrease in deposits $ - (190,907) (272,307) Interest credited to deposits - 43,509 71,853 Proceeds from FHLB advances - 107,300 - Repayments of FHLB advances - (78,400) (25,700) Net decrease in securities sold under agreement to repurchase - (35,600) (189,847) Preferred stock issuance costs - - (353) Payment for exchange of capital notes for preferred stock - - (1,855) Redemption of capital notes - (7,022) (338) Receipts of advances by borrowers for taxes and insurance, net - 33,933 34,794 Payment for advances by borrowers for taxes and insurance - (33,220) (32,678) Increase (decrease) in federal funds purchased - - (14,500) Increase in borrowings - - 1,722 Repayments of borrowings (932) (4,058) (6,408) Purchase of treasury stock - - (53) Proceeds from the issuance of subordinated debt - - 8 Loan cost - - (160) Common stock and warrants purchased by minority shareholders of BankAtlantic - - 8 ---------- ---------- ---------- Net cash (used) by financing activities (932) (164,465) (435,814) ---------- ---------- ---------- Decrease in cash and cash equivalents (71) (7,200) (7,296) Cash and due from depository institutions at beginning of period 149 38,557 45,853 ---------- ---------- ---------- Cash and due from depository institution at end of period $ 78 31,357 38,557 ========== ========== ========== See accompanying notes to consolidated financial statements. Notes to Consolidated Financial Statements For the years ended December 31, 1993, 1992 and 1991 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Financial Statement Presentation - The financial statements have been prepared in conformity with generally accepted accounting principles ("GAAP"). In preparing the financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the statements of consolidated financial condition and income and expenses for the periods presented. Actual results could differ significantly from those estimates. Material estimates that are particularly susceptible to significant change in the next year relate to the determination of the allowance for real estate acquired in connection with the Exchange transactions and in satisfaction of loans. In connection with the determination of the allowance for loan losses and real estate owned, management obtains independent appraisals for significant properties, when it is deemed prudent. Where applicable, reference is made to the financial statements and notes to consolidated financial statements of BankAtlantic, A Federal Savings Bank and Subsidiaries, included elsewhere herein. Differences in amounts between those financial statements and these financial statements would primarily pertain to amounts related to BFC Financial Corporation or purchase accounting adjustments discussed in note 2 of the notes to consolidated financial statements of BFC Financial Corporation and Subsidiaries. Principles of Consolidation - BFC Financial Corporation ("BFC" or "the Company") is a savings and loan holding company as a consequence of its ownership of the common stock of BankAtlantic, A Federal Savings Bank ("BankAtlantic"). The consolidated financial statements for the year 1993 include the accounts of BFC Financial Corporation, and its wholly-owned subsidiaries. Because the Company's ownership interest in BankAtlantic was reduced below 50% in 1993, BankAtlantic is not consolidated but is carried on the equity method for 1993. The consolidated financial statements for the years 1992 and 1991 include the accounts of BFC Financial Corporation, its majority-owned subsidiary, BankAtlantic, and its wholly owned subsidiaries. The 1993 operations includes the equity in earnings from BankAtlantic. For 1992 and 1991, the adjustments to operations relating to changes in the Company's percentage ownership of BankAtlantic are reflected in minority interest. All significant intercompany accounts and transactions have been eliminated in consolidation. Cash Equivalents - Cash and due from banks include demand deposits at other financial institutions. Tax Certificates and Other Investment Securities and Mortgage-Backed Securities - In 1992 and 1991, substantially all of these securities are owned by BankAtlantic. Tax certificates, other investment securities and mortgage-backed securities held for investment are carried at cost. Real Estate Owned - Real estate acquired in the Exchange transactions discussed in note 2 is stated at the lower of cost or net realizable value in the accompanying statements of financial condition. Profit on real estate sold is recognized when the collectibility of the sales price is reasonably assured and BankAtlantic is not obligated to perform significant activities after the sale. Any estimated loss is recognized in the period in which it becomes apparent. Office Properties and Equipment - Land is carried at cost. Office properties and equipment are carried at cost less accumulated depreciation. Depreciation is computed on the straight-line method over the estimated useful lives of the assets which generally range up to 50 years for buildings and 10 years for equipment. The cost of leasehold improvements is being amortized using the straight-line method over the terms of the related leases. Expenditures for new properties and equipment and major renewals and betterments are capitalized. Expenditures for maintenance and repairs are charged to expense as incurred and gains or losses on disposal of assets are reflected in current operations. Income Taxes - The Company does not include BankAtlantic and its subsidiaries in its consolidated income tax return with its wholly-owned subsidiaries, since the Company owns less than 80% of the outstanding stock of BankAtlantic. Income taxes are provided on the Company's interest in the portion of the BankAtlantic's earnings not subject to the 80% dividends received exclusion. Deferred income taxes are provided on elements of income that are recognized for financial accounting purposes in periods different than such items are recognized for income tax purposes. In February 1992, the Financial Accounting Standard Board ("FASB") issued Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("FAS 109"). FAS 109 requires a change from the deferred method to the asset and liability method to account for income taxes. Under the asset and liability method of FAS 109, deferred tax assets and liabilities are recognized for the future tax consequences attributable to the differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Under FAS 109, the effect of a change in tax rates on deferred tax assets and liabilities is recognized in the period that includes the statutory enactment date. BFC adopted FAS 109, as of January 1, 1993. The cumulative effect of this change in accounting for income taxes was a charge aggregating approximately $501,000. Pursuant to the deferred method under APB Opinion 11, which was applied in 1992 and prior years, deferred income taxes are recognized for income and expense items that are reported in different years for financial reporting purposes and income tax purposes using the tax rates applicable for the year of the calculation. Under the deferred method, deferred taxes are not adjusted for subsequent changes in tax rates. The Omnibus Budget Reconciliation Act of 1993 (the "Omnibus Act") was passed by Congress and signed into law by the President during August 1993. The Omnibus Act increased the maximum federal income tax rate applicable to BFC from 34% to 35% retroactive to January 1, 1993. This change did not have a material impact on the Company. Excess Cost Over Fair Value of Net Assets Acquired (Goodwill) - The ownership position in BankAtlantic was acquired at different times. At the February 1987, October 1989, June 1990, October 1990 and November 1991 acquisitions, the fair market value of the net assets of BankAtlantic were greater than the Company's cost. At other increases in ownership, the Company's cost was in excess of the fair market value of BankAtlantic's net assets. The excess of fair market value over cost was recorded as a reduction to the fair market value of non-current assets, including identified intangible assets. The excess of cost over fair market value was recorded as goodwill and is being amortized on the straight line basis over a 15 year period. Identified intangibles consist of loan servicing and escrows. These intangibles are amortized over the remaining life of the applicable loan and escrow accounts using the level yield method and at the end of 1993 had been completely amortized. The minor 3.3%, 4%, 0.5% and 2.4% increases in ownership of BankAtlantic in October 1989, June 1990, October 1990 and November 1991 were recorded utilizing BankAtlantic's cost basis of assets and liabilities as fair market value. The excess of such cost over the Company's purchase price was recorded as a reduction to property and equipment and is being amortized on a straight-line basis over a ten year period. Redeemable Common Stock - In May 1989, the Company exchanged, among other things, 353,478 shares of its common stock (including 117,483 shares of treasury stock) for 282,782 shares of common stock of BankAtlantic (See also Note 2). The exchange ratio for the shares was 1.25 to 1. The original holders of the Company's shares issued in this transaction have the right to require the Company, at any time, to purchase such shares for the higher of (i) their book value as of the date of notice or (ii) the average market value of such shares. The term "average market value" is defined as the product of (i) the average of the closing price of the common stock as reported on the over-the-counter market for the (x) 20 trading days prior to the date of the notice, (y) the date of the notice, if a trading day, and (z) 20 trading days following the date of the notice, times (ii) the number of shares of common stock held by the original holders. The Company and Alan B. Levan, individually, have the right to buy and to require the original holders to sell such shares to each, respectively, on the same terms indicated above. At the transaction date the book value of the shares was greater than their market value. Accordingly, the amount initially recorded for this redeemable common stock, $5,776,000, was at book value. Amounts subsequently reflected in the Company's Statements of Financial Condition will be adjusted to reflect the maximum liability based on the higher of either the market price or the book value of the shares. However, such liability will not be reduced from the amount initially reflected at the time of acquisition. There has been no adjustment to the amount stated since the May 1989 acquisition date. In February 1994, the parties mutually agreed to cancel the agreement with respect to the requirement to buy and or sell shares. Therefore, during the first quarter of 1994, the amount classified as redeemable common stock will be reclassified to the stockholders' deficit section of the Statement of financial condition. Earnings (Loss) Per Common Share - Earnings (loss) per share is computed using the more dilutive of (a) the weighted average number of shares outstanding, or (b) the weighted average number of shares outstanding assuming that the shares of redeemable common stock are reacquired for debt, from the latter of their date of issuance (May 10, 1989) or the beginning of the computation period, at the greater of the amount originally recorded, or the higher of the then book value or market price of the shares. Computation (b) has been utilized, assuming a rate of 12% on indebtedness for 1993, 1992 and 1991. Shares issued in connection with a 1984 acquisition are considered outstanding after elimination of 250,000 shares, representing the Company's 50% ownership of the shares issued in the acquisition. Reclassifications - For comparative purposes, certain prior year balances have been reclassified to conform with the 1993 financial statement presentation. New Accounting Standards - During May 1993, the Financial Accounting Standards Board approved two new accounting standards. Statement of Financial Accounting Standards No. 114 - Accounting by Creditors for Impairment of a Loan ("FAS 114"), and Statement of Financial Accounting Standards No. 115 - Accounting for Certain Investments in Debt and Equity Securities ("FAS 115"). FAS 114 addresses the collectibility of both contractual interest and contractual principal of all receivables when assessing the need for a loss accrual. This standard requires that unpaid loans be measured at the present value of expected cash flows by discounting those cash flows at the loan's effective interest rate. FAS 114 must be adopted by 1995, prospectively. The Company intends to implement FAS 114 in 1995. At December 31, 1993, the effect of implementation of this standard on the Company is estimated to be immaterial. FAS 115 addresses the valuation and recording of debt securities as held-to- maturity, trading and available for sale. Under this standard, only debt securities that the Company has the positive intent and ability to hold to maturity would be classified as held to maturity and reported at amortized cost. All others would be reported at fair value. FAS 115 must be adopted by 1994, prospectively. If FAS 115 were effective at December 31, 1993, the Company does not believe that based on its current portfolio any adjustment would be required. See note 1 of notes to consolidated financial statements of BankAtlantic, A Federal Savings Bank and Subsidiaries, included elsewhere herein. 2. INVESTMENTS IN BANKATLANTIC AND OTHER ACQUISITIONS AND DISPOSITIONS The Company has acquired its current 48.17% ownership of BankAtlantic through various acquisitions and sales as follows (Amounts adjusted for June 1993 15% stock dividend): Cumulative Shares Ownership % ---------- ------------ Prior to 1987 333,155 9.9% February 1987 1,214,952 43.7% October 1987 345,000 53.4% May 1989 325,199 62.3% October 1989 495,506 65.6% June 1990 541,430 69.6% October 1990 24,150 70.1% November 1991 115,000 72.5% June 1993 1,126,327 77.8% November 1993 (1,400,000) 48.2% The Company's ownership of BankAtlantic has been recorded by the purchase method of accounting. Since January 1, 1987 to December 1992, the accounts of BankAtlantic have been consolidated with those of the Company. The shares in the May 1989 acquisition were acquired from Mr. John Abdo and certain members of his family ("Mr. Abdo") in exchange for, among other things, 353,478 shares of the Company's redeemable common stock. The shares in the October 1989 acquisition were acquired directly from BankAtlantic in connection with an offering by BankAtlantic of 500,000 units, at $12.00 per unit, to its existing stockholders. Each unit consisted of one share of its common stock and three warrants, with each warrant entitling the holder to purchase one share of common stock at an exercise price of $10.00 at any time prior to May 31, 1991. On June 30, 1990, BFC exercised its warrants and converted $2.5 million of subordinated debt of BankAtlantic to 541,430 shares of BankAtlantic common stock, increasing BFC's ownership percentage of BankAtlantic to 69.6%. (See note 15.) In October 1990, the Company increased its ownership of BankAtlantic to 70.12% by purchasing 24,150 shares of BankAtlantic common stock from the BankAtlantic Security Plus Plan (the "Plan") at a cost of $2.625 per share (average of bid and asked price on date of purchase). The Plan disposed of these shares in order to meet employees withdrawal requests. In November 1991, BFC purchased 115,000 shares of BankAtlantic common stock from an unaffiliated third party at a cost of approximately $0.761 per share, increasing BFC's ownership of BankAtlantic to 72.5%. In June 1993, the Company exercised its right to purchase 1,126,327 shares of BankAtlantic's common stock at the exercise price of $1.75 per share, for a total purchase price of $1,971,072. The payment of $1,971,072 was through the tender of subordinated debentures held by BFC as of February 28, 1993 and the related accrued interest as of that date. The debentures were issued to BFC in connection with the use of funds from and escrow account established by BFC to make preferred stock dividend payments, and in connection with the related accrued interest on the debentures through February 1993. As a result of the above transaction, BFC increased its ownership in BankAtlantic to 77.83% of BankAtlantic's outstanding common stock. During July 1993, BFC received $83,704 for the interest accrued on the subordinated debentures from February 28, 1993 to June 30, 1993. Share and exercise price were adjusted subject to the dilution provisions contained in the subordinated debt agreement to reflect BankAtlantic's 15% common stock dividend of June 7, 1993. The aggregate purchase price allocation for the June 30, 1993 acquisition of BankAtlantic's common stock is as follows (in thousands): Company's interest in net assets of BankAtlantic (book value on dates of acquisition) $ 3,550 Company's ownership interest of capital contributions 1,530 Adjustment to net assets: Accretion on investment and mortgage- backed securities 1,099 Accretion loans receivable 684 Increase in other assets 39 Premium on deposits (553) Premium on FHLB advances (43) Increase in other liabilities (5) Increase in deferred income taxes (80) Decrease in office properties and equipment (4,250) ------- Purchase price of interest in BankAtlantic's common stock $ 1,971 ======= The adjustment to net assets indicated above are non-cash investing and financing activities. On November 12, 1993, a public offering of 1.8 million BankAtlantic common shares at a price of $13.50 per common share was closed. Of the 1.8 million shares sold, 400,000 shares were sold by BankAtlantic and 1.4 million shares were sold by BFC. Net proceeds to BFC and BankAtlantic from the sale were approximately $17.7 million and $4.6 million, respectively. In connection with the public offering, BankAtlantic granted the underwriters a 30 day option to purchase up to 270,000 additional shares of common stock to cover over-allotments. On November 10, 1993, the underwriters exercised this option to purchase the 270,000 shares, with a settlement date of November 18, 1993. The additional net proceeds to BankAtlantic was approximately $3.4 million. Upon the sale of the 2,070,000 shares, BFC's ownership of BankAtlantic decreased to 48.17%. The sale of the BankAtlantic shares provided the Company with the current liquidity to enable it to hold settlement discussions on the Exchange litigation discussed below. During 1992, the effect of purchase accounting, including income taxes and net amortization/accretion of adjustments to net assets acquired was to increase consolidated net earnings by approximately $807,000 and decrease consolidated net loss during 1993 and increase consolidated net loss in 1991 by approximately $252,000 and $792,000, respectively. The 1991 net loss includes an extraordinary gain of $350,000 as discussed in note 15. Assuming no sales or dispositions of the related assets or liabilities, the Company does not believe the net increase (decrease) in earnings resulting from the net amortization/accretion of the adjustments to net assets acquired resulting from the use of the purchase method of accounting will be significant in future years. Excess cost over fair value of net assets acquired at December 31, 1993 and 1992, was approximately $1,068,000 and $1,925,000, respectively. As a result of the deconsolidation in 1993, excess cost over fair value of net assets acquired at December 31, 1993 is included in the investment of BankAtlantic in the accompanying statements of financial condition. A reconciliation of the carrying value in BankAtlantic to BankAtlantic's Stockholders equity is as follows: BankAtlantic Stockholders' equity $ 90,652 Preferred stock (7,036) ------- BankAtlantic common stockholders' equity 83,616 Partnership percentage 48.17% ------ 40,278 Purchase accounting adjustments (3,842) ------ Investment in BankAtlantic $ 36,436 ======= BFC also owns 5,600 shares of BankAtlantic 12.25% Series A Preferred Stock, 529 shares of BankAtlantic 10.00% Series B Preferred Stock and 4,636 shares of BankAtlantic 8.00% Series C Preferred Stock. The aggregate purchase price relating to the acquisition of these shares was approximately $100,000. See the consolidated financial statements of BankAtlantic, A Federal Savings Bank and Subsidiaries, included elsewhere herein. On February 27, 1991 and June 12, 1991, the Company exchanged (the "1991 Exchange") approximately $9.3 million and $6.1 million (the "Original Principal Amount") of its subordinated unsecured debentures (the "Debentures") for all of the assets and liabilities of two and one affiliated limited partnership(s), respectively. The major assets and liabilities of these partnerships consisted principally of eight commercial real estate properties and related non-recourse mortgage debt. On March 29, 1989, the Company exchanged (the "1989 Exchange") approximately $30 million (the "Original Principal Amount") of its subordinated unsecured debentures (the "Debentures") for all of the assets and liabilities of three affiliated limited partnerships. The major assets and liabilities of these partnerships consisted principally of fourteen commercial real estate properties, and related non-recourse mortgage debt. The Debentures in the 1991 Exchange bear interest at a rate equal to 10.5% per annum until March 31, 1992, 11.5% per annum thereafter until March 31, 1993 and 12.5% per annum thereafter until maturity on July 1, 2011. The Debentures in the 1989 Exchange bear interest at a rate equal to 8% per annum until June 30, 1990, 9% per annum thereafter until June 30, 1991, and 10% thereafter until maturity on July 1, 2009. Interest on the Debentures in the 1991 and 1989 Exchange are due at maturity but is anticipated to be paid quarterly unless management reasonably determines that such quarterly interest payments would impair the operations of the Company. Any interest not paid quarterly by the Company ("Deferred Interest") will accrue interest at the same rate as the Debentures until paid. In the event the Company determines not to pay interest on the Debentures for eight quarters, the interest rate on the Debentures in the 1991 and 1989 Exchanges will increase to, and remain at, 13% and 12%, respectively, per annum until maturity. No dividends may be paid to the holders of any equity securities of the Company while any deferred interest remains unpaid. Since December 31, 1991, the Company has deferred the interest payments relating to the debentures issued in both the 1989 Exchange and the 1991 Exchange and therefore,the interest on the debentures in the 1991 and 1989 Exchange is now 13% and 12%, respectively per annum. The deferred interest on the exchange debentures was approximately $12 million and $6.1 million at December 31, 1993 and 1992, respectively. Debenture holders are also entitled to receive 100% of the aggregate Net Proceeds (as defined in the Debenture) received by the Company in excess of the Original Principal Amount of the Debentures issued, payable on the Distribution Date (as defined below) in cash or additional Debentures (the "Additional Consideration"). The Distribution Date is the earlier of February 1995 or 90 days after the sale of all of the real estate acquired in the 1991 Exchange. The Distribution Date was June 1993 for the 1989 Exchange. At that time, there was no Additional Consideration due with respect to the 1989 Exchange. Any Debentures issued in payment of the Additional Consideration will be identical to the Debentures originally issued, except there will be no further Additional Consideration payable with respect thereto. For financial statement purposes, the Debentures in the 1991 and 1989 Exchange have been discounted to yield 19% and 12%, respectively, over their term and the non-recourse mortgage debt has been discounted to yield 11% over its term. Such mortgage debt in the 1991 Exchange: a) had original aggregate outstanding stated principal balances of approximately $37.0 million; b) had maturities at various dates between 1991 and 2009; c) had stated interest rates ranging from 8.75% to 12.0%; and d) required aggregate monthly payments of approximately $376,000 for principal and interest. Such mortgage debt in the 1989 Exchange: a) had original aggregate outstanding stated principal balances of approximately $28.7 million; b) had maturities at various dates between 1991 and 2003; c) had stated interest rates ranging from 7.75% to 13.5%; and d) required aggregate monthly payments of approximately $275,000 for principal and interest. No value has been assigned to the Additional Consideration in the 1991 Exchange. However, future financial statements will reflect accruals as a "Cost of Sale", to the extent appropriate, for any anticipated Additional Consideration payable based on sales of properties received by the Company in this transaction, through the date of the financial statements. To the extent Additional Consideration is payable on the Distribution Date relating to unsold properties, the basis in such properties will be increased at such time by the fair value of the Additional Consideration payable as a consequence thereof. For purposes of determining Net Proceeds, such unsold properties will be appraised by an independent certified appraisal firm within 90 days of the Distribution Date. A summary of the non-cash investing and financing activities related to the 1991 transaction is as follows (in thousands): ---- Subordinated Debentures issued $ 11,926 Non-recourse mortgage debt related to real estate acquired 38,612 Other liabilities assumed 1,421 Real estate acquired (46,057) Other assets acquired (1,289) ------- Net cash received $ 4,613 ======= Through December 31, 1993, three properties acquired in the 1991 Exchange were sold to unaffiliated third parties. The properties had an aggregate sales price of approximately $28.3 million. Stated mortgage debt of approximately $18 million was eliminated including the remaining $2.0 million balance on a $5.0 million note that was also secured by 2,370,846 shares of BankAtlantic stock owned by BFC. Cash proceeds from the sales, after prorations and closing costs, of approximately $8.2 million was received. Through December 31, 1993, ten properties acquired in the 1989 Exchange were sold to unaffiliated third parties. The properties had an aggregate sales price of approximately $42.3 million. Stated mortgage debt of approximately $21.1 million was eliminated and cash proceeds, after prorations and closing costs, of approximately $20.0 million was received. No Additional Consideration is estimated to be payable with respect to these sales. In litigation brought against the Company in connection with the 1989 and 1991 Exchanges, some plaintiffs have sought to impose a constructive trust on property acquired by the Company in the Exchanges. A network television program has given wide publicity to these claims which may impair the ability of the Company to sell or refinance properties acquired in the Exchanges. There is no assurance that liquidity will be available from the disposition or refinancing of Exchange properties. In connection with the October and November 1992 sales of two properties acquired in the 1991 Exchange, BFC has agreed to limit the disposition of proceeds from these sales pending resolution of certain litigation or further order of the court. At December 31, 1992 and 1993, approximately $3.5 million currently held in escrow is included in "Tax certificates and other investment securities" in the accompanying financial statements. On December 17, 1992, a jury found that BFC Financial Corporation's issuance in 1989 of debentures in exchange for the assets and liabilities of three affiliated public limited partnerships was unfair to investors. The jury determined that BFC Financial Corporation, the affiliated Managing General Partners and BFC Financial Corporation's President, Alan Levan, did not believe that the terms of the Exchange were fair to the limited partners as stated in the prospectus. Based on that determination, the jury found that those limited partners who did not vote in favor of the transaction are entitled to receive approximately $8 million, the amount which they claimed they would have received if the partnerships had been liquidated, rather than the approximately $16 million of subordinated debentures which were issued to them as a consequence of the Exchange and those debentures will be extinguished in connection with the verdict. BFC Financial Corporation would record a pre-tax gain of approximately $6 million from the reduction in its debt resulting from the verdict, but it nonetheless believes that the verdict was not supported by the evidence at trial. The Company intends to appeal the verdict. No amounts have been reflected in the financial statements because the judgement amount was less than the Company's carrying amount of the debentures and related accrued interest and because the Company intends to appeal the verdict. In March 1994, an agreement was entered into to settle the litigation pertaining to the 1991 Exchange. Pursuant to the agreement, the company will pay approximately eighty-one percent (81%) of the face amount of the outstanding debentures held by plaintiffs and the debentures will be canceled pursuant to the procedures outlined in the agreement. The settlement is subject to, among other things, court approval. Upon effectiveness, the settlement of this action will be dismissed with prejudice and the parties will exchange releases. Other lawsuits have been filed against the Company in connection with the Exchange offers. The Company is pursuing discussions with the remaining plaintiffs in litigation relating to the Exchange offers with a view to settling the ongoing litigation but there is no assurance that a settlement will be reached. 3. TAX CERTIFICATES AND OTHER INVESTMENT SECURITIES A comparison of the book value, gross unrealized appreciation, gross unrealized depreciation and approximate market value of tax certificates and other investment securities is as follows (in thousands): ---- Gross Gross Approximate Book Unrealized Unrealized Market Value Appreciation Depreciation Value ------ ------------ ------------ ----------- Tax certificates-net $ 120,295 - - 120,295 Asset-backed securities 129 - - 129 Treasury bills 3,514 - - 3,514 Repurchase agreements 725 - - 725 Certificate of deposits 220 - - 220 Other securities 164 - - 164 -------- ------- ------- ------- Total tax certificates and other investment securities $ 125,047 - - 125,047 ========= ======= ======= ======= Included in tax certificates and other investment securities at December 31, 1993 was approximately $3,304,000, $16,881,000 and $459,000 of U.S. Treasury Bills, commercial paper and other investments, respectively. Market value at December 31, 1993 approximates book value. See note 2 of notes to consolidated financial statements of BankAtlantic, A Federal Savings Bank and Subsidiaries, included elsewhere herein. 4. LOANS RECEIVABLE - NET Loans receivable, net consist of the following (in thousands): 1993 1992 ------- ------- Real estate loans: Conventional mortgages - $ 147,654 Conventional mortgages available for sale - 7,641 Construction and development - 12,961 FHA and VA insured - 9,854 Commercial 13,161 170,257 Other loans: Second Mortgages - 72,508 Commercial (non-real estate) - 33,071 Deposit overdrafts - 356 Installment loans held by individuals - 140,553 -------- -------- 13,161 594,855 Deduct: Undisbursed portion of loans in process - 6,492 Deferred loan fees, net - 55 Unearned discounts on purchased loans - 29 Unearned discounts on installment loans - 1,704 Deferred profit related to real estate sales 3,982 4,052 Allowance for loan losses - 16,500 ------- ------- Loans receivable - net $ 9,179 566,023 ======= ======= Included in loans receivable, net at December 31, 1993 and 1992 was approximately $8,083,000 and $8,252,000, respectively, of loans due from affiliates. Activity in the allowance for loan losses is (in thousands): For the Years Ended December 31, ------------------------------ 1992 1991 ------ ------ Balance, beginning of period $ 13,750 $ 15,741 Charge-offs: Commercial loans (776) (1,694) Installment loans (10,430) (18,903) Real estate mortgages (1,473) (259) ---------- -------- (12,679) (20,856) ---------- -------- Recoveries: Commercial loans 175 191 Installment loan 8,584 1,035 Real estate mortgages 20 99 ---------- --------- 8,779 1,325 ---------- --------- Net charge-offs (3,900) (19,531) Additions charged to operations 6,650 17,540 ---------- --------- Balance, end of period $ 16,500 $ 13,750 ========== ========= Average outstanding loans during the period $ 662,809 $ 891,385 ========== ========= Ratio of net charge-offs to average outstanding loans .59% 2.19% ========== ========= See note 3 of notes to consolidated financial statements of BankAtlantic, A Federal Savings Bank and Subsidiaries, included elsewhere herein. 5. MORTGAGE-BACKED SECURITIES See note 4 of notes to consolidated financial statements of BankAtlantic, A Federal Savings Bank and Subsidiaries, included elsewhere herein. 6. ACCRUED INTEREST RECEIVABLE Accrued interest relates to the following (in thousands): 1993 1992 ------ ------ Loans receivable $ - $ 4,166 Tax certificates and other investment securities 8 14,370 Mortgage-backed securities - 3,660 ------- ------- $ 8 $ 22,196 ======= ======== See note 5 of notes to consolidated financial statements of BankAtlantic, A Federal Savings Bank and Subsidiaries, included elsewhere herein. 7. NON-PERFORMING ASSETS AND RESTRUCTURED LOANS See note 6 of notes to consolidated financial statements of BankAtlantic, A Federal Savings Bank and Subsidiaries, included elsewhere herein. 8. REAL ESTATE ACQUIRED IN DEBENTURE EXCHANGE Real estate acquired in debenture exchange consists of the following (in thousands): December 31 --------------------------- Estimated Lives 1993 1992 --------------- -------- ------- Land - $ 3,912 4,074 Buildings and improvements 14 to 31.5 years 29,509 31,126 -------- ------- 33,421 35,200 Less: Accumulated depreciation 5,295 3,942 Deferred profit 7,957 7,957 Allowance for real estate owned (a) 1,854 2,971 -------- ------- 15,106 14,870 -------- ------- $ 18,315 20,330 ======== ======= (a) The Company provided an allowance for three properties' net carrying value in 1992 and 1991 of $2,971,000 and $2,882,000, respectively, based on estimated sales price. During 1993 the allowance declined because one of the three properties was deeded back to the lender. In connection to the property deeded back to the lender the following 1993 non-cash items were removed from the financial statements: Land $ 162 Building 2,200 Less: accumulated depreciation 281 ----- 2,081 Less: prior years write-down of real estate 1,117 ----- Mortgage payables eliminated 954 Accrued interest payable eliminated 10 ----- - ===== Condensed operations and significant cash flows for real estate acquired in the debenture Exchange is as follows for the year ended December 31, 1993, 1992 and 1991 (in thousands) (a): 1993 1992 1991 -------- -------- ------- Operating Information: - ---------------------- Revenues: Property operations $ 6,805 9,724 9,257 Net gain (loss) on sales and dispositions - 2,935 2,643 Deferred (gain) loss on sales and dispositions - (2,935) (2,643) -------- -------- ------- Net revenues 6,805 9,724 9,257 -------- -------- ------- Cost and expenses: Mortgage interest 2,514 3,524 3,319 Depreciation 1,633 2,239 2,003 Property operating expenses 3,483 4,250 3,790 Write-down of real estate - 89 2,882 -------- -------- ------- Total costs and expenses 7,630 10,102 11,994 -------- -------- ------- Excess (deficit) of revenues over expenses (825) (378) (2,737) ======== ======== ======= Cash Flow Information: Operating activities: Excess (deficit) of revenues over expenses $ (825) (378) (2,737) Depreciation 1,633 2,239 2,003 Write down of real estate - 89 2,882 ------- ------- ------ Cash provided by operating activities 808 1,950 2,148 ------- ------- ------ Investing activities: Proceeds from sales of real estate (b) - 5,563 7,598 Property improvements (582) (606) (1,094) ------- -------- ------ Net cash provided by investing activities (582) 4,957 6,504 ------- -------- ------ Total cash provided $ 226 6,907 8,652 ======= ======== ====== (a) Operating and cash flow information does not include interest expense for the debentures issued in connection with the acquisition of this real estate. Mortgage interest is included with "Interest Other", interest on loans receivable is included with "Interest and fees on loans" and interest on other investments is included with "Interest and dividends on tax certificates and other investment securities" in the accompanying statements of consolidated operations. See also note 2 for additional information on the debenture Exchange and sale of properties. (b) In connection with the 1992 sales of two properties acquired in the 1991 Exchange, BFC has agreed to limit disposition of proceeds from the sales pending resolution of certain litigation. (Approximately $3.5 million.) (See also note 2.) 9. OFFICE PROPERTIES AND EQUIPMENT Office properties and equipment consist of the following (in thousands): December 31, ------------ Estimated Lives 1993 1992 --------------- ------ ------ Land - $ - 9,838 Buildings and improvements 30 to 50 years - 35,158 Furniture and equipment 5 to 10 years 1,259 14,071 ------ ------ Total 1,259 59,067 Less accumulated depreciation 1,231 23,035 ------ ------ Office properties and equipment-net $ 28 36,032 ====== ====== See note 7 of notes to consolidated financial statements of BankAtlantic, A Federal Savings Bank and Subsidiaries, included elsewhere herein. 10. INVESTMENTS IN AND ADVANCES TO JOINT VENTURES See note 20 of notes to consolidated financial statements of BankAtlantic, A Federal Savings Bank and Subsidiaries, included elsewhere herein. 11. Other Assets A detail of other assets at December 31, 1993 and 1992 follows (in thousands): 1993 1992 ---- ---- Other intangible assets, net: Excess of fair value of pension plan assets over projected benefit obligation $ - 1,048 Loan servicing fees - - Purchased servicing rights, net of amortization - 7,282 Repossessed collateral on consumer loans - 461 Receivable from insurance carrier - 6,485 Other 2,807 6,280 ------ ------ $ 2,807 21,556 ====== ====== 12. DEPOSITS Deposits at December 31, 1992 are as follows (in thousands): Weighted Average Rate at 1992 ---- December 31, 1992 Amount Percent ----------------- ------ ------- Interest-free checking - $ 52,426 4.73% Insured money fund savings 3.07% 330,255 29.80% NOW accounts 1.61% 143,580 12.96% Savings accounts 2.06% 130,379 11.77% ------- ------ Total non-certificate accounts 2.30% 656,640 59.26% ------- ------ Certificate accounts: 0.00% to 3.00% - 72,657 6.56% 3.01% to 4.00% - 164,378 14.83% 4.01% to 5.00% - 87,327 7.89% 5.01% to 6.00% - 47,015 4.24% 6.01% to 7.00% - 35,939 3.24% 7.01% and greater - 44,012 3.97% ------- ------ Total certificate accounts 4.46% 451,328 40.73% ------- ------ Total deposit accounts 1,107,968 99.99% --------- ------ Interest earned not credited to deposit accounts 147 .01% --------- ------ Total 3.18% $ 1,108,115 100.00% ========= ======= Interest expense by deposit category is (in thousands): For the Years Ended December 31, ---------------------- 1992 1991 ---- ---- Money fund savings and NOW accounts $ 14,028 24,861 Savings accounts 3,298 5,101 Certificate accounts 30,319 53,842 Less early withdrawal penalty (252) (577) ------ ------ Total $ 47,393 83,227 ====== ====== See note 8 of notes to consolidated financial statements of BankAtlantic, A Federal Savings Bank and Subsidiaries, included elsewhere herein. 13. ADVANCES FROM FEDERAL HOME LOAN BANK See note 9 of notes to consolidated financial statements of BankAtlantic, A Federal Savings Bank and Subsidiaries, included elsewhere herein. 14. SECURITIES SOLD UNDER AGREEMENT TO REPURCHASE See note 10 of notes to consolidated financial statements of BankAtlantic, A Federal Savings Bank and Subsidiaries, included elsewhere herein. 15. CAPITAL NOTES AND OTHER SUBORDINATED DEBENTURES, COMMON STOCK WARRANTS, AND COMMON STOCK OPTIONS AT BANKATLANTIC See note 11 of notes to consolidated financial statements of BankAtlantic, A Federal Savings Bank and Subsidiaries, included elsewhere herein. 16. INTEREST RATE SWAPS In March 1991, a $35.0 million interest rate swap expired. This agreement called for fixed rate interest payments by BankAtlantic of 12.00% in exchange for variable rate payments based on the corporate bond equivalent of the three month U.S. Treasury Bill rate. The net interest expense relating to interest rate swaps was approximately $450,000 for the year ended December 31, 1991 ($406,000 reflected in consolidation after purchase accounting adjustments). The impact related to these agreements on the Company's results of operations, after purchase adjustments, income taxes and minority interests, is insignificant. (See note 2.) BankAtlantic was exposed to credit loss in the event of nonperformance by the other party to the agreements, however no performance by the counterparty was required during the term of the agreement. See note 12 of notes to consolidated financial statements of BankAtlantic, A Federal Savings Bank and Subsidiaries, included elsewhere herein. 17. MORTGAGES PAYABLE AND OTHER BORROWINGS Mortgages payable and other borrowings at December 31, 1993 and 1992 are summarized as follows (in thousands): Approximate Type of Debt Maturity Interest Rate 1993 1992 - ------------ -------- ------------- ---- ---- Related to mortgage 6% - Prime receivables 1994-2010 plus 1% $ 5,105 5,335 Related to real estate 1994-2003 7.75%- Prime plus 1.5% 24,312 25,814 Other borrowings 1994 Prime plus 1% 950 1,019 ------ ------ $ 30,367 32,168 ======= ====== All mortgage payables and other borrowings above are from unaffiliated parties. Included in 1993 and 1992 amounts related to other borrowings is approximately $950,000 and $1,019,000, respectively due to financial institutions. At December 31, 1993, $3,266,000 included above in related to real estate was in default. The Company and the lender have agreed to an extension but the terms and documentation have not yet been finalized. At December 31, 1993, $950,000 included above in other borrowings is in default. The lender has exercised the acceleration provision in the note and the Company is attempting to negotiate an extension. At December 31, 1993 the aggregate principal amount of the above indebtedness maturing in each of the next five years is approximately as follows (in thousands): Years ended December 31, Amount ------------ ------ 1994 $ 5,598 1995 4,524 1996 10,175 1997 4,065 1998 881 Thereafter 5,124 ------ $30,367 ====== The above amounts relate entirely to the Company and its subsidiaries other than BankAtlantic. The majority of the Company's (not including BankAtlantic) marketable securities, mortgage receivables and real estate acquired in the 1989 and 1991 debenture Exchange are as to real estate and marketable securities, encumbered by, or, as to mortgages receivable, subordinate to mortgages payable and other debt. (See also note 28.) In June 1991, BFC's $6.4 million credit line and unsecured $1.0 million line of credit were consolidated, restated and amended into a promissory note in the original principal amount of $5.0 million. Security for the $5.0 million note included 2,370,846 shares of BankAtlantic owned by BFC, deeds of trust on three properties and an assignment of a mortgage receivable. In October 1992, the above promissory note was satisfied and the collateral released. 18. INCOME TAXES BFC adopted FAS 109 as of January 1, 1993. The cumulative effect of this change in accounting for income taxes was a charge aggregating approximately $501,000. The tax effects of temporary differences that give rise to significant components of the deferred tax assets and tax liabilities at December 31, 1993 were (in thousands): Deferred tax assets: Real estate, net $ 1,898 Mortgages payable 7 Litigation accruals 2,205 Other liabilities 12 Net operating loss carryforwards 9,394 ----- Total gross deferred tax assets 13,516 Less: Valuation allowance 9,073 ------ Net deferred tax assets 4,443 Deferred tax liabilities: Investment in BankAtlantic 3,269 Exchange Debentures 3,212 ------ Total gross deferred tax liabilities 6,481 ------ Deferred income taxes at December 31, 1993 2,038 Deferred income taxes at January 1, 1993 2,038 ------ Deferred income tax expense for 1993 $ - ====== The provision for income tax expense (benefit) consists of the following (in thousands): For the Years Ended December 31, -------------------------------------- 1993 1992 1991 ---- ---- ---- Current: Federal $ - 6,469 (396) State - 201 - ----- ----- ----- $ - 6,670 (396) ----- ----- ----- Deferred : Federal - 1,792 (4,480) State - (17) - ----- ----- ----- - 1,775 (4,480) ----- ----- ----- Utilization of net operating loss carryforward (1): Federal - (389) - State - 1,145 - ----- ----- ----- - 756 - ----- ----- ----- Total $ - 9,201 (4,876) ===== ===== ====== (1) Represents extraordinary item, before minority interest of $208,000. A reconciliation from the statutory federal income tax rates of 35% in 1993, and 34% in 1992 and 1991 to the effective tax rate is as follows (in thousands): (1) Expected tax is computed based upon earnings (loss) before minority interest in BankAtlantic and extraordinary items. (2) Expected tax is computed based upon the Company's loss before equity in earnings of BankAtlantic. At December 31, 1993, the Company had estimated state net operating loss carry forwards for state income tax purposes of approximately $21,935,000 of which $793,000 expires in 2002, $3,240,000 expires in 2003, $586,000 expires in 2004 $2,757,000 expires in 2005, $2,001,000 expires in 2006, $4,235,000 expires in 2007 and $8,323,000 expires in 2008. The Company also has a net operating loss carry forward for federal income tax purposes of approximately $26,839,000 of which $237,000 expires in 2003, $1,089,000 expires in 2004, $5,237,000 expires in 2005, $4,743,000 expires in 2006, $7,181,000 expires in 2007 and $8,323,000 expires in 2008. BankAtlantic is not included in the Company's consolidated tax return. The Company made income tax payments of $1,900 and $3,600 during the years ended December 31, 1993 and 1992, respectively. See note 13 of notes to consolidated financial statements of BankAtlantic, A Federal Savings Bank and Subsidiaries, included elsewhere herein. 19. STOCKHOLDERS' EQUITY The Company's Articles of Incorporation authorize the issuance of up to 10,000,000 shares of $.01 par value preferred stock. The Board of Directors has the authority to divide the authorized preferred stock into series or classes having the relative rights, preferences and limitations as may be determined by the Board of Directors without the prior approval of shareholders. The Board of Directors has the power to issue this preferred stock on terms which would create a preference over the Company's common stock with respect to dividends, liquidation and voting rights. No further vote of security holders would be required prior to the issuance of the shares. The Company's Articles of Incorporation authorize the Company to issue 20,000,000 shares of Special Class A Common Stock, par value $.01 per share. To the extent permitted by law, the Special Class A Common Stock may be issued in one or more series as determined from time to time by the Board of Directors and having the relative rights and preferences determined by the Board of Directors which are set forth in the Articles of Incorporation. However, in no event will the voting rights of shares of Special Class A Common Stock equal or exceed the voting rights of the Company's present Common Stock. At such time as the Board of Directors authorizes the issuance of the newly created Special Class A Common Stock the Company's presently outstanding Common Stock will be automatically redesignated Class B Common Stock and holders thereof shall have the right at any time to convert their shares to shares of the Special Class A Common Stock on a one-for-one basis at the holder's sole election. 20. EARNINGS ON REAL ESTATE OPERATIONS Following are the components of earnings on real estate operations for each of the years in the three year period ending December 31, 1993 (in thousands) (a): 1993 1992 1991 ------ ------ ------ Deferred profit recognized $ 70 67 63 Operations of properties acquired in debenture Exchange (see note 8) 1,577 3,133 3,321 ------ ------ ------ $ 1,647 3,200 3,384 ====== ====== ====== (a) The above amounts relate entirely to the company and its subsidiaries other than BankAtlantic. 21. OTHER NON-INTEREST INCOME Included in other non-interest income is approximately $5.0 million, and $5.2 million of checking account fees for the years ended December 31, 1992, and 1991, respectively, and a $415,000 recovery of prior periods reconciliation differences was also included in other non-interest income for December 31, 1991. Also, included in other non-interest income for the years ended December 31, 1993, 1992, and 1991,is approximately $69,000, $69,000, and $273,000, respectively, of property management fees earned from services provided to affiliated public real estate partnerships. 22. RELATED PARTY TRANSACTIONS (a) Related party transactions arise from transactions with affiliated entities. In addition to transactions described in notes 2, 4 and 10, a summary of significant originating related party transactions is as follows (in thousands): Year Ended December 31, ------------------------ 1993 1992 1991 ------ ------ ------ Property management fee revenue $ 69 69 273 ===== ====== ====== Reimbursement revenue for administrative, accounting and legal services $ 114 143 339 ====== ====== ====== (b) The Company has a 49.5% interest and affiliates and third parties have a 50.5% interest in a limited partnership formed in 1979, for which the Company's Chairman serves as the individual General Partner. The partnership's primary asset is real estate subject to net lease agreements. The Company's cost for this investment (approximately $441,000) and was written off in 1990 due to the bankruptcy of the entity leasing the real estate. Any recovery will be recognized in income when received. (c) The Company had amounts due from affiliates as follows (in thousands): December 31, -------------- Description 1993 1992 ----------- ---- ---- 8.5% wraparound mortgage note, due in monthly installments until maturity in December 1998, when a balloon payment of $153,174 is due $ - 187 Other receivables, due primarily from affiliated partnerships collected in the subsequent quarter 129 235 ---- ---- $ 129 422 ==== ==== (d) Alan B. Levan, President and Chairman of the Board of the Company also serves as Chairman of the Board and Chief Executive Officer of BankAtlantic (e) John E. Abdo, a director of the Company also serves as Vice Chairman of the Board of Directors of BankAtlantic and President of BankAtlantic Development Corporation a wholly owned subsidiary of BankAtlantic. (f) In May 1986, the Company issued 895 shares of stock to an officer. The aggregate price, which was at the then market value of $19.00 per share, was approximately $17,000 and payment for the shares is in the form of a non-interest bearing note that matures in May 1996 and is secured by collateral other than the stock issued. (g) Florida Partners Corporation acquired 100,000 of the 850,000 shares of the common stock sold by the Company in February 1987 and, in June 1990, acquired in a privately negotiated transaction, an additional 33,314 shares of the Company's common stock. Alan B. Levan is the principal shareholder and Chairman of the Board of Florida Partners Corporation. Other members of the Company's Board of Directors also hold positions with Florida Partners Corporation. 23. EMPLOYEE BENEFIT PLANS The Company's 1983 Stock Incentive Plan provided for the grant of stock options to purchase up to 125,000 shares of the Company's common stock to various employees of the Company and its subsidiaries upon terms and conditions (including price, exercise date and number of shares) determined by a committee appointed by the Board of Directors to administer the plan. The exercise price of $12.00 per share was equal to or greater than the market price as of the date of grant. Such options generally become exercisable over an approximate four year period. The plan expired in 1992 and the 28,211 options outstanding at the end of 1991 were canceled. On November 19, 1993, BFC Financial Corporation's stockholders approved a Stock Option Plan under which options to purchase up to 250,000 shares of common stock may be granted. The plan provided for the grant of both incentive stock options and non-qualifying options. The exercise price of an incentive stock option will not be less than the fair market value of the common stock on the date of the grant. The exercise price of non-qualifying options will be determined by a committee of the Board of Directors. On November 22, 1993, in accordance with the terms of the Stock Option Plan, non-qualifying stock options for 10,000 shares of common stock were granted to non-employee directors. The options were issued at $4.50 per share, the fair market value at the date of grant. The Company has an employee's profit-sharing plan which provides for contributions to a fund, to be held in trust by a corporate fiduciary, of a sum as defined, but not to exceed the amount permitted under the Internal Revenue Service Code as deductible expense. The provision charged to operations was approximately $5,000 for each of the years ended December 31, 1993, 1992 and 1991. Contributions are funded on a current basis. 24. PENSION PLAN OF BANKATLANTIC See note 14 of notes to consolidated financial statements of BankAtlantic, A Federal Savings Bank and Subsidiaries, included elsewhere herein. 25. LITIGATION The following is a description of certain lawsuits to which the Company is a party. Timothy J. Chelling vs. BFC Financial Corporation, Alan B. Levan, I.R.E. Advisors Series 21, Corp. and First Equity Corporation, U.S. District Court, Southern District of Florida Case No. 89-1850-Civ Nesbitt. John D. Purcell and Debra A. Purcell vs. BFC Financial Corporation, Alan B. Levan, Scott Kranz, Frank Grieco, I.R.E. Advisors Series 23, Corp. and First Equity Corporation, U.S. District Court, Southern District of Florida, Case No. 89-1284- Civ-Ryskamp. William A. Smith and Else M. Smith vs. BFC Financial Corporation, Alan B. Levan and I.R.E. Advisors Series 24, Corp. and First Equity Corporation, U.S. District Court, Southern District of Florida, Case No. 89-1605- Civ-Marcus. These actions were filed by the plaintiffs as class actions during September 1989, June 1989 and August 1989, respectively. The actions arose out of an Exchange Offer made by the Company to the limited partners of I.R.E. Real Estate Fund, Ltd. - Series 21, I.R.E. Real Estate Fund, Ltd. - Series 23, and I.R.E. Real Estate Fund, Ltd. - Series 24. The plaintiffs, who were limited partners of the above named partnerships who did not consent to the Exchange Offer, brought this action purportedly on behalf of all limited partners that did not consent to the Exchange Offer. The Exchange Offer was made through the solicitation of consents pursuant to a Proxy Statement/Prospectus dated February 14, 1989 and was approved by the holders of a majority of the limited partnership interests of each of the Partnerships in March 1989. Messrs. Levan, Grieco and Kranz served as individual general partners of each of the Partnerships, and Mr. Levan is the President and a director of the Company. The plaintiffs alleged that the Proxy Statement/Prospectus contained material misstatements and omissions, that defendants violated the federal securities laws in connection with the offer and Exchange, that the Exchange breached the respective Limited Partners Agreement and that the defendants violated the Florida Limited Partnership statute in effectuating the Exchange. The complaint also alleged that the defendant general partners violated their fiduciary duties to the plaintiffs. In a memorandum opinion and order dated December 17, 1991, the Court granted the defendant's motion for summary judgement and denied the plaintiff's motion for summary judgement, ruling that the Exchange did not violate the partnership agreements or the Florida partnership statute. In July 1992, the Court granted summary judgment in favor of the defendants and dismissed the plaintiffs' claims for breach of fiduciary duty. Subsequently, the court entered summary judgment in favor of the defendants on all claims of misrepresentations or omissions except with respect to the statement in the Proxy Statement/Prospectus to the effect that BFC, Alan Levan and the Managing General Partners believed the Exchange transaction was fair. The case on that issue was tried in December 1992, and the jury returned a verdict in the amount of $8 million but extinguished approximately $16 million of debentures held by the plaintiffs. BFC Financial Corporation would record a pre-tax gain of approximately $6 million from the reduction in its debt resulting from the verdict, but it nonetheless believes that the verdict was not supported by the evidence at trial. Based on the verdict, BFC Financial Corporation would record a pre-tax gain of approximately $6 million from the extinguishment of the $16 million of outstanding debt. No amounts have been reflected in the financial statements because the judgement amount was less that the Company's carrying amount of the debentures and related accrued interest and because the Company intends to appeal the verdict. The court denied plaintiffs' motion for prejudgment interest as to Series 21 and Series 23 and awarded prejudgment interest to plaintiffs in Series 24 to be calculated to run from March 31, 1989 through December 18, 1992, the date of entry of final judgment, at the rate of 3.54%. The plaintiffs appealed the court's denial for prejudgment interest in Series 21 and Series 23. The Company also appealed the judgment as well as the court's denial of various post-trial motions filed by the Company. Pursuant to the request of the Eleventh Circuit Court of Appeals, the parties submitted briefs regarding the issue of whether the Eleventh Circuit has jurisdiction to hear the appeal. In February 1994, the Eleventh Circuit Court dismissed the appeal for lack of jurisdiction. In September 1993, the court granted the Company's motion to stay of the execution of the final judgment pending appeal and to allow alternative form of security. In December 1993, the Company filed with the district court a motion to correct the judgment to reflect the cancellation of the outstanding debentures, which motion is still pending. Arthur Arrighi, et al. vs. KPMG Peat Marwick, BFC Financial Corporation; Alan B. Levan; Frank V. Grieco; Glen Gilbert; Al DiBenedetto; BankAtlantic, A Federal Savings Bank; Georgeson & Company, Inc.,; First Equity Corporation of Florida; I.R.E. Advisors Series 25, Corp.; I.R.E. Advisors Series 27, Corp.; I.R.E. Income Advisors, Corp.; and National Realty Consultants, in the United States District Court for the District of New Jersey, Case No. 92-1206-CDR. This case was filed on March 20, 1992 by more than 2,000 former limited partners in Series 25, Series 27 and Income Fund. The complaint alleged that BFC and certain other defendants developed a fraudulent scheme commencing in 1972 to sell the plaintiffs limited partnership units with the undisclosed goal of later taking over the assets of the partnerships in exchange for securities in a new entity in which the defendant Alan B. Levan would be a major shareholder. The complaint further alleged that the defendants made material misrepresentations and omissions in connection with the sale of the original limited partnership units in the 1980s and in connection with the 1991 Exchange, and fraudulently tallied the votes in connection with the 1991 Exchange and Solicitation of Consents described above. On March 2, 1994, the parties entered into an agreement to settle this action pursuant to which BFC will pay approximately eighty-one percent (81%) of the face amount of the outstanding debentures held by plaintiffs and the debentures will be canceled pursuant to the procedures outlined in the agreement. The settlement is subject to, among other things, court approval. Upon effectiveness, the settlement of this action will be dismissed with prejudice and the parties will exchange releases. Settlement of this matter will result in a gain to BFC for financial statement purposes. Marjory Meador, Shirley B. Daniels, Robert A. and Ruby L. Avans, and Dr. and Mrs. Czerny, individually and on behalf of all others similarly situated, Plaintiffs, vs. BFC Financial Corporation; BankAtlantic, A Federal Savings Bank; Alan B. Levan; I.R.E. Advisors Series 21, Corp.; I.R.E. Advisors Series 23, Corp.; I.R.E. Advisors Series 24, Corp.; I.R.E. Advisors Series 25, Corp.; I.R.E. Advisors Series 27, Corp.; I.R.E. Income Advisors Corp.; and First Equity Corporation of Florida; Defendants, in the Circuit Court of the Seventeenth Judicial Circuit in and for Broward County, Florida, Case No. 91- 29892 (CA-17). This action was filed as a class action during October 1991 and is brought on behalf of all persons who were limited partners in (a) I.R.E. Real Estate Fund, Ltd. - Series 21, I.R.E. Real Estate Fund, Ltd. - Series 23, or I.R.E. Real Estate Fund, Ltd. -Series 24 on the effective date of the 1989 Exchange Transaction not otherwise included in the action by limited partners who voted against the Exchange; or (b) were limited partners in I.R.E. Real Estate Fund, Ltd. - Series 25, I.R.E. Real Estate Fund, Ltd. - Series 27 or I.R.E. Real Estate Income Fund, Ltd. on the effective dates of the 1991 Exchange Transactions. The action alleges breach of the limited partnership agreements, breach of fiduciary duty, aiding and abetting a breach of fiduciary duty by BFC Financial Corporation and BankAtlantic, and negligent misrepresentation by all defendants. The action seeks damages in an unstated amount, imposition of a constructive trust on the assets of the exchanging partnerships, attorney's fees, costs and such other relief as the courts may deem appropriate. Plaintiffs have voluntarily dismissed all claims which arose out of or related to the 1991 Exchange. Shirley B. Daniels, Robert S. and Ruby L. Avans, and Dr. and Mrs. Czerny, individually and on behalf of all others similarly situated, Plaintiffs, vs. BFC Financial Corporation; BankAtlantic, A Federal Savings Bank; Alan B. Levan; I.R.E. Advisors Series 25, Corp.; I.R.E. Advisors Series 27, Corp.; I.R.E. Income Advisors Corp.; First Equity Corporation of Florida, Defendants, in the United States District Court for the Southern District of Florida, Fort Lauderdale Division, Case No. 92-6588-Civ-King. On January 18, 1991, BFC issued a prospectus and solicitation of consents in which it offered to exchange up to $17 million in subordinated unsecured debentures for all of the assets and liabilities of I.R.E. Real Estate Fund, Ltd.- ("Series 25"), I.R.E. Real Estate Fund, Ltd.- ("Series 27"), I.R.E. Real Estate ("Income Fund") and I.R.E. Pension Investors, Ltd the ("1991 Exchange"). The 1991 Exchange was approved by a majority of the limited partners in all of the partnerships except I.R.E. Pension Investors, Ltd. The Exchange subsequently was effectuated without I.R.E. Pension Investors, Ltd. In December 1992, plaintiffs filed an amended complaint, the result of which is to enlarge the class to all limited partners in the 1991 Exchange. Plaintiffs allege that the defendants orchestrated the Exchange for their own benefit and caused the issuance of the Exchange Offer and Solicitation of Consents, which contained materially misleading statements and omissions. The complaint contains counts against BFC for violations of the Securities Act and the Exchange Act. Plaintiffs also allege that Alan Levan and the managing general partners breached the limited partnership agreements, breached fiduciary duties and that BFC and BankAtlantic aided and abetted these alleged breach of fiduciary duties, that Alan Levan, the managing general partners, BFC and BankAtlantic committed fraud in connection with the 1991 Exchange and made certain negligent misrepresentations to the plaintiffs. The complaint seeks damages and prejudgment interest in an unspecified amount, attorneys' fees and costs. The defendants have filed an answer and affirmative defenses to the amended complaint. On March 2, 1994, the parties entered into an agreement to settle this action pursuant to which BFC will pay approximately eighty-one percent (81%) of the face amount of the outstanding debentures held by plaintiffs and the debentures will be canceled pursuant to the procedures outlined in the agreement. The settlement is subject to, among other things, court approval. Upon effectiveness, the settlement of this action will be dismissed with prejudice and the parties will exchange releases. Settlement of this matter will result in a gain to BFC for financial statement purposes. Cheryl and Wayne Hubbell, et al., vs. I.R.E. Advisors Series 26, Corp. et al., in the California Superior Court in Los Angeles, California, Case No. BC049913. This action was filed as a class action during March 1992 on behalf of all purchasers of I.R.E. Real Estate Fund, Ltd. - Series 25, I.R.E. Real Estate Fund, Ltd. - Series 26, I.R.E. Real Estate Fund, Ltd. - Series 27, I.R.E. Real Estate Growth Fund, Ltd. - Series 28 and I.R.E. Real Estate Income Fund, Ltd. against the managing and individual general partners of the above named partnerships and the officers and directors of those entities. The plaintiffs allege that the offering materials distributed in connection with the promotions of these limited partnerships contained misrepresentations of material fact and that the defendants misrepresented and concealed material facts from the plaintiffs during the time the partnerships were in existence. The complaint asserts two causes of action for fraud, one of which is based on a claim for intentional misrepresentation and concealment and one of which is based on a claim of negligent misrepresentation. The complaint also contains a claim for breach of fiduciary duty. The complaint seeks unspecified compensatory and punitive damages, attorneys' fees and costs. Plaintiffs filed an amended complaint, which the Court dismissed in February 1993 pursuant to a motion to dismiss filed by the Defendants. Plaintiffs thereafter filed a second amended complaint in February 1993. which was also dismissed. Plaintiffs filed a third amended complaint which defendants answered in April 1993. Management intends to vigorously defend this action. Martha Hess, et. al., on behalf of themselves and all others similarly situated, v. Gordon, Boula, Financial Concepts, Ltd., KFB Securities, Inc., et al. In the Circuit Court of Cook County, Illinois. On or about May 20, 1988, an individual investor filed the above referenced action against two individual defendants, who allegedly sold securities without being registered as securities brokers, two corporations organized and controlled by such individuals, and against approximately sixteen publicly offered limited partnerships, including two partnerships that the Company acquired the assets and liabilities of in the 1991 Exchange transaction, (the "predecessor partnerships") interests in which were sold by the individual and corporate defendants. Plaintiff alleged that the sale of limited partnership interests in the predecessor partnerships (among other affiliated and unaffiliated partnerships) by persons and corporations not registered as securities brokers under the Illinois Securities Act constitutes a violation of such Act, and that the Plaintiff, and all others who purchased securities through the individual or corporate defendants, should be permitted to rescind their purchases and recover their principal plus 10% interest per year, less any amounts received. The predecessor partnerships' securities were properly registered in Illinois and the basis of the action relates solely to the alleged failure of the Broker Dealer to be properly registered. In November 1988, Plaintiff's class action claims were dismissed by the Court. Amended complaints, including additional named plaintiffs, were filed subsequent to the dismissal of the class action claims. Motions to dismiss were filed on behalf of the predecessor partnerships and the other co-defendants. In December 1989, the Court ordered that the predecessor partnerships and the other co-defendants rescind sales of any plaintiff that brought suit within three years of the date of sale. Under the Court's order of December 1989, one of the predecessor partnerships rescinded sales of $41,500 of units. Plaintiffs appealed, among other items, the Court's order with respect to plaintiffs that brought suit after three years of the date of sale In February 1993, the Appellate court ruled that the statute of limitations was tolled during the pendency of the class action claims. Therefore, those investors that brought suit within 3.6 years and potentially 4 years from the date of sale may be entitled to rescission. The Company and the other co- defendants sought leave to appeal before the Illinois Supreme Court and on October 6, 1993, the leave to appeal was denied. Plaintiff's claims are now pending in Circuit Court. Plaintiffs have indicated that they will file amended complaints against the predecessor partnerships and other co- defendants. The amended complaints will include both individual and class claims. The individual and corporate defendants sold a total of $1,890,500 of limited partnership interests in the predecessor partnerships. Limited partners holding approximately $1,042,800 of limited partnership interests have filed an action for recision. Under the appellate decision, if recision was made to all limited partners that filed an action, refunds, at March 31, 1993, (including interest payments thereon) would amount to approximately $1,800,000. A provision for such amount has been made in the accompanying financial statements. Short vs. Eden United, Inc., et al. in the Marion County Superior Court, State of Indiana. Civil Division Case No. S382 0011. In January, 1982, an individual filed suit against a subsidiary of the Company, Eden United, Inc. ("Eden"), seeking return of an earnest money deposit held by an escrow agent and liquidated damages in the amount of $85,000 as a result of the failure to close the purchase and sale of an apartment complex in Indianapolis, Indiana. Eden was to have purchased the apartment complex from a third party and then immediately resell it to plaintiff. The third party was named as a co-defendant and such third party has also filed a cross claim against Eden, seeking to recover the earnest money deposit. In September 1983, Plaintiff filed an amended complaint, naming additional subsidiaries of the Company and certain officers of the Company as additional defendants. The amended complaint sought unspecified damages based upon alleged fraud and interference with contract. In interrogatory answers served in September 1987, Plaintiff stated for the first time that he was seeking damages in the form of lost profits in the amount of approximately $6,350,000. The case went to trial during October 1988. On April 26, 1989, the Court entered a judgement against Eden, the Company and certain additional subsidiaries of the Company jointly and severally in the sum of $85,000 for liquidated damages with interest accruing at 8% per annum from September 1, 1981, normal compensatory damages of $1.00, and punitive damages in the sum of $100,000. The judgement also rewards the Plaintiff the return of his $85,000 escrow deposit, and awards the third party $85,000 in damages plus interest accruing from September 14, 1981 against Eden. The Company has charged expense for the above amounts. Both Short and the Company appealed the judgement and in June 1991, the appellate court reversed the trial court's decision on the issue of compensatory damages, determined that Short may be entitled to an award of compensatory damages and remanded the case to the trial court to determine the amount of compensatory damages to be awarded. The Indiana Supreme Court denied review. A hearing on remand was held on February 3, 1993. On February 25, 1994, the court on remand awarded plaintiff a judgment in the amount of $85,000 for liquidated damages for breach of contract jointly and severally from the subsidiary, the Registrant and certain named affiliates, plus prejudgment interest of $52,108 through May 1, 1989, plus post-judgment interest of 10% per annum thereafter until paid. Additionally, plaintiff was awarded a judgment against the defendants in the amount of $2,570,000 for tortious interference, plus prejudgment interest of $469,400 through May 1, 1989, plus post-judgment interest of 10% per annum thereafter until paid. The Registrant which was advised of the courts decision on March 2, 1994 intends to appeal the trial court's order. A provision for the above is included in the accompanying financial statements. Scott Kranz and Investment Management Group, Inc. vs. Alan B. Levan, BFC Financial Corporation, I.R.E. Investments, Inc., Frank V. Grieco, I.R.E. Advisors Series 23, Corp., I.R.E. Advisors Series 24, Corp., I.R.E. Advisors Series 25, Corp., I.R.E. Advisors Series 26, Corp., and I.R.E. Real Estate Institutional Corp., in the Eleventh Judicial Circuit in and for Dade County, Florida, Case No. 85-08751 (the "employment case"), Scott G. Kranz in the name of I.R.E. Realty Advisory Group, Inc., vs I.R.E. Realty Advisory Group, Inc. et al in the Eleventh Judicial Circuit in and for Dade County, Florida, Case No. 84-40012 (CA25) (the "appraisal case"). On March 5, 1985 Scott Kranz and Investment Management Group, Inc. filed suit seeking damages in excess of $1,800,000 and punitive damages of at least $10,000,000 plus costs. Investment Management Group, Inc. ("IMG") is a real estate development corporation of which Scott Kranz is the President. Until his termination on August 1, 1984, Scott Kranz was associated with Registrant and/or various of its affiliates either individually or through IMG. The Complaint alleges that Alan B. Levan, acting on his own behalf and on behalf of Registrant and certain unnamed affiliates and in combination with one or more unnamed defendants wrongfully caused the termination of certain contractual relationships between the Company and Scott Kranz and IMG and of Scott Kranz as general partner of five publicly registered real estate limited partnerships. On October 29, 1984, Scott G. Kranz, a 10% shareholder of I.R.E. Realty Advisory Group, Inc. ("RAG"), of which Registrant is a 50% shareholder, filed suit in the name of RAG seeking a declaration of the rights and liabilities of the parties in relation to a merger effective August 21, 1984 by and among Gables Advisors, Inc., I.R.E. Real Estate Funds, Inc. and RAG. Plaintiff seeks damages in the amount of the fair market value of his shares in RAG as of the day before the merger. He further claims punitive damages, attorneys fees and costs. On January 30, 1985, plaintiff amended his complaint, to add claims of breach of statutory duty and willful failure to submit the merger transactions to a vote at a meeting of shareholders, in addition to a claim for punitive damages. On June 17, 1985, Plaintiff again amended his complaint adding a claim of constructive fraud. In March 1986, Plaintiff's motion for summary judgement was denied. On January 21, 1987, the Court ordered this action consolidated for trial with the action described immediately above. Defendants denied Plaintiff's claims and filed a counterclaim. The defendants also filed a motion to strike all of Kranz's and IMG's pleadings in both cases and to enter a default judgement against Kranz and IMG for gross and continuing violations of discovery orders. By order dated June 26, 1990, the judge struck all of the pleadings filed by Kranz and IMG including both of their complaints and both of their answers to the Company's counterclaims. On February 12, 1991, the trial judge entered final judgement in favor of the individual defendants, Alan Levan and Frank Grieco, specifically reserving jurisdiction for further proceedings as to the corporate entities to enter final judgement against the plaintiffs on the complaint. Kranz and IMG appealed the judgement in favor of the individual defendants and the judgement was affirmed. The corporate defendants have filed a motion for entry of judgment against Kranz and IMG and requesting damages and attorney's fees. Joseph Roma vs. I.R.E. Advisors Series 29, Corp., et al., in the Circuit Court of Cook County, Illinois, County Department, Chancery Division, Case No. 91CH2429. - This action was filed as a class action during March 1991. The action, brought on behalf of investors in I.R.E. Real Estate Fund, Ltd. - Series 29 ("Series 29"), alleged fraud and fraudulent inducement, breach of fiduciary duty, negligent misrepresentation and violations of the Blue Sky Laws by defendants relating to their promotion, marketing, control and management of Series 29, a public limited partnership. The action sought rescission of the investments, contracts and agreements relating to investments in Series 29, damages in an unstated amount and other relief as the court deemed appropriate. This action was dismissed by the court. Plaintiffs appealed such dismissal and in February 1994, the Appellate Court affirmed the dismissal as in favor of all defendants. John F. Weaver, Trustee for the Bankruptcy Estate of Milton A. Turner vs. I.R.E. Real Estate Investments, Inc., in the United States Bankruptcy Court for the Eastern District of Tennessee, Case No. 3-89-01210. - On July 25, 1991, an action was filed by John Weaver alleging that the conveyance of Turner's equity of $1,642,001 under a wrap note to I.R.E. Real Estate Investments, Inc. (successor to I.R.E. Real Estate Fund, Ltd. - Series 23) in connection with the sale of property by Series 23 to Turner was a fraudulent conveyance, as defined, in that Turner conveyed an asset, namely the cancellation of a wrap note and wrap trust, without fair consideration while insolvent. The trial on the complaint to avoid fraudulent conveyance was heard before the Bankruptcy Court in May 1993. Judgment was entered in favor of BFC and the complaint was dismissed. No appeal was taken from the judgment and it is now final. Alan B. Levan and BFC Financial Corporation v. Capital Cities/ABC, Inc. and William H. Wilson, in the United States District Court for the Southern District of Florida, Case No. 92-325-Civ-Atkins. On November 29, 1991, The ABC television program 20/20 broadcast a story about Alan B. Levan and BFC which purportedly depicted some securities transactions in which they were involved. The story contained numerous false and defamatory statements about the Company and Mr. Levan and, February 7, 1992, a defamation lawsuit was filed on behalf of the Company and Mr. Levan against Capital Cities/ABC, Inc. and William H. Wilson, the producer of the broadcast. In July 1993, a magistrate recommended that summary judgment be entered against Mr. Levan on their defamation claims. Objections to and an appeal from that recommendation were filed with the presiding judge. Such appeal remains pending. On March 21, 1988, an action captioned Elliot Borkson, et al. vs. Alan Levan, Jack Abdo and BankAtlantic, Case No. 88-12063, was filed by a group of approximately 54 shareholders of BankAtlantic in the Circuit Court of the Eleventh Judicial Circuit in and for Dade County, Florida. The complaint alleges that Messrs. Levan and Abdo breached their fiduciary duties as directors of BankAtlantic by disregarding the rights of minority shareholders under a certain option agreement between BFC and a third party dated April 9, 1986, by taking actions to depress the value of BankAtlantic's stock, by denying access to BankAtlantic's books and records and by allegedly wasting corporate assets. BankAtlantic is a nominal party to the proceeding. Plaintiffs seek punitive damages of $10.0 million, compensatory damages, attorneys' fees, costs and injunctive relief. Discovery is proceeding and the defendants are vigorously defending the action. No trial date has been set. Counsel has obtained a letter from counsel for plaintiffs in which counsel for plaintiffs conclude that there is insufficient evidence to maintain the claim against the defendants. This matter has been set for jury trial during the two-week period commencing June 6, 1994. Elliot Borkson, et al vs. BFC Financial Corporation. Circuit Court of the 11th Judicial Circuit in and for Dade County Florida. Case No. 88-11171 (CA 10). In March 1988, a group of approximately 54 shareholders of BankAtlantic filed a class action suit against Registrant alleging Registrant had breached its agreement, contained in an option agreement ("the Pearce Agreement") pursuant to which Registrant had purchased shares of BankAtlantic, to offer to acquire all of the remaining outstanding shares of BankAtlantic at a price equal to the greater of (i) $18 per share or (ii) an amount per share which, in the opinion of an investment banking firm of recognized national standing, is fair to the stockholders of BankAtlantic. Such obligation was subject to receipt of all required regulatory approvals and was relieved if there occurred a material adverse change in financial conditions affecting the savings and loan industry. Plaintiffs seek to recover compensatory damages arising from Registrant's alleged breach of contract, costs, interest and attorneys fees. In April 1988, BankAtlantic joined in a motion to stay the proceedings pending resolution of a similar action filed in Pennsylvania and transferred to the United States District Court for the Southern District of Florida. The stay with respect to the proceedings remains in effect. Marvin E. Blum, et al vs. BFC Financial Corporation; Alan B. Levan and Jack Abdo. Case No. 88-6277, U.S. District Court for the Southern District of Florida. This litigation was commenced on February 11, 1988, by International Apparel Associates as a class action against BFC Financial Corporation and Alan Levan. Subsequently, the Borkson plaintiffs and their counsel were substituted for International Apparel, with Dr. Marvin Blum being designated as the class representative. Jack Abdo was also added as a party defendant. The plaintiff class was certified by the district court as "all persons, other than defendants, and their affiliates, officers, and members of their immediate family who owned shares of BankAtlantic common stock on February 6, 1988, or their successors in interest". The Second Amended Complaint, upon which this action is presently based, asserts a claim for breach of contract and a claim for violation of Section 10(b) of the Securities Exchange Act of 1934. Plaintiffs allege that they, as minority shareholders of BankAtlantic, A Federal Savings Bank, are third party beneficiaries of an option agreement between BFC Financial Corporation and Dr. Pearce requiring BFC Financial Corporation to offer to purchase all their shares of BankAtlantic subject to certain conditions. Plaintiffs claim that none of the conditions set forth in the Pearce Agreement arose to excuse BFC Financial Corporation from offering to buy the shares; defendants claim that those conditions did in fact occur and that BFC Financial Corporation did not, therefore, have any obligation to offer to purchase the shares. Plaintiffs also allege that defendants made certain misrepresentations regarding their intentions to perform pursuant to the Pearce agreement, which defendants deny. Settlement negotiations, which had been progressing, have terminated. The plaintiffs have requested that this matter be rescheduled for trial. Pretrial conference has been conducted, however, no trial date has been set. During 1989 and 1991, the Company exchanged subordinated debentures for the assets and liabilities of certain affiliated partnerships. While, to the Company's knowledge, no formal order of investigation is pending, the Securities and Exchange Commission ("SEC") has advised the Company that it is currently reviewing the transactions. 26. COMMITMENTS AND CONTINGENCIES See note 15 of notes to consolidated financial statements of BankAtlantic, A Federal Savings Bank and Subsidiaries, included elsewhere herein. 27. QUARTERLY FINANCIAL INFORMATION (unaudited) Following is quarterly financial information for the years ended 1993, 1992 and 1991 (in thousands, except per share data): During the fourth quarter of 1993, the company's ownership interest in BankAtlantic's decreased from 77.83% to 48.17% with the ownership percentage less than 50% the accounts of BankAtlantic Financial Corporation have been removed from the consolidated financial statement and the company's investment in BankAtlantic Financial Corporation is recorded using the equity methods. The effect of this change has been applied effective January 1, 1993. The company's quarterly filings for the first three quarters of 1993 were done with the accounts of BankAtlantic Financial Corporation on a consolidated basis but are reflected herein without the inclusion of the accounts of BankAtlantic Financial Corporation. During the fourth quarter 1992, BankAtlantic sold approximately $115.4 million of mortgage-backed securities at a gain of $6.8 million including purchase accounting adjustments of $1.6 million. Additionally, BankAtlantic recovered $3.3 million in expenses, recorded loan loss recoveries of $7.3 million and increased interest income by $1.9 million for circumstances relating to the Subject Portfolio and the Covenant Not to Execute discussed in note 30. Also during the fourth quarter, the Company recorded a $548,000 ($.32 per share) extraordinary gain, net of minority interest of $208,000 from the utilization of state net operating loss carryforwards. During the quarter ended March 31, 1991, an extraordinary gain of $350,000 net of applicable taxes and minority interest amounting to $340,000 and $197,000, respectively, was attributable to the early extinguishment of 1986 Notes. 28. PARENT COMPANY FINANCIAL INFORMATION A summary of the Company's condensed statements of financial condition as of December 31, 1993 and 1992, and condensed statements of operations and cash flows for each of the years in the three year period ended December 31, 1993 follows (in thousands): STATEMENTS OF FINANCIAL CONDITION ASSETS December 31, ------------ 1993 1992 ---- ---- Cash and short term investments $ (21) 133 Investments - other 17,169 489 Investment in BankAtlantic 36,436 42,984 Investment in other subsidiaries 34,562 40,125 Mortgages receivable 1,097 1,110 Subordinated debentures receivable from BankAtlantic - 1,776 Other assets 923 944 ------ ------ $ 90,166 87,561 ====== ====== LIABILITIES AND STOCKHOLDERS' (DEFICIT) December 31, ------------ 1993 1992 ---- ---- Exchange debentures, net $ 35,651 38,996 Mortgages payable and other debt 1,250 1,323 Deferred interest exchanged debentures 12,049 6,126 Other liabilities (primarily due to subsidiaries 40,390 38,218 other than BankAtlantic) Deferred income tax 2,038 2,038 ------ ------ Total liabilities 91,378 86,701 Redeemable common stock 5,776 5,776 Stockholders' (deficit) Preferred stock of $.01 par value; authorized 10,000,000 shares; none issued - - Special class A common stock of $.01 par value; authorized 20,000,000 shares: none issued - - Common stock of $.01 par value; authorized 20,000,000 shares; issued 2,351,021 in 1993 and 1992 17 17 Additional paid in capital 15,264 15,532 Accumulated deficit (21,989) (20,185) Treasury stock (45,339 shares in 1993 and 1992) (280) (280) ------ ------- Total stockholders' (deficit) (6,988) (4,916) ------ ------- $ 90,166 87,561 ======= ======= STATEMENTS OF OPERATIONS 1993 1992 1991 ---- ---- ---- Revenue-interest and other $ 1,834 1,062 1,672 Expenses-interest and other 8,338 9,495 7,759 ------ ------ ------- (Loss) before equity in earnings (loss) of subsidiaries and extraordinary items (6,504) (8,433) (6,087) Equity in earnings (loss) of BankAtlantic before extraordinary items and cumulative effect of change in accounting for income taxes 10,764 12,135 (6,926) Equity in (loss) of other subsidiaries (5,563) (1,693) (4,696) ------ ------ ------- Earnings (loss) before income taxes, extraordinary items and cumulative effect of change in accounting for income taxes (1,303) 2,009 (17,709) Income tax benefits - - - ------ ------ ------- Earnings (loss) before extraordinary items and cumulative effect of change in accounting for income taxes (1,303) 2,009 (17,709) Cumulative effect of change in accounting for income taxes (501) - - Extraordinary item related to BankAtlantic - 548 350 ------ ------ ------- Net earnings (loss) $ (1,804) 2,557 (17,359) ====== ====== ======= STATEMENTS OF CASH FLOWS 1993 1992 1991 ---- ---- ---- Operating Activities: Earnings (loss) before extraordinary items and cumulative effect of change in accounting for income taxes (1,303) 2,009 (17,709) Adjustments to reconcile earnings (loss) to net cash used by operating activities: Equity in (earnings) loss of BankAtlantic before extraordinary item (10,764) (12,135) 6,926 Equity in net loss of other subsidiaries 5,563 1,693 4,696 Depreciation 25 11 18 Amortization of discount on loans receivable - (43) (238) Accretion on subordinated debentures 173 320 539 Tax effect on debentures (65) (107) (142) Gain on sale of real estate owned - (90) - Loss of mortgage receivables - 209 17 Gain on sale of BankAtlantic common stock (1,050) - - Increase in deferred interest on the exchange debentures 5,923 4,985 1,140 Decrease (increase) in other assets 215 269 (51) Increase (decrease) in other liabilities 362 1,811 (287) ------ ------ ------ Net cash used by operating activities (921) (1,068) (5,091) ------ ------ ------ Investing Activities: Cash used in debenture exchange - - (282) Loans purchased or originated - - (2,182) Principal collected on loans 13 1,013 87 Proceeds from sale of BankAtlantic common stock 17,691 - - Dividends from BankAtlantic common stock 271 - - Increase in investment in BankAtlantic (1,971) (88) Decrease (increase) in other investments (16,680) 717 (1,206) Increase (decrease) in subordinated debentures of BankAtlantic 1,776 (1,025) (751) Advances (to) and from other subsidiaries (228) 3,273 13,403 Additions to office properties and equipment (32) (17) (11) Proceeds from sale of real estate owned - 429 - ------ ------ ------ Net cash provided by investing activities 840 4,390 8,970 ------ ------ ------ Financing Activities: Borrowings - - 1,722 Repayment of borrowings (73) (3,098) (5,395) Purchase of treasury stock - - (53) Loan cost - - (160) ------ ------- ------ Net cash (used) by financing activities (73) (3,098) (3,886) ------ ------- ------ Increase (decrease) in cash and short term investments (154) 224 (7) Cash and short term investments at beginning of period 133 (91) (84) ------ ------- ------ Cash and short term investments at end of period $ (21) 133 (91) ====== ======= ======= Interest paid on other borrowings and subordinated debentures amounted to approximately $94,000, $342,000 and $3,720,000 for the years ended December 31, 1993, 1992 and 1991, respectively. Income taxes paid amounted to approximately $3,600, and $4,000 for the years ended December 31, 1992, and 1991 respectively. Non-cash investing activities during 1991 consisted of the Company's capitalization of subsidiaries contribution of the real estate, related mortgage debt and other assets and liabilities received by the Company in Exchange for its issuance of subordinated debentures. (See note 2.) Other non-cash investing and financing activities of BFC are the retirement of treasury stock, the issuance of redeemable common stock, loans transferred to real estate owned and proceeds from sale of real estate owned. Short term investments are defined as those investments with a maturity of three months or less. For a description of dividend restrictions related to BankAtlantic, see note 16 of notes to consolidated financial statements of BankAtlantic, A Federal Savings Bank and Subsidiaries, included elsewhere herein. 29. REGULATORY MATTERS See note 16 of notes to consolidated financial statements of BankAtlantic, A Federal Savings Bank and Subsidiaries, included elsewhere herein. 30. Dealer Reserve See note 17 of notes to consolidated financial statements of BankAtlantic, A Federal Savings Bank and Subsidiaries, included elsewhere herein. 31. Consolidated Statements of Cash Flows In addition to the non-cash investing and financing activities described in notes 2 and 8, other non-cash investing and financing activities are as follows: December 31, -------------------- 1993 1992 1991 ------ ------ ------ Retirement of treasury stock: Decrease in treasury stock $ - - 53 Decrease in common stock - - (1) Decrease in additional paid in capital - - l52 Securitization of loans - - 40,361 Loans transferred to REO and other repossessed assets - 7,994 10,810 Effect of issuance of BankAtlantic common stock to BankAtlantic minority stockholders 268 - - Loan charge-offs - 12,679 20,856 Costs of assets transferred to available for sale - 305,731 67,269 Mortgages eliminated in connection with sales of real estate acquired in debenture Exchanges - 8,821 6,951 Real estate owned charge-offs - 2,398 6,973 BankAtlantic dividends on common stock declared and not received 187 - - Interest paid on borrowings 2,948 59,933 99,980 32. Estimated Fair Value of Financial Instruments The information set forth below provides disclosure of the estimated fair value of the Company's financial instruments presented in accordance with the requirements of Statement of Financial Accounting Standards No. 107, "Disclosures about Fair Value of Financial Instruments" (FAS 107) issued by the FASB. Management has made estimates of fair value discount rates that it believes to be reasonable. However, because there is no market for many of these financial instruments, management has no basis to determine whether the fair value presented would be indicative of the value negotiated in an actual sale. The Company's fair value estimates do not consider the tax effect that would be associated with the disposition of the assets or liabilities at their fair value estimates. Fair value for the 1989 Exchange debentures is based upon the value established in a December 1992 jury verdict in connection with litigation regarding that transaction. With respect to the 1991 Exchange debentures, fair value has been determined based upon the amount included in a settlement agreement regarding litigation pertaining to those debentures. The following table presents information for the Company's financial instruments as of December 31, 1993 and 1992 (in thousands): 1993 1992 -------------- -------------- Carrying Fair Carrying Fair Amount Value Amount Value -------- ----- ------- ------- Financial assets: Cash and due from depository institutions $ 78 78 31,357 31,357 Mortgage-backed securities - - 486,886 498,995 Tax certificates and other investment securities 20,644 20,644 125,047 126,911 Loans receivable 9,179 9,179 582,523 607,153 Financial liabilities: Deposits - - 1,108,115 1,118,194 Securities sold under agreements to repurchase - - 21,532 21,532 Capital notes and other subordinated debentures - - 7,928 8,572 Mortgage payable and other borrowings 30,367 30,367 32,168 32,168 Exchange debentures, net 35,651 29,166 38,996 32,385 Advances from Federal Home Loan Bank - - 66,100 66,921 ======== ====== ======= ======= See note 21 of notes to consolidated financial statements of BankAtlantic, A Federal Savings Bank and Subsidiaries, included elsewhere herein. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III -------- Items 10 through 13 is incorporated by reference to the Company's definitive proxy statement to be filed with the Securities and Exchange Commission, no later than 120 days after the end of the year covered by this Form 10-K, or, alternatively, by amendment to this Form 10-K under cover of Form 8 not later than the end of such 120 day period. PART IV ------- ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a)-1 Financial Statements - See Item 8 (a)-2 Financial Statement Schedules - All schedules are omitted as the required information is either not applicable or presented in the financial statements or related notes. (a)-3 Index to Exhibits (3) Articles of Incorporation, as amended - See Exhibit (3) of Registrant's Annual Report on Form 10-K for the year ended December 31, 1989. By-laws - See Exhibit E of Proxy Statement/Prospectus dated June 20, 1980. (4) Instruments defining the rights of security holders, including indentures - Not applicable. (9) Voting trust agreement - Not applicable. (10) Material contracts: - Proposed form of Supervisory Agreement. Attached as Exhibit 10. - Stock Purchase Agreement dated as of December 22, 1987 by and among John E. Abdo and certain members of his immediate family and BFC Financial Corporation. See Exhibit (10) of Registrant's Annual Report on Form 10-K for the year ended December 31, 1987. (11) Statement re computation of per share earnings - Not applicable. (12) Statement re computation of ratios - Ratio of earnings to fixed charges - attached as Exhibit 12. (13) Annual Report to security holders, Form 10-Q or quarterly report to security holders - Not applicable. (16) Letter re change in certifying accountant - Not applicable. (18) Letter re change in accounting principles - Not applicable. (19) Previously unfiled documents - Not applicable. (22) Subsidiaries of the registrant: State of Name Organization ---- ------------ BankAtlantic, A Federal Savings Bank Federal Charter Realty 2000 Corporation Florida Eden Services, Inc. Florida Eden United, Inc. Florida First Pensacola Mortgage Company, Inc. Florida U.S. Capital Securities, Inc. Florida I.R.E. Property Analysts, Inc. Florida I.R.E. Realty Advisory Group, Inc. Florida I.R.E. Real Estate Investments, Inc. Florida I.R.E Real Estate Investments, Series 2, Inc. Florida I.R.E. Property Management, Inc. Florida I.R.E. Real Estate Funds, Inc. Florida I.R.E. Advisors Series 21, Corp. Florida I.R.E. Advisors Series 23, Corp. Florida I.R.E. Advisors Series 24, Corp. Florida I.R.E. Advisors Series 25, Corp. Florida I.R.E. Advisors Series 26, Corp. Florida I.R.E. Advisors Series 27, Corp. Florida I.R.E. Advisors Series 28, Corp. Florida I.R.E. Advisors Series 29, Corp. Florida I.R.E. Income Advisors Corp. Florida I.R.E. Pension Advisors, Corp. Florida I.R.E. Pension Advisors II, Corp. Florida (23) Published report regarding matters submitted to vote of security holders - Not applicable. (24) Consents of experts and counsel - Not applicable. (25) Power of attorney - Not applicable. (28) Additional exhibits - Not applicable. (b) Reports on Form 8-K No reports on Form 8-K have been filed during the last quarter of the period covered by this report. (c) Exhibits - See 14(a) - 3 above. (d) Financial statements of subsidiaries not consolidated and fifty percent or less owned persons: BankAtlantic, A Federal Savings Bank and Subsidiaries: Consolidated Financial Statements: Independent Auditors' Report Consolidated Statements of Financial Condition as of December 31, 1993 and 1992 Consolidated Statements of Operations for each of the years in the three year period ended December 31, 1993 Consolidated Statements of Stockholders' Equity for each of the years in the three year period ended December 31, 1993 Consolidated Statements of Cash Flows for each of the years in the three year period ended December 31, 1993 Notes to Consolidated Financial Statements Selected Consolidated Financial Data Management's Discussion and Analysis of Results of Operations and Financial Condition 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. BFC FINANCIAL CORPORATION Registrant By: /S/ Alan B. Levan ------------------------------ Alan B. Levan, President 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 dates indicated. /S/ Alan B. Levan March 30, 1994 - ---------------------------------------- ALAN B. LEVAN, Director and Principal Executive Officer /S/ Glen R. Gilbert March 30, 1994 - ---------------------------------------- GLEN R. GILBERT, Chief Financial Officer /S/ John E. Abdo March 30, 1994 - ---------------------------------------- JOHN E. ABDO, Director /S/ Earl Pertnoy March 30, 1994 - ---------------------------------------- EARL PERTNOY, Director /S/ Carl E.B. McKenry, Jr. March 30, 1994 - ---------------------------------------- CARL E. B. McKENRY, JR., Director Consolidated Financial Statements: Independent Auditors' Report Consolidated Statements of Financial Condition as of December 31, 1993 and 1992 Consolidated Statements of Operations for each of the years in the three year period ended December 31, 1993 Consolidated Statements of Stockholders' Equity for each of the years in the three year period ended December 31, 1993 Consolidated Statements of Cash Flows for each of the years in the three year period ended December 31, 1993 Notes to Consolidated Financial Statements Selected Consolidated Financial Data Management's Discussion and Analysis of Results of Operations and Financial Condition INDEPENDENT AUDITORS' REPORT The Board of Directors BankAtlantic, A Federal Savings Bank: We have audited the accompanying consolidated statements of financial condition of BankAtlantic, A Federal Savings Bank ("the Bank") and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, stockholders' equity and cash flows for each of the years in the three year period ended December 31, 1993. These consolidated financial statements are the responsibility of the Bank's management. Our responsibility is to express an opinion on these consolidated 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 consolidated 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 BankAtlantic, A Federal Savings Bank and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the years in the three year period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed in Note 13, the Bank changed its method of accounting for income taxes on 1993 to adopt the provisions of the Financial Accounting Standard Board's SFAS No. 109, "Accounting for Income Taxes." March 8, 1994 KPMG Peat Marwick CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION December 31, 1993 1992 ---------- ---------- (In thousands, except share data) ASSETS Cash and due from depository institutions $ 36,351 31,208 Tax certificates and other investment securities (approximate market value $97,588 and $120,424) 97,701 120,424 Loans receivable (net of unearned discount of $2,944 and $1,733) 607,135 565,521 Loans originated for resale 5,752 7,641 Less: Allowance for loan losses (17,000) (16,500) ---------- ---------- Total loans receivable, net 595,887 556,662 ---------- ---------- Mortgage-backed securities (approximate market value: $453,346 and $353,984) 443,249 349,531 Mortgage-backed securities available for sale (approximate market value: $87,572 and $145,011) 83,116 137,963 Accrued interest receivable 17,574 22,188 Real estate owned 9,651 14,997 Office properties and equipment, net 37,373 38,596 Federal Home Loan Bank stock at cost, which approximates market value ($1,288 and $924 available for sale) 8,730 8,366 Purchased mortgage servicing rights 19,833 7,282 Deferred tax asset, net 423 - Other assets 9,307 15,854 ---------- ---------- Total assets $ 1,359,195 1,303,071 ========== ========== LIABILITIES AND STOCKHOLDERS' EQUITY Liabilities: Deposits $ 1,076,360 1,108,115 Advances from FHLB 128,300 66,100 Securities sold under agreements to repurchase 21,135 21,532 Capital notes and other subordinated debentures - 9,524 Drafts payable 573 1,246 Advances by borrowers for taxes and insurance 15,991 9,193 Other liabilities 26,184 18,816 Deferred income taxes, net - 2,380 ---------- ---------- Total liabilities 1,268,543 1,236,906 ---------- ---------- Commitments and contingencies Stockholders' equity: Non-cumulative preferred stock, $25.00 per share preference value, $0.01 par value: 10,000,000 shares authorized all series; 12.25% Series A, 188,600; 10.00% Series B, 17,120; 8.00% Series C, 129,870 3 3 Additional paid-in capital - preferred stock 7,033 7,033 Common stock, $0.01 par value, authorized 15,000,000 shares; issued and outstanding, 6,478,605 and 4,681,628 shares 65 41 Additional paid-in capital 46,726 29,394 Retained earnings 36,825 29,694 ---------- ---------- Total stockholders' equity 90,652 66,165 ---------- ---------- Total liabilities and stockholders' equity $ 1,359,195 1,303,071 ========== ========== See Notes to Consolidated Financial Statements CONSOLIDATED STATEMENTS OF OPERATIONS For the Years Ended December 31, 1993 1992 1991 ---------- ---------- ---------- (In thousands, except per share data) Interest income: Interest and fees on loans $ 47,649 62,229 89,638 Interest on mortgage-backed securities 24,891 36,541 34,364 Interest on mortgage-backed securities available for sale 9,473 527 1,172 Interest and dividends on tax certificates and other investment securities 11,903 17,179 20,358 Other 587 - - ---------- ---------- ---------- Total interest income 94,503 116,476 145,532 ---------- ---------- ---------- Interest expense: Interest on deposits 31,798 47,411 83,253 Interest on advances from FHLB 2,359 3,725 3,603 Interest on securities sold under agreements to repurchase 1,082 2,881 1,671 Interest on capital notes and other subordinated debentures 748 1,550 2,014 Other - - 457 ---------- ---------- ---------- Total interest expense 35,987 55,567 90,998 ---------- ---------- ---------- Net interest income 58,516 60,909 54,534 Provision for loan losses 3,450 6,650 17,540 ---------- ---------- ---------- Net interest income after provision for loan losses 55,066 54,259 36,994 Non-interest income: Loan servicing and other loan fees 2,080 3,189 4,344 Gain on sales of loans 1,246 976 330 Gain on sales of mortgage-backed securities - 5,726 748 Gain on sales of investment securities - 143 62 Other 8,265 7,337 8,622 ---------- ---------- ---------- Total non-interest income 11,591 17,371 14,106 ---------- ---------- ---------- Non-interest expenses: Employee compensation and benefits 19,617 19,202 24,062 Occupancy and equipment 8,417 8,864 10,626 Federal insurance premium 2,750 2,772 3,281 Advertising and promotion 960 480 1,143 (Income) loss from joint venture investments 25 245 (2,335) Foreclosed asset activity, net 1,243 4,323 8,922 (Recovery) write-down of dealer reserve - (2,739) 2,739 Provision for branch consolidation - - 1,618 Other 10,474 13,990 15,108 ---------- ---------- ---------- Total non-interest expenses 43,486 47,137 65,164 ---------- ---------- ---------- (Continued) For the Years Ended December 31, 1993 1992 1991 ---------- ---------- ---------- Income (loss) before income taxes and extraordinary items 23,171 24,493 (14,064) Provision (benefit) for income taxes 7,093 9,201 (4,841) ---------- ---------- ---------- Income (loss) before extraordinary items 16,078 15,292 (9,223) Extraordinary items - 756 660 ---------- ---------- ---------- Net income (loss) 16,078 16,048 (8,563) Dividends on non-cumulative preferred stock paid by BFC escrow 147 880 715 Dividends on non-cumulative preferred stock 733 0 0 ---------- ---------- ---------- Total dividends on non-cumulative preferred stock 880 880 715 ---------- ---------- ---------- Net income (loss) on common shares $ 15,198 15,168 (9,278) ========== ========== ========== Income (loss) per common and common equivalent share: Income (loss) before extraordinary items $ 2.52 3.07 (2.12) Extraordinary items - 0.16 0.14 ---------- ---------- ---------- Net income (loss) $ 2.52 3.23 (1.98) ========== ========== ========== Income per common and common equivalent share assuming full dilution: Income before extraordinary item $ 2.51 2.65 N/A Extraordinary item - 0.14 N/A ---------- ---------- ---------- Net income $ 2.51 2.79 N/A ========== ========== ========== See Notes to Consolidated Financial Statements CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY For Each of the Years in the Three Year Period Ended December 31, 1993 Additional Paid-in Additional Capital Common Paid-in Retained Preferred Preferred Stock Capital Earnings Stock Stock Total ----- -------- -------- -------- -------- -------- (In thousands) Balance, December 31, 1990 $ 41 29,385 23,804 - - 53,230 Net loss - - (8,563) - - (8,563) Dividends on preferred stock - - (715) - - (715) Conversion of subordinated debt to preferred stock - - - 3 7,033 7,036 Proceeds from issuance of common stock and warrants - 9 - - - 9 ----- -------- -------- -------- -------- -------- Balance, December 31, 1991 $ 41 29,394 14,526 3 7,033 50,997 Net income - - 16,048 - - 16,048 Dividends on preferred stock - - (880) - - (880) ----- -------- -------- -------- -------- -------- Balance, December 31, 1992 $ 41 29,394 29,694 3 7,033 66,165 Net income - - 16,078 - - 16,078 Dividends on preferred stock - - (880) - - (880) Dividends on common stock - - (738) - - (738) 15% common stock dividend 6 7,323 (7,329) - - 0 Common stock issued to BFC upon conversion of warrants 11 1,960 - - - 1,971 Proceeds from issuance of common stock 7 8,049 - - - 8,056 ----- -------- -------- -------- -------- -------- Balance 65 46,726 36,825 3 7,033 90,652 December 31, 1993 ===== ======== ======== ======== ======== ======== See Notes to Consolidated Financial Statements CONSOLIDATED STATEMENTS OF CASH FLOWS For the Years Ended December 31, 1993 1992 1991 ---------- ---------- ---------- (In thousands) Operating activities: Income (loss) before extraordinary item $ 16,078 15,292 (9,223) Adjustments to reconcile income (loss) before extraordinary item to net cash provided by operating activities: Provision for loan losses 3,450 6,650 17,540 Provision for declines in real estate owned 2,675 3,827 7,273 FHLB stock dividends (364) (498) (618) Depreciation 3,408 3,332 2,868 Amortization of purchased mortgage servicing rights 4,452 2,573 1,274 Increase (decrease) in deferred income taxes (2,803) 1,775 (4,480) Utilization of net operating loss carryforward - 756 - Net accretion of securities 9 (456) (243) Net amortization of deferred loan origination fees (794) (41) (40) Loss (gain) on sales of real estate owned (1,211) (648) 59 Proceeds from loans originated for sale 46,229 37,030 15,279 Origination of loans for sale (43,094) (39,888) (18,756) Gain on sales of loans (1,246) (976) (330) Gain on sales of mortgage-backed securities available for sale - (5,726) (748) Loss (gain) on sales of office properties and equipment 73 71 (7) Gain on sale of investment securities - (143) (62) Loss (income) from joint venture operations 25 245 (2,335) Decrease in accrued interest receivable 4,614 2,253 4,647 Amortization of dealer reserve 3,464 6,406 5,491 Prepayments of dealer reserve - - (1,417) Write-down of dealer reserve - - 2,739 (Increase) decrease in other assets 3,057 (4,567) 3,481 Decrease in drafts payable (673) (9,410) (1,403) Increase (decrease) in other liabilities 7,206 (757) 3,524 Write-off of office properties and equipment 222 - 461 Provision for branch consolidation - - 1,618 Provision for tax certificate losses 1,660 1,160 811 ---------- ---------- ---------- Net cash provided by operating activities $ 46,437 18,260 27,403 ---------- ---------- ---------- Investing activities: Proceeds from sales of investment securities$ - 2,137 30,235 Purchase of tax certificates and other investment securities (121,538) (125,197) (121,826) Proceeds from redemption and maturities of tax certificates and other investment securities 142,559 110,695 117,714 Loans purchased (5,142) - - Principal reduction on loans 289,037 297,263 298,076 Loans originated for portfolio (220,130) (136,179) (122,511) Bankers acceptances purchased (109,931) - - Proceeds from sales of mortgage-backed securities available for sale - 155,243 70,903 (Continued) For the Years Ended December 31, 1993 1992 1991 ---------- ---------- ---------- Mortgage-backed securities purchased (206,854) (271,041) (98,587) Principal collected on mortgage-backed securities 168,016 95,266 56,634 Proceeds from sales of real estate owned 6,278 11,113 2,937 Purchases and additional investments in real estate owned - - (1,374) Additions to office properties and equipment (2,525) (728) (1,026) Sales of office equipment 46 105 525 Advances to joint ventures - (26) (2,690) Repayments of advances to joint ventures - 77 12,929 Investments in joint ventures - - (115) Cash distributions from joint ventures - - 561 FHLB stock sales - 142 3,071 FHLB stock purchased - (65) - Settlement of amount due from broker - - 154,686 Servicing rights purchased (17,003) (3,832) (3,457) ---------- ---------- ---------- Net cash provided (used) by investing activities $ (77,187) 134,973 396,685 ---------- ---------- ---------- Financing activities: Net decrease in deposits $ (59,370) (190,907) (272,307) Interest credited to deposits 27,615 43,509 71,853 Proceeds from FHLB advances 95,000 107,300 - Repayments of FHLB advances (32,800) (78,400) (25,700) Net decrease in securities sold under agreements to repurchase (397) (35,600) (189,847) Decrease in federal funds purchased - - (14,500) Payments for exchange of capital notes for preferred stock - - (1,855) Redemption of capital notes and other subordinated debentures (7,927) (7,022) (225) Issuance of common stock and warrants, net 8,056 - 9 Receipts of advances by borrowers for taxes and insurance 43,782 33,933 34,794 Payment for advances by borrowers for taxes and insurance (36,984) (33,220) (32,678) Preferred stock issuance costs - - (353) Proceeds from issuance of subordinated debt - - 8 Preferred stock dividends paid (733) - - Common stock dividends paid (349) - - ---------- ---------- ---------- Net cash provided (used) by financing activities 35,893 (160,407) (430,801) ---------- ---------- ---------- Increase (decrease) in cash and cash equivalents 5,143 (7,174) (6,713) Cash and cash equivalents at beginning of period 31,208 38,382 45,095 Cash and cash equivalents at ---------- ---------- ---------- end of period $ 36,351 31,208 38,382 ========== ========== ========== For the Years Ended December 31, 1993 1992 1991 ---------- ---------- ---------- Supplementary disclosure of non-cash investing and financing activities: Interest paid on borrowings $ 36,536 55,795 92,814 Income taxes paid 11,198 5,800 355 Income taxes refunded 1,629 370 - Loans transferred to real estate owned 2,396 7,994 6,729 Loans charged-off 4,487 12,679 20,856 Real estate owned charged-off 775 1,927 6,973 Costs of assets transferred to available for sale - 305,731 67,269 Capital notes exchanged for preferred stock - - (8,389) Preferred stock issued - - 7,389 Extraordinary gain from early extinguishment of capital notes - - 660 Extraordinary gain-income taxes payable - - 340 Subordinated debentures due to BFC which was utilized by BFC to exercise related warrants to purchase common stock of BankAtlantic 1,971 - - Common stock issued to BFC upon exercise of warrants (1,971) - - Issuance of subordinated debentures to BFC for payment of preferred stock dividends 147 880 715 Preferred stock dividends paid by BFC escrow (147) (880) (715) Common stock dividends declared and not paid 389 - - Loans securitized - - 40,361 ========== ========== ========== See Notes to Consolidated Financial Statements NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 1. Summary of Significant Accounting Policies Basis of Financial Statement Presentation - The financial statements have been prepared in conformity with generally accepted accounting principles ("GAAP"). In preparing the financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the statements of financial condition and operations for the periods presented. Actual results could differ significantly from those estimates. Material estimates that are particularly susceptible to significant change in the next year relate to the determination of the allowance for loan losses and the valuation of real estate acquired in connection with foreclosure or in satisfaction of loans. In connection with the determination of the allowances for loan losses and real estate owned, management obtains independent appraisals for significant properties when it is deemed prudent. Principles of Consolidation - The consolidated financial statements include the accounts of BankAtlantic and its wholly-owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation. At December 31, 1993, BankAtlantic, a Federal Savings Bank ("BankAtlantic") was 48.17% owned by BFC Financial Corporation ("BFC"). Certain amounts for prior years have been reclassified to conform with statement presentations for 1993. The reclassifications have no effect on the financial position or results of operations as previously reported. Cash Equivalents - Cash and due from depository institutions include demand deposits at other financial institutions and federal funds sold. Generally, federal funds are sold for one-day periods. Tax Certificates, Other Investment Securities and Mortgage-Backed Securities - Tax certificates, other investment securities and mortgage-backed securities held for investment are carried at cost. Amortization of premiums and accretion of discounts is based on the interest method which for mortgage- backed securities relates to the estimated remaining lives of the underlying loans. Mortgage-backed securities available for sale are carried at the lower of aggregate cost or market value. The held for investment classification includes only those securities that management has both the intent and ability to hold until maturity. The available for sale category would include all securities that BankAtlantic may elect to sell when events which were not reasonably foreseeable at the time of acquisition make a sale advisable including such events as changes in the interest rate environment, changes in BankAtlantic's interest rate position and sensitivity gap, nature of other available investments, and existing and proposed regulatory requirements make such sales likely. Securities transferred to the available for sale category are transferred at the lower of aggregate cost or market value. Any excess of aggregate cost over market is charged to operations at the time of transfer. Gains or losses on sales of securities are determined by the specific identification method. Allowance for Loan Losses - The allowance for loan losses represents the total amount available to absorb loan losses. Management believes that the allowance for loan losses is adequate. The allowance is based on management's evaluation, which includes a review of all loans on which full collectibility may not be reasonably assured and considers, among other matters, the estimated fair value of the underlying collateral on the loan and such factors as changes in the nature and volume of the loan portfolio, overall portfolio quality, review of specific non-performing loans, and current economic conditions and trends that may affect the borrower's ability to repay. Increases in the allowance for loan losses are recorded when losses are both probable and estimable. In addition, various regulatory agencies, as an integral part of their examination process, periodically review BankAtlantic's allowance for loan losses. Such agencies may require BankAtlantic to recognize additions to the allowance based on their judgments about information available to them at the time of their examination. Construction and Development Lending - BankAtlantic's construction and development lending generally requires an equity investment in the form of contributed assets from the borrower. Other than advances to joint ventures, BankAtlantic has no loans which provide for a participation in profits at December 31, 1993 and 1992. Accordingly, construction and development lending arrangements have been classified and accounted for as loans. Non-Accrual Loans and Real Estate Owned - Loans are generally placed on non-accrual status when the loans become 90 days past due as to principal and interest or when, in management's opinion, collection of interest or principal becomes uncertain. Accrued interest is reversed against current income, amortization of deferred net fees and discounts are discontinued, and interest income collected is recognized when the loan is returned to a current status. Loans that have been placed on non-accrual are generally not restored to an accrual basis until all delinquent principal and/or interest has been brought current. Real estate owned ("REO") is comprised of real estate acquired in settlement of loans and loans treated as in-substance foreclosures. Real estate acquired for development by BankAtlantic, or joint ventures in which BankAtlantic has an equity interest, is stated at the lower of cost or estimated net realizable value. During the period of the accompanying financial statements, BankAtlantic did not have any real estate acquired for development. Profit on real estate sold is recognized when the collectibility of the sales price is reasonably assured and BankAtlantic is not obligated to perform significant activities after the sale. Any estimated loss is recognized in the period in which it becomes apparent. REO is recorded at the lower of the loan balance, plus acquisition costs, or fair value, less estimated disposition costs. Expenditures for capital improvements made thereafter are generally capitalized. Real estate acquired in settlement of loans is anticipated to be sold and valuation allowance adjustments are made to reflect any subsequent changes in fair values from the initially recorded amount. Costs of holding REO are charged to operations as incurred. Provisions and recoveries in the REO valuation allowance are reflected in operations. Office Properties and Equipment - Land is carried at cost. Office properties and equipment are carried at cost less accumulated depreciation. Depreciation is computed on the straight-line method over the estimated useful lives of the assets which generally range up to 50 years for buildings and 10 years for equipment. The cost of leasehold improvements is being amortized using the straight-line method over the terms of the related leases. Expenditures for new properties and equipment and major renewals and betterments are capitalized. Expenditures for maintenance and repairs are charged to expense as incurred and gains or losses on disposal of assets are reflected in current operations. Investments in Joint Ventures - Investments in joint ventures are accounted for by the equity method. Loans Originated for Sale - Residential first mortgage loans originated for sale are reported at the lower of cost or market. Loan origination fees and related direct loan origination costs for these loans are deferred until the related loan is sold. Generally these loans are committed for sale prior to origination. Accordingly, the holding period for such loans is minimal. Loan Origination and Commitment Fees, Premiums and Discounts on Loans and Mortgage Banking Activities - Origination and commitment fees collected are deferred net of direct costs and are being amortized to interest income over the loan life using the level yield method. Amortization of deferred fees is discontinued when collectibility of the related loan is deemed to be uncertain. Commitment fees related to expired commitments are recognized as income when the commitment expires. Unearned discounts on installment, second mortgage and home improvement loans are amortized to income using the level yield over the terms of the related loans. Unearned discounts on purchased loans are amortized to income using the effective interest method over the estimated life of the loans. Loan Servicing Fees - BankAtlantic services mortgage loans for investors. These mortgage loans serviced are not included in the accompanying consolidated statements of financial condition. Loan servicing fees are based on a stipulated percentage of the outstanding loan principal balances being serviced and are recognized as income when related loan payments from mortgagors are collected. Loan servicing costs are charged to expense as incurred. Amounts paid for purchased mortgage servicing rights are amortized to expense using the level yield over the estimated life of the loan, and continually adjusted for prepayments. Management evaluates the carrying value of purchased mortgage servicing by estimating the future net servicing income of the portfolio on a discounted, disaggregated basis, based on estimates of the remaining loan lives. Mortgage servicing rights related to loans originated by BankAtlantic, are not capitalized. Dealer Reserves, Net - The dealer reserve receivable represents the portion of interest rates passed through to dealers on indirect consumer loans. BankAtlantic had funded 0 - 100% of the total dealer reserve at the inception of the loan. Dealer reserves are amortized over the contractual life of the related loans, adjusted for actual prepayments, using the interest method except for the Subject Portfolio discussed further in Note 17 herein. Dealer reserves are stated net of accumulated amortization, allowances, valuation adjustments, and any unfunded amounts due to the dealer. Income Taxes - BankAtlantic and its subsidiaries file consolidated federal and state income tax returns. In February 1992, the FASB issued FAS 109. FAS 109, which was implemented by BankAtlantic in 1993, requires a change from the deferred method to the asset and liability method to account for income taxes. Under the asset and liability method of FAS 109, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Under FAS 109, the effect of a change in tax rates on deferred tax assets and liabilities is recognized in the period that includes the statutory enactment date. Pursuant to the deferred method under APB Opinion 11, which was applied in 1992 and prior years, deferred income taxes are recognized for income and expense items that are reported in different years for financial reporting purposes and income tax purposes using the tax rate applicable for the year of the calculation. Under the deferred method, deferred taxes are not adjusted for subsequent changes in tax rates. Preferred Stock - All three Series of Preferred Stock have a preference value of $25.00 per share and are redeemable by BankAtlantic at $25.25 per share in 1994 and $25.00 thereafter. At December 31, 1993, no shares of Preferred Stock had been redeemed. Income (Loss) Per Common Share - In calculating income (loss) per common and common equivalent share ("primary income per share") preferred stock dividends are deducted from income before extraordinary item and the resulting amount and any extraordinary item is divided by the weighted average number of common and common equivalents shares outstanding, when dilutive. Common stock equivalents consist of common stock warrants and options. Income per common and common equivalent share assuming full dilution ("fully diluted income per share") is calculated as above and, if dilutive, after adjustment for interest charges as a result of the hypothetical conversion of the BFC subordinated debentures, through their actual conversion date of June 30, 1993. Fully diluted income per share also utilizes the period end market price of common stock if such price is greater than the average market price utilized in computing primary income per share. During 1991, no effect was given to options outstanding under BankAtlantic's Stock Option Plan and the common stock warrants issued as a result of the 1989 and 1991 rights offering and in connection with the issuance of the 1990 and 1991 subordinated debentures since the effect of their exercise was anti-dilutive. Common stock equivalents are not reflected in income per share until the market price of the common stock obtainable has been in excess of the exercise price for substantially all of three consecutive months, ending with the last month of the period. For the Years Ended December 31 ------------------------------------- 1993 1992 1991 ---------- --------- --------- Weighted average number of common and common equivalent shares outstanding 6,054,402 4,694,099 4,680,439 ========== ========= ========= Weighted average number of common and common equivalent shares outstanding assuming full dilution 6,091,800 5,440,798 N/A ========== ========== ========== New Accounting Standards - During May 1993, the Financial Accounting Standards Board approved two new accounting standards. Financial Accounting Standards No. 114 - Accounting by Creditors for Impairment of a Loan ("FAS 114"), and Financial Accounting Standards No. 115 - Accounting for Certain Investments in Debt and Equity Securities ("FAS 115"). FAS 114 addresses the collectibility of both contractual interest and contractual principal of all receivables when assessing the need for a loss accrual. This standard requires that unpaid loans be measured at the present value of expected cash flows by discounting those cash flows at the loan's effective interest rate. FAS 114 must be adopted by 1995, prospectively. BankAtlantic intends to implement FAS 114 in 1995. At December 31, 1993, the effect of implementation of this standard on BankAtlantic is estimated to be immaterial. FAS 115 addresses the valuation and recording of debt securities as held-to-maturity, trading and available for sale. Under this standard, only debt securities that BankAtlantic has the positive intent and ability to hold to maturity would be classified as held to maturity and reported at amortized cost. All others would be reported at fair value. FAS 115 must be adopted by 1994, prospectively. If FAS 115 were effective at December 31, 1993, BankAtlantic does not believe that it would be required to reclassify its debt securities and that the effect of implementation would be an increase in stockholders' equity of approximately $2.7 million, net of tax; the amount resulting when BankAtlantic implemented FAS 115 on January 1, 1994. However, BankAtlantic believes that implementation of FAS 115 may result in the volatility of capital amounts reported over time and could in the future negatively impact the institution's regulatory capital position. 2. Tax Certificates and Other Investment Securities A comparison of the book value, gross unrealized appreciation, gross unrealized depreciation, and approximate market value of BankAtlantic's tax certificates and other investment securities at December 31 was (in thousands): ---------------------------------------------------- Gross Gross Approximate Book Unrealized Unrealized Market Value Appreciation Depreciation Value --------- ------------ ------------ --------- Tax certificates-net $ 83,927 - - 83,927 Asset-backed securities 111 - - 111 Corporate bonds 3,663 - 7 3,656 Federal agency obligations 10,000 - 106 9,894 --------- ------------ ------------ --------- Total tax certificates and other investment securities $ 97,701 - 113 97,588 ========= ============ ============= ========= ==================================================== Gross Gross Approximate Book Unrealized Unrealized Market Value Appreciation Depreciation Value --------- ------------ ------------ --------- Tax certificates-net $ 120,295 - - 120,295 Asset-backed securities 129 - - 129 --------- ------------ ------------ --------- Total tax certificates and other investment securities $ 120,424 - - 120,424 ========= ============ ============= ========= Management considers approximate market value equivalent to book value for tax certificates since these securities have no readily traded market. However, for the fair value of tax certificates based on Financial Accounting Standards Board Statement Number 107 ("FASB 107") assumptions, see Note 20. Contractual or estimated maturities by category are shown below with related market values as of December 31, 1993. Actual maturities will probably differ from the maturities indicated below: Book Value Market Value ------------- ------------- Tax Certificates (In thousands) Due in one year or less $ 60,225 $ 60,225 Due after one year through five years 23,561 23,561 Due after five years through ten years 141 141 ------------- ------------- Total Tax Certificates 83,927 83,927 ------------- ------------ Other Investment Securities Due in one year or less 10,024 9,918 Due after one year through five years 3,750 3,743 ------------- ------------- Total Other Investments 13,774 13,661 ------------- ------------- Total Tax Certificates and Other Investment Securities $ 97,701 97,588 ============= ============= During the year ended December 31, 1993, BankAtlantic invested in repurchase agreements. The maximum amount of repurchase agreements outstanding at any month end and the average amount invested for the period was $29.0 million and $13.1 million, respectively. The underlying securities were in the possession of BankAtlantic. Proceeds from the sale of other investment securities were $2.1 million and $30.2 million for the years ended December 31, 1992, and 1991, respectively. The gross realized gains were $143,000 and $62,000 for the years ended December 31, 1992 and 1991, respectively. There were no sales of investment securities during the year ended December 31, 1993. In Florida, tax certificates represent a priority lien against real property for which assessed real estate taxes are delinquent. BankAtlantic's experience with this type of investment has been favorable as rates earned are generally higher than many alternative investments and substantial repayment occurs over a two year period. The primary risks BankAtlantic has experienced with tax certificates have related to the risk that additional funds may be required to purchase other certificates related to the property, the risk that the liened property may be unusable and the risk that potential environmental concerns may make taking title to the property untenable. 3. Loans Receivable - Net December 31 ------------------------------ 1993 1992 ------------- ----------- (In thousands) ------------------------------ Real estate loans: Conventional mortgages $ 120,531 $ 147,654 Conventional mortgages available for sale 5,752 7,641 Construction and development 11,333 12,961 FHA and VA insured 7,972 9,854 Commercial 198,095 156,844 Other loans: Second mortgages 52,563 72,508 Commercial (non-real estate) 27,979 33,071 Banker's acceptance 110,652 Deposit overdrafts 419 356 Installment loans held by individuals 86,138 140,553 ------------- ----------- Total gross loans 621,434 581,442 Deduct: Undisbursed portion of loans in process 5,570 6,492 Deferred loan fees, net 33 55 Unearned discounts on commercial loans 2,124 - Unearned discounts on installment and purchased loans 820 1,733 Allowance for loan losses 17,000 16,500 ------------- ----------- Loans receivable - net $ 595,887 556,662 ============= =========== No loans were securitized during the years ended December 31, 1993 and 1992. BankAtlantic is subject to economic conditions which could adversely affect both the performance of the borrower or the collateral securing the loan. At December 31, 1993, 79% of total aggregate outstanding loans were to borrowers in Florida, 12% of total loans were to borrowers in the Northeastern United States and 9% were to borrowers located elsewhere. Commitments to sell residential mortgage loans were $12.8 million and $7.6 million at December 31, 1993 and 1992, respectively. Approximately $1.8 million and $5.0 million of commitments to sell relate to residential mortgage loans with variable rates of interest whereas $11.0 million and $2.7 million of commitments to sell relate to residential mortgage loans with fixed rates of interest at December 31, 1993 and 1992, respectively. Such residential mortgage loan sales relate to loans recently originated for sale. Activity in the allowance for loan losses was (in thousands): For the Years Ended (1) December 31, --------------------------------------- 1993 1992 1991 ------------- ---------- ---------- Balance, beginning of period $ 16,500 $ 13,750 $ 15,741 Charge-offs: Commercial loans (835) (776) (1,694) Installment loans (3,350) (10,430) (18,903) Real estate mortgages (302) (1,473) (259) ------------- ---------- ---------- (4,487) (12,679) (20,856) ------------- ---------- ---------- Recoveries: Commercial loans 262 175 191 Installment loans 1,259 8,584 1,035 Real estate mortgages 16 20 99 ------------- ---------- ---------- 1,537 8,779 1,325 ------------- ---------- ---------- Net charge-offs (2,950) (3,900) (19,531) Additions charged to operations 3,450 6,650 17,540 ------------- ---------- ---------- Balance, end of period 17,000 16,500 13,750 ============= ========== ========== Average outstanding loans during the period 532,317 652,374 876,283 ============= ========== ========== Ratio of net charge-offs to average outstanding loans 0.56%(1) 0.60% 2.23% ============= ========== ========== (1) Excludes banker's acceptances. The percentage would be 0.55% if banker's acceptances were included. Included in installment loan recoveries for 1993 and 1992 is approximately $1.0 million and $7.3 million received from BankAtlantic's fidelity bond carrier (see Note 17). The ratio of net charge-offs to average outstanding loans, excluding this recovery, would have been 0.74% and 1.72% for 1993 and 1992, respectively. At December 31, 1993, 1992 and 1991, BankAtlantic serviced loans for the benefit of others amounting to approximately $1.9 billion, $1.0 billion and $868.4 million, respectively. At December 31, 1993 and 1992, other liabilities includes approximately $2.4 million and $2.3 million, respectively, of loan payments due to others. Activity in purchased mortgage servicing rights was (in thousands): For the Years Ended December 31, ---------------------------------------- 1993 1992 1991 ------------- ----------- ----------- Balance, beginning of period $ 7,282 $ 6,023 $ 3,840 Servicing rights purchased 17,003 3,832 3,457 Amortization of purchased servicing rights (4,452) (2,573) (1,274) ------------- ----------- ----------- Balance, end of period $ 19,833 7,282 6,023 ============= =========== =========== Aggregate loans to and repayments of loans by directors, executive officers, principal stockholders and other related interests for the years ended December 31, 1993 and 1992, were (in thousands): (1) $450 of the 1992 deletions relates to a loan to an executive officer no longer employed by BankAtlantic. (2) Not included herein are conventional mortgage loans of approximately $372 to executive officers. These loans were originated for sale and were sold to unrelated third parties. (3) $772 of the 1993 deletions relates to a loan to a related party no longer associated with BankAtlantic. 4. Mortgage-Backed Securities Mortgage-backed securities held for investment consisted of (in thousands): The amortized cost, gross unrealized appreciation, gross unrealized depreciation and approximate market value of mortgage-backed securities held for investment was (in thousands): BankAtlantic's held for investment portfolio at December 31, 1993 consisted of FNMA fixed rate 7 year balloon securities that mature in 1999, FHLMC fixed rate 5 and 7 year balloon securities that mature in 1996 - 2000 and FHLMC adjustable rate securities that mature in 2022 and 2023. Pledged as collateral were $3.7 million, $500,000 and $2.8 million of mortgage-backed securities for commercial letters of credit, treasury tax and loan and retail repurchase agreements, respectively. An objective of BankAtlantic has been to improve its cumulative rate sensitivity gap. In furtherance of this objective, BankAtlantic purchased, from 1990 through December 31, 1993, approximately $504.8 million of five and seven year balloon FNMA and FHLMC mortgage backed securities. Purchases of this type of security are directed at reducing the intermediate term interest rate sensitivity, reinvesting funds from principal repayments, reducing market volatility compared to the longer term fixed rate mortgage-backed securities and also providing future opportunities to improve liquidity. Funds for the purchase of these securities were obtained from principal repayments, proceeds from sales of longer term fixed rate mortgage-backed securities, and short to intermediate term borrowings. Due to monetary policy changes which resulted in additional interest rate cuts and the continued outflow of time deposits, management decided in September 1992 to dispose of the fixed rate mortgage-backed securities in order to, among other things, fund substantially all of the purchases of these replacement securities. BankAtlantic has the ability and intent to hold its remaining mortgage- backed securities held for investment until their scheduled maturities. Market values of the securities available for sale at December 31, 1993 were greater than BankAtlantic's cost of such securities. All fixed rate mortgage- backed securities having original maturities of 15 to 30 years are classified as available for sale. The amortized cost, gross unrealized appreciation, gross unrealized depreciation and approximate market value at December 31, 1993 and 1992 of mortgage-backed securities available for sale were (in thousands): During the year ended December 31, 1993, there were no sales of mortgage-backed securities. During the year ended December 31, 1992, BankAtlantic transferred to available for sale approximately $305.7 million of fixed rate mortgage-backed securities and received proceeds amounting to $144.6 million for sales of FNMA securities and $10.6 million of FHLMC securities for gross realized gains of $5.2 million and $500,000, respectively. Proceeds from the sales of FHLMC and FNMA securities were $ 49.0 million and $ 21.9 million, respectively, for the year ended December 31, 1991. Gross realized gains from the sales of FHLMC and FNMA securities were $174,000 and $574,000, respectively, for the year ended December 31, 1991. All sales occurred subsequent to classification as available for sale. 5. Accrued Interest Receivable December 31 ------------------------------ 1993 1992 ------------- ------------ (In thousands) ------------------------------ Loans receivable $ 3,403 $ 4,158 Tax certificates and other investment Securities 10,473 14,370 Mortgage-backed securities 3,698 3,660 ------------- ------------ $ 17,574 $ 22,188 ============= ============ 6. Non-Performing Assets and Restructured Loans Risk elements consist of non-accrual loans, restructured loans, past-due loans, REO, repossessed assets, and other loans which management has doubts about the borrower's ability to comply with the contractual repayment term. Non-accrual loans are loans on which interest recognition has been suspended because of doubts as to the borrower's ability to repay principal or interest. Restructured loans are where the terms have been altered to provide a reduction or deferral of interest or principal because of a deterioration in the borrower's financial position. BankAtlantic did not have any commitments outstanding to lend additional funds on restructured loans at December 31, 1993. Past-due loans are accruing loans that are contractually past due 90 days or more as to interest or principal payments. The following summarizes the risk elements at the dates indicated were (in thousands): For the Years Ended December 31, --------------------------------------- 1993 1992 1991 ------------- ---------- ---------- Non-accrual $ 7,246 $ 10,436 $ 13,745 90 days or more past due 2,580 (1) 1,108 689 Real Estate Owned 9,651 14,997 21,295 Other Repossessed assets 512 461 902 ------------- ---------- ---------- Total non-performing $ 19,989 $ 27,002 $ 36,631 Restructured $ 2,647 $ 2,661 $ 7,580 ------------- ---------- ---------- Total risk elements $ 22,636 $ 29,663 $ 44,211 ============= ========== ========== (1) The majority of these loans have matured, but are current as to payments under the prior loan terms. At December 31, 1993, there were no loans which were not disclosed in the above schedule where known information about the possible credit problems of the borrowers caused management to have serious doubts as to the ability of the borrower to comply with present loan repayment terms and which may result in disclosure of such loans in the schedule above in the future. Interest income which would have been recorded under the original terms of non-accrual and restructured loans and the interest income actually recognized are summarized below (in thousands): For the Years Ended December 31, --------------------------------------- 1993 1992 1991 ------------- ---------- ---------- Interest income which would have been recorded $ 1,068 $ 1,301 $ 2,476 Interest income recognized (486) (311) (1,581) ------------- ---------- ---------- Interest income foregone $ 582 $ 990 $ 895 ============= ========== ========== The components of "Foreclosed asset activity, net" were (in thousands): For the Years Ended December 31, --------------------------------------- 1993 1992 1991 ------------- ---------- ---------- Real estate acquired in settlement of loans: Operating expenses (income), net $ (221) $ 1,144 $ 1,590 Provision of declines in REO 2,675 3,827 7,273 Net (gains) losses on sales (1,211) (648) 59 ------------- ---------- ---------- $ 1,243 $ 4,323 $ 8,922 Total ============= ========== ========== Activity in the allowance for real estate owned consisted of (in thousands): For the Years Ended December 31, --------------------------------------- 1993 1992 1991 ------------- ---------- ---------- Balance, beginning of period $ 2,200 $ 300 $ - Charge-offs: Commercial loans $ (706) (1,816) (6,760) Residential loans (69) (111) (213) ------------- ---------- ---------- (775) (1,927) (6,973) 2,675 $ 3,827 7,273 ------------- ---------- ---------- $ 4,100 $ 2,200 $ 300 Total ============= ========== ========== 7. Office Properties and Equipment December 31 ------------------------------ 1993 1992 ------------- ------------ (In thousands) ------------------------------ Land $ 9,618 $ 9,838 Building and improvements 35,906 35,158 Furniture and equipment 16,139 14,362 ------------- ------------ Total $ 61,663 $ 59,358 Less accumulated depreciation 24,290 20,762 ------------- ------------ Other properties and equipment-net $ 37,373 $ 38,596 ============= ============ 8. Deposits The weighted average nominal interest rate payable on deposit accounts at December 31, 1993 and 1992 was 2.83% and 3.18%, respectively. The stated rates and balances at which BankAtlantic paid interest on deposits were: Interest expense by deposit category was (in thousands): For the Years Ended December 31, --------------------------------------- 1993 1992 1991 ------------- ---------- ---------- Money fund savings and NOW accounts $ 11,413 $ 14,028 $ 24,861 Savings accounts 2,363 3,298 5,101 Certificate accounts - below $100,000 16,247 27,449 50,647 Certificate accounts, $100,000 and above 1,941 2,888 3,221 Less early withdrawal penalty (166) (252) (577) -------------- ---------- --------- Total $ 31,798 $ 47,411 $ 83,253 ============== ========== ========= Included in other non-interest income is approximately $5.2 million, $5.0 million and $5.2 million of checking account fees for the years ended December 31, 1993, 1992 and 1991, respectively. At December 31, 1993, the amounts of scheduled maturities of certificate accounts were (in thousands): Time deposits $100,000 and over have the following maturities at (in thousands): December 31 ------------------------------ 1993 1992 ------------- ------------ Less than 3 months $ 8,071 $ 2,976 3 to 6 months 6,377 7,104 6 to 12 months 15,784 16,827 More than 12 months 21,195 15,433 ------------- ------------ Total $ 51,427 $ 42,340 ============= ============ Beginning in 1990, the Office of the Comptroller for the State of Florida ("Comptroller") commenced a review of BankAtlantic's procedures for the assessment of fees on dormant accounts. The Comptroller subsequently indicated that BankAtlantic was not in compliance with applicable Florida law as interpreted by the Comptroller. The difference in interpretation concerns approximately $500,000 and has not yet been resolved. BankAtlantic intends to amend its procedures to satisfy the Comptroller's interpretation. However, pending resolution of the issue and modification of the procedures, dormant account assessments, approximately $10,000 per month, have been eliminated since 1992, and an allowance has been established for the amount which is in question. 9. Advances from Federal Home Loan Bank Advances from Federal Home Loan Bank ("FHLB advances") incur interest and were repayable as follows (in thousands): Repayable During Year Interest December 31, Ending December 31, ---------------------- Rate 1993 1992 -------------------------- ----------- --------- 1993 3.50% to 7.80% $ - $ 32,800 1994 3.25% to 7.80% 111,250 18,300 1995 4.92% to 7.80% 17,050 15,000 ----------- --------- Total $ 128,300 $ 66,100 =========== ========= Overnight FHLB advances at December 31, 1993 and 1992, amounted to $95.0 million and $26.0 million, respectively. At December 31, 1993 and 1992, BankAtlantic pledged specific adjustable rate mortgage loans as collateral in the amount of $33.3 million and $71.6 million, respectively, for FHLB advances. During October, 1992 and December, 1993, the FHLB granted BankAtlantic, subject to various terms and conditions, lines of credit of $300 million and $115 million expiring in October 1995 and December, 1994, respectively. As of December 31, 1993 BankAtlantic had not utilized these lines of credit. 10. Securities Sold Under Agreements to Repurchase The following table provides information on the agreements (dollars in thousands): Periods Ended December 31, --------------------------------------- 1993 1992 1991 ------------- ---------- ---------- Maximum borrowing at any month-end within the period $ 69,295 $ 120,207 $ 87,252 Average borrowing during the period 33,962 73,309 25,426 Average interest cost during the period 3.19% 3.93% 6.57% Average interest at end of the period 3.30% 3.38% 4.62% ============= ========== ========== Average borrowing was computed based on average daily balances during the period. Average interest rate during the period was computed by dividing interest expense for the period by the average borrowing during the period. Securities sold under agreements to repurchase are summarized below (in thousands): December 31, ---------------------- 1993 1992 ----------- --------- Agreements to repurchase the same security $ 18,152 $ 20,000 Customer repurchase agreements 2,983 1,532 ----------- --------- Total $ 21,135 $ 21,532 =========== ========= The following table lists the book and approximate market value of securities sold under repurchase agreements, and the repurchase liability associated with such transactions was (dollars in thousands): Weighted Approximate Average Book Market Repurchase Interest Value Value Balance Rate --------- ------------ ------------ ---------- December 31, 1993 FNMA $ 13,406 $ 13,424 $ 13,165 $ 3.50% FHLMC 10,983 11,521 7,970 2.96% --------- ------------ ------------ ---------- Total $ 24,389 $ 24,945 $ 21,135 $ 3.30% ========= ============ ============ ========== December 31, 1992 FHLMC $ 25,101 $ 25,833 $ 21,532 $ 3.38% ========= ============ ============ ========== All repurchase agreements at December 31, 1993 and 1992, matured and were repaid in January 1994 and 1993, respectively. These securities were held by unrelated broker dealers. 11. Capital Notes and Other Subordinated Debentures, Preferred Stock, Common Stock Warrants, and Common Stock Options In order to increase its regulatory capital, BankAtlantic issued $25.0 million of its 1986 Capital Notes between January and August 1986. In March 1991, $10.2 million of 1986 Capital Notes were exchanged for noncumulative preferred stock, cash payments and cash bonuses. The Preferred Stock was recorded at a fair value of $7.0 million, net of offering costs of $353,000 and BankAtlantic recognized an extraordinary gain of $660,000 net of applicable income taxes of $340,000 due to this early extinguishment of the 1986 Capital Notes. All three series of Preferred Stock have a preference value of $25 per share and are redeemable by BankAtlantic at $25.25 per share in 1994 and $25.00 per share thereafter. At December 31, 1993, no shares of Preferred Stock have been redeemed. Effective July 31, 1992, BankAtlantic redeemed approximately $6.9 million of 1986 Capital Notes. Such redemption was at face value plus accrued interest and without payment of any penalty or premium. The portion of 1986 Capital Notes selected for redemption had an average interest rate of approximately 11.7%, and matured primarily in 1993. At December 31, 1993 and 1992, BFC owned 5.600, 529 and 4,636 shares of the Series A, B and C Preferred Stock, respectively. Such ownership was obtained through open market purchases and represents approximately 2.97%, 3.09% and 3.57% of the Series A, B and C Preferred Stock, respectively. As a condition of the exchange of 1986 Capital Notes for Preferred Stock, BFC placed cash in an escrow account equal to dividends payable on the Preferred Stock for the first two years. The amount placed in escrow was approximately $1.7 million. This escrow account had been utilized by BankAtlantic to pay the Preferred Shareholder dividends during the first two years after issuance. Upon establishing the escrow account, BankAtlantic entered into an agreement with BFC, that BFC will be issued 13% subordinated debentures in the amount of the escrow utilized, as well as non-detachable warrants to acquire additional shares of BankAtlantic common stock on the basis of $1.75 per share purchase price to the extent of subordinated debentures issued and any interest accrued and not currently paid thereon. As of December 31, 1992, BankAtlantic had issued approximately $1.6 million of subordinated debentures to BFC for the payment of monthly Preferred Stock dividends. The related warrants were to expire at maturity of the related subordinated debentures on March 7, 1998. At December 31, 1992, interest of $180,000 had accrued to BFC on its debentures and approximately 1,017,750 warrants had been issued. The exercise price of the warrants subject to the agreement was established at the greater of 120% of the average market price of BankAtlantic stock during the 30 days prior to the funding of the escrow or $1.74 per common share. At March 7, 1991, 120% of the average market price of BankAtlantic common stock was $1.75, resulting in the exercise price of the warrants being set at $1.75 per common share. The subordinated debentures issued to BFC for payment of Preferred Stock dividends, related interest and the dividends paid are reflected herein. For regulatory capital purposes, dividend amounts, although paid by BFC, are not includable as capital and the related subordinated debentures issued were not includable in determining risk-based capital until BFC exercised the warrants issued to it in connection with the subordinated debentures. Payments of any interest or principal to BFC on any subordinated debentures issued to BFC in consideration of the utilization of the escrowed amounts was subject to regulatory approvals. Effective June 30, 1993, BFC exercised its warrants to acquire 1,126,327 shares of BankAtlantic's common stock at an exercise price of $1.75 per share. The payment of the $1,971,072 purchase price was through the tender of subordinated debentures held by BFC. During July 1993, accrued interest of $83,704 was paid to BFC for interest accrued on the subordinated debentures from March 1, 1993 to June 30, 1993. From March 1991 through February 1993, BFC provided funds for the payment of dividends on BankAtlantic's preferred stock. BFC has no further obligation to provide funds for payment of any dividends by BankAtlantic. Future dividends, if declared, will be paid by BankAtlantic and will be subject to receipt of all required regulatory approvals. BankAtlantic has paid the preferred stock dividends since March 1993 and expects to continue paying such dividends; subject to maintaining capital at least equal to the fully phased-in capital requirements. Future payments will be subject to approval by the Board of Directors, to additional regulatory notice or approval, and continued compliance with capital requirements. In July 1993, BankAtlantic received approval from the OTS to redeem all remaining capital notes and other subordinated debentures. BankAtlantic redeemed the $6.8 million of 1986 Capital Notes and $1 million of 14% other subordinated debentures on August 31, 1993 at par. The Capital Notes bore interest at a weighted average rate of 11.83%, substantially in excess of then current market rates. Funds for the redemption were provided from loan repayments. On February 28, 1990, BankAtlantic filed an application with the OTS to issue up to $12.0 million of subordinated debentures in private transactions and to include such subordinated debentures as regulatory capital. This offering was closed in 1990. During the quarter ended March 31, 1990, BFC advanced BankAtlantic $2.5 million for the purchase of such subordinated debentures, subject to regulatory approval. On May 30, 1990, BankAtlantic received OTS approval, subject to certain conditions, to include up to $12.0 million of the subordinated debentures as regulatory capital. Effective March 30, 1990, BFC acquired $2.5 million of such subordinated debentures. In June 1990, a third party acquired $1.0 million of BankAtlantic's subordinated debentures. The subordinated debentures had an interest rate of 14% per annum. The subordinated debentures was issued with warrants entitling the holder to purchase shares of BankAtlantic common stock at an exercise price of $4.62 per share at any time prior to maturity. On June 30, 1990, BFC exercised its warrants and converted $2.5 million of subordinated debentures to 541,430 shares of BankAtlantic common stock, increasing BFC's common stock ownership percentage of BankAtlantic to 69.9% at that time. The conversion of the subordinated debentures to common stock was approved at BankAtlantic's Annual Meeting of shareholders held on July 10, 1990. Included in risk-based capital at December 31, 1992 was $3.8 million of Capital Notes and subordinated debentures. The $1.0 million subordinated debentures issued to the unaffiliated third party was to mature in June 1997 and had detachable warrants to purchase 216,573 common shares of BankAtlantic, at $4.62 per share. On March 31, 1991, BankAtlantic issued to its existing shareholders, 4,878 shares of common stock and $8,000 of 14% subordinated debentures, having a March 1998 maturity date, with related warrants to purchase 4,600 shares of common stock. The warrants for the 4.600 shares may be exercised at $1.74 per share any time prior to maturity of the related debentures by payment of the exercise price in cash or by surrendering related debentures having an outstanding principal amount and accrued interest, if any, equal to the amount payable or a combination thereof. The remaining $1.0 million and $8,000 of subordinated debentures were redeemed along with the Capital Notes on August 31, 1993. However, the warrants related to such debentures are detachable and may remain outstanding until the earlier of exercise or original maturity of the subordinated debentures. The warrants outstanding at December 1993, relating to the redeemed debentures are 216,573 and 4,025 with exercise prices of $4.62 and $1.74, respectively. On November 12, 1993, BankAtlantic closed a public offering of 1.8 million common shares at a price of $13.50 per common share. Of the 1.8 million shares sold, 400,000 shares were sold by BankAtlantic and 1.4 million shares were sold by BFC. Net proceeds to BankAtlantic from the sale of the 400,000 shares were approximately $4.6 million. In connection with the public offering, BankAtlantic granted the underwriters a 30 day option to purchase up to 270,000 additional shares of common stock to cover over-allotments. On November 10,1993, the underwriters exercised this option to purchase the 270,000 shares, with a closing date of November 18, 1993. The additional net proceeds to BankAtlantic were approximately $3.4 million. Upon sale of the 2,070,000 shares, BFC's ownership of BankAtlantic changed from 77.83% to 48.17%. On April 6, 1984, BankAtlantic's stockholders approved a Stock Option Plan under which options to purchase up to 310,000 shares of common stock may be granted. The plan provided for the grant of both incentive stock options and non-qualifying options. The exercise price of an incentive stock option will not be less than the fair market value of the common stock on the date of the grant. The exercise price of non-qualifying options will be determined by a committee of the Board of Directors. On May 25, 1993, the Board of Directors authorized the issuance of 232,440 incentive stock options and 66,560 non-qualifying options. Of the incentive and non-qualifying stock options, 43,560 were issued at 110% of the fair market value at the date of grant. The remaining incentive and non- qualifying stock options were issued at the fair market value at the date of grant. Non-qualifying stock options for 23,000 shares were issued outside of the Plan to non-employee directors. These options have similar terms and conditions as non-qualifying options under the Plan. A summary of plan activity was: Exercisable Price Shares Per Share ------------ -------------------------------- Outstanding December 31, 1990 71,191 $ 8.70 - 11.63 Expired (44,563) 11.30 - 11.63 Outstanding December 31, 1991 and 1992 26,628 8.70 - 11.63 Expired (173) 11.30 Issued 299,000 11.48 - 12.63 ------------ -------------------------------- Outstanding December 31, 1993 325,455 $ 8.70 - 12.63 ============ ================================ The stock options issued in May 1993 expire on May 25, 1998, and have the following commencement dates based on applicable vesting schedules: 99,667 on May 25, 1993; 99,667 on May 25, 1994 and 99,666 on May 25, 1995. The remaining 26,455 options outstanding may currently be exercised and will expire in August 1996. At May 31, 1993, all issuable options under the Plan were outstanding and no further options will be granted under the Plan. 12. Interest Rate Swaps In March 1991, a $35.0 million interest rate swap expired. This agreement called for fixed rate interest payments by BankAtlantic of 12.00% in exchange for variable rate payments based on the corporate bond equivalent of the three month U.S. Treasury Bill rate. The net interest expense relating to the interest rate swap was approximately $450,000 for the year ended December 31, 1991. BankAtlantic was exposed to credit loss in the event of nonperformance by the other party to the agreements, however no performance by the counter-party was required during the term of the agreement. 13. Income Taxes BankAtlantic is permitted under the Internal Revenue Code to deduct an annual addition to a reserve for bad debts in determining taxable income, subject to certain limitations. To the extent that (i) a savings institution's reserve for losses on qualifying real property loans exceeds the amount that would have been allowed under the experience method and (ii) it makes distributions to shareholders that are considered to result in withdrawals from that excess bad debt reserve, then the amounts withdrawn will be included in its taxable income. The amount considered to be withdrawn by a distribution will be the amount of the distribution plus the amount necessary to pay the tax with respect to the withdrawal. Dividends paid out for the savings institution's current or accumulated earnings and profits, as calculated for federal income tax purposes, will not be considered to result in withdrawals from its bad debt reserves. Accordingly, purchases of its outstanding common or preferred stock by BankAtlantic could result in an increase in BankAtlantic's taxable income in the period such stock is repurchased. The increase in taxable income would be the lesser of the amount repurchased divided by the reciprocal of the income tax rate or at December 31, 1993, $4.8 million. BankAtlantic adopted FAS 109 as of January 1, 1993. The cumulative effect of this change in accounting for income taxes was immaterial, and thus, there was no cumulative effect adjustment. In accordance with FAS 109 deferred tax liabilities are not recognized on the base year tax bad debt reserve unless it becomes apparent that the reserve will be reduced and result in taxable income in the foreseeable future. At December 31, 1993, BankAtlantic's base year tax bad debt reserve was $6.6 million for which no deferred income taxes have been provided. The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and tax liabilities at December 31, 1993 were: (In thousands) Deferred tax assets: Bad debt reserves for financial statement purposes $ 5,686 Allowances recorded for financial statement purposes not currently recognized for tax purposes 4,770 Deferred compensation accrued for financial statement purposes not currently recognized for tax purposes 112 Unearned commitment fees 204 Other 228 --------------- Total gross deferred tax assets 11,000 Less valuation allowance (1,464) --------------- Total deferred tax assets 9,536 Deferred tax liabilities: Bad debt reserve recorded for tax purposes not recorded for financial statement purposes 1,164 Office properties and equipment, due to differences in depreciation 1,537 FHLB stock, due to differences in the recognition of stock dividends 1,647 Deferred point income, due to differences in the recognition of loan origination fees 1,507 Receivable from the carrier recorded for financial statement purposes 865 Discount on mortgage-backed securities, due to the accretion of discounts 848 Capital leases for financial reporting purposes and operating leases for tax purposes 686 Pre-paid pension expenses 459 Other 400 --------------- Total gross deferred tax liabilities 9,113 --------------- Net deferred tax assets at December 31, 1993 423 Deferred income tax liability at December 31, 1992 2,380 --------------- Deferred income tax (benefit) for 1993 $ (2,803) =============== The valuation allowance for deferred tax assets as of January 1, 1993 was $2.4 million. The net change in the total valuation allowance for the year ended December 31, 1993 was a decrease of $963,000. The change in the valuation allowance was due to management's determination that, more likely than not, this deferred tax asset is realizable. The provision (benefit) for income taxes consisted of (in thousands): For the Years Ended December 31, --------------------------------------- 1993 1992 1991 ------------- ---------- ---------- Current: Federal $ 9,695 $ 6,469 $ (361) State 1,633 201 - ------------- ---------- ---------- 11,328 6,670 (361) ------------- ---------- ---------- Deferred: Federal (2,445) 1,792 (4,480) State (358) (17) - ------------- ---------- ---------- (2,803) 1,775 (4,480) ------------- ---------- ---------- Utilization of net operating loss carryforwards: Federal - (389) - State - 1,145 - ------------- ---------- ---------- - 756 - ------------- ---------- ---------- Settlement with IRS, net (1,432) - - ------------- ---------- ---------- Total $ 7,093 $ 9,201 $ (4,841) ============= ========== ========== BankAtlantic's actual provision (benefit) differs from the Federal expected income tax provision (benefit) as follows (in thousands): For the Years Ended December 31, ----------------------------------- 1993 1992 1991 --------- ---------- ---------- Income tax provision (benefit) at expected federal income tax rate(1) $ 8,110 $ 8,328 $ (4,782) Increase (decrease) resulting from: Adjustment to allowance for loan losses recognized for financial statement purposes not currently recognized for tax purposes 613 - - Tax-exempt interest income (119) (115) (58) Provision for state taxes net of federal benefit 828 877 - Other-net (4) 111 (1) Change in the beginning of the year balance of the valuation allowance for deferred tax assets allocated to income tax expense (963) - - Adjustment to deferred tax assets and liabilities for enacted changes in the tax laws and rates 60 - - Settlement with IRS, net(2) (1,432) - - --------- ---------- ---------- Total $ 7,093 $ 9,201 $ (4,841) ========= ========== ========== (1) The federal income tax rate is 35% for the year ended December 31, 1993 and 34% for the years ended December 31, 1992 and 1991. (2) During the second quarter of 1993, BankAtlantic settled a claim with the IRS relating to net operating loss carrybacks and previous Federal income tax examinations through 1988, resulting in an increase in other interest income of $587,000 and a reduction in the provision for income taxes of $1.4 million. Deferred income tax expense (benefit) was comprised of (in thousands): At December 31, 1991, BankAtlantic had a net operating loss carryforward for federal income tax purposes of approximately $5.2 million which would have expired in 2006. All 1991 net operating loss carryforwards were utilized during the year ended December 31, 1992. At December 31, 1991, BankAtlantic had a net operating loss carryforward for state income tax purposes of approximately $21.6 million of which approximately $1.6 million expire in 1999, $4.7 million expire in 2003, $8.5 million expire in 2004, and $6.8 million expire in 2006. All state net operating loss carryforwards were utilized during the year ended December 31, 1992. On August 12, 1993, President Clinton signed the Omnibus Budget Reconciliation Act of 1993 (the "Omnibus Act"). The most significant change to be implemented by the 1993 Omnibus Act, as it relates to BankAtlantic, is to increase the highest corporate rate from 34% to 35% retroactively to January 1, 1993. The impact on BankAtlantic's Consolidated Statement of Earnings at the enactment date was to increase the provision for income taxes by approximately $175,000. 14. Pension Plan BankAtlantic sponsors a non-contributory defined benefit pension plan (the "Plan") covering substantially all of its employees. The benefits are based on years of service and the employee's average earnings received during the highest five consecutive years out of the last ten years of employment. The funding policy is to contribute an amount not less than the ERISA minimum funding requirement nor more than the maximum tax-deductible amount under Internal Revenue Service rules and regulations. No contributions were made to the Plan during the three years ended December 31, 1993. Plan assets consist generally of fixed income investment securities, corporate equities and cash equivalents as of the most recent reporting date. The following table sets forth the Plan's funded status and amounts recognized in BankAtlantic's Statements of Financial Condition: December 31 ------------------------------ 1993 1992 ------------- ----------- (In thousands) ------------------------------ Actuarial present value of accumulated benefit obligation, including vested benefits of $9,093 and $6,225 $ (9,555) $ (6,561) --------------- ----------- Actuarial present value of projected benefit for service rendered to date (12,609) (8,882) Plan assets at fair value 11,362 11,002 Plan assets in excess (below) projected benefit --------------- ----------- obligation (1,247) 2,120 Unrecognized net loss from past experience different from that assumed and effects of changes in assumptions 4,805 1,694 Prior service cost not yet recognized in net periodic pension cost (95) (11) Unrecognized net asset at October 1, 1987 being recognized over 15 years (2,344) (2,612) --------------- ----------- Prepaid pension cost included in other assets $ 1,119 $ 1,191 =============== =========== Net pension cost includes the following components: For the Years Ended December 31, ----------------------------------- 1993 1992 1991 --------- ---------- ---------- Service cost benefits earned during the period $ 594 $ 610 $ 602 Interest cost on projected benefit obligation 714 642 612 Actual return on plan assets (793) (325) (890) Net amortization and deferral (442) (1,006) (224) Curtailment gain - - (351) --------- ---------- ---------- Net period pension benefit $ 73 $ (79) $ (251) ========= ========== ========== During the year ended December 31, 1991, BankAtlantic reduced its work force resulting in a pension curtailment gain of $351,000. The assumptions used in accounting for the Plan were: 1993 1992 1991 --------- -------- ------- Weighted average discount rate 7.00% 8.25% 8.25% Rate of increase in future compensation levels 4.00% 5.00% 5.00% Expected long-term rate of return(1) 9.50% 9.50% 9.50% ======== ======== ======= (1) The expected long-term rate of return has been adjusted during 1994 to 9.00%. BankAtlantic sponsors a defined contribution plan ("401k Plan") for all employees that have completed six months of service. Employees can contribute up to 14% of their salary, not to exceed $8,994 at December 31, 1993. For employees that fall within the highly compensated criteria, maximum contributions are 8% of salary. During part of 1991, BankAtlantic matched employee contributions based on employee's salary and BankAtlantic's profits. Effective October 1991, BankAtlantic's 401k Plan was amended to include only a discretionary match as deemed appropriate by the Board of Directors. In November 1993 and 1992, the Board of Directors declared discretionary matches in the aggregate amount of approximately $60,000 and $40,000, respectively to be paid during March 1994 and 1993 to participants of record as of December 31, 1993 and 1992. Included in employee compensation and benefits on the consolidated statement of operations was $72,000 and $52,000 and $113,000 of expenses related to the 401k Plan for the years ended December 31, 1993, 1992 and 1991, respectively. 15. Commitments and Contingencies BankAtlantic is lessee under various operating leases for real estate and equipment extending to the year 2072. The approximate minimum rental under such leases, at December 31, 1993, for the periods shown was (in thousands): Year Ending December 31, Amount ----------------- 1994 $ 1,400 1995 1,083 1996 646 1997 247 1998 199 Thereafter 2,970 ----------------- Total $ 6,545 ================= Rental expense for premises and equipment was $2.3 million, $3.5 million and $4.6 million for the years ended December 31, 1993, 1992 and 1991, respectively. Included in other liabilities at December 31, 1993 and 1992, is an allowance of $400,000 and $740,000, respectively, for future rental payments on closed branches. During the ordinary course of business, BankAtlantic and its subsidiaries are involved as plaintiff or defendant in various lawsuits. Management, based on discussions with legal counsel, is of the opinion that no significant loss will result from these actions. BankAtlantic is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby and documentary letters of credit. Those instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the statement of financial position. BankAtlantic's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit written is represented by the contractual amount of those instruments. BankAtlantic uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments. Financial instruments with off-balance sheet risk were (in thousands) : December 31, ---------------------- 1993 1992 ----------- --------- Commitments to extend credit, including the undisbursed portion of loans in process $ 77,509 $ 32,834 Standby and documentary letters of credit $ 3,898 $ 7,154 Commitments to purchase mortgage-backed securities $ 10,000 $ 80,000 Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. BankAtlantic evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained if deemed necessary by BankAtlantic upon extension of credit is based on management's credit evaluation of the counter-party. Collateral held varies but may include first mortgages on commercial and residential real estate. As part of the commitment for standby letters of credit, BankAtlantic is required to collateralize 120% of the commitment balance with mortgage- backed securities. At December 31, 1993, $7.5 million of mortgage-backed securities were pledged against the commitment balance. Standby letters of credit written are conditional commitments issued by or for the benefit of BankAtlantic to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. BankAtlantic may hold certificates of deposit and residential and commercial liens as collateral supporting those commitments which are collateralized similar to other types of borrowings. BankAtlantic is required to maintain average reserve balances with the Federal Reserve Bank. Such reserves consisted of cash and amounts due from banks of $9.4 million and $15.3 million at December 31, 1993 and 1992, respectively. BankAtlantic is a member of the FHLB system. As a member, BankAtlantic is required to purchase and hold stock in the FHLB of Atlanta, in amounts at least equal to the greater of (i) 1% of its aggregate unpaid residential mortgage loans, home purchase contracts and similar obligations at the beginning of each year or (ii) 5% of its outstanding advances from the FHLB of Atlanta. As of December 31, 1993, BankAtlantic was in compliance with this requirement with an investment of approximately $8.7 million in stock of the FHLB of Atlanta. 16. Regulatory Matters The Financial Institutions Reform Recovery and Enforcement Act of 1989 (FIRREA) was signed into law on August 9, 1989, and FIRREA's regulations for savings institutions' minimum capital requirements went into effect on December 7, 1989. The regulations require savings institutions to have minimum regulatory tangible capital equal to 1.5% of adjusted total assets, a minimum 3% core capital ratio and a minimum 8.0% risk-based capital ratio. Among other things, the ability to include investments in impermissible activities in core and tangible capital will be phased out by July 1, 1994. At December 31, 1993, BankAtlantic's regulatory capital position was (unaudited): Tangible Core Risk-Based Capital Capital Capital ------------- ----------- ---------- GAAP stockholders' equity $ 90,652 $ 90,652 $ 90,652 Adjustments: Non-includable subsidiaries (642) (642) (642) Additional capital: Allowable allowances for loans and tax certificates - - 9,035 ------------- ----------- ---------- Regulatory capital 90,010 90,010 99,045 Minimum capital requirement 20,378 40,757 59,176 ------------- ----------- ---------- Regulatory capital excess $ 69,632 $ 49,253 $ 39,869 ============= =========== ========== Regulatory capital as a percent of adjusted total assets: Required 1.50% 3.00% 8.00% ============= =========== ========== Actual 6.63% 6.63% 13.40% ============= =========== ========== In addition, savings institutions are also subject to the provisions of the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"), which was signed into law on December 19, 1991. Regulations implementing the prompt corrective action provisions of FDICIA became effective on December 19, 1992. In addition to the prompt corrective action requirements, FDICIA includes significant changes to the legal and regulatory environment for insured depository institutions, including reductions in insurance coverage for certain kinds of deposits, increased supervision by the federal regulatory agencies, increased reporting requirements for insured institutions, and new regulations concerning internal controls, accounting and operations. The FDICIA requires financial institutions to take certain actions relating to their internal operations, including: providing annual reports on financial condition and management to the appropriate Federal banking regulators, having an annual independent audit of financial statements performed by an independent public accountant, and establishing an independent audit committee comprised solely of outside directors. The FDICIA also imposes certain operational and managerial standards on financial institutions relating to internal controls, loan documentation, credit underwriting, interest rate exposure, asset growth and compensation, fees, and benefits. The prompt corrective action regulations define specific capital categories based on an institution's capital ratios. The capital categories, in declining order, are "well capitalized," "adequately capitalized," "undercapitalized" "significantly undercapitalized", and "critically undercapitalized." Institutions categorized as "undercapitalized" or worse are subject to certain restrictions, including requirements to file a capital plan with the OTS, prohibitions on the payment of dividends and management fees, restrictions on executive compensation, and increased supervisory monitoring, among other things. Other restrictions may be imposed on the institution either by the OTS or by the FDIC, including requirements to raise additional capital, sell assets, or sell the entire institution. Once an institution becomes "critically undercapitalized" it is generally placed in receivership or conservatorship within 90 days. To be considered "well capitalized," a savings institution must generally have a core capital ratio of at least 5%, a Tier 1 risk-based capital ratio of at least 6%, and a total risk-based capital ratio of at least 10%. An institution is deemed to be "critically undercapitalized" if it has a tangible equity ratio of 2% or less. At December 31, 1993 BankAtlantic's core, Tier 1 risk-based and total risk based capital ratios were 6.63%, 12.18% and 13.40%, respectively, thus, meeting the requirements of "well capitalized" (unaudited). The payment of dividends by BankAtlantic is limited by federal regulations. Effective August 1, 1990, the OTS adopted a new regulation that limits all capital distributions made by savings institutions, including cash dividends, by permitting only certain institutions that meet specified capital levels to make capital distributions without prior OTS approval. The regulation established a three-tiered system, with the greatest flexibility afforded to well-capitalized institutions. An institution that meets all of its fully phased-in capital requirements and is not in need of more than normal supervision would be a "Tier 1 Institution." An institution that meets its minimum regulatory capital requirements but does not meet its fully phased-in capital requirements would be a "Tier 2 Institution." An institution that does not meet all of its minimum regulatory capital requirements would be a "Tier 3 Institution." A Tier 1 Institution may, after prior notice, but without the approval of the OTS, make capital distributions during a calendar year up to 100% of net income earned to date during the current calendar year plus 50% of its capital surplus ("Surplus" being the amount of capital over its fully phased-in capital requirement). Any additional capital distributions would require prior regulatory approval. A Tier 2 institution may, after prior notice, but without the approval of the OTS, make capital distributions of between 50% and 75% of its net income over the most recent four-quarter period (less any dividends previously paid during such four- quarter period) depending on how close the institution is to its fully phased- in risk-based capital requirement. A Tier 3 Institution would not be authorized to make any capital distributions without the prior approval of the OTS. Notwithstanding the provision described above, the OTS also reserves the right to object to the payment of a dividend on safety and soundness grounds. In August and December, 1993, BankAtlantic declared cash dividends of $0.06 per share (totaling $0.12 per share), payable September 1993 and January 1994, respectively, to its common stockholders. A 15% common stock dividend was declared in May, 1993. BankAtlantic expects to continue dividend payments on its non-cumulative preferred stock. In March 1994, the Board of Directors declared a cash dividend of $.06 per share payable in April 1994 to its common stockholders. On April 16, 1991, BankAtlantic voluntarily entered into a Supervisory Agreement ("Agreement") with the OTS. The Agreement required BankAtlantic to implement additional policies and reporting procedures relating to the internal operations of BankAtlantic within specified time frames, and to particularly address concerns relating to classified assets, general valuation allowances and the policies, procedures, information reporting and guidelines in the consumer loan department. Furthermore, BankAtlantic has agreed it will not increase the level of its consumer loans above its April 16 1991 level of consumer loans until such time as BankAtlantic's new consumer lending policy is deemed acceptable by the OTS. BankAtlantic believes that it has addressed the requirements of the agreements and that it is in compliance with such agreements. BankAtlantic does not believe that the terms and conditions of the agreements will have any material adverse effect on its anticipated business or that they will materially effect BankAtlantic's relationships with its customers or depositors and accordingly, should not have any significant effect on its financial condition and results of operations. 17. Subject Portfolio From 1987 through 1990, BankAtlantic purchased in excess of $50 million of indirect home improvement loans from certain dealers, primarily in the northeastern United States. BankAtlantic ceased purchasing loans from such dealers in the latter part of 1990. These dealers are affiliated with each other but are not affiliated with BankAtlantic. In connection with loans originated through these dealers, BankAtlantic funded amounts to the dealers as a dealer reserve. Such loans and related dealer reserves are hereafter referred to as the "Subject Portfolio." The risk of amounts advanced to the dealers is primarily associated with loan performance but secondarily is dependent on the financial condition of the dealers. The dealers were to be responsible to BankAtlantic for the amount of the reserve only if the loan giving rise to the reserve became delinquent or was prepaid. These dealers have currently not indicated any financial ability to fund the dealer reserve. In late 1990, questions arose relating to the practices and procedures used in the origination and underwriting of the Subject Portfolio, which suggested that the dealers, certain home improvement contractors and borrowers engaged in practices intended to defraud BankAtlantic. Due to these questions and potential exposure, BankAtlantic performed, and continues to perform, certain investigations, notified appropriate regulatory and law enforcement agencies, and notified its fidelity bond carrier. After an initial review and discussions with the carrier, BankAtlantic concluded that any losses sustained from the Subject Portfolio would adequately be covered by its fidelity bond coverage and, in fact, on August 13, 1991, the carrier advanced $1.5 million against BankAtlantic's losses. This payment and future payments by the carrier were to be subject to identification and confirmation of the losses which are appropriately covered under the fidelity bond. Subsequently, commencing in September, 1991, as a consequence of issues raised by the carrier, BankAtlantic reviewed the Subject Portfolio without regard to the availability of any fidelity bond coverage. As a result of the review, the provision for loan losses for the year ended December 31, 1991 was increased by approximately $5.7 million, approximately $5.5 million of loans were charged off, and $2.7 million of dealer reserves were charged to current operations. On December 20, 1991, the carrier denied coverage and BankAtlantic thereafter filed an appropriate action against the carrier. On October 30, 1992, BankAtlantic and the carrier entered into the Covenant Not To Execute (the "Covenant"). Pursuant to the Covenant, BankAtlantic will continue to pursue its litigation against the carrier, which is currently in the early stages of discovery, but has agreed to limit execution on any judgement obtained against the carrier to $18 million. Further, BankAtlantic agreed to join certain third parties as defendants in that action. The carrier paid BankAtlantic $6.1 million during the fourth quarter of 1992 and paid an additional $3 million in November 1993, and has agreed to pay an additional $2.9 million in November 1994. Such amounts related to losses and expenses previously charged to operations by BankAtlantic. Additional reimbursements are made on a quarterly reporting basis commencing with the period ended December 31, 1992. Reimbursable amounts are as defined in the Covenant. Based upon such definitions BankAtlantic has and will continue to record estimated charges to operations in advance of when such charges become reimbursable. Amounts to be reimbursed will be reflected in the period for which reimbursement is requested. Through December 31, 1993, the carrier has paid or committed to pay approximately $15.4 million. The 1993 and 1994 committed amounts noted above have been accrued after imputing interest at 9%. The financial statement effect of the Covenant for the fourth quarter and year ended December 31, 1992 was to reduce expenses by $3.3 million, increase interest income by $1.9 million and to record $7.3 million of loan loss recoveries. The financial statement effect of the Covenant for 1993 was to reduce expenses by $942,000, to increase interest income by $757,000 and record $972,000 of loan loss recoveries. Included in other assets was a $3.3 million receivable due from the carrier at December 31, 1993. In no event will the carrier be obligated to pay BankAtlantic in the aggregate more than $18 million. However, in the event of recovery by BankAtlantic of damages from third party wrongdoers, BankAtlantic will be entitled to retain such amounts until such amounts, plus any payments received from the carrier equal to $22 million. Thereafter, the carrier will be entitled to any such recoveries to the extent of its payments to BankAtlantic. To the extent that BankAtlantic incurs losses in excess of $18 million plus available recoveries from third parties, BankAtlantic will be required to absorb any such losses. At December 31, 1993, the remaining amount of reimbursement available from the carrier was approximately $2.6 million. BankAtlantic does not currently anticipate that the aggregate losses in the Subject Portfolio will exceed $18 million. BankAtlantic also agreed to exercise reasonable collection activities with regard to the Subject Portfolio and to provide the carrier with a credit for any recoveries with respect to such loans against future losses that the carrier would otherwise be obligated to reimburse. The balance of the loans and dealer reserve associated with the Subject Portfolio amounted to approximately $24.4 million and zero at December 31, 1993, and $29.9 million and $2.5 million at December 31, 1992, respectively. At December 31, 1993, 10% of the loans were secured by collateral in South Florida and 90% of such loans were secured by collateral in the northeastern United States. Collateral for these loans in generally a second mortgage on the borrower's property. However, it appears that in most cases, the property is encumbered with loans having high loan to value ratios. Although as indicated above, the dealer reserves are not collateralized, the risk relating to amounts advanced to the dealers are primarily associated with loan performance. Loans in the "Subject Portfolio" are charged-off if payments are more than 90 days delinquent. Related to the above are suits filed in New Jersey and New York. The New Jersey action seeks civil remedies against certain contractors and a dealer and also seeks to cancel or modify certain mortgage loans. BankAtlantic had purchased individual loans from the named dealer and such purchased loans include loans for which a named contractor is listed as providing home improvements. While BankAtlantic is not a party to that action, a status conference was held in December 1993 which indicated that discovery is to be completed by May 1994 and BankAtlantic must determine by April 1994 whether to intervene in the action. The New York action purports to be a class action against over 25 individuals and entities, including BankAtlantic. The named plaintiffs purport to also represent other unnamed plaintiffs that may have obtained loans from dealers who subsequently sold such loans to BankAtlantic. Plaintiffs base their claims on various grounds and seek, among other things, rescission of the loan agreements, damages, punitive damages, costs, attorney fees, penalties under the truth in lending act and treble damages under RICO. The plaintiffs' Motion to Certify the Class was made in November, 1993. The court has not yet ruled on this motion. 18. Selected Quarterly Results (Unaudited) The following tables summarize the quarterly results of operations for the years ended December 31, 1993 and 1992 (in thousands except per share data): During the second quarter, BankAtlantic settled a claim with the IRS relating to net operating loss carrybacks and previous Federal income tax examinations through 1988, resulting in an increase in other interest income of $587,000 and a reduction in the provision for income taxes of $1.4 million. The weighted average number of common and common equivalent shares outstanding during the first quarter of 1993 were not restated to reflect the exercise of warrants by BFC. During the fourth quarter, BankAtlantic sold approximately $115.4 million of mortgage-backed securities at a gain of $5.2 million. Additionally, BankAtlantic recovered $3.3 million in expenses, recorded loan loss recoveries of $7.3 million and increased interest income by $1.9 million for circumstances relating to the Subject Portfolio and the Covenant discussed in Note 17. Also during the fourth quarter, BankAtlantic recorded a $756,000 ($.16 and $.14 per share for primary and fully diluted income per share, respectively) extraordinary gain from the utilization of state net operating loss carryforwards. 19. Other Information On November 14, 1991, BFC increased its common stock ownership in BankAtlantic to 72.50% by acquiring in the open market an additional 115,000 shares of BankAtlantic common stock at a per share price of $.76. The increase in ownership was subject to all regulatory approvals which have been received. As further discussed in Note 11, BFC increased its common stock ownership in BankAtlantic to 77.83% at June 30, 1993 and subsequently, in November 1993, sold 1.4 million shares of BankAtlantic common stock to decrease their ownership percentage to 48.17% at December 31, 1993. The Chairman and President of BFC is Alan B. Levan, who also serves as the Chairman and Chief Executive Officer of BankAtlantic. John E. Abdo, a director of BFC, is the Vice Chairman of BankAtlantic and Chairman and President of BankAtlantic Development Corporation, a wholly owned subsidiary of BankAtlantic. BankAtlantic is exploring the formation of a holding company which will own 100% of BankAtlantic's common stock. Any such formation would be subject to shareholder approval and would generally involve a shareholder exchanging their shares of BankAtlantic for shares in the new entity. At the time of any such exchange, a shareholder's proportionate ownership position in the new entity would be equal to the proportionate interest previously held in BankAtlantic. BFC has indicated that it would vote in favor of this type of shareholder proposal. 20. Investments In and Advances To Joint Ventures BankAtlantic, through its wholly-owned subsidiary, BankAtlantic Development Corporation ("BDC"), has non-consolidated equity interests ranging from 35% to 50% in joint ventures engaged primarily in the acquisition, development and construction of various real estate projects. By December 31, 1991, all development and construction activities had been completed and the remaining real estate of the ventures consists of single family homes and lots held for sale. Included in "Other Assets" in the consolidated statement of condition is $1.2 million of investments and advances to joint ventures at December 31, 1993 and 1992, respectively. Summarized combined financial information (unaudited) of the joint ventures was (in thousands): December 31 ------------------------------ 1993 1992 ------------- ------------- Condensed Statements of Financial Condition Assets: Cash $ 864 $ 298 Real estate held for sale 313 1,014 Other assets 249 104 ------------- ------------- Total income $ 1,426 $ 1,416 ============= ============= Liabilities and partners' equity: Loans and notes payable $ 1,264 $ 1,269 Accounts payable and other liabilities 448 378 Partners' (deficit) equity (286) (231) ------------- ------------- Total $ 1,426 $ 1,416 ============= ============= For the Years Ended December 31, ----------------------------------- 1993 1992 1991 --------- ---------- ---------- Condensed Statements of Operations Income: Sales $ 721 $ 160 $ 47,527 Cost of sales 725 162 40,983 --------- ---------- ---------- Net (loss) gain on sales (4) (2) 6,544 Interest and other income 87 90 2,208 --------- ---------- ---------- Total income 83 88 8,752 --------- ---------- ---------- Expenses: Interest expense 73 84 1,433 Other expense 65 198 2,531 --------- ---------- ---------- Total expenses 138 282 3,964 --------- ---------- ---------- Net (loss) income $ (55) $ (194) $ 4,788 ========= ========== ========== Included in loans and notes payable above as of December 31, 1993 and 1992, respectively, was $1.0 million due to BankAtlantic. These loans are included with "Investments In and Advances To Joint Ventures" in BankAtlantic's financial statements. During 1991, two joint venture projects were sold for gains of $1.9 million and $1.2 million. Proceeds from the sales reduced the investments in and advances to joint ventures by approximately $8.4 million in 1991. During 1992, BDC established a $250,000 allowance account against its investment in the remaining properties, of which a balance of $182,000 remained at December 31, 1993. Such amount is included in (income) loss from joint venture investments in BankAtlantic's Consolidated Statement of Operations, but is not in the condensed statement of the ventures due to a dispute and related litigation with the joint venture partners. 21. Estimated Fair Value of Financial Instruments The information set forth below provides disclosure of the estimated fair value of BankAtlantic's financial instruments presented in accordance with the requirements of Statement of Financial Accounting Standards No. 107, "Disclosures about Fair Value of Financial Instruments" (FAS 107) issued by the FASB. Management has made estimates of fair value discount rates that it believes to be reasonable. However, because there is no market for many of these financial instruments, management has no basis to determine whether the fair value presented would be indicative of the value negotiated in an actual sale. BankAtlantic's fair value estimates do not consider the tax effect that would be associated with the disposition of the assets or liabilities at their fair value estimates. Fair values are estimated for loan portfolios with similar financial characteristics. Loans are segregated by category such as commercial, commercial real estate, residential mortgage, second mortgages, and other installment. Each loan category is further segmented into fixed and adjustable rate interest terms and by performing and non-performing categories. The fair value of performing loans, except residential mortgage and adjustable rate loans, is calculated by discounting scheduled cash flows through the estimated maturity using estimated market discount rates that reflect the credit and interest rate risk inherent in the loan. The estimate of average maturity is based on BankAtlantic's historical experience with prepayments for each loan classification, modified, as required, by an estimate of the effect of current economic and lending conditions. For performing residential mortgage loans, fair value is estimated by discounting contractual cash flows adjusted for national historical prepayment estimates using discount rates based on secondary market sources adjusted to reflect differences in servicing and credit costs. For adjustable rate loans, the fair value is estimated at book value after adjusting for credit risk inherent in the loan. BankAtlantic's interest rate risk is considered insignificant since the majority of BankAtlantic's adjustable rate loans are based on prime rates or one year Constant Maturity Treasuries ("CMT") rates and adjust monthly or generally not greater than one year. Fair values of non-performing loans are based on the assumption that non- performing loans are on a non-accrual status discounted at market rates during a 24 month work-out period. Assumptions regarding credit risk are judgementally determined using available market information and specific borrower information. The fair value of tax certificates and other investment securities is calculated by discounting estimated cash flows using estimated market discount rates that reflect the credit and interest rate risk inherent in the investment. Tax certificates do not have stated maturities. Estimated cash flows were based on BankAtlantic's historical experience, modified by current economic conditions. Fair value of mortgage-backed securities is estimated based on bid prices available from security dealers. Under FAS 107, the fair value of deposits with no stated maturity, such as non-interest bearing demand deposits, savings and NOW accounts, and money market and checking accounts, is equal to the amount payable on demand at December 31, 1993. The fair value of certificates of deposit is based on the discounted value of contractual cash flows. The discount rate is estimated using alternative borrowing rates adjusted for maintenance and insurance costs. The book value of securities sold under agreements to repurchase approximates market value. The fair values of advances from FHLB, capital notes and other subordinated debentures were based upon comparable terms to maturity, interest rates and issuer credit standing. The following table presents information for BankAtlantic's financial instruments at December 31, 1993 and 1992 (in thousands): The contract amount and related fees of BankAtlantic's commitments to extend credit, standby letters of credit, and financial guarantees approximates fair value (see Note 16 for the contractual amounts of BankAtlantic's financial instrument commitments). BankAtlantic, A Federal Savings Bank and Subsidiaries ITEM 6. SELECTED FINANCIAL DATA Selected Consolidated Financial Data December 31, ------------------------------------------------- 1993 1992 1991 1990 1989 --------- --------- --------- --------- --------- (In thousands) Statement of Financial Condition: Total assets $1,359,195 1,303,071 1,455,822 1,896,587 1,886,453 Loans receivable-net 595,887 556,662 728,515 964,863 1,116,313 Mortgage-backed securities 526,365 487,494 460,780 439,509 461,406 Tax certificates and other investment securities, net (1) 97,701 120,424 109,076 115,763 142,057 Purchased mortgage servicing rights and other intangibles 19,833 7,655 6,748 4,663 4,067 Deposits 1,076,360 1,108,115 1,255,513 1,455,967 1,430,219 Advances from FHLB and securities sold under agreements to repurchase 149,435 87,632 94,332 309,879 329,875 Total stockholders' equity $ 90,652 66,165 50,997 53,230 57,977 ========= ========= ========= ========= ========= For the Years Ended December 31, ------------------------------------------ 1993 1992 1991 1990 1989 --------- --------- --------- --------- --------- (In thousands, except share data) Statement of Operations Data: Total interest income $ 94,503 116,476 145,532 175,979 192,453 Total interest expense 35,987 55,567 90,998 127,718 149,451 --------- --------- --------- --------- --------- Net interest income 58,516 60,909 54,534 48,261 43,002 Provision for loan losses 3,450 6,650 17,540 17,655 5,350 --------- --------- --------- --------- --------- Net interest income after provision for loan losses 55,066 54,259 36,994 30,606 37,652 --------- --------- --------- --------- --------- Non-interest income: Loan servicing and other loan fees 2,080 3,189 4,344 4,188 3,409 Gain on sales of loans and mortgage-backed securities 1,246 6,702 1,078 6,727 1,589 Gain (loss) on sales of investment securities 0 143 62 (151) (282) Other 8,265 7,337 8,622 7,772 7,747 --------- --------- --------- --------- --------- Total non-interest income 11,591 17,371 14,106 18,536 12,463 --------- --------- --------- --------- --------- Non-interest expenses: Employee compensation and benefits 19,617 19,202 24,062 26,254 26,745 Occupancy and equipment 8,417 8,864 10,626 11,218 10,659 Federal insurance premium 2,750 2,772 3,281 2,883 3,060 Advertising and promotion 960 480 1,143 2,498 2,728 (Income) loss from joint venture investments 25 245 (2,335) 897 819 Foreclosed asset activity-net 1,243 4,323 8,922 1,704 1,049 Other 10,474 11,251 19,465 12,887 13,881 --------- --------- --------- --------- --------- Total non-interest expense 43,486 47,137 65,164 58,341 58,941 --------- --------- --------- --------- --------- Income (loss) before income taxes and extraordinary items 23,171 24,493 (14,064) (9,199) (8,826) Provision (benefit) for income taxes 7,093 9,201 (4,841) (1,952) (2,941) --------- --------- --------- --------- --------- Income (loss) before extraordinary items 16,078 15,292 (9,223) (7,247) (5,885) Extraordinary items net of taxes - 756 660 - 2,331 --------- --------- --------- --------- --------- Net Income (loss) $ 16,078 16,048 (8,563) (7,247) (3,554) ========= ========= ========= ========= ========= Income (loss) per common and common equivalent share: Income (loss) before extraordinary items $ 2.52 3.07 (2.12) (1.64) (1.60) Extraordinary items - 0.16 0.14 - 0.63 --------- --------- --------- --------- --------- Net income (loss) $ 2.52 3.23 (1.98) (1.64) (0.97) ========= ========= ========= ========= ========= Actual common shares outstanding at year end 6,478,605 4,681,628 4,681,628 4,676,750 4,135,320 ========= ========= ========= ========= ========= Weighted average number of common and common equivalent shares outstanding 6,054,402 4,694,099 4,680,439 4,409,743 3,669,019 ========= ========= ========= ========= ========= Income per common and common equivalent share assuming full dilution: Income before extraordinary items $ 2.51 2.65 N/A N/A N/A Extraordinary items - 0.14 N/A N/A N/A --------- --------- --------- --------- --------- Net income $ 2.51 2.79 N/A N/A N/A ========= ========= ========= ========= ========= Weighted average number of common and common equivalent shares assuming full dilution 6,091,800 5,440,798 N/A N/A N/A ========= ========= ========= ========= ========= BankAtlantic, A Federal Savings Bank and Subsidiaries SELECTED CONSOLIDATED FINANCIAL DATA Years Ended December 31, ---------------------------------- 1993 1992 1991 1990 1989 ------- ------- ------- ------- ------- Other Financial and Statistical Data: Performance Ratios: Income (loss) on average assets (5) 1.25 % 1.10 % (0.57)% (0.38)% (0.29)% Income (loss) on average equity (5) 21.32 % 27.09 % (16.36)% (12.48)% (10.26)% Dividend payout percent (6) 4.78 % N/A N/A N/A N/A Average equity to average assets 5.85 % 4.07 % 3.51 % 3.08 % 2.81 % Interest rate margin during period 4.90 % 4.78 % 3.71 % 2.76 2.24 % Average yield on loans, mortgage-backed securities, tax certificates, and investment securities 7.95 % 9.14 % 9.89 % 10.05 % 10.05 % Average cost of deposits and borrowings 3.18 % 4.45 % 6.24 % 7.41 % 8.01 % Net interest spread (7) - during period 4.77 % 4.69 % 3.65 % 2.64 % 2.04 % Net interest spread (7) - end of period 4.36 % 4.63 % 4.28 % 2.80 % 2.32 % Operating expenses as a percent of net interest income plus non-interest income 62.03 % 60.22 % 94.94 % 87.34 % 106.27 % Asset quality ratios: Non-performing assets as a percent of total loans and real estate owned 3.21 % 4.59 % 4.80 % 4.36 % 1.79% Charge-offs as a percent of total loans 0.73 % 2.21 % 2.81 % 0.88 % 0.51% Loan loss allowance as a percent of total loans 2.77 % 2.88 % 1.85 % 1.61 % 0.52% Loan loss allowance as a percent of non-performing loans 173.01 % 142.93 % 95.26 % 88.31 % 71.81% Non-performing loans as a percent of total loans 1.60 % 2.01 % 1.94 % 1.82 % 0.72% Non-performing assets as a percent of total assets 1.47 % 2.07 % 2.52 % 2.31 % 1.08% Ratio of earnings to fixed charges: (8) Including interest on deposits 1.64 1.44 0.85 0.93 0.94 Excluding interest on deposits 6.53 4.00 (0.82) 0.71 0.79 Dollar deficiency of earnings to fixed interest charges (000's omitted) $ - $ - $ 14,064 $ 9,199 $ 8,826 Number of: Offices (all full-service) 31 31 34 46 46 Deposit accounts 113,459 120,558 144,942 165,486 175,547 Total loans 19,163 27,761 36,936 46,218 42,926 ======= ======= ======= ======= ======= MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION General BankAtlantic commenced operations in 1952 as Atlantic Federal Savings and Loan Association, a federally chartered mutual savings and loan association; converting to a stock association in 1983. In 1987, BFC Financial Corporation acquired control of BankAtlantic. From 1952 to 1987, BankAtlantic operated as a traditional savings and loan association. During the periods ended December 31, 1987 and 1988, BankAtlantic had a thin capital base (with a surplus of only $258,000 of capital over the applicable requirements at December 31, 1988), high cost interest sensitive time deposits and borrowings, low levels of fee income, poorly structured interest rate swaps, no automatic teller machines, no drive through operations, outdated computer systems and a loan portfolio primarily consisting of long term , fixed rate mortgages. Additionally, shortly after the 1987 change in control, it was announced that the FSLIC was insolvent and all savings and loans associations, including BankAtlantic, were required to write-off their FSLIC secondary reserve fund assets. Based on the industry wide problems and the institution's structure, management concluded that a new direction and focus was required in order for the institution to survive and prosper in the changing economic and regulatory climate. The fundamental strategy was to shift from traditional thrift activities to activities more closely related to commercial banking. This strategy emphasized changing the deposit mix to transaction accounts from time deposits and providing a full range of other banking services to customers. Acting upon this plan, the institution, in 1987, converted to a federal savings bank and changed its name from Atlantic Federal Savings and Loan Association of Fort Lauderdale to BankAtlantic, A Federal Savings Bank. This overall strategy required substantial expenditures for marketing, equipment, computer software and personnel. During the same time period, regulations requiring increased capital ratios for savings institutions were adopted. As a consequence, in addition to its efforts to restructure its assets and liabilities, BankAtlantic was required to focus on increasing capital. As of December 31, 1993, BankAtlantic met all of the more stringent capital requirements established by FIRREA and FDICIA. It did so by reducing its size, operations earnings and increasing its equity capital. Results of Operations Net income of $16.1 million, $16.0 million and a net loss of $8.6 million were recorded for the three years ended December 31, 1993, 1992 and 1991, respectively. Operations for 1993 include, during the second quarter, settlement of a claim with the Internal Revenue Service ("IRS") relating to net operating loss carrybacks and previous federal income tax examinations through 1988, resulting in an increase in other interest income of $587,000 and a reduction in the provision for income taxes of $1.4 million. Net income during December 31, 1992 included a $756,000 net extraordinary gain during the fourth quarter, resulting from the utilization of state net operating loss carryforwards. Operations during the fourth quarter of 1992 also included amounts relating to the October 30, 1992 Covenant and to the Subject Portfolio. During the fourth quarter of 1992, and for the year ended December 31, 1992, the financial effect of the Covenant was to reduce expenses by $3.3 million, increase interest income by $1.9 million and recognize loan loss recoveries of $7.3 million. The Covenant was operative for all of 1993 and the financial effect of the Covenant for 1993 was to reduce expenses by $942,000, increase interest income by $757,000 and recognize loan loss recoveries of $972,000. Non-interest income for December 31, 1992 also includes gains of $5.9 million from sales of mortgage-backed and investment securities, compared to gains of $810,000 in 1991 and none in 1993, due to an absence of such sales. The loss during December 31, 1991 included a $660,000 net extraordinary gain from BankAtlantic's early retirement of $10.2 million of Capital Notes by exchanging cash payments, cash bonuses, and Non-Cumulative Preferred Stock ("Preferred Stock") to Capital Noteholders. During 1991, BankAtlantic wrote off $2.7 million in dealer reserves relating to loans in the Subject Portfolio, which, as indicated above, was subsequently recovered in 1992 from BankAtlantic's fidelity bond carrier. Income per common and common equivalent share (primary income per share) and income assuming full dilution (fully dilutive income per share) for the years ended December 31, 1993 and 1992 were $2.52 and $2.51; $3.23 and $2.79, respectively. For the year ended December 31, 1991, loss per common and common equivalent share was $1.98. Although 1993 net earnings increased compared to 1992, income per share in 1993 decreased due to the approximately 1.7 million of additional shares issued during 1993 relating to the second quarter exercise of warrants to acquire common stock by BFC and also the additional 670,000 shares issued in a November 1993 public offering. The effect of these new shares and the impact relating to the calculation of common stock equivalent shares outstanding decreased primary and fully dilutive income per share during 1993. The average and end-of-period stock price utilized in the calculation of dilutive securities was $12.88 and $13.75, and $3.84 and $7.17 at December 31, 1993 and 1992, respectively. Operations for the years ended December 31, 1993 and 1992 were also favorably impacted by lower provisions for loan losses and improved results in the operation and disposition of foreclosed properties as compared to each prior year. Another significant operating benefit during the three year period ended December 31, 1993 related to the interest rate environment and BankAtlantic's interest rate sensitivity gap position during these periods. From 1991 through mid-1993, BankAtlantic had a one-year negative interest rate sensitivity gap. Since that time, BankAtlantic has had a positive one-year interest rate sensitivity gap. A negative interest rate sensitivity gap provides the potential for widening interest margins and increased earnings during times of declining rates, the environment that existed during the periods under discussion. However, a negative gap will correspondingly negatively impact earnings when rates increase. During periods of declining rates, a significant amount of repayments and prepayments of loans and mortgage-backed securities occur due to refinancing alternatives at lower rates. BankAtlantic continues to experience this type of activity which will generally result in lower rates earned on interest-bearing assets newly acquired or which bear floating interest rates compared to the interest rates earned on prior year investments, loans and mortgage-backed securities. However, rates earned in 1994 will benefit from the final amortization in 1993 of dealer reserves relating to the Subject Portfolio, such net amortization amounted to approximately $2.2 million in 1993. Additional details concerning the items discussed above are contained in specific sections and tables of this Management's Discussion and Analysis. Net-Interest Income A financial summary of net interest income follows: The changes in net interest income for the years ended December 31, 1993, 1992 and 1991 resulted from the following: the decrease in interest on loans primarily resulted from lower average loan balances and secondarily lower yields. BankAtlantic's average loan portfolio balances declined from $876.3 million during 1991 to $652.4 million during 1992 and to $532.3 million during 1993. These declines resulted from principal repayments exceeding loan originations primarily due to reduced originations in consumer lending and prepayments of residential loans and consumer loans. The average yield on BankAtlantic's loan portfolio has declined from 10.23% for the year ended December 31, 1991 to 8.95% for the year ended December 31, 1993. The decline in loan yields reflects the general decline in market interest rates, and repayment of higher yielding consumer loans. The decline in loan yields in 1993 was partially offset by an overall improvement in BankAtlantic's non- accruing loan balances, resulting in fewer reversals of interest income. The decrease in interest and dividends on tax certificates and other investment securities resulted primarily from lower yields on tax certificates during the comparable periods, and lower tax certificate balances during 1993 compared to 1992 and 1991. BankAtlantic purchased $78 million, $125.2 million and $121.8 million of tax certificates (at auctions and by purchases of deeds) during the years ended December 31, 1993, 1992 and 1991, respectively. Decreased interest on mortgage-backed securities resulted from lower yields earned on the mortgage-backed securities portfolio, offset, in whole or in part, by higher mortgage-backed securities portfolio balances in 1993 compared to 1992 and in 1992 compared to 1991. The higher balances and lower yields were the result of BankAtlantic restructuring its securities portfolio during 1992 and 1993 by using proceeds from loan repayments and sales of long-term fixed rate mortgage-backed securities to purchase adjustable rate and fixed rate five and seven year balloon mortgage-backed securities. During the year ended December 31, 1993, BankAtlantic used principal repayments on loans and tax certificates to purchase an additional $206.9 million of adjustable rate and fixed rate seven year balloon mortgage-backed securities. These actions reflected management's goal to minimize interest income volatility. Other interest income was solely related to an IRS settlement in June 1993. The decreases in interest expense on deposits resulted substantially from lower certificate account balances and lower short-term interest rates in 1993 and 1992 compared to the preceding years, and the continuing change in the deposit mix in 1993 from generally higher rate certificates of deposit to lower rate transaction accounts. Average transaction accounts to total deposits increased from 45.1% in 1991 to 51.3% and 58.5% in 1992 and 1993, respectively. The change in the deposit mix resulted from management's decision to pay commercial bank interest rates on time deposits and to actively pursue transaction and relationship accounts. Management's goal in changing the deposit mix is to improve BankAtlantic's net margin. Total deposits declined by $179 million from $1.26 billion at December 31, 1991 to $1.1 billion at December 31, 1993. During the period, time deposits declined by $206 million, while non-interest bearing deposits increased by $14.5 million. Management believes that a significant portion of the decline is a result of a historically low interest rate environment and the increasing availability of alternative investments for time deposits. The decline in interest on Capital Notes and other subordinated debentures was primarily due to the July 1992 redemption at par of $6.9 million of 1986 Capital Notes, the redemption of the remaining $67.8 million of both 1986 Capital Notes and the $1 million of 14% subordinated debentures during the third quarter of 1993, at par and the June 30, 1993 conversion of approximately $2.0 million of 13% subordinated debentures due to BFC into common stock of BankAtlantic. The Capital Notes and subordinated debentures were redeemed because the rates paid on this debt was in excess of the then current market rates. The effect of these redemptions on regulatory capital was not material. The decline in interest on FHLB advances was due to the maturity of higher yielding FHLB advances during 1992 and 1993, offset by higher balances of lower yielding short-term adjustable rate FHLB advances during 1992. Interest on securities sold under agreements to repurchase declined due to lower average borrowings and yields in 1993 compared to 1992, while the benefit of decreased yields paid during 1992 was more than offset by higher borrowings compared to 1991. During each of the three years ended December 31, 1993, BankAtlantic's average interest earning assets and average interest bearing liabilities decreased and the average rates earned and paid, respectively, also declined. The effect of lower rates and decreased volume resulted in lower interest income of $22.6 million in 1993. This decline was partially offset by a $19.6 million benefit from lower interest expenses due to lower volume and lower interest rates. These significant volume and rate changes occurred in 1992, with lower interest income of $29.1 million and lower interest expense of $35.4 million compared to 1991. Other interest expense declined in 1992 due to the March 1991 expiration of a $35.0 million interest rate swap. Details of these changes are further discussed below and are illustrated in the "Yields Earned and Rates Paid" and "Rate/Volume Analysis" tables included elsewhere herein. The average interest margin was 4.90%, 4.78% and 3.71% for the three years ended December 31, 1993, 1992 and 1991, respectively. The improved margin in 1993 compared to 1992 and 1991 resulted from the shift in the deposit mix previously discussed, lower short term interest rates, the redemption of Capital Notes and subordinated debentures, and the expiration of the interest rate swap. The present interest rate environment is expected to continue to reduce the average rate earned by BankAtlantic on its interest earning assets. However, this reduction may be offset, in whole or in part, by lower borrowing rates and a continued shift in the deposit mix to lower rate transaction accounts from higher rate time deposits. As described in "Asset and Liability Management", BankAtlantic has been changing the composition of its loan portfolio to shorter term, adjustable rate, higher yielding loans from traditional fixed rate, long term mortgage loans. This change in portfolio composition is intended to produce a continuing benefit in BankAtlantic's interest rate margin volatility. Shorter term, adjustable rate, higher yielding loans include consumer, construction and permanent (5-7 year) commercial real estate loans. These loans are generally considered to involve a higher risk of default than single-family residential loans. Repayment of construction and permanent commercial real estate loans is generally dependent on the successful operation of the related real estate project and thus may be subject, to a greater extent, to adverse conditions in the real estate market or in the economy. Construction loans involve additional risks because loan funds are advanced upon the security of the project under construction, which is of uncertain value prior to completion of construction. Provision for Loan Losses and Declines in Value of Real Estate Owned Management conducts a monthly review of BankAtlantic's allowance for loan losses and all identified potentially problematic loans to determine if the allowance is adequate to absorb estimated loan losses and to evaluate appropriate courses of action. This review includes risk elements, all loans for which full collectibility may not be reasonably assured, and takes into consideration such factors as changes in the nature and volume of the loan portfolio, overall portfolio quality, review of specific non-performing loans, and current economic conditions and trends that may affect the borrower's ability to repay. The review is conducted by using the most current information available to BankAtlantic such as appraisals, inspection reports and borrower financial statements. An evaluation is also made of the estimated fair value of any underlying loan collateral. During the years ended December 31, 1993, 1992 and 1991, the provision for loan losses was $3.5 million, $6.7 million and $17.5 million, respectively. The provision in each of these years was substantially impacted by installment loan quality. Installment loan charge-offs amounted to $3.4 million, $10.4 million and $18.9 million in 1993, 1992 and 1991, respectively. Management believes that the declines in charge-offs resulted from portfolio maturity and runoff, lower interest rates and improved collection activity. Net installment loan charge-offs of $2.1 million, $1.8 million and $17.9 million in 1993, 1992 and 1991, respectively, were significantly impacted by the recoveries associated with the October 1992 Covenant with an insurance carrier. Installment loan recoveries from this source were $7.3 million in 1992 and $1 million in 1993. Charge-offs related to the installment loans for which the Covenant was executed, declined from $5.5 million 1991 to $2.5 million in 1992 and to $1 million in 1993. BankAtlantic's "risk elements" consist of restructured loans and "non- performing" assets. The classification of loans as "non-performing" is based upon management's evaluation of the overall loan portfolio and current and anticipated future economic conditions. BankAtlantic generally designates any loan that is 90 days or more delinquent as non-performing. BankAtlantic may designate loans as non-performing prior to the loan becoming 90 days delinquent, if the borrower's ability to repay is questionable. A "non- performing" classification alone does not indicate an inherent principal loss; however, it generally indicates that management does not expect the asset to earn a market rate of return in the current period. Restructured loans are loans for which BankAtlantic has modified the loan terms due to the financial difficulties of the borrower. At both December 31, 1993 and 1992, restructured loans were $2.7 million compared to $7.6 million in 1991. Non- performing assets, net of write downs and allowances, decreased in 1993 by $7.0 million to $20.0 million at December 31, 1993. Risk elements, net of write downs and dispositions, decreased in 1993 by $7.0 million to $22.6 million at December 31, 1993 and decreased in 1992 by $14.5 million to $29.7 million at December 31, 1992. The 1993 decline primarily resulted from sales of $5.1 million of real estate owned and a $3.2 million decline in non-accruing loans. The 1992 decrease primarily related to a $6.3 million decrease in real estate owned, a $3.3 million decrease in non- accrual assets, primarily consumer, and a $4.9 million decrease in restructured loans. The decrease in real estate owned primarily resulted from a provision for declines in value of real estate owned of $3.8 million, and proceeds received from the sales of real estate owned of $11.1 million offset by transfers of $2.4 million and $5.5 million of residential and commercial loans to real estate owned. The $3.3 million decrease in non-accrual assets resulted primarily from a $2.6 million and $476,000 decline in consumer and tax certificate non-accruals as of December 31, 1992, respectively. The decline in consumer non-accruals related to (a) repossessions occurring at an earlier stage in the collection process, (b) a reduction in size of the general loan portfolio, (c) charge-offs and (d) more stringent underwriting standards on new loans. The non-accrual tax certificate decline resulted from write-downs of affected certificates prior to reaching a non-accrual status. The $4.9 million decrease in restructured loans resulted from $7.2 million of commercial loans being taken off restructured status in 1992 offset by $2.3 million of commercial loans being restructured. At December 31, 1993, gross real estate loans amounted to $343.7 million, $134.3 million of which were residential loans which management believes carry minimal credit risk. The remaining real estate loans consisted of $198.1 million of commercial real estate loans, and $11.3 million of construction and development loans. Management believes that BankAtlantic's commercial real estate loans are adequately collateralized and generally involve no unusual risks of collectibility. Gross other loans amounted to $277.8 million, and included commercial (non-real estate) loans, bankers acceptances and installment (including second mortgage) loans of $28.0 million, $110.7 million and $139.1 million, respectively. Commercial and installment loans involve greater risks of collectibility, but management does not believe that such risks have been greater than normal industry experience for these types of loans except for the Subject Portfolio discussed under "Financial Condition." Bankers acceptances are short-term loans with minimal credit risk. Management estimates that net charge-offs for 1994 will be approximately $3-4 million for consumer loans, and $2-3 million for real estate and other loans. During the years ended December 31, 1993, 1992 and 1991, BankAtlantic's provisions for declines in real estate owned were $2.7 million, $3.8 million and $7.3 million, respectively. For the years ended December 31, 1993, 1992 and 1991, charge-offs were $775,000, $1.9 million and $7.0 million, respectively. The allowance for real estate owned is established by management based on its evaluation of the foreclosed properties. The 1993 charge-offs included a $350,000 write-off of an insubstance foreclosed commercial real estate loan due to an unfavorable environmental analysis of the property. The 1992 charge-offs included a $600,000 write down of a shopping center. The remaining charge-offs for 1993 and 1992 were related to various commercial and residential real estate properties. During 1991, BankAtlantic wrote-down one commercial residential construction property by $2.8 million and one commercial shopping center by $1.7 million. The remaining 1991 charge-offs related to various commercial and residential real estate properties based on the depressed real estate market in South Florida and management's evaluation of the properties at the time. Non-Interest Income A financial summary of non-interest income follows: During 1993, 1992 and 1991, BankAtlantic paid $17.0 million, $3.8 million, and $3.5 million, respectively, for the purchase of $1.2 billion, $333.8 million, and $253.0 million, respectively, of mortgage servicing from other financial institutions. The purchase of servicing provides BankAtlantic with an opportunity to replace normal run-off, upgrade its portfolio, and utilize economies of scale in the loan servicing function. BankAtlantic upgraded its portfolio by purchasing the servicing of loans with higher average balances than contained in its previous portfolio. However, income from servicing declined in 1993 and 1992 by $875,000 and $880,000, respectively, due to accelerated amortization of servicing acquisition fees resulting from early prepayments of the underlying mortgage loans. The early prepayments were caused by the refinancing of mortgage loans due to declining long term interest rates throughout the three years ended December 31, 1993. The servicing purchased during 1993 related to recently originated loans in the Southeast United States. The early prepayments were caused by the refinancing of mortgage loans due to declining long-term interest rates throughout the two years ended December 31, 1993. During 1991, prepayments were approximately 7% of loans serviced, compared to approximately 22% in 1992 and 19% in 1993. Based upon the significant amount of servicing purchased in 1993 relating to recently originated loans and a relatively stable residential interest rate environment, BankAtlantic's recent monthly prepayment experience has been less than that experienced in 1992 and 1993. The impact of prepayments on servicing income is partially offset by increased gains from sales of recently originated residential loans. See also "Sales on Mortgage-Backed Securities, Investment Securities and Loans." The major component of non-interest income-other was fees from transaction accounts which amounted to $5.2 million, $5.0 million and $5.2 million in 1993, 1992 and 1991, respectively. The increase in non-interest income-other for the year ended December 31, 1993, as compared to the same period in 1991 was due to additional income received from a broker dealer that rents space in BankAtlantic's branches and fee income received related to cashier and operating checks. The decrease in non-interest income-other for the year ended December 31, 1992, as compared to the same period in 1991, was due to a reversal in 1991 of a $415,000 allowance related to reconciliation differences recorded in prior years and a reversal in 1992 of dormant account fee income. Beginning in 1990, the Office of the Comptroller for the State of Florida ("Comptroller") commenced a review of BankAtlantic's procedures for the assessment of fees on dormant accounts. The Comptroller subsequently indicated that BankAtlantic was not in compliance with applicable Florida law as interpreted by the Comptroller. The difference in interpretation concerns approximately $500,000 and has not yet been resolved. Pending resolution of the issue and modification of the procedures, dormant account assessments, approximately $10,000 per month, have been eliminated since 1992, and an allowance has been established for the amount which is in question. Non-Interest Expense A financial summary of non-interest expense follows: The decline in occupancy and equipment expenses for the year ending December 31, 1993, as compared to December 31, 1992, primarily resulted from BankAtlantic discontinuing its lease agreement on teller equipment as part of its branch network modernization project. See "Liquidity and Capital Resources" for a further discussion of these efforts. During the year ended December 31, 1992, occupancy expenses declined from the comparable periods in 1991 due to BankAtlantic consolidating back office operations into bank owned buildings during the latter part of 1990 and in 1991. The office space consolidation resulted in a decline in rental expense of approximately $1.1 million during the year ended December 31, 1992, compared to the year ended December 31, 1991. Foreclosed asset activity, net decreased during 1993 compared to 1992, primarily due to a decline in real estate owned which resulted in $1.4 million lower related operating expenses, and $1.2 million lower provision for declines in real estate owned and a $563,000 increased in gains on sales of foreclosed properties. Foreclosed asset activity, net decreased for the year ended December 31, 1992, compared to the year ended December 31, 1991. The decline was the result of a $3.4 million decrease in the provision for declines in value of real estate owned, a $446,000 decrease in expenses associated with such real estate owned expenses and a $707,000 improvement in net gains and losses on sales of real estate owned. For a further discussion, see "Provision for Loan Losses and Declines in Value of Real Estate Owned." Employee compensation and benefits during 1993 remained approximately at 1992 levels. The decline in employee compensation and benefits during 1992 as compared to 1991 was due to BankAtlantic closing 15 branches, resulting in a decline in the number of employees. In addition, the branch consolidation also resulted in lower occupancy expenses during 1992 as compared to the same period in 1991. During early 1992, BankAtlantic completed the consolidation of 15 branches into existing branches. The consolidation, which commenced during 1991, required a provision for costs relating to employee severance, lease terminations and write-offs of leasehold improvements at December 31, 1991. Due primarily to the branch consolidation, and a reduction in BankAtlantic's back office operations, BankAtlantic's full time equivalent employees decreased from 765 at December 31, 1990, to 620 at December 31, 1992 and increased to 632 at December 31, 1993, resulting in a reduction of employee compensation and benefits for the year ended December 31, 1992, compared to the same period in 1991. The slight increase during 1993, compared to 1992 related primarily to additional personnel and salary changes. The 1991 reduction in employees and the branch consolidations resulted from BankAtlantic downsizing its operations in order to gain operating efficiencies and to assist it in meeting regulatory capital requirements. Included in employee compensation and benefits was a $351,000 pension curtailment gain arising from the reduction in work force during 1991. The increase during the year ended December 31, 1993 compared to the year ended December 31, 1992 in advertising and promotion was due to increased media expenses incurred to promote new transaction account packages and to originate residential mortgage loans for resale. The reduced advertising during 1992, compared to 1991 was a result of BankAtlantic's downsizing discussed above. The decline in non-interest expense-other during the year ended December 31, 1993 compared to the same period in 1992 resulted from a $550,000 decline in legal fees inclusive of $800,000, relating to the reimbursement under the Covenant, and a $300,000 decline in supervisory and examination expenses which management believes was due mainly to BankAtlantic's status as a well capitalized institution. An additional $450,000 decrease related to improved operations in the installment collections and repossessions areas. The remaining decline in non-interest expense-other was due to lower operating expenses in 1993 as compared to 1992. The decrease in non-interest expense- other for the year ended December 31, 1992, was the result of a $568,000 recovery of legal fees pursuant to the Covenant and a $1.2 million decline in repossession expenses and write-downs in 1992 compared to the same period in 1991. The decline in repossession expenses and write-downs resulted from management's decision to charge-off consumer loans at an earlier stage in the collection process during the latter part of 1991, and reduced consumer loan originations. Included in (income) loss from joint venture investments for the year ended December 31, 1991 was a gain of $3.1 million. The gain was generated by one of BankAtlantic's wholly-owned subsidiaries, BankAtlantic Development Corporation ("BDC"), which participated with joint venture partners in the sales of real estate projects. At December 31, 1991, all development and construction activities had been completed and the remaining real estate of the ventures consists of a minimal amount of single family homes and lots available for sale. There were no significant sales of joint venture properties during the year ended December 31, 1993 and 1992. Included in (income) loss from joint venture investments for 1992 was a $250,000 allowance against BankAtlantic's investment in the remaining properties. For the year ended December 31, 1991, the gains on the sale of the joint venture properties were partially offset by operations of the properties. During the year ended December 31, 1991, BankAtlantic wrote down $2.7 million of dealer reserves related to the Subject Portfolio. During the year ended December 31, 1992, BankAtlantic recovered the same amount from its fidelity bond carrier pursuant to the Covenant. Sale of Mortgage-Backed Securities, Investment Securities and Loans During the year ended December 31, 1992, BankAtlantic, in its efforts to reduce its interest rate sensitivity, transferred to available for sale all fixed rate mortgage-backed securities having original terms of 15 and 30 years to maturity. In accordance with then existing Generally Accepted Accounting Principles ("GAAP"), assets available for sale are recorded at the lower of cost or market and, since the aggregate market value was greater than cost at the date of transfer and at all times subsequent, through December 31, 1993, this reclassification had no effect on net income or stockholders' equity at the transfer date and through December 31, 1993. upon implementation of FAS 15, commencing on January 1, 1994. During the year ended December 31, 1993, there were no mortgage-backed securities or investment securities transferred to available for sale. Approximately $139.4 million of Federal National Mortgage Corporation ("FNMA") securities and $10.1 million of Federal Home Loan Mortgage Corporation ("FHLMC") securities of the $305.7 million of securities transferred to available for sale during 1992 were sold in 1992 for gains of $5.2 million and $500,000, respectively. In addition, BankAtlantic sold $2.0 million of federal agency obligations for a gain of $143,000. The 1992 gains on sales of investment securities and mortgage-backed securities all resulted from sales of securities classified as available for sale. Proceeds from these sales were used to purchase fixed rate balloon mortgage- backed securities having five to seven year maturities, adjustable rate mortgage-backed securities and tax certificates and to repay borrowings. During the years ended December 31, 1993, 1992 and 1991, BankAtlantic sold $45.0 million, $36.1 million and $14.9 million, respectively of recently originated fixed rate and adjustable rate residential loans for gains of $1.2 million, $976,000 and $330,000, respectively. BankAtlantic currently sells substantially all residential mortgage loans it originates. Commencing on January 1, 1994, upon implementation of FAS 115, changes in carrying classifying values of assets held for sale will be reflected as a component of stockholders' equity. BankAtlantic currently sells substantially all residential mortgage loans which it originates. During the year ended December 31, 1991, BankAtlantic securitized $40.4 million of loans and sold the resulting FHLMC mortgage-backed securities for a loss of $30,000. BankAtlantic also sold $8.5 million and $21.3 million of FHLMC and FNMA securities and $30.0 million of treasury notes and federal agency obligations for gains of $200,000, and $574,000 and $62,000, respectively. BankAtlantic sold , for a total gain of $62,000. BankAtlantic has the ability and positive intent to hold its mortgage- backed securities held for investment until their scheduled maturities. Market values of both investments and mortgage-backed securities available for sale at December 31, 1993 were greater than BankAtlantic's cost of such securities. Financial Condition BankAtlantic's total assets at December 31, 1993 and at December 31, 1992 were approximately $1.36 billion and $1.30 billion, respectively. At December 31, 1993, compared to December 31, 1992, mortgage-backed securities (including mortgage-backed securities available for sale) and loans increased by $38.9 million and $39.7 million, while tax certificates and other investment securities declined by $22.7 million. The increase in mortgage-backed securities was due primarily to the purchase of approximately $206.9 million of adjustable rate and balloon mortgage-backed securities during 1993. The decrease in tax certificates and other investment securities was due to the repayment of $112.9 million of tax certificates offset by the purchase of an aggregate of approximately $78.2 million of tax certificates during 1993, including both tax certificates purchased at the 1993 tax certificate auctions (approximately $64 million) and tax certificates purchased in connection with "Applications for Deed" in connection with obtaining title to the underlying property (approximately $14 million). See "Business--Investment Activities". The increase in loans was primarily due to the purchase of $110 million of bankers acceptances, all of which mature by March 1994, offset by principal repayments exceeding loan originations. However, 1993 loan originations exceeded 1992 originations by approximately 50% and 1992 originations exceeded 1991 originations by 25%. Loan originations during the 1993 period amounted to $263.2 million, compared to $289.0 million of loan repayments. At December 31, 1993, compared to December 31, 1992, deposits declined by $31.8 million. The decline in deposits was related to decreased certificate and insured money fund accounts, partially offset by increased deposits in interest-free checking and lower costing NOW accounts. At December 31, 1993, BankAtlantic met all applicable regulatory capital and liquidity requirements. Subject Portfolio From 1987 through 1990, BankAtlantic purchased in excess of $50 million of indirect home improvement loans from certain dealers, primarily in the northeastern United States. BankAtlantic ceased purchasing loans from such dealers in the latter part of 1990. These dealers are affiliated with each other but are not affiliated with BankAtlantic. In connection with loans originated through these dealers, BankAtlantic funded amounts to the dealers as a dealer reserve. Such loans and related dealer reserves are hereafter referred to as the "Subject Portfolio." The risk of amounts advanced to the dealers is primarily associated with loan performance but secondarily is dependent on the financial condition of the dealers. The dealers were to be responsible to BankAtlantic for the amount of the reserve only if the loan giving rise to the reserve became delinquent or was prepaid. These dealers have currently not indicated any financial ability to fund the dealer reserve.There is no assurance that if called upon, a dealer will have the financial ability to fund the unearned dealer reserve. In late 1990, questions arose relating to the practices and procedures used in the origination and underwriting of the Subject Portfolio, which suggested that the dealers, certain home improvement contractors and borrowers engaged in practices intended to defraud BankAtlantic. Due to these questions and potential exposure, BankAtlantic performed, and continues to perform, certain investigations, notified appropriate regulatory and law enforcement agencies, and notified its fidelity bond carrier. After an initial review and discussions with the carrier, BankAtlantic concluded that any losses sustained from the Subject Portfolio would adequately be covered by its fidelity bond coverage and, in fact, on August 13, 1991, the carrier advanced $1.5 million against BankAtlantic's losses. This payment and future payments by the carrier were to be subject to identification and confirmation of the losses which are appropriately covered under the fidelity bond. Subsequently, commencing in September, 1991, as a consequence of issues raised by the carrier, BankAtlantic reviewed the Subject Portfolio without regard to the availability of any fidelity bond coverage. As a result of the review, the provision for loan losses for the year ended December 31, 1991 was increased by approximately $5.7 million, approximately $5.5 million of loans were charged off, and $2.7 million of dealer reserves were charged to current operations. On December 20, 1991, the carrier denied coverage and BankAtlantic thereafter filed an appropriate action against the carrier. On October 30, 1992, BankAtlantic and the carrier entered into the Covenant. Pursuant to the Covenant, BankAtlantic will continue to pursue its litigation against the carrier, which is currently in the early stages of discovery, but has agreed to limit execution on any judgement obtained against the carrier to $18 million. Further, BankAtlantic agreed to join certain third parties as defendants in that action. The carrier paid BankAtlantic $6.1 million during the fourth quarter of 1992 and paid an additional $3 million in November 1993, and has agreed to pay an additional $2.9 million in November 1994. Such amounts related to losses and expenses previously charged to operations by BankAtlantic. Additional reimbursements will be made on a quarterly reporting basis commencing with the period ended December 31, 1992. Reimbursable amounts are as defined in the Covenant. Based upon such definitions BankAtlantic has and will continue to record estimated charges to operations in advance of when such charges become reimbursable. Amounts to be reimbursed will be reflected in the period for which reimbursement is requested. Through December 31, 1993, the carrier has paid or committed to pay approximately $15.4 million. The 1993 and 1994 committed amounts noted above have been accrued after imputing interest at 9%. The financial statement effect of the Covenant for the fourth quarter and year ended December 31, 1992 was to reduce expenses by $3.3 million, increase interest income by $1.9 million and to record $7.3 million of loan loss recoveries. The financial statement effect of the Covenant for 1993 was to reduce expenses by $942,000, to increase interest income by $757,000 and record $972,000 of loan loss recoveries. Included in other assets was a $3.3 million receivable due from the carrier at December 31, 1993. In no event will the carrier be obligated to pay BankAtlantic in the aggregate more than $18 million. However, in the event of recovery by BankAtlantic of damages from third party wrongdoers, BankAtlantic will be entitled to retain such amounts until such amounts, plus any payments received from the carrier equal to $22 million. Thereafter, the carrier will be entitled to any such recoveries to the extent of its payments to BankAtlantic. To the extent that BankAtlantic incurs losses in excess of $18 million plus available recoveries from third parties, BankAtlantic will be required to absorb any such losses. At December 31, 1993, the remaining amount of reimbursement available from the carrier was approximately $2.6 million. BankAtlantic does not currently anticipate that the aggregate losses in the Subject Portfolio will exceed $18 million. BankAtlantic also agreed to exercise reasonable collection activities with regard to the Subject Portfolio and to provide the carrier with a credit for any recoveries with respect to such loans against future losses that the carrier would otherwise be obligated to reimburse. The balance of the loans and dealer reserve associated with the Subject Portfolio amounted to approximately $24.4 million and zero at December 31, 1993, and $29.9 million and $2.5 million at December 31, 1992, respectively. At December 31, 19932, 10% of the loans were secured by collateral in South Florida and 90% of such loans were secured by collateral in the northeastern United States. Collateral for these loans is generally a second mortgage on the borrower's property. However, it appears that in most cases, the property is encumbered with loans having high loan to value ratios. Although as indicated above, the dealer reserves are not collateralized, the risk relating to amounts advanced to the dealers are primarily associated with loan performance. Loans in the "Subject Portfolio" are charged-off if payments are more than 90 days delinquent. Related to the above are suits filed in New Jersey and New York. The New Jersey action seeks civil remedies against certain contractors and a dealer and also seeks to cancel or modify certain mortgage loans. BankAtlantic had purchased individual loans from the named dealer and such purchased loans include loans for which a named contractor is listed as providing home improvements. While BankAtlantic is not a party to that action, a status conference was held in December 1993 which indicated that discovery is to be completed by May 1994 and BankAtlantic must determine by April 1994 whether to intervene in the action. The New York action purports to be a class action against over 25 individuals and entities, including BankAtlantic. The named plaintiffs purport to also represent other unnamed plaintiffs that may have obtained loans from dealers who subsequently sold such loans to BankAtlantic. Plaintiffs base their claims on various grounds and seek, among other things, rescission of the loan agreements, damages, punitive damages, costs, attorney fees, penalties under the truth in lending act and treble damages under RICO. The plaintiffs' Motion to Certify the Class was made in November, 1993. The court has not yet ruled on this motion. Asset and Liability Management During the past several years, BankAtlantic's operating objectives have included actions to increase its regulatory capital and to reduce its negative interest rate sensitivity gap. However, activities in furtherance of these various objectives sometimes involve conflicting short term strategies. In general, BankAtlantic has attempted to achieve these objectives through the replacement of fixed rate, long term securities with floating rate mortgage- backed securities or intermediate term fixed rate, balloon mortgage-backed securities, restructuring deposit liabilities by reducing interest rate sensitive certificates of deposit as a percent of total liabilities and focusing on transaction accounts, and changing the emphasis of loan originations. See "Sale of Mortgage-Backed Securities, Investment Securities and Loans." Included in these replacement securities are tax certificates, adjustable rate mortgage-backed securities, five- and seven-year balloon mortgage-backed securities amounting to approximately $83.9 million, $92.9 million and $350.3 million, respectively, at December 31, 1993. BankAtlantic has been attempting to change the composition of its loan portfolio from predominately long term, fixed rate mortgage loans by currently emphasizing the origination of floating rate commercial business and commercial real estate loans, which generally achieve a two to three year duration. and mortgage loans, which are considered higher yielding. These types of loans generally have higher interest rates than residential loans. However, these loans also involve a greater credit risk and will generally result in higher loan loss experience than that of traditional mortgage lending. Management is of the opinion that the increased credit risk will be offset by the increased rates earned on such loans and the positive effect these shorter terms have on the interest rate sensitivity gap. Origination and underwriting policies and practices for such loans are designed to limit BankAtlantic's exposure to normal industry risk for this form of lending. Additionally, as previously indicated, during the first quarter of 1991 BankAtlantic reduced loan production in its consumer lending portfolio, and BankAtlantic is not currently originating indirect consumer loans. However, BankAtlantic anticipates increasing 1994 consumer loan originations from amounts originated in the prior three years. BankAtlantic continues to originate fixed-rate mortgage loans with 15 and 30 year amortization periods, but these loans are generally originated for sale. Included as loans at December 31, 1993 are $110.7 million of banker's acceptances, all of which were purchased in the fourth quarter of 1993 and all of which mature by March 1994. Based upon BankAtlantic's capital position, alternate uses for funds and availability of acceptable borrowing alternatives, BankAtlantic may continue to utilize banker's acceptances to increase net interest income. Interest Rate Sensitivity BankAtlantic's net earnings are materially affected by the difference between the income it receives from its loan portfolio (including mortgage- backed securities) and investment securities portfolio and its cost of funds. The interest paid by BankAtlantic on deposits and borrowings determines its cost of funds. The yield on BankAtlantic's loan portfolio changes principally as a result of loan repayments and the rate and the volume of new loans. Fluctuations in income from tax certificates and other investment securities will occur based on the amount invested during the period and interest rate levels yielded by such securities. BankAtlantic's net interest spread will fluctuate in response to interest rate changes. because BankAtlantic's cost of funds responds more quickly to changes in interest rates than does its income from loans and investments Like many savings institutions, BankAtlantic's interest rate sensitive liabilities (generally, deposits with maturities of one year or less) has in the past exceeded its interest rate sensitive assets (assets which reprice based on an index or which have short term maturities). This imbalance is referred to as a negative interest rate sensitivity gap, and measures an institution's ability to adjust to changes in the general level of interest rates. The effect of the "mismatch" is that a rise in interest rates will have a negative impact on earnings as the cost of funds increases to a greater extent than the yield earned on interest-earning assets, while a decline in interest rates will have a positive impact on earnings. The larger the gap, whether positive or negative, the greater the impact of changing interest rates. One of BankAtlantic's long term objectives has been the reduction of its interest rate sensitivity gap. However, short-term strategies may differ from this objective in order to meet other objectives, such as compliance with applicable regulatory requirements. BankAtlantic has taken steps, when possible, to minimize its interest rate sensitivity gap. Such actions have included reducing fixed-rate mortgage loan production held in portfolio, purchasing shorter term and adjustable rate mortgage-backed securities and increasing its emphasis on the production of floating rate commercial business loans and commercial real estate loans which generally have a shorter duration and a higher yield than longer term fixed-rate residential mortgage loans. Also, extensive efforts have been made to attract transaction accounts which are generally less rate sensitive than other types of accounts. These actions have involved employing experienced commercial bankers, focusing sales and marketing on transaction oriented customer segments, training existing staff in product sales and commercial operations, offering new transaction products, improving data processing so as to handle increased check clearing and building and remodeling branches so as to accommodate transaction account customers. Further, BankAtlantic has reduced the rates which it offers on certificates of deposit to the rates generally offered by commercial banks (rates generally lower than those offered by savings and loan institutions). Assets such as commercial loans are interest rate sensitive assets both because they generally bear interest at an adjustable rate and because they generally have a shorter term maturity. Consumer and commercial real estate loans are generally considered interest rate sensitive because of the short term nature of such loans. Long term residential loans are considered interest rate sensitive only if they bear interest at an adjustable rate. On the liability side, long term certificates of deposit are generally not interest rate sensitive. As a result of implementing and continuing these asset and liability initiatives, and the accelerated prepayments of long-term mortgage loans due to declining interest rates, BankAtlantic's one year interest rate gap, which is the difference between the amount of interest bearing liabilities which are projected to mature or reprice within one year and the amount of interest earning assets which are similarly projected to mature or reprice, all divided by total assets, amounted to a positive 3.79% at December 31, 1993 compared to a negative 15.83% at December 31, 1992. The absolute amount of BankAtlantic's one year gap changed from a negative $206.2 million at December 31, 1992 to a positive $51.5 million at December 31, 1993. Liquidity and Capital Resources BankAtlantic's primary sources of funds have been deposits, principal repayments of loans, mortgage-backed securities and tax certificates, proceeds from the sale of loans originated for sale, mortgage-backed securities and investment securities, proceeds from securities sold under agreements to repurchase, advances from the FHLB, operations and capital transactions. These funds were primarily utilized to fund loan disbursements, paydowns of securities sold under agreements to repurchase, maturity of advances from the FHLB, purchases of mortgage-backed securities and tax certificates, bankers acceptances and payments of maturing certificates of deposit. During October, 1992 and December, 1993, the FHLB granted BankAtlantic, subject to various terms and conditions, lines of credit of $300 million and $115 million expiring in October 1995 and December, 1994, respectively. As of December 31, 1993 BankAtlantic had not utilized these lines of credit. During the first quarter of 1993, management approved a plan to modernize BankAtlantic's branch network. Management believes that the branch re- engineering project will improve overall efficiencies and enable BankAtlantic to offer additional products and financial services to its customers. In order to achieve the branch modernization, management approved capital expenditures of $2.1 million, of which approximately $965,000 was disbursed for replacement equipment installed during 1993. The branch modernization project is expected to be completed during the second quarter of 1994. Regulations currently require that savings institutions maintain an average daily balance of liquid assets (cash and short-term United States Government and other specified securities) equal to 5% of net withdrawable accounts and borrowings payable in one year or less. BankAtlantic had a liquidity ratio of 28.22% under these regulations at December 31, 1993, respectively. See "Regulation and Supervision." Total commitments to originate and purchase loans and mortgage-backed securities, excluding the undisbursed portion of loans in process, were approximately $64.3, $93.5 and $37.5 million at December 31, 1993, 1992 and 1991, respectively. BankAtlantic expects to fund its commitments out of loan repayments and, for a limited period of time, short-term borrowings. At December 31, 1993, loan commitments were approximately 9.11% of loans receivable, net. In order to increase its regulatory capital, BankAtlantic issued in prior years, $25.0 million of its 1986 Capital Notes. On May 30, 1990, BankAtlantic received OTS approval, subject to certain conditions, to issue up to an additional $12.0 million of subordinated debt in private transactions and to include such subordinated debentures as regulatory capital. On June 19, 1990, an unaffiliated third party acquired $1.0 million of such subordinated debentures bearing interest at the rate of 14% per annum and maturing in seven years from the date of issuance, and including detachable warrants to purchase 216,450 shares of BankAtlantic's common stock, at $4.62 per share. BFC also acquired $2.5 million of such subordinated debt and warrants. On June 30, 1990, BFC exercised its warrants and converted the debt for 541,430 shares of BankAtlantic common stock. During November 1990, BankAtlantic offered to the holders of the Capital Notes, the option to exchange their Capital Notes for any one of three combinations of non-cumulative Preferred Stock ("Preferred Stock"), cash payments and cash bonuses. The Preferred Stock issued in this transaction improved BankAtlantic's regulatory and equity capital. Effective July 31, 1992, BankAtlantic redeemed, at par and prior to scheduled maturity approximately $6.9 million of the Capital Notes. This redemption had no significant effect on liquidity and capital resources. In July 1993, BankAtlantic received approval from the OTS to redeem all remaining Capital Notes and other subordinated debentures. BankAtlantic redeemed the $7.8 million of Capital Notes and other subordinated debentures during the third quarter of 1993 at par. The Capital Notes debt bore a weighted average rate at 11.83%, substantially in excess of current market rates and at June 30, 1993, only $3.2 million relating to the Capital Notes and other subordinated debentures was included in regulatory risk-based capital. Funds for the redemption were provided from loan repayments. On March 31, 1991, BankAtlantic issued to its existing shareholders, 4,878 shares of common stock and $8,000 of subordinated debentures with related warrants to purchase 4,600 shares of common stock. The subordinated debentures were redeemed in August 1993, whereas the warrants remain outstanding. During the first quarter of 1993, warrants were exercised to purchase 575 shares at a price of $1.74 per share. Effective June 30, 1993, BFC exercised its warrants to purchase 1,126,327 shares of BankAtlantic common stock, resulting in BFC's ownership percentage in BankAtlantic increasing to 77.83%. The purchase price in connection with the exercise was paid by the tender and subsequent retirement of approximately $2.0 million of subordinated debentures held by BFC. See Note 11 of the Consolidated Financial Statements for further discussion. On November 12, 1993, BankAtlantic sold, in a public offering, 400,000 common shares at a price of $13.50 per common share. As part of that offering, BFC sold 1.4 million shares of BankAtlantic common stock. Net proceeds to BankAtlantic from the sale of the 400,000 shares were approximately $4.6 million. In connection with the public offering, BankAtlantic granted the underwriters a 30-day option to purchase up to 270,000 additional shares of common stock to cover over-allotments. On November 10, 1993, the underwriters exercised this option to purchase the 270,000 shares, with a closing date of November 18, 1993. The additional net proceeds to BankAtlantic were approximately $3.4 million. Upon completion of this public offering, BFC owned 48.17% of BankAtlantic common stock.The sale decreased BFC's ownership in BankAtlantic to 48.17%. As more fully described under "Regulation and Supervision--Capital Requirements," BankAtlantic is required to meet all capital standards promulgated pursuant to FIRREA and FDICIA. Under FIRREA, capital standards are: core capital equal to at least 3.0% of adjusted total assets, tangible capital equal to at least 1.5% of adjusted total assets, and total capital equal to at least 8.0% of its risk-weighted assets. To be considered "well capitalized" under FDICIA, a savings institution must generally have a core capital ratio of at least 5%, a Tier 1 risk-based capital ratio of at least 6%, and a total risk-based capital ratio of at least 10%. BankAtlantic, at December 31, 1993, met all regulatory capital requirements, and its regulatory capital met the definition of "well capitalized." At December 31, 1993, BankAtlantic's regulatory capital position was: Dividends In August and December, 1993, BankAtlantic declared cash dividends of $0.06 per share (totaling $0.12 per share), payable September 1993 and January 1994, respectively, to its common stockholders. A 15% common stock dividend was declared in May, 1993. Where appropriate, amounts throughout this report have been adjusted to reflect this stock dividend. BankAtlantic expects to continue dividend payments on its non-cumulative preferred stock. In March 1994, the Board of Directors declared a cash dividend of $.06 per share payable in April 1994 to its common stockholders. Effective August 1, 1990, the OTS adopted a new regulation that limits all capital distributions made by savings institutions, including cash dividends, by permitting only certain institutions that meet specified capital levels to make capital distributions without prior OTS approval. BankAtlantic presently meets all required and fully phased-in capital requirements and has had operating income in the prior eight quarters. BankAtlantic currently intends to seek to pay Common Stock dividends on a regular basis in the future; however, all such capital distributions will be subject to the OTS' right to object to a distribution on safety and soundness grounds. BankAtlantic has paid the preferred stock dividends since March 1993 and has received OTS approval through June 1994 to pay the preferred stock dividends; subject to maintaining capital at least equal to the fully phased in capital requirements. Future cash dividends on common and preferred stock will be subject to declaration by the Board of Directors in its discretion, to additional regulatory notice or approval, and continued compliance with capital requirements. Accordingly, there is no assurance that such dividends will be paid in the future. Preferred Stock All three Series of Preferred Stock have a preference value of $25.00 per share and are redeemable by BankAtlantic at $25.25 per share in 1994 and $25.00 thereafter. At December 31, 1993, no shares of Preferred Stock had been redeemed. Cash Flows Liquidity refers to BankAtlantic's ability to generate sufficient cash to meet funding needs to support loan demand, to meet deposit withdrawals and to pay operating expenses. BankAtlantic's investment portfolio provides an internal source of liquidity as a consequence of its short-term investments as well as scheduled maturities and interest payments. Loan repayments and sales also provide an internal source of liquidity. A summary of BankAtlantic's consolidated cash flows follows (in thousands): The changes in cash used or provided in operating activities are affected by the changes in operations, which are discussed elsewhere herein, and by certain other adjustments. These other adjustments include additions to operating cash flows for nonoperating charges such as depreciation and the provision for loan losses and write downs of assets. Cash flow of operating activities is also adjusted to reflect the use or the providing of cash for increases and decreases in operating assets and decreases or increases, in operating liabilities. Accordingly, the changes in cash flow of operating activities in the periods indicated above has been impacted not only by the changes in operations during the periods but also by these other adjustments. The reasons for the changes in investing and financing activities are discussed in "Asset and Liability Management", "Liquidity and Capital Resources" and "Sale of Mortgage-Backed Securities, Investment Securities and Loans." Management believes that BankAtlantic has adequate liquidity to meet its business needs and regulatory requirements. Impact of Inflation The financial statements and related financial data and notes presented herein have been prepared in accordance with GAAP, which require the measurement of financial position and operating results in terms of historical dollars, without considering changes in the relative purchasing power of money over time due to inflation. Unlike most industrial companies, virtually all of the assets and liabilities of BankAtlantic are monetary in nature. As a result, interest rates have a more significant impact on BankAtlantic's performance than the effects of general price levels. Although interest rates generally move in the same direction as inflation, the magnitude of such changes varies. The possible effect of fluctuating interest rates is discussed more fully under the previous section entitled "Interest Rate Sensitivity." RISK ELEMENTS December 31, --------------------------------------------- 1993 1992 1991 1990 1989 -------- -------- -------- -------- -------- (In thousands) Contractually Past Due 90 Days or More - ------------------------- (1) Commercial $ 2,580 1,108 689 - - Consumer - - - 5,048 3,448 --------- --------- --------- --------- --------- 2,580 1,108 689 5,048 3,448 --------- --------- --------- --------- --------- Non-Accrual - ------------------------- 1-4 Family 2,468 3,642 3,514 4,136 1,898 Commercial 3,802 5,317 5,660 8,641 2,745 Consumer 976 1,477 4,095 - - Tax certificates - - 476 - - --------- --------- --------- --------- --------- 7,246 10,436 13,745 12,777 4,643 --------- --------- --------- --------- --------- Repossessed - ------------------------- 1-4 Family 319 756 1,660 1,379 1,107 Commercial real estate 9,332 14,241 19,635 22,082 9,444 Consumer 512 461 902 2,470 1,645 --------- --------- --------- --------- --------- 10,163 15,458 22,197 25,931 12,196 --------- --------- --------- --------- --------- TOTAL NON-PERFORMING ASSETS$ 19,989 27,002 36,631 43,756 20,287 --------- --------- --------- --------- --------- Restructured - ------------------------- Commercial 2,647 2,661 7,580 3,781 4,428 --------- --------- --------- --------- --------- TOTAL RISK ELEMENTS $ 22,636 29,663 44,211 47,537 24,715 ========= ========= ========= ========= ========= Total risk elements as a percentage of: Total assets 1.67% 2.28% 3.04% 2.51% 1.31% ========= ========= ========= ========= ========= Loans and real estate owned 3.64% 5.04% 5.79% 4.73% 2.18% ========= ========= ========= ========= ========= TOTAL ASSETS $1,359,195 1,303,071 1,455,822 1,896,587 1,886,453 ========= ========= ========= ========= ========= TOTAL LOANS AND REAL ESTATE OWNED $ 622,538 588,159 763,560 1,004,065 1,132,674 ========= ========= ========= ========= ========= (1) The majority of these loans have matured, but are current as to payments under the prior loan terms. At December 31, 1993, there were no loans which were not disclosed in the above schedule where known information about the possible credit problems of the borrowers caused management to have serious doubts as to the ability of the borrower to comply with present loan repayment terms and which may result in disclosure of such loans in the schedule above in the future. Interest income which would have been recorded under the original terms of nonaccrual and restructured loans and the interest income actually recognized for the years indicated are summarized below (in thousands): For the Years Ended December 31, --------------------------- 1993 1992 1991 -------- -------- -------- (In thousands) Interest income which $ would have been recorded 1,068 1,301 2,476 Interest income recognized (486) (311) (1,581) --------- --------- --------- Interest income foregone 582 990 1,572 $ ========= ========= ========= Changes in the allowance for loan losses were: For the Years Ended December 31, --------------------------------------------- 1993 1992 1991 1990 1989 -------- -------- -------- -------- -------- (In thousands) Balance, beginning of period $ 16,500 13,750 15,741 5,810 5,611 Charge-offs: Commercial loans (835) (776) (1,694) (2,349) (1,586) Installment loans (3,350) (10,430) (18,903) (5,605) (3,801) Real estate mortgages (302) (1,473) (259) (667) (380) --------- --------- --------- --------- --------- (4,487) (12,679) (20,856) (8,621) (5,767) --------- --------- --------- --------- --------- Recoveries: Commercial loans 262 175 191 117 6 Installment loans 1,259 8,584 1,035 735 422 Real estate mortgages 16 20 99 45 188 --------- --------- --------- --------- --------- 1,537 8,779 1,325 897 616 --------- --------- --------- --------- --------- Net charge-offs (2,950) (3,900) (19,531) (7,724) (5,151) Additions charged to operations 3,450 6,650 17,540 17,655 5,350 --------- --------- --------- --------- --------- $ 17,000 16,500 13,750 15,741 5,810 ========= ========= ========= ========= ========= Allowance as a percentage of (1) Total loans 3.38% 2.88% 1.85% 1.61% 0.52% Non-performing assets 85.05% 61.11% 37.54% 35.97% 28.64% ========= ========= ========= ========= ========= Ratio of net charge-offs to (1) average outstanding loans 0.56% 0.60% 2.23% 0.69% 0.46% ========= ========= ========= ========= ========= (1) Excludes $110.7 million of banker's acceptances. Including these banker's acceptances, its percentages would be 2.77% and 0.55%, respectively. The allocation of the allowance for loan losses by loan category and the percent of the related gross loans in each category to total loans follows (in thousands): (1) Excludes banker's acceptances. Prior to 1992, BankAtlantic did not allocate the allowance for loan loss by category. Relevant information for prior years is discussed under "Provision for Loan Losses and Declines in Value of Real Estate Owned." Tax Certificate and Other Investment Securities A comparison of the book value and approximate market value of tax certificates and other investment securities wasis (in thousands): The maturities of tax certificates and other investment securities at December 31, 1993 were are (in thousands): (1) There is no contractual maturity; amounts indicated are based on historical payment experience. (2) Based upon contractual maturity. Activity in the allowance for tax certificate losses was: For the Years Ended December 31, -------------------------------------------- 1993 1992 1991 ------------- ------------ ------------- Balance, beginning of period $ 1,558 $ 795 $ 104 Charge-offs (810) (552) (395) Recoveries 562 155 275 ------------- ------------ ------------- Net charge-offs (248) (397) (120) Additions charged to operations 1,660 1,160 811 ------------- ------------ ------------- Balance, end of period $ 2,970 $ 1,558 $ 795 ------------- ------------ ------------- Average yield on tax certificates and other Investment securities during the period 9.08% 10.94% 12.83% ============ ============ ============= Loan Activity - The following table shows loan activity by major categories for the periods indicated (in thousands): For the Years Ended December 31, --------------------------------------------- 1993 1992 1991 1990 1989 -------- -------- -------- -------- -------- (In thousands) Originations: Residential loans $ 52,674 41,336 17,320 33,302 63,283 Construction loans 13,744 18,912 10,157 36,608 65,849 Commercial loans 186,584 108,744 85,931 93,085 275,904 Installment loans 10,222 7,075 27,859 211,184 223,419 --------- --------- --------- --------- --------- Total originations 263,224 176,067 141,267 374,179 628,455 --------- --------- --------- --------- --------- Purchases:(2) Commercial loans 5,142 - - 20 - Banker's acceptances 109,931 - - - - Residential loans - - - 689 - --------- --------- --------- --------- --------- Total purchases 115,073 - - 709 - --------- --------- --------- --------- --------- Total loan production 378,297 176,067 141,267 374,888 628,455 --------- --------- --------- --------- --------- Loan sales (44,983) (36,054) (14,949) (45,503) - Principal reductions (289,037) (297,263) (298,076) 340,133 (549,064) Loan securitization - - (40,361) (106,080) - Transfer to real estate owned(1) (2,396) (7,994) (6,729) (17,208) (2,532) --------- --------- --------- --------- --------- Net loan activity $ 41,881 (165,244) (218,848) (134,036) 76,859 ========= ========= ========= ========= ========= (1) Includes foreclosures and loans treated as in substance foreclosures. (2) Does not include individual installment loans purchased through dealers. Principal Repayments - The following table sets forth the scheduled contractual principal repayments at maturity date of BankAtlantic's loan portfolios and mortgage-backed securities at December 31, 1993. As of December 31, 1993, the total amount of principal repayments on loans and mortgage-backed securities contractually due after December 31, 1994 was $928.4 million, $663.3 million of which had fixed interest rates and $265.1 million of which had floating or adjustable interest rates. Year Ended December 31, (1) (In thousands) --------------------------------------------------------- 1997- 1998- 2004- 1994 1995 1996 1998 2003 2008 >2009 Total ------- --------------------- ------- -------------- ------- Real estate mortgage $ 59,702 11,155 13,167 54,889 76,913 21,989 94,535 332,350 Banker's acceptances 110,652 - - - - - - 110,652 Real estate construction 11,333 - - - - - - 11,333 Installment 15,947 7,296 8,948 9,816 23,513 16,179 57,421 139,120 Commercial non- real estate 21,714 1,668 1,981 743 1,873 - - 27,979 ------- ------ ------ ------- ------- ------ ------- ------- Total loans $219,348 20,119 24,096 65,448 102,299 38,168 151,956 621,434 ======= ====== ====== ======= ======= ====== ======= ======= Total mortgage- backed securities $ 12 95 43,093 126,917 249,744 6,774 99,730 526,365 ======= ====== ====== ======= ======= ====== ======= ======= (1) Does not include deductions for undisbursed portion of loans in process, deferred loan fees, unearned discounts and allowance for loan losses. Loan Concentration - BankAtlantic's loan concentration of total loans at December 31, 1993 was: Florida 79% Northeast 12% Other 9% The loan concentration for BankAtlantic's portfolio is primarily in South Florida where the economic conditions have improved in the latter part of 1992 and 1993. The concentration of BankAtlantic's loan portfolio in the Northeastern states is primarily related to those loans identified in the Subject Portfolio. Economic conditions in the Northeast have remained sluggish with high rates of unemployment and declining real estate values, however, 1993 has shown some signs of improvement. The rest of the portfolio is throughout the United States without any specific concentration. Loan maturities and sensitivity of loans to changes in interest rates for commercial non-real estate loans and real estate construction loans at December 31, 1993 were (in thousands): Commercial Non-Real Real Estate Estate Construction Total ---------- ---------- ---------- One year or less $ 19,484 11,333 30,817 Over one year but less than five years 8,495 - 8,495 Over five years - - - ---------- ---------- ---------- $ 27,979 11,333 39,312 ========== ========== ========== Sensitivity of loans to changes in interest rates - loans due agter one year Pre-determined interest rate $ 6,399 - 6,399 Floating or adjustable interest rate 2,096 - 2,096 ---------- ---------- ---------- $ 8,495 - 8,495 ========== ========== ========== Deposits - Deposit accounts consisted of the following (in thousands): December 31, ------------------------------ 1993 1992 1991 ---------- ---------- ---------- Non-interest bearing deposits $ 62,065 52,426 47,576 Interest bearing deposits: Insured money fund savings 301,572 330,255 312,781 NOW account 152,186 143,580 129,326 Savings account 124,699 130,379 124,163 Time deposits less than $100,000 384,411 409,135 580,489 Time deposits $100,000 and over 51,427 42,340 61,178 ---------- ---------- ---------- Total $ 1,076,360 1,108,115 1,255,513 ========== ========== ========== Time deposits, $100,000 and over, have the following maturities at December 31, 1993: Less than three months $ 8,071 3 to 6 months 6,377 6 to 12 months 15,784 More than 12 months 21,195 ---------- $ 51,427 ========== The stated rates at which BankAtlantic paid interest on deposits were (in thousands): December 31, ------------------------------ 1993 1992 1991 ---------- ---------- ---------- Interest free checking $ 62,065 52,426 47,576 Insured money fund savings: 2.52% at December 31, 1993, 3.07% at December 31, 1992 and 4.22% at December 31, 1991 301,572 330,255 312,781 NOW account: 1.79% at December 31, 1993, 1.61% at December 31, 1992 and 2.93% at December 31, 1991 152,186 143,580 129,326 Savings account: 1.78% at December 31, 1993, 2.06% at December 31, 1992 and 3.74% at December 31, 1991 124,699 130,379 124,163 ---------- ---------- ---------- Total non-certificate accounts 640,522 656,640 613,846 ---------- ---------- ---------- Certificate accounts: 0.00% to 3.00% 106,521 72,657 3,059 3.01% to 4.00% 135,753 164,378 3,623 4.01% to 5.00% 105,214 87,327 81,104 5.10% to 6.00% 48,770 47,015 186,279 6.01% to 7.00% 15,690 35,939 196,738 7.01% and greater 23,757 44,012 170,595 ---------- ---------- ---------- Total certificate accounts 435,705 451,328 641,398 ---------- ---------- ---------- 1,076,227 1,107,968 1,255,244 ---------- ---------- ---------- Interest earned not credited to deposit accounts 133 147 269 ---------- ---------- ---------- Total deposit accounts $ 1,076,360 1,108,115 1,255,513 ========== ========== ========== Weighted average stated interest rate on at the end of each respective period 2.83% 3.18% 5.10% ========== ========== ========== At December 31, 1993, the amounts of scheduled maturities of certificate accounts were: The following table sets forth the deposit activities for the periods indicated (in thousands): December 31, ------------------------------ 1993 1992 1991 ---------- ---------- ---------- Net decrease before interest credited (59,370) (190,907) (272,307) Interest credited 27,615 43,509 71,853 ---------- ---------- ---------- Total (31,755) (147,398) (200,454) ========== ========== ========== A summary of the cost and gross excess (deficiency) of market value compared to cost of tax certificates and other investment securities and mortgage-backed securities, including mortgage-backed securities available for sale, follows: December 31, 1993 --------------------------------------------- Gross Gross Approximate Book Unrealized Unrealized Market Value AppreciationDepreciation Value ----------- ----------- ----------- ----------- Tax certificates and other investment securities: Cost equals market $ 83,927 - - 83,927 Cost over market 13,774 - 113 13,661 Mortgage-backed securities: Market over cost 489,453 14,620 - 504,073 Cost over market 36,912 - 67 36,845 ----------- ----------- ----------- ----------- $ 624,066 14,620 180 638,506 =========== =========== =========== =========== December 31, 1992 --------------------------------------------- Gross Gross Approximate Book Unrealized Unrealized Market Value AppreciationDepreciation Value ----------- ----------- ----------- ----------- Tax certificates and other investment securities: Cost equals market $ 120,424 - - 120,424 Mortgage-backed securities: Market over cost 336,720 12,234 - 348,954 Cost over market 150,774 - 733 150,041 ----------- ----------- ----------- ----------- $ 607,918 12,234 733 619,419 =========== =========== =========== =========== December 31, 1991 --------------------------------------------- Gross Gross Approximate Book Unrealized Unrealized Market Value AppreciationDepreciation Value ----------- ----------- ----------- ----------- Tax certificates and other investment securities: Cost equals market $ 107,082 - - 107,082 Cost over market 1,994 109 - 2,103 Mortgage-backed securities: Market over cost 454,596 22,950 - 477,546 Cost over market 6,184 - 74 6,110 ----------- ----------- ----------- ----------- $ 569,856 23,059 74 592,841 =========== =========== =========== =========== BankAtlantic, A Federal Savings Bank and Subsidiaries Loans receivable composition, including mortgaged-backed securities, at the dates indicated was (dollars in thousands): 1993 1992 1991 1990 1989 ------------- ------------- ------------- ------------- ------------- Amount Percent Amount Percent Amount Percent Amount Percent Amount Percent --------- ------- --------- ------- --------- ------- --------- ------- --------- ------- Loans receivable: Real estate loans: Conventional mortgages $ 120,531 20.23 % $ 147,654 26.52 % $ 185,677 25.49 % $ 260,577 27.00 % $ 393,783 35.28 % Conventional mortgages available for sale 5,752 0.96 7,641 1.37 3,807 0.52 - - - - Construction and development 11,333 1.90 12,961 2.33 23,913 3.28 33,452 3.47 62,903 5.63 FHA and VA insured 7,972 1.34 9,854 1.77 11,459 1.57 13,223 1.37 15,536 1.39 Commercial 198,095 33.24 156,844 28.18 157,878 21.67 186,205 19.30 211,471 18.94 Other loans: Home improvement 52,563 8.82 72,508 13.03 100,556 13.80 104,546 10.84 66,838 5.99 Commercial (non-real estate) 27,979 4.70 33,071 5.94 38,742 5.32 58,220 6.03 68,746 6.16 Bankers acceptances 110,652 18.57 - - - - - - - - Installment loans held by individuals 86,557 14.53 140,909 25.31 233,165 32.01 345,768 35.84 345,892 30.99 --------- ------- --------- ------- --------- ------- --------- ------- --------- ------- Total 621,434 104.29 581,442 104.45 755,197 103.66 1,001,991 103.85 1,165,169 104.38 --------- ------- --------- ------- --------- ------- --------- ------- --------- ------- Deduct: Undisbursed portion of loans in process 5,570 0.93 6,492 1.17 9,033 1.24 13,399 1.39 29,884 2.68 Deferred loan fees 33 0.01 55 0.01 99 0.01 385 0.04 780 0.07 Unearned discounts on commercial loans 2,124 0.36 - - - - - - - - Unearned discounts on purchaed & installment loans 820 0.14 1,733 0.31 3,800 0.52 7,603 0.79 12,382 1.11 Allowance for loan losses 17,000 2.85 16,500 2.96 13,750 1.89 15,741 1.63 5,810 0.52 --------- ------- --------- ------- --------- ------- --------- ------- --------- ------- Loans receivable, net $ 595,887 100.00 % $ 556,662 100.00 % $ 728,515 100.00 % $ 964,863 100.00 % $1,116,313 100.00 % ========= ======= ========= ======= ========= ======= ========= ======= ========= ======= Mortgage-backed securities: FNMA participation certificates 178,928 33.99 % $ 174,666 35.83 % $ 214,700 46.59 % $ 270,196 61.48 % $ 249,878 54.16 % GNMA and FHLMC mortgage- backed securities 347,437 66.01 312,828 64.17 246,080 53.41 169,313 38.52 211,528 45.84 Mortgage-backed --------- ------- --------- ------- --------- ------- --------- ------- --------- ------- securities $ 526,365 100.00 % $ 487,494 100.00 % $ 460,780 100.00 % $ 439,509 100.00 % $ 461,406 100.00 % ========= ======= ========= ======= ========= ======= ========= ======= ========= ======= /TABLE BankAtlantic, A Federal Savings Bank and Subsidiaries CUMULATIVE RATE SENSITIVITY GAP 0-90 91-180 181 Days 1-3 3-5 5-10 10-20 >20 Days Days - 1 Year Years Years Years Years Years Total -------- -------- -------- -------- -------- -------- -------- -------- -------- (Dollars in thousands) Interest earning assets: Tax certificates and other investment securities (5) $ 42,575 $ 17,074 $ 18,370 $ 25,392 $ 2,879 $ 141 $ - $ - $ 106,431 Residential loans (1) (2) Conventional single family 7,084 6,150 10,039 21,978 8,622 9,577 585 21 64,056 Adjustable single family 31,576 15,571 23,052 - - - - - 70,199 Mortgage-backed securities FHLMC and FNMA (3) 63,924 53,744 87,828 182,149 39,901 5,583 341 12 433,482 Adjustable montgage-backed securities 47,770 1,722 42,657 734 - - - - 92,883 Commercial real estate loans 6,256 6,396 13,229 68,918 66,522 5,241 - - 166,562 Adjustable commercial real estate loans 42,866 - - - - - - - 42,866 Other loans: Commercial business 585 599 1,243 7,713 782 - - - 10,922 Commercial business adjustabl 17,057 - - - - - - - 17,057 Bankers acceptances 110,652 - - - - - - - 110,652 Installment 13,900 12,337 20,661 46,845 17,402 3,179 6,102 - 120,426 Installment prime rate 18,694 - - - - - - - 18,694 ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- Total interest earning assets$ 402,939 $ 113,593 $ 217,079 $ 353,729 $ 136,108 $ 23,721 $ 7,028 $ 33 $1,254,230 ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- Interest bearing liabilities: Money fund savings (4) 59,560 47,797 76,715 61,558 29,308 26,634 - - 301,572 Savings and NOW (4) 19,377 17,850 32,904 87,457 35,910 83,387 - - 276,885 Certificate accounts 117,628 85,151 92,790 103,501 34,678 1,957 - - 435,705 Borrowings: Securities sold under agreements to repurchase 21,135 - - - - - - - 21,135 Advances from FHLB 97,150 2,050 12,050 17,050 - - - - 128,300 ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- Total interest bearing liabilities $ 314,850 $ 152,848 $ 214,459 $ 269,566 $ 99,896 $ 111,978 $ - $ - $1,163,597 ========== ========== ========== ========== ========== ========== ========== ========== ========== GAP (repricing difference) $ 88,089 $ (39,255)$ 2,620 $ 84,163 $ 36,212 $ (88,257)$ 7,028 $ 33 $ 90,633 Cumulative GAP $ 88,089 $ 48,834 $ 51,454 $ 135,617 $ 171,829 $ 83,572 $ 90,600 $ 90,633 Cumulative ratio of GAP to total assets 6.48 % 3.59 % 3.79 % 9.98 % 12.64 % 6.15 % 6.67 % 6.67 % ========== ========== ========== ========== ========== ========== ========== ========== (1) Fixed rate mortgages are shown in periods which reflect normal amortization plus prepayments of 18-64% per annum depending on coupon. (2) Adjustable rate mortgages are shown in the periods in which the mortgages are scheduled for repricing. (3) MBS are shown in periods which reflect normal amortization plus prepayments equal to BankAtlantic's experience of 42% per annum. (4) BankAtlantic determines deposit run-off on money fund checking, savings and NOW accounts based on statistics developed in conjunction with the OTS. BankAtlantic does not believe its experience differs significantly from the OTS. Interest free transaction accounts are non-interest bearing liabilities and are accordingly, excluded from the cumulative rate sensivity gap analysis. Within 1-3 3-5 Over 5 1 Year Years Years Years -------- -------- -------- -------- Savings accounts decay rates 17% 17% 16% 14% Insured money fund savings (excluding tiered savings) decay rates 79% 31% 31% 31% NOW and tiered savings accounts decay rates 37% 32% % 17% 17% ========== ========== ========== ========== (5) Includes FHLB Stock. /TABLE

1993 ITEM 1. BUSINESS Overview - - - -------- Federal-Mogul Corporation (which together with its consolidated subsidiaries is referred to herein as "Federal-Mogul", the "Company" or "Registrant") is a global distributor and manufacturer of a broad range of non-discretionary parts, primarily vehicular components for automobiles, light trucks, heavy duty trucks and farm and construction vehicles and industrial products. Through the Company's worldwide distribution network, Federal-Mogul sells replacement parts in the vehicular aftermarket ("Aftermarket" products). The Company also sells parts to original equipment manufacturers ("OE" products), principally the major automotive manufacturers in the United States and Europe. The Company was incorporated in 1924 under Michigan law to carry on a business begun in 1900. The Company's executive offices are located at 26555 Northwestern Highway, Southfield, Michigan 48034, telephone (810) 354-7700. Vehicular components sold by Federal-Mogul include ball and roller bearings, suspension and steering parts, engine and transmission products, sealing devices, fuel pumps and related systems, and lighting and electrical components. Industrial products sold by the Company include ball and roller bearings, sealing products, and specialized heavy duty fluid-film bearings. Federal-Mogul also manufactures heavy wall bearings and precision forged powdered metal parts. Sales of these products account for the balance of the Company's sales. The following table sets forth the Company's net sales by market segment and geographic region as a percentage of total net sales. Year Ended December 31, -------------------------------------------- 1993 1993 1992 1992 1991 Pro Actual Pro Actual Actual Forma Forma (1) (2) Aftermarket U.S. and Canada. 48% 43% 44% 36% 34% International 18 20 19 19 19 Original Equipment U.S. and Canada 21 23 20 24 23 International 8 8 10 13 13 Other (3) U.S. and Canada 3 3 4 4 6 International 2 3 3 4 4 100% 100% 100% 100% 100% (1) Pro forma for the acquisition of SPX Corporation's automotive aftermarket business ("SPR") in October 1993 as if such acquisition had occurred in January 1, 1993. (2) Pro forma for the acquisition of TRW's automotive aftermarket business ("AAB") in October 1992 as if such acquisition had occurred on January 1, 1992. (3) Sales of these products -- air bearing spindles, heavy wall bearings, and precision forged powdered metal parts -- are accounted for by the Company primarily as OE sales for financial reporting purposes. The Company's air bearing spindles operation was sold in May 1993. Recent Acquisitions - - - ------------------- In line with the Company's strategy to emphasize Aftermarket product sales, the Company recently acquired two distributors of automotive Aftermarket products. The Company acquired AAB in October 1992 for approximately $220 million, and SPR in October 1993 for approximately $140 million (collectively, the "Acquisitions"). Primarily as a result of the Acquisitions, Federal-Mogul increased its Aftermarket combined net sales as a percentage of new sales from 53% in 1991 to 66% for 1993 on a pro forma basis as if SPR had been acquired on January 1, 1993. The Acquisitions have enabled the Company to increase its presence as a distributor of Aftermarket products in North America and Europe, broaden its customer base, increase its product offerings and realize substantial cost savings. SPR Acquisition. SPR, which had 1992 net sales of $163 million, is a distributor of engine and chassis components to the North American aftermarket. The Company believes that the primary strategic benefits of the acquisition of SPR (the "SPR Acquisition") include: Increased Customer Base -- The addition of SPR's customers has increased the Company's customer base. For example, SPR is a major distributor of components to machine shops, a distribution channel in which Federal-Mogul previously did not have a significant presence. Expanded Parts Coverage -- SPR is a major distributor of replacement parts for heavy truck, agricultural and construction equipment vehicles. Prior to the SPR Acquisition, Federal-Mogul had not been a major distributor of parts for these vehicles, the market for which currently represents a significant portion of worldwide replacement parts sales. As result of the SPR Acquisition, the Company is able to offer, for the first time, a complete set of agricultural and heavy truck engine parts in the form of an engine kit. Consolidation of Distribution Systems -- The Company expects to achieve significant cost savings through the consolidation of the distribution systems of the two companies. Federal-Mogul and SPR have duplicate warehouse locations in 34 of the 36 cities served by the two companies in the United States and Canada. The Company intends to combine all of the overlapping facilities in these cities by early 1995. AAB Acquisition. In October 1992, the Company acquired from TRW Inc. the assets of AAB for approximately $220 million (the "AAB Acquisition"). AAB distributed a full line of suspension and steering parts and engine components to the vehicular Aftermarket in North, Central and South America as well as in Europe, Africa and the Middle East. Since the date of the AAB Acquisition, Federal-Mogul has completed the consolidation of the operations of the businesses. The Company believes that it will meet or exceed its projected total annual savings of approximately $21 million during and after 1995, with approximately $15 million of these savings having been realized during 1993 and approximately $20 million to be realized during 1994. Aftermarket - - - ----------- The Company supplies a wide variety of Aftermarket products, including engine and transmission products (engine bearings, pistons, piston rings, valves, camshafts, valve lifters, valvetrain parts, timing components and engine kits, bushings and washers), ball and roller bearings, sealing devices (gaskets and oil seals and other high performance specialty seals), lighting and electrical components, and automotive fuel pumps, water pumps, oil pumps and related systems. The Company also sells steering and suspension parts which include such items as tie rod ends, ball joints, idler and pitman arms, center links, constant velocity parts, rack and pinion assemblies, coil springs, U-joints, engine mounts and alignment products. Federal-Mogul sells Aftermarket products under its own brand names, under brand names for which it has long term licenses such as TRW and Sealed Power, and also packages its products under third-party private brand labels such as NAPA and CARQUEST. The Company's Aftermarket business supplies approximately 150,000 part numbers to almost 10,000 customers, including more than 2,000 customers in North America and Europe added as a result of the Acquisitions. Federal-Mogul's customers are located in more than 90 countries around the world. For 1993, Aftermarket net sales in the United States and Canada represented 69% of total Aftermarket net sales, with net sales outside of the United States and Canada representing 31% of such sales. On a pro forma basis as if the SPR Acquisition had occurred on January 1, 1993, Aftermarket combined net sales in the United States and Canada represented 72% of total Aftermarket combined net sales for 1993. Domestic customers include industrial bearing distributors, distributors of heavy duty vehicular parts, machine shops, retail parts stores and independent warehouse distributors who redistribute products to local parts suppliers called jobbers. Internationally, the Company sells Aftermarket products to jobbers, local retail parts stores and independent warehouse distributors. Aftermarket sales to jobbers and local retail parts stores comprise a larger proportion of total international Aftermarket sales than of total domestic Aftermarket sales. Federal-Mogul's distribution centers in Jacksonville, Alabama; LaGrange, Indiana; Olive Branch, Tennessee; and Maysville, Kentucky (the "Distribution Centers") serve as the hub of the Company's domestic Aftermarket distribution network. Products are shipped from the Distribution Centers to North America service centers. For international sales, products are shipped through a facility in Port Everglades, Florida to seven international regional distribution centers and six Latin American branches. The Distribution Centers apply sophisticated computer technology which allows the Company to better manage its inventory and respond to customer needs. Techniques such as the Company's Reduced Inventory Management System, which was implemented in the fall of 1990, allow customers to reduce their inventories by providing them with the ability to order smaller quantities of products more frequently. This allows customers to increase their return on inventory investment. Original Equipment - - - ------------------ Federal-Mogul supplies original equipment ("OE") customers with a wide variety of parts under a number of well-established brand names, including Federal-Mogul and Glyco engine bearings, National and Mather oil seals, BCA ball bearings, Carter fuel systems and Signal-Stat and Switches electrical components. The Company manufacturers all of the OE products it sells. Customers consist primarily of automotive, heavy duty vehicle and farm and industrial equipment manufacturers. In 1993, pproximately 16% of the Company's net sales were to the three major automotive manufacturers in the United States, with General Motors Corporation ("GM") accounting for approximately 9% of the Company's net sales, Ford Motor Company accounting for approximately 5% of the Company's net sales and Chrysler Corporation accounting for approximately 2% of net sales. In addition, the Company sells OE products to most of the major automotive manufacturers headquartered outside the United States. The Glyco facility in Germany sells OE products to Volkswagen, Daimler-Benz and BMW. The Company also sells Federal-Mogul engine bearings to Renault and Peugeot in France and to Fiat in Italy. In addition, the Company sells a small amount of OE products to certain Japanese manufacturers, including Nissan-Mexico and certain Toyota operations in the United States. Recently, the Company began exporting oil seals to Komatsu in Japan for heavy duty diesel engines. The remaining net sales in 1993 were divided among almost 10,000 customers. Manufactured Products - - - ---------------------- The Company manufactures the following vehicular and industrial components: Engine and Transmission Products -- The Company manufactures engine bearings and other engine and transmission products, including pistons, bushings and washers. Bimetallic engine bearings, bushings and washers are used in automotive, truck, industrial, construction and farm equipment applications. These products are marketed under the brand names of Federal- Mogul, Glyco and Sterling. Ball Bearings -- The Company manufactures ball bearings for use chiefly in farm and construction equipment, trucks, automobiles and some industrial machinery under the brand name BCA. The Company also produces clutch and other specialty type precision ball bearings. Sealing Devices -- The Company manufactures a line of sealing products consisting of oil seals and other specialty seals, including oil bath seals and high performance sealing products. Sealing products are used in the automotive, truck, farm and off-highway construction equipment markets. Sealing devices are also supplied for aircraft, marine, stationary machinery and fuel power equipment. These products are marketed under the brand names of Bruss, Mather, and National. Lighting and Electrical Products -- The Company manufactures lighting and safety components for heavy duty truck applications, and electrical switches, controls and assemblies for vehicular applications. These products are marketed under the brand names of Switches and Signal Stat. The Company focuses on the heavy duty truck market segment where strict government regulations require that all lighting and electrical systems be operational at all times. Fuel Systems -- The Company manufactures a full line of automotive fuel pumps and related systems under the Carter brand name. Other Business - - - -------------- The Company also manufactures: Heavy Wall Bearings -- Braunschweiger Huttenwerk GmbH ("BHW"), an indirect, wholly-owned German subsidiary of the Company, manufacturers heavy wall bearings used primarily for large diesel engines in ships and stationary power plants. The Company also manufactures heavy wall bearings at facilities in Indiana and Brazil. Precision Forged Powdered Metal Parts -- The Company manufactures intricate component parts from compressed metal powders. These parts are used in applications requiring high fatigue strength, such as clutch races for automatic transmissions, engine connecting rods, and engine camshaft lobes. Suppliers - - - --------- Federal-Mogul sells Aftermarket parts manufactured by other manufacturers as well as those produced by the Company and its subsidiaries. The products not manufactured by Federal-Mogul are supplied by over 600 companies. In 1993, no outside supplier of the Company provided products which accounted for more than 10% of the Company's net sales. In connection with the acquisition of AAB, the Company and TRW entered into a Supply Agreement for an initial term of 15 years (the "Supply Period") pursuant to which TRW has agreed to supply to the Company parts manufactured by TRW and distributed by the Company. For the first five years of the Supply Period (the "Exclusive Period"), the Company will be an exclusive distributor of such TRW parts and thereafter will be a nonexclusive distributor for the remaining term of the Supply Agreement, subject to certain exceptions. Both the Exclusive Period and the Supply Period are automatically renewable for one-year periods thereafter, terminable on one year's notice by either party. Employee Relations - - - ------------------ On January 1, 1994, the Company had approximately 14,400 full-time employees of whom 8,800 were employed in the United States. Approximately 55% of the Company's U.S. employees are represented by one of four unions. Approximately 55% of the Company's foreign employees are represented by various unions. Each manufacturing facility of the Company has its own contract with differing expiration dates so no contract expiration date affects more than one facility. The Company believes its labor relations to be good. Research and Development - - - ------------------------- The Company is actively engaged in research and developments to improve existing products and manufacturing processes and to design and develop new products and materials. The development of superior quality control systems is a major focus as well. Each of the Company's operating units is engaged in various engineering and research and development efforts. These efforts are conducted primarily at the Company's four major research centers as well as at several manufacturing locations. Total expenditures for research and development activities were approximately $17.2 million in 1993, $18.2 million in 1992 and $20.3 million in 1991. The reduced research and development expenditures between 1991 and 1993 were in large part due to reduced spending at the Company's Glyco operation in Germany. Environmental Regulations - - - -------------------------- The Company's operations, in common with those of industry generally, are subject to numerous existing and proposed laws and governmental regulations designed to protect the environment, particularly regarding plant wastes and emissions and solid waste disposal. Capital expenditures for property, plant and equipment for environment control activities were not material during 1993 and are not expected to be material in 1994 or 1995. Raw Materials - - - ------------- The Company does not normally experience supply shortages of raw materials. Although shortages may occur occasionally, the Company generally buys from many reliable long-term suppliers and purchases most raw material, purchased parts, components and assemblies from multiple sources. Backlog - - - ------- The majority of the Company's products are not on a backlog status. They are produced from readily available materials and have a relatively short manufacturing cycle. For products supplied by outside suppliers, the Company generally purchases products from more than one source. The Company expects to be capable of handling the anticipated 1994 sales volumes. Patents and Licenses - - - --------------------- The Company has a large number of patents which relate to a wide variety of products and processes, and has pending a substantial number of patent applications. While in the aggregate its patents are of material importance to its business, the Company does not consider that any patent or group of patents relating to a particular product or process is of material importance when judged from the standpoint of the business as a whole. Competition - - - ------------ The global vehicular parts business is highly competitive. The Company competes with many of its customers that produce their own components as well as independent manufacturers and distributors of component parts in the United States and abroad. In general, competition for such sales is based on price, product quality, customer service and the breadth of products offered by a given supplier. The Company has attempted to meet these competitive challenges through more efficiently integrating its manufacturing and distribution operations, expanding its product coverage within its core businesses, and expanding its worldwide distribution network. Information About International and Domestic Operations and Export Sales ------------------------------------------------------- The Company has both manufacturing and distribution facilities for its products, principally in the United States, Europe, Latin America, Mexico and Canada. Certain of these products, primarily engine bearings and oil seals, are sold to international original equipment manufacturers and vehicular aftermarket customers. International operations are subject to certain risks inherent in carrying on business abroad, including expropriation and nationalization, currency exchange rate fluctuations and currency controls, and export and import restrictions. The likelihood of such occurrences and their potential effect on the Company vary from country to country and are unpredictable. Aftermarket and original equipment sales by major geographical region were: 1993 1992 1991 (Millions of Dollars) -------------------------------- Aftermarket United States and Canada $ 683.8 $ 460.5 $ 377.4 International 309.1 239.5 205.1 Original Equipment United States and Canada 408.5 357.0 319.9 International 174.1 207.0 196.3 Total Sales $1,575.5 $1,264.0 $1,098.7 Detailed results of operations by geographic area for each of the years ended December 31, 1993, 1992 and 1991 appear in Note 11 to the Consolidated Financial Statements contained in Item 8 of this Report. Executive Officers of the Registrant - - - ------------------------------------ Set forth below are the names, ages (at December 31, 1993), positions and offices held, and a brief account of the business experience during the past five years of each executive officer. D.J. Gormley (54) Chairman of the Board since May, 1990 and President and Chief Executive Officer since May 1989; Chief Operating Officer, February 1988 to May 1989; Executive Vice President, January 1986 to February 1988. Mr. Gormley first became an executive officer in 1980. G.N. Bashara, Jr. (59) Vice President, General Counsel and Secretary since April 1987. Mr. Bashara first became an executive officer in 1987. J.B. Carano (44) Vice President and Controller since December 1992; International Distribution Manager - Port Everglades, Florida, February 1990 to November 1992; Group Controller - Worldwide Aftermarket Operation January 1989 to February 1990. Mr. Carano first became an executive officer in 1992. D.J. Davis (42) Vice President of the Company and Vice President of Chassis Operations since December 1993; Vice President of Ball Bearing Products November 1992 to December 1993; General Manager Ball Bearing Products October 1991 to November 1992; General Manager, Lighting and Electrical Division November 1987 to October 1991. Mr. D. J. Davis first became an executive officer in 1993. J.O. Davis (45) Vice President, Distribution and Logistics, Worldwide Aftermarket Operation since December 1993; General Manager, Lighting and Electrical Division October 1992 to December 1993; Plant Manager, Lighting and Electrical Division January 1989 to October 1991. Mr. J. O. Davis first became an executive officer in 1993. J.M. Eastman (57) Vice President - Employee Relations since January 1980; Mr. Eastman first became an executive officer in 1980. R.F. Egan (47) Vice President of the Company and Vice President of Automotive Sales - Worldwide Aftermarket Operation since December 1993; Vice President of Automotive Sales - Worldwide Aftermarket Operation November 1992 to December 1993; National Sales Manager, Automotive Aftermarket - Worldwide Aftermarket Operation May 1985 to November 1992. Mr. Egan first became an executive officer in 1993. T.J. English (53) Vice President - Information Services since March 1989. Director of Information Services, November 1983 to March 1989; Mr. English first became an executive officer in 1989. C.B. Grant (49) Vice President - Corporate Development since December 1992; Vice President and Controller, May 1988 to December 1992. Mr. Grant first became an executive officer in 1985. S.G. Heim (41) Assistant Secretary and Associate General Counsel since May 1988; Associate Genera Counsel since June 1987; Ms. Heim first became an executive officer in 1988. A.C. Johnson (45) Vice President of the Company and Vice President of Powertrain Operations - Americas since December 1993; Vice President and General Manager of Seal Operations November 1992 to December 1993; General Manager, Oil Seals Operations January 1990 to November 1992; Manager, Worldwide Distribution Center August 1988 to January 1990. Mr. Johnson first became an executive officer in 1993. F.J. Musone (49) Vice President of the Company and President of Worldwide Manufacturing since November 1993; President of Chassis Products Operation January 1989 to November 1993; Vice President and General Manager - Federal-Mogul Service, January 1986 to January 1989. Mr. Musone first became an executive officer in 1986. W.A. Schmelzer (53) Vice President and Group Executive, Engine and Transmission Products - Europe since January 1992; General Manager, Engine and Transmission Products - America April 1987 to December 1991. Mr. Schmelzer first became an executive officer in 1992. W.G. Smith (44) Vice President of the Company and President of Worldwide Aftermarket Operation since January 1989; Vice President and General Manager - North American Aftermarket, February 1988 to January 1989; General Manager North American Aftermarket, August 1987 to February 1988. Mr. Smith first became an executive officer in 1988. M.J. Viola (39) Vice President and Treasurer since December 1992; Director of Corporate Finance, April 1992 to December 1992; Manager - Domestic Planning and Analysis, Chrysler Corporation, March 1991 to April 1992; Manager - Foreign Exchange and Financing Studies, Chrysler Corporation, January 1989 to March 1991; Manager - Corporate Financial Analysis, Chrysler Corporation March 1987 to January 1989. M.E. Welch III (45) Senior Vice President and Chief Financial Officer since December 1991; Assistant Treasurer, Chrysler Corporation, September 1988 to November 1991; General Auditor, Chrysler Corporation, July 1987 to September 1988. Chief Financial Officer, Chrysler Canada Ltd., March 1986 to July 1987. Mr. Welch joined Chrysler in 1982 as corporate accounting manager and served in positions of increasing responsibility in a wide range of areas including banking, audit and international finance, acquiring diverse and comprehensive experience in corporate financial operations. Mr. Welch first became an executive officer of the Company in December of 1991 when he left Chrysler to assume the position of Senior Vice President and Chief Financial Officer with the Company. J.J. Zamoyski (47) Vice President and General Manager Worldwide Aftermarket Operation International since November 1993; General Manager, Worldwide Aftermarket, Distribution and Logistics August 1991 to November 1993; Vice President and General Manager, Distribution and Logistics Operations, March 1990 to August 1991; Vice President - Corporate Development and Assistant Treasurer March 1989 to March 1990; Director of Corporate Development and Assistant Treasurer, May 1988 to March 1989; Mr. Zamoyski first became an executive officer in 1980. Generally, officers of the Company are elected at the time of the Annual Meeting of Shareholders but the Board also elects officers are various times during the year. Each officer holds office until his or her successor is elected or appointed or until his or her resignation or removal. ITEM 2. ITEM 2. PROPERTIES - - - ------------------- The Company conducts its business from its World Headquarters complex in Southfield, Michigan, which is leased pursuant to a sale-lease back arrangement. The principal manufacturing and other materially important physical properties of the Company at December 31, 1993 are listed below. All properties are owned in fee except where otherwise noted. A. Manufacturing Facilities. - - - ------------------------------- # Of Sq. Ft. North American Manufacturing Facilities Facilities @ 12/31/93 - - - --------------------------------------- ---------- ---------- Frankfort, Indiana 1 160,000 Greensburg, Indiana 1 204,845 Leiters Ford, Indiana 1 116,900 Lititz, Pennsylvania 1 275,000 Milan, Michigan 1 83,000 # Of Sq. Ft. North American Manufacturing Facilities Facilities @ 12/31/93 - - - --------------------------------------- ---------- ---------- Van Wert, Ohio 1 222,835 Blacksburg, Virginia 1 190,386 Gallipolis, Ohio 1 125,000 Greenville, Michigan 1 197,070 (2) Lafayette, Tennessee 1 110,400 Logansport, Indiana 1 161,000 (1) Malden, Missouri 1 120,000 Mooresville, Indiana 1 65,934 Plymouth, Michigan 1 15,000 Romulus, Michigan 1 170,000 St. Johns, Michigan 1 266,000 Puebla, Mexico 1 100,572 Juarez, Mexico 1 33,000 Mexico City, Mexico 1 72,210 Mexico City, Mexico 1 192,950 (1) Juarez, Mexico 1 33,000 Summerton, South Carolina 1 110,200 22 3,025,302 # Of Sq. Ft. International Manufacturing Facilities Facilities @ 12/31/93 - - - -------------------------------------- ---------- ---------- Braunschweiger, Germany 1 16,191 Cataguases/MG, Brazil 1 46,600 Cuorgne, Italy 1 114,930 Laplata, Argentina 1 64,691 Orleans, France 1 120,300 Wiesbaden, Germany 1 192,919 (1) Wiesbaden, Germany 2 1,030,822 (1) Walldorf, Germany 1 43,600 (1) San Luis, Argentina 1 6,995 10 1,457,530 Total Manufacturing Facilities 33 4,482,832 (1) This facility is leased by the company and accounted for as an operating lease. The company believes that these leases could be renewed or comparable facilities could be obtained without materially affecting operations. (2) The company has announced plans to close this facility in 1994. Operations are being consolidated into the Logansport plant. B. Aftermarket Warehouses. The Company operates one hundred twenty-six warehouses and distribution centers of which one hundred twenty-one are leased. In addition, two warehouses are financed and leased through the issuance of Industrial Revenue Bonds. Following the acquisition of SPR, the Company announced plans to consolidate duplicative operations and close 34 of these facilities before the end of 1994. C. Retail Properties. The Company leases 6 retail facilities in Australia, 9 facilities in Venezuela and 4 in Chile. All owned and leased properties are suitable, well maintained and equipped for the purposes for which they are used. The Company considers that its facilities are suitable and adequate for the operations involved. ITEM 3. ITEM 3. LEGAL PROCEEDINGS - - - ------------------------- A. The Company is a party to three lawsuits filed in various jurisdictions alleging claims pursuant to the Comprehensive Environmental Response Compensation and Liability Act of 1980 ("CERCLA") or other state or federal environmental laws. In addition the Company has been notified by the Environmental Protection Agency and various state agencies that it may be a potentially responsible party ("PRP") for the cost of cleaning up seven other hazardous waste storage or disposal facilities pursuant to CERCLA and other federal and state environmental laws. PRP designation requires the funding of site investigations and subsequent remedial activities. Although these laws could impose joint and several liability upon each party at any site, the potential exposure is expected to be limited because at all sites other companies, generally including many large, solvent public companies, have been named as PRP's as well as the Company. In addition, the Company has identified six present and former properties at which it may be responsible for resolving certain environmental matters, which the Company is actively seeking to resolve. Although difficult to quantify based on the complexity of the issues and the limited available information, the Company has accrued the estimated costs associated with such matters. Management believes these accruals, which have not been discounted or reduced by any anticipated insurance proceeds, will cover the Company's estimated foreseeable total liability for these sites. The Company is involved in other legal actions arising in the normal course of business. After taking into consideration legal counsel's evaluation of such actions, management is of the opinion that their outcome will not have a significant effect on the Company's consolidated financial statements. B. There were no material legal proceedings which were terminated during the fourth quarter of 1993. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - - - ----------------------------------------------------------- No matter was submitted during the fourth quarter of 1993 to a vote of security holders through the solicitation of proxies or otherwise. PART II - - - ------- ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCK HOLDER MATTERS - - - --------------------------------------------------------- The Company's common stock is listed on the New York Stock Exchange under the trading symbol (FMO). The approximate number of shareholders of record of the Company's common stock at December 31, 1993 was 12,374. The following table sets forth the high and low sale price of the Company's common stock as reported on the New York Stock Exchange Composite Transactions Tape for the last two years: 1993 1992 Quarter High Low High Low First $20 1/2 $ 16 1/4 $ 18 1/8 $ 14 7/8 Second 22 17 5/8 20 15 5/8 Third 26 1/4 19 7/8 18 14 1/2 Fourth 29 7/8 23 1/4 18 15 1/4 Quarterly dividends of $.12 per common share were declared during 1993 and 1992. The payment of dividends is subject to the restrictions described in Note 6 to the consolidated financial statements contained in Item 8 of this Report. In February 1994, the Company's Board of Directors declared a quarterly dividend of $.12 per common share. This was the 232nd consecutive quarterly dividend declared by the Company. ITEM 6. ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA ------------------------------------ SIX YEAR FINANCIAL SUMMARY -------------------------- FEDERAL-MOGUL CORPORATION ------------------------- CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY ----------------------------------------------- FEDERAL-MOGUL CORPORATION ------------------------- ITEM 7. ITEM 7. MANAGEMENTS DISCUSSION AND ANALYSIS ----------------------------------- FEDERAL-MOGUL CORPORATION ------------------------- Overview - - - -------- Federal-Mogul's core business is providing value added services based on the distribution and manufacture of non-discretionary parts to the global vehicular aftermarket and to vehicular and industrial original equipment manufacturers. The strategic direction of the company is to increase the emphasis on its aftermarket business opportunities, capitalizing on its strength of global distribution and systems logistics to improve customer service. Distribution is focused on markets where the diverse and complex vehicular population complements our broad range of products. On October 26, 1993, the company completed its most recent strategic acquisition in the vehicular aftermarket with the purchase of SPX Corporation's United States and Canadian automotive aftermarket operations, Sealed Power Replacement (SPR). The SPR acquisition further expands the broad base of products and provides additional vendor sourcing opportunities. The consolidation of the two businesses is expected to result in significant cost savings through the elimination of duplicative processes and facilities. Since the date of the acquisition, the newly-acquired business has contributed $26.6 million or 1.7% of the company's total 1993 sales. On a pro forma basis, assuming the acquisition had been completed on January 1, 1993, SPR would have contributed 10% of pro forma combined sales for the year. On October 20, 1992, Federal-Mogul completed the purchase of TRW Inc.'s automotive aftermarket business (AAB). The AAB acquisition was a major step in expanding aftermarket activity through an increased presence as a distributor of replacement parts for European and Japanese manufactured vehicles. In addition, the acquisition expanded the company's engine and chassis product offerings and increased purchasing power with outside suppliers. This acquisition contributed approximately 20% of total company sales in 1993. Throughout 1993, the company sold a number of non-strategic businesses and assets that were no longer consistent with the company's primary focus on vehicular parts for the global aftermarket. These included the sale of Westwind Air Bearings Ltd. and its affiliated operations in the United States and Japan, an equity interest in the Japanese engine bearing manufacturer Taiho Kogyo Co., and an equity interest in a Bermuda-based insurance company. It is the company's plan to divest non-strategic businesses and assets and utilize the proceeds to finance restructuring activities in core businesses, while neutralizing, to the extent possible, the earnings impact. In 1993, gains from the sale of businesses and assets were used to offset restructuring charges for the closing of a fuel systems manufacturing facility and the future consolidation of fuel systems operations in the company's lighting and electrical business. Also, the gain from the sale of idle land in Germany has been reserved for the restructuring of the Glyco engine bearing operations. The net effect of he sale of businesses and assets, and restructuring charges in 1993 was insignificant to the pretax earnings. The company reported 1993 earnings from continuing operations of $40.1 million or $1.13 per share, including a one-time after tax gain of $.07 per share on asset sales net of restructuring charges. Earnings for 1993 improved significantly over 1992 and 1991 due to added margin from the acquired AAB business, as well as the timely rationalization of that business which reduced approximately $15 million in operating expenses. Additionally, improved economic conditions in the North American original equipment markets and increased productivity in domestic manufacturing operations contributed to the earnings improvement. In 1992, the company reported earnings from continuing operations of $4.4 million. Due to the adoption of Statement of Financial AccountiNg Standards Nos. 106 and 112, "Employers' Accounting for Postretirement Benefits Other than Pensions" (SFAS 106), and "Employers' Accounting for Postemployment Benefits" (SFAS 112), the company incurred a net loss in 1992 of $83.7 million, or $3.94 per share. In 1991, the company incurred a net loss of $3.7 million, or $.31 per share. During 1991, the company sold its fastening systems business that was no longer consistent with the company's strategic direction, resulting in a net gain of $16.2 million. This gain was offset by a restructuring charge of $25 million for process changes to improve operating efficiencies. Excluding the effect of these items, the company would have reported 1991 net earnings of $2 million, or a loss of $.05 per common share after the payment of preferred dividends. The company has made a strategic decision to emphasize and expand the company's global aftermarket business. Management believes that aftermarket sales are less cyclical than original equipment sales, and aftermarket expansion will offer greater potential for long-term growth and higher operating margins. Additionally, the company expects to benefit from improvements in the reduction of manufacturing lead time and other process changes, particularly in European operations. Rationalization Costs of Acquired Businesses - - - -------------------------------------------- A key aspect of the recent acquisitions of SPR and AAB is the opportunity to realize significant savings through consolidation of operations in North America and, to a lesser extent, in Europe. Savings realized in 1993 from the integration of AAB exceeded $15 million and the company estimates increasing annual cost savings by an additional $6 million in 1994. As a result of the SPR integration, the company anticipates cost savings of $12.5 million in 1994, with an incremental $10 million of cost savings thereafter. The company believes by 1995 it will meet or exceed combined annual cost savings of $43 million: $21 million from the integration of AAB and $22 million from the integration of SPR. The components of these savings include eliminating redundancies with sales staff, overlapping warehouses, distribution and administration facilities and consolidating freight. The projected 1994 cost savings from the SPR integration is reflected in the pro forma net earnings data for the combined operations as if the acquisition had been completed at the beginning of 1993 as disclosed in Note 2 to the company's consolidated financial statements for 1993. In order to obtain these anticipated cost savings and achieve the benefit of increased sales volume, the company expects to incur one-time costs of approximately $32 million in connection with the integration of Federal- Mogul and AAB and $26 million in the consolidation of SPR. Of the total rationalization costs, $1 million was expensed for SPR in 1993 and $14 million was expensed for AAB in 1992. The remaining portion of the rationalization costs of $18 million for AAB and $25 million for SPR has been capitalized as goodwill. The rationalization expense was significantly higher in the case of AAB based on the greater number of Federal-Mogul locations impacted by the consolidation. Results of Operations - - - --------------------- Sales - - - ----- The company experienced a sales increase of $311.5 million, or 24.6%, in 1993 and $165.3 million, or 15%, in 1992. Excluding the impact of the SPR acquisition, sales grew 22.5% to $1,549 million in 1993. This increase was largely due to the AAB acquisition in the fourth quarter of 1992. Other factors include increased sales to domestic original equipment customers in nearly every manufactured product line and price increases in aftermarket channels. Aftermarket and original equipment sales by major geographic area were: (Millions of Dollars) 1993 1992 1991 -------- -------- -------- Aftermarket: United States and Canada $ 683.8 $ 460.5 $ 377.4 International 309.1 239.5 205.1 Original Equipment: United States and Canada 408.5 357.0 320.1 International 174.1 207.0 196.1 ------- ------- ------- Total sales 1,575.5 $1,264.0 $1,098.7 ------- ------- ------- ------- ------- ------- Sales to aftermarket customers represented 63% of total company sales in 1993. On a pro forma basis, assuming the company acquired SPR on January 1, aftermarket sales would have been 66% of 1993 total sales. Comparatively, aftermarket sales were 55% of 1992 sales and 53% of 1991 sales. SPR contributed $26.6 million, or 3.9%, in aftermarket sales to the United States and Canada in 1993. The company has entered into a long-term trademark agreement making it the exclusive distributor of parts sold under the Sealed Power and Speed-Pro brand names. In addition, United States and Canada aftermarket sales improved $223.3 million primarily due to the increased sales of steering and suspension parts sold under the TRW brand name and an increased market presence in engine parts. Federal-Mogul is the North American automotive aftermarket leader in engine bearings, engine parts, ball and roller bearings, fuel pumps, sealing products and lighting and electrical components. International aftermarket sales increased $69.6 million, or 29% in 1993, largely as a result of the acquisition of AAB European operations, additional market share in Japanese application engine part components and the acquisition of an Australian wholesale and retail business. The company has made modest gains in expanding its retail stores by opening several retail stores in late 1993. In the future, the company intends to expand the number of retail stores it owns and operates in strategic areas throughout the world. United States and Canada original equipment sales increased $51.5 million, or 14.4% in 1993. Stronger automotive and light truck production rates in North America contributed to this growth. Sales growth also continued in the new seal application for bonded pistons in transmissions. United States and Canada original equipment sales improved $36.9 million, or 11.5%, between 1992 and 1991, due to new product programs and a recovering demand for light trucks and automobiles. In 1993, European original equipment sales declined $33 million, $6.5 million of which was due to the divestiture of the Westwind Air Bearing business in May 1993. European automotive and heavy duty vehicle production felt the effects of depressed economic conditions resulting in lower sales volumes and price erosion. In 1992, international original equipment sales increased $10.9 million, or 5.6% due to market penetration in heavy duty engine seals and engine bearings. Operating Margin - - - ---------------- Operating margins improved $40.8 million, or 93.6%, in 1993 and $14.6 million, or 50.3%, in 1992 and were: (Millions of Dollars) 1993 1992 1991 ------ ------ ------ Total operating margin $ 84.4 $ 43.6 $ 29.0 ------ ------ ------ ------ ------ ------ Margin percentage 5.4% 3.4% 2.6% ------ ------ ------ ------ ------ ------ The successful integration of AAB had a favorable earnings impact of more than $15 million in cost savings in 1993, as well as the additional margin generated from incremental AAB sales. SPR contributed $1 million in operating margin in 1993 from slightly more than two months of operations. Worldwide aftermarket pricing actions and productivity in the domestic manufacturing operations also contributed to the improvement. As the economic recovery continues in the United States, auto and light truck build rates are expected to remain strong. The company anticipates that North American earnings will continue to improve in 1994. However, after a more than 20% decline in German original equipment production in 1993, continued weak volume and competitive pricing pressures in 1994 are anticipated. The European engine bearing business is expected to offset these economic conditions somewhat through lead time reductions, process improvements and employment reductions. The recently-signed North American Free Trade Agreement (NAFTA) is expected to foster increased competition in the North American vehicle parts business. It is possible that operating margins in the company's Mexican operations will decrease as a result of this agreement. Although the impact of NAFTA on the company's business is uncertain, the company's Mexican operations are approved suppliers to the three major United States automobile manufacturers, as well as a major supplier to the automotive replacement market. Due to the strategic position of operations in Mexico, management believes that NAFTA will provide certain opportunities for the company after the current economic slowdown in Mexico subsides. There is substantial and continuing pressure from major global automotive companies to reduce costs, including costs associated with outside suppliers such as Federal-Mogul. The company has reduced exposure in this area based on recent acquisitions that have significantly modified the sales mix and reduced sales volatility. However, there can be no assurance that the company will be able to maintain its gross margins on product sales to original equipment manufacturers. The global vehicular parts business is highly competitive. The company competes with many of its customers that produce their own components, as well as independent manufacturers and distributors of component parts in the United States and abroad. In general, competition for such sales is based on price, product quality, customer service and product coverage. The company's strategic response to these competitive challenges is to more efficiently and effectively integrate its distribution and manufacturing operations, consolidate its purchasing requirements and expand its product coverage within its global base of aftermarket and original equipment businesses. Other Income and Expense - - - ------------------------ Net interest expense decreased to $18.3 million in 1993 from $19.3 million in 1992. This was the result of several actions taken to repay and refinance debt. The company sold $40 million in accounts receivable in March 1993, bringing the total accounts receivable securitization to $95 million. In April 1993, 6,250,000 shares of Federal-Mogul common stock were issued. Proceeds from these actions were used to repay the term loan associated with the acquisition of AAB. International currency exchange losses totalled $5.7 million in 1993, compared to $5.8 million in 1992 and $4.8 million in 1991. The effect of the continued devaluation of the Brazilian cruzeiro represents the majority of the foreign exchange losses. When deemed prudent and cost effective, the company uses foreign exchange options and forward exchange contracts to hedge material net foreign exchange transaction exposures. However, the company does not typically hedge translation exposures in countries whose local currency is the functional currency. At December 31, 1993, the company's most significant translation exposures were in German deutsche marks and Mexican pesos. Changes in the exchange rate between the U.S. dollar and these currencies are recorded directly as a component of shareholder's equity. Amortization of intangible assets increased in 1993 to $6.8 million from $2.8 million and $1.6 million in 1992 and 1991, respectively. The amortization of trademark and non-compete agreements and the goodwill associated with the acquisitions of AAB and SPR represent the increase in this expense. SFAS 106 & SFAS 112 - - - ------------------- In 1992, in accordance with Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions", the company began accruing the cost of providing future postretirement benefits, such as health care and life insurance, over the related employee's service period. Prior to the adoption, the cost of providing these benefits to retired employees was recognized by the company when payments were made. The company elected to immediately recognize the accumulated postretirement benefit obligation at the date of adoption. The charges to operations were: (Millions of Dollars) 1993 1992 ------ ------ Incremental annual expense $ 6.6 $ 7.6 Income tax benefit (2.4) (2.7) -------- ------- 4.2 4.9 Cumulative effect of accounting change 135.7 Income tax benefit (47.6) ------ 88.1 ------ Net effect of SFAS 106 $ 4.2 $ 93.0 ------- ------ ------- ------ Also in 1992, the company adopted Statement of Financial Accounting Standard No. 112, "Employers' Accounting for Postemployment Benefits", which requires the accrual of future postemployment benefits, when such amounts can be estimated. The impact of adopting this standard on the company's financial position in operating results is not significant. Income Taxes - - - ------------ The company accounts for income taxes in accordance with Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS 109). At December 31, 1993, the company had deferred tax assets of $106.4 million and deferred tax liabilities of $72.5 million. The company records valuation allowances ($21.0 million at December 31, 1993) for all deferred tax assets, except where management believes it is more likely than not that the tax benefit will be realized. A valuation allowance was not established against deferred tax assets attributable to the company's postretirement benefit obligation and its German net operating loss carryforward. The deferred tax asset for the company's postretirement benefit obligation was $55.3 million at December 31, 1993. The company expects that the tax deduction associated with this obligation will be claimed over a period of 35 to 40 years. The total amount of future taxable income in the United States necessary to realize the asset is approximately $150 million. The company could generate approximately $67 million of taxable income from the execution of tax planning strategies, principally through revoking the company's LIFO election. The company will need to generate the additional taxable income in the United States through future operations in order to fully realize the deferred tax asset for the company's postretirement benefit obligation. The deferred tax asset attributable to the German net operating loss carryforward was $19.0 million at December 31, 1993. The carryforward is not subject to expiration. Sufficient taxable income will be generated through the reversal of existing taxable temporary differences to enable the carryforward to be utilized. Liquidity and Financial Condition - - - --------------------------------- Assets - - - ------ The acquisitions of SPR and AAB in 1993 and 1992, respectively, added the following operating assets at the time of the purchase. (Millions of Dollars) SPR AAB ----- ----- Accounts receivable $ 21 $ 54 Inventories 64 117 Property and equipment 8 12 The additions of the above assets reflects the most significant transactions affecting comparisons of these accounts from year to year. The increase in intangible assets for both 1993 and 1992 represents the cost of long-term non-compete and trademark agreements with SPX and TRW and goodwill of the acquired businesses. Excluding the acquisition of SPR and the accounts receivable securitized in 1993, accounts receivable at December 31, 1993 increased approximately $40 million. This increase results primarily from the overall increase in sales. Inventories decreased by approximately $6 million from December 31, 1992 excluding the impact of SPR. This was achieved during a period where sales increased by more than 20%, demonstrating the continued success of lead time reductions and inventory management programs. Liabilities - - - ----------- In the fourth quarter of 1993, the company renegotiated its revolving credit facility (revolver), increasing the amount available from $150 million to $300 million. The renegotiated revolver immediately lowered interest on borrowings by 75 basis points. Interest on the revolver is based on LIBOR plus a range of 50 to 150 basis points which are charged based on the company's Moody's and S&P bond ratings. At December 31, 1993 the company pays interest on the revolver at LIBOR plus 100 basis points which is a reduction of 150 basis points from the prior year. During 1993, the company drew $245 million against the revolver to repay the $100 million 8 3/8% notes due October 1, 1993 and complete the purchase of SPR. At December 31, 1993, the outstanding balance on the revolver was $245 million. In December 1993, the company filed a shelf registration with the SEC that will allow the company to issue a combination of debt and equity securities up to $300 million over a two year period. In February 1994, the company used the shelf registration to offer 5 million shares of common stock to the public. The underwriters of the offering subsequently exercised an option to cover overallotments resulting in the sale of an additional 750,000 shares. The total sale of 5.75 million common shares generated net proceeds to the company of nearly $191 million. The offering proceeds were used to repay a portion of the company's outstanding debt. During the first quarter of 1994, the Company attained an investment grade status from the Moody's and Standard & Poor's rating agencies, primarily as a result of acts taken to repay and refinance debt in 1993 and early 1994. This should provide improved access to capital markets. To finance the 1992 AAB acquisition, the company used net proceeds of $76.6 million from the issuance of 1,600,000 shares of Series D preferred stock in September 1992 and $125 million of unsecured senior bank financing pursuant to a bank credit agreement maturing September 1998 (the $125 million term loan). During the first half of 1993, the $125 million term loan was repaid with the net proceeds from the sale of $40 million of accounts receivable and $85 million of the $116 million net proceeds from the sale of 6,250,000 shares of the company's common stock in April 1993. The increase in other accrued liabilities represents amounts accrued for the rationalization of the AAB and SPR acquisitions and the restructuring of manufacturing operations at the Glyco and the lighting, electrical and fuel systems businesses. The discount rate used to determine the actuarial present value of domestic postretirement pension, health insurance and life insurance benefits was lowered to 7 1/2% for 1993 from 8 3/4% in 1992. The 7 1/2% discount rate reflects the current expected yield for long-term, high quality investments. The lowered discount rate reduced net pension income from domestic plans by about $.6 million for 1993. Assumptions for expected long-term rates of return on plan assets and future compensation increases were also adjusted for current conditions. The changes in assumptions had an insignificant effect on 1993 operating results and the impact in the future is expected to be minimal. The company also lowered the discount rate on its international plans from 9% in 1992 to 8% in 1993, increasing 1993 pension expense by approximately $.3 million. Combined changes in the discount rate increased the recorded liability for pensions by approximately $20 million at December 31, 1993. The impact of changing the discount rate on the recorded liability for postretirement health care and life insurance benefits was largely offset by better than expected experience, lowering the medical trend rate and changes made to certain plan provisions. Environmental Matters - - - --------------------- The company is a party to three lawsuits filed in various jurisdictions alleging claims pursuant to the Comprehensive Environmental Response Compensation and Liability Act of 1980 (CERCLA) or other state or federal environmental laws. In addition, the company has been notified by the Environmental Protection Agency and various state agencies that it may be a potentially responsible party (PRP) for the cost of cleaning up seven other hazardous waste storage or disposal facilities pursuant to CERCLA and other federal and state environmental laws. PRP designation requires the funding of site investigations and subsequent remedial activities. Although these laws could impose joint and several liability upon each party at any site, the potential exposure is expected to be limited because at all sites other companies, generally including many large, solvent public companies, have been named as PRP's. In addition, the company has identified six present and former properties at which it may be responsible for cleaning up certain environmental contamination. The company is actively seeking to resolve these matters. Although difficult to quantify, based on the complexity of the issues, the company has accrued the estimated cost associated with such matters. Management believes these accruals, which have not been discounted or reduced by any anticipated insurance proceeds, will be adequate to cover the company's estimated liability for these sites. Cash Flows - - - ---------- Operating Activities - - - -------------------- The company generated cash of $29.6 million from operations in 1993 compared to $52.7 million and $47.9 million in 1992 and 1991, respectively. These year-to-year changes include net earnings from continuing operations of $40.1 million and $4.4 million in 1993 and 1992, respectively, and a loss of $19.8 million in 1991. The 1993 results were lower than previous years as the company spent approximately $22 million dollars on the integration of AAB. It is the company's belief that cash from operations will continue to be sufficient to meet its ongoing working capital requirements including the requirements for the continued integration of SPR and restructuring of the Glyco and the lighting, electrical and fuel systems operations. Investing Activities - - - -------------------- Other than the purchases of SPR and AAB, the company's principal investing activity in 1993, 1992 and 1991 was the acquisition of property and equipment for its existing operations. Approximately $59 million, $40 million and $44 million of cash in 1993, 1992 and 1991, respectively, was reinvested in productive assets of the company. These investments were made to support the company's long-term objective of improving operating productivity and product mix. These investments were funded in 1993 and 1992 with cash from operating and financing activities. In 1991, investments were funded with proceeds from the sale of the company's fastening systems business. Capital expenditures for 1994 are anticipated to be approximately $55 million, as the company continues to enhance manufacturing capabilities in the United States and Europe. Financing Activities - - - -------------------- As previously noted, the sale of common stock and the securitization of accounts receivable in 1993 helped the company reduce debt associated with the purchase of AAB in 1992. The company borrowed approximately $145 million to finance the acquisition of SPX Corporation's automotive aftermarket operations in 1993 which will be repaid from the proceeds of a common stock offering in early 1994. The issuance of Series D Convertible Exchangeable Preferred Stock, borrowings under short and long-term agreements and proceeds from the accounts receivable securitization contributed an additional $274 million in cash in 1992. Cash of $73 million used for long-term debt repayments in 1992 was $24.6 million less than in 1991, as the earlier year included a large debt reduction with the proceeds from the sale of the company's fastening systems business. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ------------------------------------------- CONSOLIDATED STATEMENTS OF EARNINGS - - - ----------------------------------- FEDERAL-MOGUL CORPORATION - - - ------------------------- CONSOLIDATED STATEMENTS OF CASH FLOWS - - - ------------------------------------- FEDERAL-MOGUL CORPORATION - - - ------------------------- See accompanying Notes to Consolidated Financial Statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - - - ------------------------------------------ FEDERAL-MOGUL CORPORATION - - - ------------------------- 1. ACCOUNTING POLICIES ------------------- Principles of Consolidation - The consolidated financial statements include the accounts of Federal-Mogul Corporation and its majority-owned subsidiaries (the company). Intercompany accounts and transactions have been eliminated in consolidation. Cash and Equivalents - The company considers all highly liquid investments with maturities of ninety days or less from the date of purchase to be cash equivalents. Inventories - Inventories are stated at the lower of cost or market. Cost determined by the last-in, first-out (LIFO) method was used for 66% and 62% of the inventory at December 31, 1993 and 1992, respectively. The remaining inventories are costed using the first-in, first-out (FIFO) method. If inventories had been valued at current cost, amounts reported at December 31 would have been increased by $65.3 million in 1993 and $64.7 million in 1992. At December 31, inventories consisted of the following: (Millions of Dollars) 1993 1992 ------ ------ Finished products $279.7 $217.5 Work-in-process 21.3 31.3 Raw materials 21.3 18.6 ----- ----- $322.3 $267.4 ----- ----- ----- ----- Inventory quantity reductions resulting in liquidations of certain LIFO inventory layers and the reduction in international locations using the LIFO method increased net earnings in 1993, 1992, and 1991 by $5.3 million ($.19 per share), $6.9 million ($.31 per share) and $13.5 million ($.60 per share), respectively. Intangible Assets - Intangible assets, which result principally from acquisitions, consist of goodwill, trademark and non-compete agreements, patents and other intangibles and are amortized on a straight-line basis over appropriate periods, generally ranging from 7 to 40 years. Intangible assets reflected in the consolidated balance sheets are net of accumulated amortization of $12.0 million and $6.8 million in 1993 and 1992, respectively. Currency Translation - Exchange adjustments related to international currency transactions and translation adjustments for subsidiaries whose functional currency is the United States dollar (principally those located in highly inflationary economies) are reflected in the consolidated statements of earnings. Translation adjustments of international subsidiaries whose local currency is the functional currency are reflected in the consolidated financial statements as a separate component of shareholders' equity. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - - - ------------------------------------------ FEDERAL-MOGUL CORPORATION - - - ------------------------- 1. ACCOUNTING POLICIES (continued) ------------------- Earnings Per Share - The computation of primary earnings per share is based on the weighted average number of outstanding common shares during the period plus, when their effect is dilutive, common stock equivalents consisting of certain shares subject to stock options. Fully diluted earnings per share additionally assumes the conversion of outstanding Series C ESOP and Series D preferred stock and the contingent issuance of common stock to satisfy the Series C ESOP preferred stock redemption price guarantee. The number of contingent shares used in the fully diluted calculation is based on the market price of the company's common stock on December 31, 1993, and the number of preferred shares held by the Employee Stock Ownership Plan (ESOP) that were allocated to participants' accounts as of December 31 of each of the respective years. Fully diluted earnings per share amounts are not reported as there is an insignificant difference in the 1993 calculation and the effects are anti-dilutive in 1992 and 1991. The primary weighted average number of common and equivalent shares outstanding (in thousands) was 27,342, 22,390, and 22,314 for 1993, 1992 and 1991, respectively. The fully diluted weighted average number of common and equivalent shares outstanding (in thousands) was 33,927 for 1993, 25,552 for 1992 and 24,673 for 1991. Net earnings used in the computation of primary earnings per share are reduced by preferred stock dividend requirements. Net earnings used in the computation of fully diluted earnings per share are reduced by amounts representing the additional after-tax contribution that would be necessary to meet ESOP debt service requirements under an assumed conversion of the Series C ESOP preferred stock. Financial Instruments and Concentrations of Credit Risk - Foreign exchange options and forward contracts on foreign currencies and copper futures are entered into by the company as hedges against the impact of currency and raw material price fluctuations and are not used to engage in speculation. Gains and losses are recognized when these instruments are settled. Financial instruments which potentially subject the company to concentrations of credit risk consist primarily of accounts receivable and cash investments. The company's customer base includes virtually every significant automotive manufacturer and a large number of distributors and installers of automotive replacement parts. However, the company's credit evaluation process, reasonably short collection terms and the geographical dispersion of sales transactions help to mitigate this concentration of credit risk. The company also has cash investment policies that limit the amount of credit exposure to any one financial institution and require placement of investments in financial institutions evaluated as highly credit worthy. Changes in Accounting Method - During the fourth quarter of 1992, the company adopted the provisions of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS 109), retroactively to 1989. Accordingly, retained earnings at January 1, 1990, were increased by $2.9 million, representing the cumulative effect of the change in the method of accounting for income taxes. The loss from continuing operations for the year ended December 31, 1991 has been restated for the effect of adopting SFAS 109 as follows: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - - - ------------------------------------------ FEDERAL-MOGUL CORPORATION - - - ------------------------- 1. ACCOUNTING POLICIES (continued) ------------------- (Millions of Dollars, Except Per Share Amounts) 1991 -------- As previously reported $(21.0) Effect of adoption of SFAS 109 1.2 ----- As restated $(19.8) ----- ----- Per common share as previously reported $(1.08) Effect of adoption of SFAS 109 .05 ----- Per common share as restated $(1.03) ----- ----- Also in the fourth quarter of 1992, the company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions" (SFAS 106), effective as of January 1, 1992, and restated previously reported 1992 quarterly results. Prior to adoption, the cost of providing health care and life insurance benefits to retired employees was recognized as expense as payments were made. The company recorded a charge of $88.1 million, or $3.93 per common share, net of applicable tax benefits of $47.6 million to reflect the cumulative effect for years prior to 1992 of the change in accounting method. In addition to the cumulative effect, the company's 1993 and 1992 postretirement health care and life insurance costs increased $6.6 million and $7.6 million, respectively, as a result of adopting SFAS 106. Reclassifications - Certain items in the prior year financial statements have been reclassified to conform with the presentation used in 1993. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - - - ------------------------------------------ FEDERAL-MOGUL CORPORATION - - - ------------------------- 2. ACQUISITIONS ------------ On October 26, 1993, the company completed its acquisition of SPX Corporation's United States and Canadian automotive aftermarket operations, Sealed Power Replacement (SPR). The acquisition has been accounted for as a purchase and, accordingly, the total cost of $167 million was allocated to the acquired assets and assumed liabilities based on their estimated fair values as of the acquisition date. The company and SPX Corporation also executed a non-compete agreement and a long-term trademark agreement making Federal-Mogul the sole distributor of engine and chassis parts sold under the Sealed Power and Speed-Pro brand names in North America. Federal-Mogul also acquired the right to use these trademarks throughout the rest of the world. The excess of the consideration paid over the estimated fair value of net assets acquired of $65 million has been recorded as goodwill. The earnings statement includes the operating results of the acquired business from October 26, 1993. On October 20, 1992, the company acquired substantially all of TRW Inc.'s automotive aftermarket business (AAB). The acquisition has been accounted for as a purchase and, accordingly, the total cost of $232 million was allocated to the acquired assets and assumed liabilities based on their estimated fair values as of the acquisition date. The company and TRW Inc. also executed a non-compete agreement and completed a long-term supply contract and a trademark agreement (valued at $48.2 million in the aggregate) making the company the exclusive supplier of TRW-brand engine and chassis parts to the independent automotive aftermarket. The excess of the consideration paid over the estimated fair value of net assets acquired of $34 million has been recorded as goodwill. The consolidated statement of earnings includes the operating results of the acquired business from October 20, 1992. The following unaudited pro forma results of operations for the years ended December 31, 1993 and 1992 assume the described acquisitions occurred as of the beginning of the respective periods, after giving effect to certain adjustments, including amortization of intangible assets, increased interest expense on acquisition debt and related income tax effects, with the SPR acquisition impacting 1993 and the SPR and AAB acquisitions impacting 1992. The pro forma results have been prepared for comparative purposes only and do not purport to indicate the results of operations which would actually have occurred had the combination been in effect on the dates indicated, or which may occur in the future. (Millions of Dollars, Except Per Share Amounts) 1993 1992 ---------- ---------- Net sales $1,705.3 $1,672.0 Earnings from continuing operations 74.3 42.0 Net earnings (loss) 50.2 (62.1) Net earnings (loss) per common share: Primary $ 1.50 $ (3.17) Fully diluted 1.41 (3.17) Operating results for 1993 include a $1 million ($.02 per share) charge and for 1992 a $14 million ($.40 per share) charge to provide for certain aspects of the rationalization of the company's present aftermarket business. This charge includes costs incurred for severance, eliminating redundant company facilities and equipment, and integrating the operations of the acquired businesses. On April 27, 1993, the company's wholly-owned Australian subsidiary, Federal-Mogul Pty. Ltd., acquired the automotive aftermarket business and certain assets of Brown & Dureau Automotive Pty. Limited. The acquisition was accounted for as a purchase and the cost of $5.6 million was allocated to the acquired assets and assumed liabilities. The required rationalization expense was insignificant to total operating results. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - - - ------------------------------------------ FEDERAL-MOGUL CORPORATION - - - ------------------------- 3. SALES OF BUSINESSES AND RELATED MATTERS --------------------------------------- In 1993, the company sold a number of non-strategic businesses and assets, using the proceeds to restructure manufacturing operations to enhance future profitability. On an after-tax basis, a gain of $.07 per share was recorded primarily due to a favorable tax treatment on the sale of Westwind Air Bearings, Ltd. In 1992 and 1991, the effect of similar transactions was a charge to income of $14 million and $25 million, respectively. The pretax gain on the sale of these non-strategic businesses and assets totalled $19.2 million and were offset by restructuring charges amounting to $19.2 million. The significant components of these transactions are: In April 1993, the company sold the assets and business of its subsidiary, Westwind Air Bearings, Ltd. in England and its affiliated operations in the United States and Japan for $16.3 million in cash and a 20% equity position in the new Westwind operating company. The pretax earnings effect was a gain of $5.1 million. In September 1993, the company sold its equity interest in the Japanese engine bearing manufacturer, Taiho Kogyo Co., for $9.3 million. A total of 1,544,400 shares were sold to Taiho's principal shareholders, Toyota Motor Corporation and certain Toyota affiliates. The pretax earnings effect was a gain of $8.8 million. In November 1993, the company sold equity interests in a Bermuda-based insurance company, Corporate Officers and Directors Assurance Holding Ltd. for $5.5 million to ACE Limited. The pretax earnings effect was a gain of $2.7 million. During the second half of 1993, the company recorded special charges relating to the rationalization of manufacturing operations. In November 1993, the company announced the closing of its Lafayette, Tennessee fuel systems plant with a plan to consolidate operations with the Lighting and Electrical Division. A restructuring reserve was recorded for $7 million based on the plan to consolidate these two businesses. The company also announced plans to restructure Glyco manufacturing operations in Germany. A reserve of $8.4 million was recorded to provide for personnel reductions and reengineering of manufacturing facilities. The company also sold idle land for $5 million connected with its Glyco operations, resulting in a pretax gain of $1.5 million. In November 1991, the company sold the net assets and operations of its wholly-owned subsidiary, Huck Manufacturing Company, which constituted all operations of the company's fastening systems segment. Total cash proceeds from the sale were $151.9 million. The sale resulted in a net gain of $16.1 million, including an after-tax operating loss of $.1 million. Sales of $142.2 million and expenses of $141.4 million are excluded from the consolidated statements of earnings under captions applicable to continuing operations. Interest expense of $8.3 million was allocated to discontinued operations to the sum of total consolidated net assets and consolidated debt. During the fourth quarter of 1991, the company recorded a $25 million ($.98 per share) restructuring charge for inventory and equipment valuations, severance, reorganizing certain operations and other costs associated with process changes being implemented throughout the company. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - - - ------------------------------------------ FEDERAL-MOGUL CORPORATION - - - ------------------------- 4. ACCOUNTS RECEIVABLE SECURITIZATION ---------------------------------- In June 1992 and March 1993, the company entered into agreements to sell, on a revolving basis, an undivided interest in a designated pool of accounts receivable. Accordingly, the company irrevocably and without recourse transferred all of its U.S. dollar denominated trade accounts receivable (approximately $182 million at December 31, 1993 and principally representing amounts owed to the company by original equipment and aftermarket customers in the U.S. automotive and related industries) and $7 million Canadian receivables to the Federal-Mogul Trade Receivables Master Trust. The Trust sold investor certificates representing an interest in $55 million and $40 million of trust assets in 1992 and 1993, respectively. The company holds seller certificates representing an interest in the remaining assets of the Trust, which certificates are included with accounts receivable in the company's balance sheet at December 31, 1992. The agreement expires in 1997. The trust agreement requires the company to maintain its interest in the assets of the Trust at a certain calculated participation level which, if not met, requires the company to contribute cash or additional trade accounts receivable in order to satisfy such participation requirement. The company exceeded the required participation level by approximately $46 million and $16 million as of December 31, 1993 and 1992, respectively. All losses, credits or other adjustments on receivables owned by the Trust are deductions from the assets represented by the seller certificates owned by the company. Accordingly, the owners of the investor certificates have no recourse to the company beyond the assets represented by the seller certificates. The company does not generally require collateral for its trade accounts receivable and maintains an allowance ($14.5 million and $8.6 million at December 31, 1993 and 1992, respectively) based upon the expected collectibility of all trade accounts receivable, including receivables sold. Accounts receivable in the 1993 and 1992 consolidated balance sheet exclude $95 million and $55 million, respectively, representing investor certificates sold. The discount related to the sale of receivables under this agreement of $5.3 million in 1993 and $2 million in 1992 have been classified as a reduction of other income. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - - - ------------------------------------------ FEDERAL-MOGUL CORPORATION - - - ------------------------- 5. PROPERTY, PLANT AND EQUIPMENT ----------------------------- Properties are stated at cost, which includes expenditures for additional facilities and those which materially extend the useful lives of existing buildings and equipment. Fully depreciated assets have been eliminated from the accounts. Depreciation is computed principally by the straight-line method for financial reporting purposes and by accelerated methods for income tax purposes. At December 31, property, plant and equipment consisted of the following: (Millions of Dollars) 1993 1992 -------- -------- Land $ 30.8 $ 35.0 Buildings 162.3 151.9 Machinery and equipment 423.4 403.1 ------ ------ 616.5 590.0 Accumulated depreciation (216.7) (199.3) ------ ------ $ 399.8 $ 390.7 ------ ------ ------ ------ The company leases various facilities and equipment under both capital and operating leases. Net assets subject to capital leases are not significant at December 31, 1993. The balance of a deferred gain resulting from the 1988 sale and leaseback of a portion of the corporate headquarters complex was $9.9 million at December 31, 1993. The deferred gain is being amortized over the term of the lease as a reduction of rent expense. Future minimum payments under noncancelable operating leases with initial or remaining terms of more than one year are, in millions: 1994--$16.7; 1995--$16.1; 1996--$14.3; 1997--$13.6; 1998--$10.7 and thereafter--$51.9. Future minimum lease payments have been reduced by approximately $37.6 million for amounts to be received under sublease agreements and the balance of the deferred gain. Total rental expense under operating leases was $21.1 million in 1993, $17.7 million in 1992 and $17.2 million in 1991, exclusive of property taxes, insurance and other occupancy costs generally payable by the company. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - - - ------------------------------------------ FEDERAL-MOGUL CORPORATION - - - ------------------------- 6. DEBT ---- In October 1993, the company renegotiated its revolving credit facility and increased the availability of funds from $150 million to $300 million. The company borrowed $245 million against the facility to finance the acquisition of Sealed Power Replacement and to retire the $100 million 8 3/8% notes which were due October 1, 1993. The outstanding revolver balance matures in October, 1997. The revolver carries a variable interest rate (approximately 4.38% at December 31, 1993). The unused portion of the revolver is subject to a variable commitment fee (.375% as of December 31, 1993). The company has additional established lines of credit with several banks in the maximum amount of $49.1 million. At December 31, 1993 and 1992, borrowings under these lines of credit amounted to $35.7 and $28.1 million, respectively. Long-term debt at December 31 consists of the following: (Millions of Dollars) 1993 1992 -------- -------- Revolver due 1997 $245.0 $ - Term loan due 1998 - 125.0 8 3/8% notes due 1993 - 100.0 Notes payable due 2000 75.0 75.0 ESOP obligation 43.9 48.4 Other 30.7 18.9 ----- ----- 394.6 367.3 Less current maturities included in short-term debt 12.1 16.7 ----- ----- $382.5 $350.6 ----- ----- ----- ----- The notes payable due in 2000 require semi-annual interest payments (approximately 10% as of December 31, 1993) and, commencing December 1994, annual principal payments of $3.4 million (increasing to $16.2 million beginning December 1997). The Employee Stock Ownership Plan (ESOP) obligation represents the unpaid principal balance on an eleven-year loan entered into by the company's ESOP in 1989. Proceeds of the loan were used by the ESOP to purchase the company's Series C ESOP preferred stock. Payment of principal and interest on the notes is unconditionally guaranteed by the company, and therefore the unpaid principal balance of the borrowing is classified as long-term debt. Company contributions and dividends on the preferred shares held by the ESOP are used to meet semi-annual principal and interest obligations. In 1993, the company exercised an option to prepay principal in the amount of $4.5 million on the original ESOP loan, which bears interest at 11.2% per annum. The prepayment is being refinanced with bank debt that carries a variable interest rate based on LIBOR plus 100 basis points (4 1/2% as of December 31, 1993). NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - - - ------------------------------------------ FEDERAL-MOGUL CORPORATION - - - ------------------------- 6. DEBT (continued) ---- Certain of the company's debt agreements contain restrictive covenants that, among other matters, require the company to maintain certain financial ratios and minimum levels of working capital and tangible net worth. The revolving credit agreement additionally restricts the payment of common stock cash dividends to the greater of $.135 per common share per quarter or 80% of the company's average net earnings available for common shares, as defined in the agreements, for its four most recent fiscal quarters. The carrying value of the company's debt is not materially different from its fair value, which is estimated using discounted cash flow analysis and the company's current incremental borrowing rates for similar types of arrangements. Aggregate maturities of long-term debt for each of the four years following 1994 are, in millions: 1995--$13.3; 1996--$13.3; 1997--$277.3; and 1998--$27.9. Cash interest paid in 1993, 1992 and 1991 was $26.9 million, $27.1 million and $40.1 million, respectively. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - - - ------------------------------------------ FEDERAL-MOGUL CORPORATION - - - ------------------------- 7. CAPITAL STOCK AND PREFERRED SHARE PURCHASE RIGHTS ------------------------------------------------- The company's articles of incorporation authorize 60,000,000 shares of common stock with a stated value of $5, of which 29,497,994 shares, 22,391,154 shares and 22,354,354 shares were outstanding at December 31, 1993, 1992 and 1991, respectively. In April 1993, the company sold 6,250,000 shares of its common stock in a public offering with net proceeds of approximately $116 million that were used to repay a portion of the debt incurred with the 1992 acquisition of AAB. Simultaneously, the company issued 500,000 additional shares, valued at approximately $9.6 million, to contribute to the company's domestic pension plans. The articles of incorporation also authorize 5,000,000 shares of preferred stock. On September 24, 1992, the company completed an $80,000,000 private issue of 1,600,000 shares of its $3.875 Series D convertible exchangeable preferred stock. Sold to institutional investors in a private placement under rule 144A of the Securities Act, each share of stock has a liquidation preference of $50 and is convertible into the company's common stock at a conversion price of $18 per share. The shares are not redeemable prior to September 1996, but they may be exchanged at the company's option for 7.75% convertible subordinated debentures due in 2012. Such debentures would be convertible into the company's common stock at a rate of $50 principal amount for each share of common stock and at the same conversion price as the Series D preferred stock. The company's ESOP covers substantially all domestic salaried employees and allocates Series C ESOP convertible preferred stock to eligible employees based on their contributions to the Salaried Employees' Investment Program and their eligible compensation. The company had 944,016 shares, 954,196 shares and 978,170 shares of Series C ESOP preferred stock outstanding at December 31, 1993, 1992 and 1991, respectively. The company repurchased and retired 10,180 Series C ESOP preferred shares valued at $.7 million during 1993 and 23,974 Series C ESOP preferred shares valued at $1.4 million during 1992, all of which were forfeited by participants upon early withdrawal from the plan. The Series C ESOP preferred stock is convertible into shares of the company's common stock at a rate of two shares of common stock for each share of preferred stock. The Series C ESOP preferred stock may only be issued to a trustee acting on behalf of an employee stock ownership plan or other employee benefit plan of the company. The shares are automatically converted into shares of common stock in the event of any transfer to any person other than the plan trustee. The preferred stock is redeemable, in whole or in part, at the option of the company. The charge to operations for the cost of the ESOP was $4.9 million in 1993, $4.7 million in 1992 and $3.8 million in 1991. The company made cash contributions to the plan of $9.2 million in 1993 and 1992, and $8.3 million in 1991 for debt service, including preferred stock dividends of $4.5 million in 1993, $4.6 million in 1992 and $4.8 million in 1990. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - - - ------------------------------------------ FEDERAL-MOGUL CORPORATION - - - ------------------------- 7. CAPITAL STOCK AND PREFERRED SHARE PURCHASE RIGHTS (continued) ------------------------------------------------- In 1988, the company's Board of Directors authorized the distribution of one Preferred Share Purchase Right for each outstanding share of common stock of the company. Each Right entitles shareholders to buy one-half of one-hundredth of a share of a new series of preferred stock at a price of $70. As distributed, the Preferred Share Purchase Rights trade together with the common stock of the company. They may be exercised or traded separately only after the earlier to occur of: (i) 10 days following a public announcement that a person or group of persons has obtained the right to acquire 10% or more of the outstanding common stock of the company (20% in the case of certain institutional investors), or (ii) 10 business days (or such later date as may be determined by action of the Board of Directors) following the commencement or announcement of an intent to make a tender offer or exchange offer which would result in beneficial ownership by a person or group of persons of 10% of more of the company's outstanding common stock. Additionally, if the company is acquired in a merger or other business combination, each Right will entitle its holder to purchase, at the Right's exercise price, shares of the acquiring company's common stock (or stock of the company if it is the surviving corporation) having a market value of twice the Right's exercise price. The Preferred Share Purchase Rights may be redeemed at the option of the Board of Directors for $.005 per Right at any time before a person or group of persons acquires 10% or more of the company's common stock. The Board may amend the Rights at any time without shareholder approval. The Rights will expire by their terms on November 14, 1998. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - - - ------------------------------------------ FEDERAL-MOGUL CORPORATION - - - ------------------------- 8. INCENTIVE STOCK PLANS --------------------- The company's shareholders adopted stock option plans in 1976 and 1984 and a performance incentive stock plan in 1989. These plans provide generally for awarding restricted shares or granting options to purchase shares of the company's common stock. Restricted shares entitle employees to all the rights of common stock shareholders, subject to certain transfer restrictions or forfeitures. Options entitle employees to purchase shares at an exercise price not less than 100% of the fair market value on the grant date and expire after ten years. Under the plans, options become exercisable ranging from six months to four years as determined by the Board of Directors at the time of grant. At December 31, 1993, 775,010 shares were available for future grants under the plans. The following table summarizes the activity relating to the company's incentive stock plans: Number of Shares Share Price ------------- --------------- (In Millions) Outstanding at January 1, 1991 1.4 $ 9.47 - $26.19 Options granted 1.1 $15.69 - $22.00 Options exercised (.1) $9.47 Options lapsed or cancelled - --- Outstanding at December 31, 1991 2.4 $ 9.47 - $26.19 Options granted .1 $16.44 - $22.00 Options exercised - Options lapsed or cancelled (.1) --- Outstanding at December 31, 1992 2.4 $14.34 - $26.19 Options granted .5 $19.25 - $24.13 Options exercised (.3) $14.34 - $22.69 Options lapsed or cancelled - --- Outstanding at December 31, 1993 2.6 $15.69 - $26.19 --- --- Exercisable at December 31, 1993 1.0 $15.69 - $26.19 --- --- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - - - ------------------------------------------ FEDERAL-MOGUL CORPORATION - - - ------------------------- 9. PENSIONS AND OTHER POSTRETIREMENT BENEFITS ------------------------------------------ The company maintains several defined benefit pension plans which cover substantially all domestic employees. Benefits for domestic salaried employees are based on compensation and years of service, while hourly employees' benefits are primarily based on negotiated rates and years of service. In addition, certain employees in other countries are covered by pension plans. International plans maintained by the company provide benefits based on years of service and compensation. The company's funding policy is consistent with funding requirements of federal and international laws and regulations. Plan assets consist primarily of listed equity securities and fixed income instruments. As of December 31, 1993, plan assets included 444,000 shares of Federal-Mogul common stock valued at approximately $12.9 million. Net periodic pension cost for the company's defined benefit plans in 1993, 1992 and 1991 consist of the following: (Millions of Dollars) U.S. Plans International Plans ---------------------- --------------------- Year Ended December 31, 1993 1992 1991 1993 1992 1991 ------ ------ ------ ------ ------ ----- (Income)/Expense Service cost - benefits earned during the period $ 6.8 $ 5.6 $ 5.9 $ .4 $ .3 $ .4 Interest cost on projected benefit obligation 12.9 12.7 11.7 2.2 2.2 2.2 Actual return on plan assets (29.8) (5.7) (27.8) N/A N/A N/A Net amortization and deferral 7.3 (16.9) 6.7 - - - ---- ---- ---- ---- ---- ---- Net periodic pension cost $(2.8) $(4.3) $(3.5) $ 2.6 $ 2.5 $ 2.6 ---- ---- ---- ---- ---- ---- ---- ---- ---- ---- ---- ---- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - - - ------------------------------------------ FEDERAL-MOGUL CORPORATION - - - ------------------------- 9. PENSIONS AND OTHER POSTRETIREMENT BENEFITS (continued) ------------------------------------------ The following table sets forth the funded status for the company's defined benefit plans at December 31, 1993 and 1992: (Millions of Dollars) International U.S. Plans Plans ------------------------------- -------------- Assets Exceed Accumulated Accumulated Accumulated Benefits Benefits Benefits Exceed Assets Exceed Assets December 31, 1993 1992 1993 1992 1993 1992 ------ ------ ------ ------ ------ ------ Actuarial present value of benefit obligations: Vested benefit obligation $ 79.0 $ 68.9 $ 82.8 $ 58.0 $ 26.7 $ 24.4 ----- ----- ----- ----- ----- ----- ----- ----- ----- ----- ----- ----- Accumulated benefit obligation $ 83.1 $ 75.2 $ 97.2 $ 67.3 $ 28.0 $ 25.7 ----- ----- ----- ----- ----- ----- ----- ----- ----- ----- ----- ----- Projected benefit obligation $ 84.0 $ 76.3 $ 97.4 $ 67.4 $ 28.1 $ 25.9 Plan assets at fair value 151.1 145.7 78.7 55.5 - - Plan assets in excess of (less than) projected benefit obligation 67.1 69.4 (18.7) (11.9) (28.1) (25.9) Unrecognized net (asset) liability at transition (15.2) (19.1) .6 1.3 - - Unrecognized prior service cost (1.8) (1.1) 10.5 8.1 - - Unrecognized net (gain) loss (15.8) (18.4) 9.2 (1.8) 2.6 (.9) ----- ----- ----- ----- ----- ----- Accrued pension asset (liability) included in the consolidated balance sheet $ 34.3 $ 30.8 $ 1.6 $ (4.3) $(25.5) $(26.8) ----- ----- ----- ----- ----- ----- ----- ----- ----- ----- ----- ----- The assumptions used in computing the above information are as follows: U.S. Plans International Plans ---------------------- ---------------------- 1993 1992 1991 1993 1992 1991 ------ ------ ------ ------ ------ ------ Discount rates 7 1/2% 8 3/4% 9% 8% 9% 9% Rates of increase in compensation levels 4 1/2% 5 1/2% 6 1/2% 5% 5% 5% Expected long-term rates of return on assets 10% 9% 9% N/A N/A N/A NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - - - ------------------------------------------ FEDERAL-MOGUL CORPORATION - - - ------------------------- 9. PENSIONS AND OTHER POSTRETIREMENT BENEFITS (continued) ------------------------------------------ The company's minimum liability adjustment at December 31 was $20.2 million for U.S. plans and $2.5 million for international plans in 1993 and $7.7 million for U.S. plans in 1992. In addition to providing pension benefits, the company provides health care and life insurance benefits for certain domestic retirees covered under company-sponsored benefit plans. Employees who are participants in these plans may become eligible for these benefits if they reach normal retirement age while working for the company. Beginning in 1992, the company is required to accrue the cost of providing post-retirement benefits over the employees' service period. The company's policy is to fund benefit costs as they are provided, with retirees paying a portion of the costs. Periodic postretirement benefit costs were $13.8 million in 1993 and $14.4 million in 1992. The cost of these benefits in 1991, which were previously recognized as expense when paid, amounted to $5.4 million. The components of net periodic postretirement benefit costs are as follows: (Millions of Dollars) Year Ended December 31, 1993 1992 -------- -------- Service Cost $ 2.7 $ 2.7 Interest Cost 11.1 11.7 ---- ---- $13.8 $14.4 ---- ---- ---- ---- The accumulated postretirement benefits obligation (APBO) at December 31, 1993 and 1992 was as follows: (Millions of Dollars) December 31, 1993 1992 -------- -------- Accumulated postretirement benefit obligations: Retirees $ 96.2 $ 90.0 Fully eligible plan participants 15.0 18.7 Other active plan participants 39.5 34.6 Other loss (.8) (.2) ----- ----- $149.9 $143.1 ----- ----- ----- ----- The discount rate used in determining the APBO was 7 1/2% at December 31, 1993 and 8 3/4% at December 31, 1992. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - - - ------------------------------------------ FEDERAL-MOGUL CORPORATION - - - ------------------------- 9. PENSIONS AND OTHER POSTRETIREMENT BENEFITS (continued) ------------------------------------------ The assumed annual health care cost trend used in measuring the APBO approximated 9% in 1993, declining to 8 1/2% in 1994 and to an ultimate annual rate of 5 1/2% estimated to be achieved in 2008. At December 31, 1992, the health care cost trend rate approximated 9 1/2% in 1992, declining to 9% in 1993 to an annual rate of 6% to be achieved in 2007. Increasing the assumed cost trend rate by 1% each year would have increased the APBO by approximately 11% and 10% at December 31, 1993 and 1992, respectively. Aggregate service and interest costs would have increased by approximately 13% and 12% for 1993 and 1992, respectively. In 1991, the company established a retiree health benefits account (as defined in Section 401 of the Internal Revenue Code) within its domestic salaried employees' pension plan. Annually through 1995, the company may elect to transfer excess pension plan assets (subject to defined limitations) to the 401(h) account for purposes of funding current salaried retiree health care costs. The company transferred excess pension plan assets of $3.6 million in 1993, $3.9 million in 1992 and $7.8 million in 1991 ($4.2 million related to 1991 expenses and $3.6 million related to 1990 expenses) to the 401(h) account to fund salaried retiree health care benefits. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - - - ------------------------------------------ FEDERAL-MOGUL CORPORATION - - - ------------------------- 10. INCOME TAXES ------------ Under Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS 109) adopted by the company in 1992, the liability method is used in accounting for income taxes. Under this method, deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. The components of earnings (loss) from continuing operations before income taxes consisted of the following: (Millions of Dollars) 1993 1992 1991 -------- -------- -------- Domestic $ 54.5 $ 7.1 $(22.0) International 3.1 1.9 3.3 ----- ----- ----- $ 57.6 $ 9.0 $(18.7) ----- ----- ----- ----- ----- ----- Significant components of the provision for income taxes attributable to continuing operations are as follows: (Millions of Dollars) 1993 1992 1991 -------- -------- -------- Current: Federal $ 16.1 $ 4.1 $ 8.5 State and local 1.9 1.0 .8 International 6.5 5.0 4.2 ----- ----- ----- Total current 24.5 10.1 13.5 Deferred: Federal 5.2 (2.7) (12.5) State and local .1 (.2) (.7) International (12.3) (2.6) .8 ----- ----- ----- Total deferred (7.0) (5.5) (12.4) ----- ----- ----- $ 17.5 $ 4.6 $ 1.1 ----- ----- ----- ----- ----- ----- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - - - ------------------------------------------ FEDERAL-MOGUL CORPORATION - - - ------------------------- 10. INCOME TAXES (continued) ------------ The reconciliation of income tax attributable to continuing operations computed at the United States federal statutory tax rates to income tax expense is: (Millions of Dollars) 1993 1992 1991 -------- -------- -------- Tax at U.S. statutory rates $ 20.1 $ 3.0 $ (6.4) Increase (decrease) from: State income taxes 1.3 .6 .5 International earnings subject to varying tax rates and tax effect of losses (.2) 1.3 5.0 Tax effect on sale of business (1.8) Tax effect of rate changes U.S. (1.4) Germany (2.9) Other differences 2.4 (.3) 2.0 ----- ----- ----- $ 17.5 $ 4.6 $ 1.1 ----- ----- ----- ----- ----- ----- In 1993 the company was subject to statutory rate changes both in the United States and in Germany. Income tax expense was decreased by $1.4 million and $2.9 million as a result of applying the newly enacted tax rates to the deferred tax balances as of the beginning of the period in the United States and Germany, respectively. However, the effect of the change in tax rates on the current year's income was to increase income tax expense by $.6 million and $1 million, respectively. As a result, net tax benefits of $.8 million and $1.9 million have been recognized, respectively. The following table summarizes the company's total provision for income taxes: (Millions of Dollars) 1993 1992 1991 -------- -------- -------- Continuing operations $ 17.5 $ 4.6 $ 1.1 Cumulative effect of accounting change (47.6) Discontinued operations 2.4 Allocated to equity: Currency translation (3.0) (2.5) Preferred dividends (1.6) (1.7) (1.7) Other (.7) ----- ----- ----- $ 12.9 $(47.9) $ 1.8 ----- ----- ----- ----- ----- ----- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - - - ------------------------------------------ FEDERAL-MOGUL CORPORATION - - - ------------------------- 10. INCOME TAXES (continued) ------------ Significant components of the company's deferred tax liabilities and assets as of December 31 are as follows: (Millions of Dollars) 1993 1992 1991 -------- -------- -------- Deferred tax liabilities: Fixed asset basis differences $(60.0) $(67.9) $(69.0) Pension (12.5) (9.4) (8.3) ----- ----- ----- Total deferred tax liabilities (72.5) (77.3) (77.3) Deferred tax assets: Postretirement benefits other than pensions 55.3 51.6 - Special charges .2 11.9 6.0 Other non-deductible expenses 29.3 14.3 24.1 AMT credit carryforwards - 5.6 5.3 Foreign tax credit carryforwards 2.4 7.9 7.7 Net operating loss carryforwards of international subsidiaries 37.6 28.0 17.2 Other, net 2.6 4.3 (2.2) ----- ----- ----- Total deferred tax assets 127.4 123.6 58.1 Valuation allowance for deferred tax assets (21.0) (24.3) (21.2) ----- ----- ----- Net deferred tax assets 106.4 99.3 36.9 ----- ----- ----- $ 33.9 $ 22.0 $(40.4) ----- ----- ----- ----- ----- ----- At December 31, 1993, the company had net operating loss carryforwards in Germany of $46 million that are not subject to expiration. Net operating loss carryforwards of $49.5 million exist at other international subsidiaries subject to various expiration dates. Foreign tax credit carryforwards of $2.4 million will expire in years 1994 through 1998. Valuation allowances have been recognized against the net operating loss carryforwards (other than in Germany) and the foreign tax credit carryforwards. The company is not required to record valuation allowances for deferred tax assets where management believes it is more likely than not that the tax benefit will be realized. Valuation allowances were not established against deferred tax assets attributable to the company's postretirement benefit obligation and the German net operating loss carryforward. The deferred tax asset for the company's postretirement benefit obligation is $55.3 million at December 31, 1993. The total amount of future taxable income in the U.S. necessary to realize the asset is $149.5 million. The company could generate approximately $67 million of taxable income from the execution of reasonable and prudent tax planning strategies, principally through revoking the company's LIFO election. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - - - ------------------------------------------ FEDERAL-MOGUL CORPORATION - - - ------------------------- 10. INCOME TAXES (continued) ------------ In addition to tax planning strategies, the company will need to generate additional taxable income of approximately $82.5 million in the U.S. through future operations in order to fully realize the deferred tax asset for the company's postretirement benefit obligation. Over the past ten years, the company has generated taxable income in the U.S., on average, of approximately $52 million per year. Based on the company's history of taxable income and its projection of future earnings, management believes that it is more likely than not that sufficient taxable income will be generated in the foreseeable future to realize the deferred tax asset. The deferred tax asset attributable to the German net operating loss carryforward is $19 million. Sufficient taxable income will be generated through the reversal of existing taxable temporary differences to enable the carryforward to be utilized. Deferred tax liabilities and assets are recorded in the consolidated balance sheets as follows: (Millions of Dollars) 1993 1992 -------- -------- Assets: Prepaid expenses and income tax benefits $ 19.4 $ 14.6 Business investments and other assets 27.5 34.7 Liabilities: Deferred income taxes (13.0) (27.3) ----- ----- $ 33.9 $ 22.0 ----- ----- ----- ----- Income taxes paid in 1993, 1992 and 1991 were $16.3 million, $10.5 million and $17.5 million, respectively. Undistributed earnings of the company's international subsidiaries amounted to approximately $70 million at December 31, 1993. No taxes have been provided on the $63 million of these earnings which are considered by the company to be permanently reinvested. Upon distribution of these earnings, the company would be subject to U.S. income taxes and foreign withholding taxes. Determining the unrecognized deferred tax liability on the distribution of these earnings is not practicable. However, the company believes the foreign withholding taxes would be insignificant and any United States income tax would be largely offset by foreign tax credits. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - - - ------------------------------------------ FEDERAL-MOGUL CORPORATION - - - ------------------------- 11. OPERATIONS BY INDUSTRY SEGMENT AND GEOGRAPHIC AREA -------------------------------------------------- The company is a global distributor and manufacturer of a broad range of non-discretionary parts, primarily vehicular components for automobiles, light trucks, heavy duty trucks and farm and construction vehicles and industrial products. Through its worldwide distribution network, the company sells replacement parts in the vehicular aftermarket. The company also sells parts to original equipment manufacturers, principally the major automotive manufacturers in the United States and Europe. All of these activities constitute a single business segment. Financial information, summarized by geographic area, is as follows: (Millions of Dollars) 1993 1992 1991 -------- -------- -------- Net sales: United States and Canada $1,092.3 $ 817.5 $ 697.5 Europe 270.4 268.3 243.5 Other international 212.8 178.2 157.7 ------- ------- ------- $1,575.5 $1,264.0 $1,098.7 ------- ------- ------- ------- ------- ------- Operating profit: United States and Canada $ 91.0 $ 30.8 $ 18.6 Europe (2.3) (.9) (7.4) Other international 20.0 22.1 11.4 ------- ------- ------- Total operating profit (a) 108.7 52.0 22.6 Corporate expenses and other (24.3) (22.4) (18.6) ------- ------- ------- Operating earnings $ 84.4 $ 29.6 $ 4.0 ------- ------- ------- ------- ------- ------- Identifiable assets: United States and Canada $ 804.5 $ 618.2 $ 451.6 Europe 243.2 290.1 328.9 Other international 244.1 195.4 133.4 ------- ------- ------- $1,291.8 $1,103.7 $ 913.9 ------- ------- ------- ------- ------- ------- (a) Operating profit included special charges of $14 million and $25 million in 1992 and 1991, respectively. Transfers between geographic areas are not significant, and when made, are recorded at prices comparable to normal unaffiliated customer sales. Sales to domestic automotive manufacturers were approximately 16% of net sales in 1993 and included sales to General Motors Corporation of $141.7 million, $115.7 million and $112.2 million in 1993, 1992 and 1991, respectively. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - - - ------------------------------------------ FEDERAL-MOGUL CORPORATION - - - ------------------------- 12. LITIGATION ---------- The company is involved in various legal actions arising in the normal course of business. After taking into consideration legal counsel's evaluation of such actions, management is of the opinion that their outcome will not have a significant effect on the company's consolidated financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - - - ------------------------------------------ FEDERAL-MOGUL CORPORATION - - - ------------------------- 13. SUBSEQUENT EVENTS ----------------- In December 1993, the company filed a shelf registration with the SEC that permits the issuance of a combination of debt and equity securities up to $300 million over a two year period. In February 1994, the company used the shelf registration to offer 5.75 million shares of common stock to the public, generating net proceeds to the company of nearly $191 million. The offering proceeds were used to repay a portion of the outstanding debt which was principally used to purchase SPR. Had the February 1994 offering occurred on January 1, 1993, primary earnings per share for 1993 would have been unchanged at $1.13. MANAGEMENT'S RESPONSIBILITY FOR FINANCIAL REPORTING - - - --------------------------------------------------- To Our Shareholders: The management of Federal-Mogul has the responsibility for preparing the accompanying financial statements and for their integrity and objectivity. The financial statements were prepared in accordance with generally accepted accounting principles and include amounts based on the best estimates and judgments of management. Management also prepared the other financial information in this report and is responsible for its accuracy and consistency with the financial statements. Federal-Mogul has retained independent auditors, ratified by election of the shareholders, to audit the financial statements. Federal-Mogul maintains a strong system of internal accounting controls supplemented by written policies and procedures, implemented by the careful selection and training of qualified personnel and verified by an extensive internal audit program. These measures, the cost of which is balanced against the benefits that may reasonably be expected therefrom, are designed to prevent significant misuse of company assets or misstatements of financial reports and to assure that business is conducted as directed by management in accordance with all applicable laws and the Federal-Mogul Code of Conduct. The Audit Committee of the Board of Directors, comprised of five outside directors, performs an oversight role related to financial reporting. The Committee periodically meets jointly and separately with the independent auditors, internal auditors and management to review their activities and reports, and to take any action appropriate to their findings. At all times the independent auditors have the opportunity to meet with the Audit Committee, without management representatives present, to discuss matters related to their audit. Dennis J. Gormley Chairman and Chief Executive Officer Martin E. Welch III Senior Vice President Chief Financial Officer James B. Carano Vice President and Controller REPORT OF INDEPENDENT AUDITORS - - - ------------------------------ Shareholders and Board of Directors Federal-Mogul Corporation We have audited the accompanying consolidated balance sheets of Federal-Mogul Corporation and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of earnings, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 1993. 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 financial statements referred to above present fairly, in all material respects, the consolidated financial position of Federal-Mogul Corporation and subsidiaries at December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed in Note 1 to the consolidated financial statements, in 1992 the company changed its method of accounting for postretirement benefits other than pensions. Detroit, Michigan February 8, 1994 QUARTERLY FINANCIAL DATA (UNAUDITED) - - - ------------------------------------ FEDERAL-MOGUL CORPORATION - - - ------------------------- Net earnings in the first quarter of 1992 were adversely impacted by $88.1 million ($3.93 per share) representing the cumulative effect of a change in the method of accounting for postretirement benefits other than pensions. Quarterly net earnings and earnings per share for the first three quarters of 1992 have been restated from amounts previously reported. Net earnings in the fourth quarter of 1992 were adversely impacted by a special charge of $.40 per share. Refer to Notes 1 and 2 to the consolidated financial statements for further discussion of these matters. In the fourth quarter of 1992, the company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS 109), retroactively to 1989. Quarterly net earnings and earnings per share have been restated from amounts previously reported in conjunction with the provisions of SFAS 109. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE - - - ------------------------------------------------------------- None. PART III - - - -------- ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT - - - ----------------------------------------------------- The information required by this item is incorporated by reference from pages 1 through 5 of the company's definitive proxy statement dated March 18, 1994 relating to its 1994 annual meeting of shareholders (the "1994 Proxy") under the heading "Nominees for Election as Directors" except that the information required by Item 10 with respect to executive officers included under Part I of this report. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION - - - ---------------------------------- The information required by this item is incorporated by reference from the 1994 Proxy under the headings "Information on Executive Compensation" on pages 9 to 11 and under the heading "Retirement Plans" on page 15 and "Nominees for Election as Directors" on pages 4 and 5 of the Proxy. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT - - - -------------------------------------------------------------------------- The information required by this item is incorporated by reference from pages 15 through 18 of the 1994 Proxy under the heading "Information on Securities". ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS - - - ----------------------------------------------------------- Not applicable. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K - - - -------------------------------------------------------- (a) The following documents are filed as part of this report: 1. Financial Statements: Financial statements filed as part of this Form 10-K are listed under Part II, Item 8 of this Form 10-K. 2. Financial Statement Schedules: Schedule V - Property, plant and equipment Schedule VI - Accumulated depreciation, depletion and amortization of property, plant and equipment Schedule VIII - Valuation and qualifying accounts Schedule IX - Short-term borrowings Schedule X - Supplementary income statement information Financial Statements and Schedules Omitted: Schedules other than those listed above are omitted because they are not required under instructions contained in Regulation S-X or because the information called for is shown in the financial statements and notes thereto. Individual financial statements of subsidiaries of the Company have been omitted as the Company is primarily an operating company and all subsidiaries included in the consolidated financial statements filed, in the aggregate, do not have minority equity interests and/or indebtedness to any person other than the Company or its consolidated subsidiaries in amounts which together exceed 5% of the total assets of the Company as shown by the most recent year-end Consolidated Balance Sheet. SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT - - - ------------------------------------------ FEDERAL-MOGUL CORPORATION AND SUBSIDIARIES ------------------------------------------ (In Millions) SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT - - - ----------------------------------------------------------- FEDERAL-MOGUL CORPORATION AND SUBSIDIARIES ------------------------------------------ (In Millions) SCHEDULE IX - SHORT-TERM BORROWINGS - - - ----------------------------------- FEDERAL-MOGUL CORPORATION AND SUBSIDIARIES ------------------------------------------ (In Millions, Except Percents) SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION - - - ------------------------------------------------------- FEDERAL-MOGUL CORPORATION AND SUBSIDIARIES ------------------------------------------ (In Millions) COLUMN A COLUMN B - - - -------------------------------------- --------------------------------- Item Charged to Costs and Expenses - - - -------------------------------------- --------------------------------- Year Ended December 31 3. Exhibits: 3.1 The Registrant's Second Restated Articles of Incorporation, as amended (filed as Exhibit 3.1 to Registrant's Form 10-Q for the quarter ended September 30, 1993, and incorporated herein by reference). 3.2 The Registrant's Bylaws, as amended (filed as Exhibit 3.2 to Registrant's Form 10-K for the year ended December 31, 1993, and incorporated herein by reference). 4.2 Rights Agreement ("Rights Agreement") between Registrant and National Bank of Detroit as Rights Agent with Bank of New York as successor Rights Agent (filed as Exhibit 1 to Registrant's Form 8-A Registration Statement dated November 7, 1988, and incorporated herein by reference). 4.3 Amendments dated July 25, 1990, to Rights Agreement (filed as Exhibit 4.5 to the 1990 Second Quarter 10-Q). 4.4 Amendment dated September 23, 1992 to Rights Agreement (filed as Exhibit 4.4 to Registrant's Form 10-K for the year ended December 31, 1993 and incorporated herein by reference). 4.5 Reference is made to Exhibit 3.1 hereto which contains provisions defining the rights of securities holders of the long- term debt securities of the Registrant and any of its subsidiaries for which consolidated or unconsolidated financial statements are required to be filed. Other instruments defining the rights of holders of long-term debt of the Registrant and its subsidiaries have not been filed because in each case the total amount of long-term debt permitted thereunder does not exceed 10% of the Registrant's consolidated assets and the Registrant hereby agrees to furnish such instruments to the Securities and Exchange Commission upon its request. 4.6 Second Amended and Restated Revolving Credit Agreement dated October 19, 1993, among the Company, various banks, and Chemical Bank, as agent (filed as Exhibit 4.6 to Registrant's Registration Statement on Form S-3 No. 33-51265 dated December 3, 1993 and incorporated herein by reference). 10.1 The Registrant's 1976 Stock Option Plan, as last amended November 3, 1988 (filed as Exhibit 10.27 to the 1988 10-K, and incorporated herein by reference). 10.2 The Registrant's 1984 Stock Option Plan as last amended, (filed as Exhibit 10.26 to the 1988 10-K, and incorporated herein by reference). 10.3 The Registrant's 1977 Supplemental Compensation Plan, as amended and restated effective as of January 1, 1986 (refiled as Exhibit 10.3 to the 1993 10-K, and incorporated herein by reference). 10.4 Registrant's Supplemental Compensation Retirement Trust Agreement (filed as Exhibit 10.1 to the 1988 Third Quarter 10-Q and incorporated herein by reference). 10.6 Form of Executive Severance Agreement between the Registrant and certain executive officers, (refiled as Exhibit 10.6 to the 1990 10-K, and incorporated herein by reference). 10.7 Amended and Restated Deferred Compensation Plan for Corporate Directors (refiled as Exhibit 10.7 to the 1990 10-K, and incorporated herein by reference). 10.10 Supplemental Executive Retirement Plan, as amended (refiled as Exhibit 10.10 to the 1992 10-K, and incorporated herein by reference). 10.11 Description of Umbrella Excess Liability Insurance for the Executive Council (refiled as Exhibit 10.11 to the 1990 10- K, and incorporated herein by reference). 10.12 Guaranty and Contingent Purchase Agreement of Federal-Mogul Corporation dated February 15, 1989, between the Registrant and Aetna Life Insurance Company ("Guaranty and Contingent Purchase Agreement" filed as Exhibit 10.28 to the 1988 10-K, and incorporated herein by reference). 10.13 Note Agreement dated February 15, 1989, between the Federal-Mogul Corporation Salaried Employees Stock Ownership Trust and Aetna Life Insurance Company (filed as Exhibit 10.29 to the 1988 10-K, and incorporated herein by reference). 10.14 Federal-Mogul Corporation 1989 Performance Incentive Stock Plan (filed as Exhibit 10.31 to the 1988 10-K, and incorporated herein by reference). 10.15 Supply Agreement dated as of October 19, 1992 between the Company and TRW Inc. (filed as Exhibit 10.15 to the 1992 10-K, and incorporated herein by reference). 10.16 Federal-Mogul Corporation Note Agreement dated December 1, 1990 ("12/1/90 Note Agreement") between the Registrant and various financial institutions listed therein(filed as Exhibit 10.17 to the 1991 10-K, and incorporated herein by reference). 10.17 First Amendment dated as of March 9, 1992 to Note Agreement dated February 15, 1989, between the Federal-Mogul Corporation Salaried Employees Stock Ownership Trust and Aetna Life Insurance Company (filed as Exhibit 10.19 to the Registrant's Quarterly Report on Form 10-Q for the first quarter of 1993, and incorporated herein by reference). 10.18 First Amendment dated as of March 9, 1992 to Guaranty and Contingent Purchase Agreement (filed as Exhibit 10.20 to the Registrant's Quarterly Report on Form 10-Q for the first quarter of 1993, and incorporated herein by reference). 10.19 Pooling and Servicing Agreement dated as of June 1, 1992 ("Pooling and Servicing Agreement") among Federal-Mogul Funding Corporation, as Seller, Federal-Mogul Corporation, as Servicer, and Chemical Bank, as trustee (filed as Exhibit 10.21 to the Registrant's Quarterly Report on Form 10-Q for the second quarter of 1993, and incorporated herein by reference). 10.20 Series 1992-1 Supplement dated as of June 1, 1992 to the Pooling and Servicing Agreement (filed as Exhibit 10.22 to the registrant's Quarter Report on Form 10-Q for the second quarter of 1992, and incorporated herein by reference). 10.21 Receivables Purchase Agreement dated as of June 1, 1992 between the Company and Federal-Mogul Funding Corporation (filed as Exhibit 10.23 to the 1992 Form 10-K, and incorporated herein by reference). 10.22 Second Amendment dated as of October 19, 1992 to Guaranty and Contingent Purchase Agreement (filed as Exhibit 10.24 to the 1992 Form 10-K and incorporated herein by reference). 10.23 First Amendment dated as of December 11, 1992, to 12/1/90 Note Agreement (filed as Exhibit 10.27 to the 1992 Form 10- K, and incorporated herein by reference). 10.24 Series 1993-1 Supplement dated as of March 1, 1993 to the Pooling and Servicing Agreement dated June 1, 1992 among the Company, Federal-Mogul Funding Corporation and Chemical Bank trustee (filed as Exhibit 10.29 to the Form 10-K for the first quarter of 1992 and incorporated herein by reference). 10.25 Amendment to Rights Agreement between Federal-Mogul Corporation and the Bank of New York, (filed as Exhibit 10.30 to the second quarter 1992 Form 10-Q and incorporated herein by reference). 11.1 Statement Re: Computation of Per Share earnings (filed herewith). 21.1 Subsidiaries of the Registrant (filed herewith). 23.1 Consent of Ernst & Young (filed herewith). 24.1 Powers of Attorney (filed herewith). The Company will furnish upon request any exhibit described above upon payment of the Company's reasonable expenses for furnishing such exhibit. (b) Report on Form 8-K: A report on Form 8-K dated November 10, 1993 was filed pursuant to Item 2 by the Company during the fourth quarter of 1993 concerning the Company's acquisition of the automotive aftermarket business of Sealed Power Replacement Division of SPX Corporation ("SPR"). The report was amended by Form 8-K/A dated December 3, 1993 to include financial statements of SPR and pro forma financial statements of SPR and the Company which were unavailable at the time the report was filed. 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, thereto duly authorized. FEDERAL-MOGUL CORPORATION By: (Martin E. Welch III) ------------------------------ Martin E. Welch III Senior Vice President and Chief Financial Officer Dated as of March 25, 1994 Pursuant to the required 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 as of the date(s) indicated. Signature Title (D.J. Gormley)* - - - ------------------------ Chairman of the Board, D. J. Gormley President and Chief Executive Officer (M.E. Welch III) - - - ------------------------ Senior Vice President and M. E. Welch III Chief Financial Officer (Principal Financial Officer) (J.B. Carano) - - - ------------------------ Vice President and Controller J. B. Carano (Principal Accounting Officer) (Thomas F. Russell)* - - - ------------------------ Director Thomas F. Russell (Roderick M. Hills)* - - - ------------------------ Director Roderick M. Hills (John J. Fannon)* - - - ------------------------ Director John J. Fannon (Antonio Madero)* - - - ------------------------ Director Antonio Madero (Walter J. McCarthy, Jr.)* - - - ------------------------ Director Walter J. McCarthy, Jr. (Robert S. Miller, Jr.)* - - - ------------------------ Director Robert S. Miller, Jr. (John C. Pope)* - - - ------------------------ Director John C. Pope (Dr. Hugo Michael Sekyra)* - - - ------------------------ Director Dr. Hugo Michael Sekyra *By: (George N. Bashara, Jr.) ------------------------- George N. Bashara, Jr. Attorney-in-fact Dated as of March 25, 1994

1993 ITEM 1. BUSINESS WPL Holdings, Inc. (herein sometimes referred to as the "company") was incorporated under the laws of the State of Wisconsin on April 22, 1981 and operates as a holding company with both utility and nonregulated businesses. It is the parent company of a public utility, Wisconsin Power and Light Company (WP&L) and its related subsidiaries, and of Heartland Development Corporation ("HDC"), the parent corporation for the company's nonregulated businesses. WP&L WP&L incorporated in Wisconsin on February 21, 1917, as the Eastern Wisconsin Electric Company, is a public utility predominately engaged in the transmission and distribution of electric energy and the generation and bulk purchase of electric energy for sale. It also transports, distributes and sells natural gas purchased from gas suppliers. Nearly all of the WP&L's customers are located in south and central Wisconsin. WP&L operates in municipalities pursuant to permits of indefinite duration which are regulated by Wisconsin law. WP&L does not derive a material portion of its revenues from any one customer. WP&L owns all of the outstanding capital stock of South Beloit Water, Gas and Electric Company ("South Beloit"), a public utility supplying electric, gas and water service, principally in Winnebago County, Illinois, which was incorporated on July 23, 1908. WP&L also owns varying interests in several other subsidiaries and investments which are not material to WP&L's operations. Regulation The company and WP&L are subject to regulation by the Public Service Commission of Wisconsin ("PSCW") as to retail utility rates and service, accounts, issuance and use of proceeds of securities, certain additions and extensions to facilities, and in other respects. South Beloit is subject to regulation by the Illinois Commerce Commission ("ICC") for similar items. The Federal Energy Regulatory Commission ("FERC") has jurisdiction under the Federal Power Act over certain of the electric utility facilities and operations, wholesale rates and accounting practices of WP&L and in certain other respects. Certain of WP&L's natural gas facilities and operations are subject to the jurisdiction of the FERC under the Natural Gas Act. The company is presently exempt from all provisions of the Public Utility Holding Company Act of 1935, except provisions relating to the acquisition of securities of other public utility companies. An anticipated change in the regulatory environment is the movement towards the deregulation of certain aspects of utility operations. WP&L is in the process of evaluating the impacts of such deregulation. With respect to environmental matters, the United States Environmental Protection Agency administers certain federal statutes; others are delegated to the Wisconsin Department of Natural Resources ("DNR"). In addition, the DNR has jurisdiction over air and water quality standards associated with fossil fuel fired electric generation and the level and flow of water, safety and other matters pertaining to hydroelectric generation. WP&L is subject to the jurisdiction of the Nuclear Regulatory Commission ("NRC") with respect to the Kewaunee nuclear plant and to the jurisdiction of the United States Department of Energy ("DOE") with respect to the disposal of nuclear fuel and other radioactive wastes from the Kewaunee Nuclear Power Plant ("Kewaunee"). Employees At year-end 1993, WP&L employed 2,673 persons, of whom 2,136 were considered electric utility employees, 387 were considered gas utility employees and 150 were considered other utility employees. WP&L has a three-year contract with members of the International Brotherhood of Electrical Workers, Local 965, that is in effect until June 1, 1996. The contract covers 1,742 of WP&L's employees. ELECTRIC OPERATIONS: General The company, through WP&L provides electricity in a service territory of approximately 16,000 square miles in 35 counties in southern and central Wisconsin and four counties in northern Illinois. As of December 31, 1993, the company provided retail electric service to approximately 360,000 customers in 609 cities, villages and towns, and wholesale service to 25 municipal utilities, 1 privately owned utility, three rural electric cooperatives and to Wisconsin Public Power, Inc. System, which provides retail service to nine communities. WP&L owns 21,579 miles of electric transmission and distribution lines and 351 substations located adjacent to the communities served. WP&L's electric sales are seasonal to some extent with the yearly peak normally occurring in July or August. WP&L also experiences a smaller winter peak in December or January. Fuel In 1993, approximately 80 percent of WP&L's net kilowatthour generation of electricity was fueled by coal and 17 percent by nuclear fuel (provided by WP&L's 41 percent ownership interest in Kewaunee). The remaining electricity generated was produced by hydroelectric, oil-fired and natural gas generation. Coal WP&L anticipates that its average fuel costs will increase in the future, due to cost escalation provisions in existing coal and transportation contracts and increases in the costs of new coal contracts due to emission requirements under federal and state laws. The estimated coal requirements of WP&L's generating units (including jointly-owned facilities) for the years 1994 through 2013 total about 166 million tons. Present coal supply contracts and transportation contracts (excluding extension options) cover approximately 25 percent and 24 percent, respectively, of this estimated requirement. WP&L will seek renewals of existing contracts or additional sources of supply and negotiate new or additional transportation contracts to satisfy the requirements of approved environmental regulations. Nuclear Kewaunee is jointly owned by WP&L (41%), Wisconsin Public Service Corporation (41.2%) and Madison Gas & Electric Company (17.8%). Wisconsin Public Service Corporation is the operating partner. The plant began commercial operation in 1974. The supply of fuel for Kewaunee involves the mining and milling of uranium ore to uranium concentrates, the conversion of uranium concentrates to uranium hexafluoride, enrichment of the uranium hexafluoride and fabrication of the enriched uranium into usable fuel assemblies. The following narrative discusses the nuclear fuel supplies for Kewaunee which requires approximately 250,000 pounds of uranium concentrates per year. Additionally, WP&L and the other Kewaunee co-owners formed a limited partnership of subsidiaries in the mid-1970's to secure uranium reserves and maintain a long-term uranium concentrates supply capability. (a) Requirements for uranium are met through spot market purchases of uranium. In general a four-year supply of uranium is maintained. (b) Uranium hexafluoride, from inventory and from spot market purchases, was used to satisfy converted material requirements in 1993. Such conversion services will be purchased on the spot market in the future. (c) In 1993, enriched uranium was procured from COGEMA, Inc. pursuant to a contract last amended in 1991. The partnership is obligated to take delivery of additional enriched uranium contracted from COGEMA in 1993 and 1994. The partnership also purchased enriched uranium on the spot market in 1993. Enrichment services were purchased from the DOE under the terms of the utility services contract. This contract is in effect for the life of Kewaunee. The partnership is committed to take 70 percent of its annual requirements in 1994 and 1995, and in alternate years thereafter from the DOE. (d) Fuel fabrication requirements through 1995 are covered by contract. This contract contains an option to allow the partnership to extend the contract through 1998. (e) Beyond the stated periods for Kewaunee, additional contracts for uranium concentrates, conversion to uranium hexafluoride, fabrication and spent fuel storage will have to be procured. The prices for the foregoing are expected to increase. The National Energy Policy Act of 1992 provides that both the Federal government and the nuclear utilities fund the decontamination and decommissioning of the three federal gaseous diffusion plants in the United States. This will require the owners of Kewaunee to pay approximately $15 million, in current dollars over a period of 15 years. WP&L's share amounts to an annual payment of approximately $410,000. The steam generator tubes at Kewaunee are susceptible to corrosion characteristics seen throughout the nuclear industry. Annual inspections are performed to identify degraded tubes. Degraded tubes are either repaired by sleeving or are plugged with approximately 15 percent heat transfer margin, meaning that full power should be sustainable with the equivalent of 15 percent of the steam generator tubes plugged. Currently, the equivalent of 10 percent of the tubes in the steam generators are plugged. WP&L and the other joint owners continue to evaluate appropriate strategies, including replacement, as well as continued operation of the steam generators without replacement. WP&L and the joint owners intend to operate Kewaunee until at least 2013, the expiration of the present operating license. WP&L and the joint owners are also evaluating initiatives to improve the performance of Kewaunee. These initiatives include funding of the development of welded repair technology for steam generator tubes and numerous cost reduction measures such as the conversion from a 12-month to an 18-month fuel cycle. If the steam generators are not replaced, and excluding the possible affect of the aforementioned repair strategies, a gradual power reduction of approximately 1 percent per year may begin as soon as 1995. Physical decommissioning is expected to occur during the period 2014 to 2021 with additional expenditures being incurred during the period 2022 to 2050 related to the storage of spent nuclear fuel at the site. WP&L's share of the decommissioning costs of this plant is estimated to be $149 million (in 1993 dollars) based on a site specific study, performed in 1992, using immediate dismantlement as the method of decommissioning. Wisconsin utilities operating nuclear generating plants are required by the PSCW to establish external trust funds to provide for the decommissioning of such plants. The market value of the investments in the funds established by WP&L at December 31, 1993 totaled $45.1 million. Pursuant to the Nuclear Waste Policy Act of 1982, the DOE has entered into a contract with WP&L to accept, transport and dispose of spent nuclear fuel beginning not later than January 31, 1998. It is likely that the DOE will delay the acceptance of spent nuclear fuel beyond 1998. A fee to offset the costs of the DOE's disposal for all spent fuel used since April 7, 1983 has been assessed by the DOE at one mill per net kilowatthour of electricity generated and sold by the Kewaunee nuclear power plant. An additional one-time fee was paid for the disposal of spent nuclear fuel used to generate electricity prior to April 7, 1983. Spent fuel is currently stored at Kewaunee. The existing capacity of the spent fuel storage facility will enable storage of the projected quantities of spent fuel through April 2001. WP&L is currently evaluating options for the storage of additional quantities beyond 2001. Several technologies are available. It is expected that the larger capacity requirements for spent nuclear fuel storage will require a capital investment in the late 2000's. The Low-Level Radioactive Waste Policy Act of 1980 as amended in 1985 provides that states may enter into compacts to provide for regional low-level waste disposal facilities. The amended Act provides that after January 1, 1993, compact members may restrict the use of regional disposal facilities to waste generated within the region. Wisconsin is a member of the Midwest Interstate Low-Level Radioactive Waste Compact which includes six Midwestern states and was ratified by Congress. A Midwest disposal facility is not expected to be operational until the late 1990's. Presently, the state of Ohio has been selected as the host state for the Midwest Compact and is proceeding with the preliminary phases of site selection. In the meantime, WP&L has access to an existing low level waste storage space to temporarily store low level waste generated. Recovery of Electric Fuel Costs WP&L does not automatically pass changes in electric fuel cost through to its Wisconsin retail electric customers. Instead, rates are based on estimated per unit fuel costs established during rate proceedings and are not subject to change by fuel cost fluctuations unless actual costs are outside specified limits. If actual fuel costs vary from the estimated costs by more than +10 percent in a month or by more than +3 percent for the test year to date, projected annual variances are then estimated. If the projected annual variance is more than +3 percent, rates are subject to hearings and increase or decrease by the PSCW. WP&L's wholesale rates and South Beloit's retail rates contain fuel adjustment clauses pursuant to which rates are adjusted monthly to reflect changes in the costs of fuel. Environmental Matters WP&L cannot precisely forecast the effect of future environmental regulations by federal, state and local authorities upon its generating, transmission and other facilities, or its operations, but has taken steps to anticipate the future while meeting the requirements of approved environmental regulations of today. The Clean Air Act Amendments of 1977 and subsequent amendments to the Clean Air Act, as well as the new laws affecting the handling and disposal of solid and hazardous wastes along with clean air legislation passed in 1990 by Congress, could affect the siting, construction and operating costs of both present and future generating units (see "Item 3. Legal Proceedings"). Under the Federal Clean Water Act, National Pollutant Discharge Elimination System permits for generating station discharge into water ways are required to be obtained from the DNR, to which the permit program has been delegated. These permits must be periodically renewed. WP&L has obtained such permits for all of its generating stations or has filed timely applications for renewals of such permits. Air quality regulations promulgated by the DNR in accordance with Federal standards impose statewide restrictions on the emission of particulates, sulfur dioxide, nitrogen oxides and other air pollutants and require permits from the DNR for the operation of emission sources. WP&L currently has the necessary permits to operate its fossil-fueled generating facilities. However, new permits will be required for all major facilities in Wisconsin beginning in 1994. The schedule for application of these new permits has been staggered by the DNR to accomodate staffing at the DNR. WP&L's Columbia Generating facility is required to submit a permit application on May 1, 1994. The remaining facilities will be addressed later in 1994 and early 1995. Pursuant to Wisconsin statutes 144.386(2), WP&L has submitted data and plans for 1993 sulfur dioxide emissions compliance. WP&L will make any necessary operational changes in fuel types and power plant dispatch to comply with the Plan. WP&L's compliance strategy for Wisconsin's 1993 sulfur dioxide law and the Federal Clean Air Act Amendments required plant upgrades at its generating facilities. The majority of these projects were completed in 1993. WP&L has installed continuous emissions monitoring systems at all of its coal fired boilers (Edgewater and Nelson Dewey facilities) in 1993 and will complete the installation of these monitors at the remaining facilities in 1994. No additional costs for compliance with these acid rain requirements are anticipated at this time. WP&L maintains licenses for all its ash disposal facilities and regularly reports to the DNR groundwater data and quantities of ash landfilled or reused. The landfills are operated according to a Plan of Operation approved by the DNR. WP&L's accumulated pollution abatement expenditures through December 31, 1993, totaled approximately $122 million. The major expenditures consist of about $60 million for the installation of electrostatic precipitators for the purpose of reducing particulate emissions from WP&L's coal-fired generating stations and approximately $62 million for other pollution abatement equipment at the Columbia, Edge- water, Kewaunee, Nelson Dewey, Rock River and Blackhawk plants. Expenditures during 1993 totaled approximately $6 million. Estimated pollution abatement expenditures total $.7 million through 1995. WP&L's estimated pollution abatement expenditures are subject to continuing review and are revised from time to time due to escalation of construction costs, changes in construction plans and changes in environmental regulations. See "Electric Operations - Fuel" for information concerning the disposal of spent nuclear fuel and high level nuclear waste. GAS OPERATIONS: General As of December 31, 1993, the company, through its subsidiary WP&L, provided retail natural gas service to approximately 136,000 customers in 217 cities, villages and towns in 22 counties in southern and central Wisconsin and one county in northern Illinois. WP&L's gas sales follow a seasonal pattern. There is an annual base load of gas used for heating, cooking, water heating and other purposes, with a large peak occurring during the heating season. In 1993, WP&L purchased significant volumes of lower cost gas directly from producers and marketers and transported those volumes over its two major pipeline supplier's systems. This replaced higher cost gas historically purchased directly from the major pipeline systems. WP&L transported gas for 85 end users at year-end 1993. Gas Supplies In 1992 the FERC issued Order No. 636 and 636-A which requires interstate pipelines to restructure their services. Under these orders, existing pipeline sales service would be "unbundled" such that gas supplies would be sold separately from interstate transportation services. Both of the interstate pipelines which serve WP&L, ANR Pipeline and Northern Natural Pipeline, completed their transition to unbundled services as mandated by the FERC in its Order 636 during 1993. As a result, WP&L now contracts with these two parties for various unbundled services such as firm and interruptible transportation, firm and interruptible storage service and "no-notice" service. WP&L has benefited from enhanced access to competitively priced gas supplies, and from more flexible transportation services. Pipelines are, however, seeking to recover from their customers certain transition costs associated with restructuring. Any such recovery is subject to prudence hearings at the FERC and state regulatory commissions. With the pipelines exiting their historic role of selling gas to WP&L, the utility has increased its contracting activity with producers and marketers of natural gas correspondingly. WP&L's portfolio of gas supply contracts are designed to meet the needs of gas customers and extend from one month to 10 years in term. The most significant change in WP&L's mix of gas contracts for 1993 are: 1) a significant increase in the volume of Canadian gas contracted for, and 2) a large increase in firm storage service from the pipelines. The new Canadian contract commitments represent WP&L's successful negotiations to minimize the "transition costs" of moving to the unbundled, post-Order 636 environment. In mid 1993, WP&L was faced with the decision of whether to negotiate with the Canadians to reform the terms of long-term contracts which were in place with the two pipelines and assume the contracts on the renegotiated terms, or pay the pipelines to buy out of these contract commitments with the Canadians. WP&L opted for the latter approach at an estimated savings of over $16 million to WP&L's customers. In 1993, WP&L increased its peak-day entitlements on ANR pipeline by 16,000 dekatherms per day reflecting the need for additional firm capacity in order to meet the load growth of firm customers. WP&L maintains gas storage agreements with ANR Pipeline and a third party storage service provider. The storage agreements allow WP&L to purchase a portion of its gas supply between April and October, when natural gas costs usually are lower. The less expensive gas is stored in the storage fields and is withdrawn between November and March when gas costs typically are higher. The agreements have terms extending through March 31, 1995 and March 31, 1997. WP&L's current portfolio of contracts is as follows: The future cost of natural gas is expected to be market sensitive. WP&L's rate schedules applicable to all retail gas customers provide for adjustments of its rates, upon notice by WP&L to the PSCW, to reflect all increases or decreases in the cost of gas purchased for resale. Increases or decreases in such costs are reflected automatically by adjustments to customers' bills commencing with meters read following the effective date of any changes in such costs. One of the biggest changes which WP&L faces in the post-Order 636 environment is dealing with the heightened emphasis placed upon daily balancing of the economic utilization of WP&L's two pipelines. As the natural gas market continues to evolve, WP&L continuously evaluates products and services provided by pipelines and gas suppliers to meet the changing needs of its firm and interruptible gas customers. Environmental Matters Manufactured Gas Plant Sites. Historically, WP&L has owned 11 properties that have been associated with the production of manufactured gas. Currently, WP&L owns five of these sites, three are owned by municipalities, and the remaining three are owned by private companies. In 1989, WP&L initiated investigation of these manufactured gas plant sites. The Wisconsin Department of Natural Resources ("DNR") has been involved in reviewing preliminary investigation plans and has received reports regarding these investigations. Based on the results of WP&L's preliminary investigations, WP&L recorded an estimated liability and corresponding deferred charge of approximately $15 million as of December 31, 1991. In 1992, and into the beginning of 1993, WP&L continued its investigations and studies. WP&L confirmed that there was no contamination at two of the sites and received a close out letter from the DNR related to one of those sites and requested a close out letter for the other site. Additionally, the investigation of historical records at a third site indicated a minimal likelihood of any significant environmental impacts. In February 1993, WP&L completed more current cost estimates for the environmental remediation of the eight remaining sites. The results of this more current analysis indicated that during the next 35 years, WP&L will expend approximately $81 million for feasibility studies, data collection, soil remediation activities, groundwater research and groundwater remediation activities, including construction of slurry containment walls and the installation of groundwater pump and treatment facilities. This estimate was based on various assumptions, and is subject to continuous review and revision by management. Based on the cost estimate set forth above, which assumes a 4 percent average inflation over the 35 year period, WP&L will spend approximately $4.2 million, $1.5 million, $2.1 million, $4.4 million and $4.2 million in 1994 through 1998, respectively. The cost estimate also contemplates that primarily groundwater pump and treatment activities will take place after 1998 through and including 2027. During this time, WP&L estimates that it will incur average annual costs of $2.0 million to complete the planned groundwater remediation activities. With respect to rate recovery of these costs, the PSCW has approved a five year amortization of the unamortized balance of incurred environmental costs deferred to date. Based on the present regulatory record at the PSCW, management believes that future costs of remediating these manufactured gas plant sites will be recovered in rates. HDC Incorporated in 1988, HDC is the parent company of all nonutility companies within the holding company system. HDC and its principal subsidiaries are engaged in business development in three major areas: (1) environmental engineering and consulting through the Environmental Holding Company ("EHC") which is the parent company of RMT, Inc. ("RMT"), Jones and Neuse, Inc. ("J & N"), Hydroscience, Inc. ("Hydroscience") and Four Nines, Inc. ("Four Nines"), (2) affordable housing and historic rehabilitation properties through Heartland Properties, Inc. ("HPI"), and (3) energy related products and services which includes, in addition to Enserv, Inc., the recent acquisition of A&C Enercom, EcoGroup, and Entec Consulting, Inc. At year-end 1993, HDC employed 1,391 persons, of whom 830 were considered environmental engineering and consulting employees. ENVIRONMENTAL ENGINEERING AND CONSULTING: RMT was acquired by WP&L on July 30, 1983 and became a wholly owned subsidiary of HDC in March 1988. In 1992, HDC transferred to EHC its ownership of RMT. RMT is a Madison, Wisconsin-based environmental and engineering consulting company that serves clients nationwide in a variety of industrial segment markets. The most significant of these are foundries, chemical companies, pulp and paper processors and other manufacturers. RMT specializes in solid and hazardous waste management, ground water quality protection, industrial design and hygiene engineering, laboratory services, and air and water pollution control. RMT owns and operates chemical and soil-testing laboratories in Madison, Wisconsin and leases biological-testing laboratories in Greenville, South Carolina. The company believes that RMT will be favorably impacted by the enforcement of current environmental regulations and programs, and legislation and regulations being developed or implemented to address ground-water protection, acid rain, and air and water toxics legislation and regulations. During 1993, HDC acquired three environmental consulting and engineering service companies J & N, Hydroscience and Four Nines which are being treated as operating subsidiaries of RMT. J & N is operating out of Austin, Texas as RMT's Gulf Coast Region. J & N also has four additional Texas offices, a Louisiana office and a Mexican subsidiary, ABC Estudios y Projectos. It provides full capabilities in air quality, water quality, hazardous and solid waste engineering, and remedial projects. Hydroscience is a South Carolina based consulting engineering firm specializing in wastewater treatment and toxicity assessments to industrial and municipal entities. Four Nines is a Philadelphia based company specializing in air pollution control engineering. See "Item 8. Financial Statements and Supplementary Data", Notes to Consolidated Financial Statements, Note 12, for financial information related to business segments. OTHER NONREGULATED Formed by HDC on June 24, 1988, HPI is responsible for the development and management of the company's real estate and housing investments. HPI's primary focus has been the development, construction and management of affordable housing and historic rehabilitation properties in selected Wisconsin communities. As of December 31, 1993, HPI's level of investment in housing was approximately $91 million, providing nearly 2,175 units to a diverse group of residents. As in prior years, long-term financing on many new investments has been structured with the cooperation of municipal housing and community development authorities. In 1993, HPI enhanced its operations with the organization of two new subsidiaries: (1) Toolkit Property Management Systems, Inc. ("Toolkit") and Heartland Retirement Services, Inc. ("HRS"). Toolkit provides property management services for many of HPI's housing investments, aiming to attract and maintain good residents. HRS provides a comprehensive range of housing related products for the fastest growing segment of the American population, older adults. To facilitate HPI's development and financing efforts, HDC incorporated Capital Square Financial Corporation ("Capital Square") in 1992 to provide mortgage banking services to the affordable housing market. Capital Square has become a Federal National Mortgage Association ("FNMA") single and multi-family seller-servicer. This designation enables Capital Square to underwrite first mortgages on affordable housing investments to be packaged by FNMA for resale to the secondary markets as mortgaged backed securities. ENSERV has historically focused its efforts on the commercialization of a coal-benefication process called "K-Fuel". "K-Fuel" is a registered trademark for a low-sulfur, high-energy content processed coal. ENSERV is continuing to pursue commercialization of the "K-Fuel" process, but there is no assurance that this commercialization can be successfully completed. HDC acquired A&C Enercom ("A&C") in February 1993. A&C is based out of Atlanta, Georgia, and provides marketing and demand side management services primarily to public electric and gas utility companies. They have 13 offices spread throughout the United States. During 1993, HDC also acquired Entec Consulting, Inc. ("Entec"), a Madison, Wisconsin based firm, to act as a subsidiary of A&C. Entec provides full-service consulting to the utility industry for power generation computer software programs. A&C acquired EcoGroup, a Phoenix, Arizona based company during 1993. EcoGroup provides energy and environmental programs primarily for the electric and gas utility industry. All references to the company or WPL Holdings, Inc. herein include the company and its subsidiaries, except where the context otherwise indicates. ITEM 2. ITEM 2. PROPERTIES WP&L The following table gives information with respect to electric generating facilities of WP&L (including WP&L's portion of those facilities jointly owned). The maximum net hourly peak load on WP&L's electric system was 1,971,000 kwh's and occurred on August 26, 1993. At the time of such peak load, 2,310,000 kwh's were produced by generating facilities operated by WP&L (including other company shared jointly owned facilities) and WP&L delivered 812,000 kwh's of power and received 473,000 kwh's of power from external sources. During the year ended December 31, 1993, about 86.4 percent of WP&L's total kilowatthour requirements was generated by company-owned and jointly-owned facilities and the remaining 13.6 percent was purchased. Substantially all of WP&L's facilities are subject to the lien of its first mortgage bond indenture. HDC: The following table gives information with respect to rental properties associated with HDC's affordable housing and historic rehabilitation project developments (through its subsidiary, HPI) as of December 31, 1993. Occupancy rates in the 66 properties/investments owned by HPI averaged 92 percent during 1993. This occupancy percentage excludes properties in the first six months of initial occupancy. Substantially all of these properties are pledged as security for HDC's mortgage notes and bonds payable. See page 3 of "Item 1. Business-HDC", for a discussion of additional properties owned by HDC's subsidiaries. ITEM 3. ITEM 3. LEGAL PROCEEDINGS There are no material pending legal proceedings, other than ordinary routine litigation incidental to the business, to which the company or any of its subsidiaries is a party or to which any of their property is subject. ENVIRONMENTAL MATTERS The information required by Item 3 is included in this Form 10-K as Item 8 - Notes to Consolidated Financial Statements, Note 10c, incorporated herein by reference. RATE MATTERS The information required by Item 3 is included in Item 7 of this Form 10-K within the Management's Discussion and Analysis of Financial Condition and Results of Operations narrative under the caption "Rates and Regulatory Matters." ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. EXECUTIVE OFFICERS OF THE REGISTRANT Erroll B. Davis, Jr, 49, was elected President on January 17, 1990 and Chief Executive Officer, effective July 1, 1990. He has served as President and Chief Executive Officer of WP&L since August 1, 1988. Prior positions held with WP&L include, Executive Vice President, May 1984, Vice President - Finance and Public Affairs, November 1982 and Vice President - Finance, August 1978. Mr. Davis was elected President of WPL Holdings, Inc. on January 17, 1990. He has served as a director of WPL Holdings, Inc. since March 1988. Daniel A. Doyle, 35, was appointed controller and treasurer of WP&L effective October 3, 1993. He previously served as controller of WP&L since July 1992. Prior to joining the company, he was Controller of Central Vermont Public Service Corporation since December 1988. During the period 1981 to 1988, he was employed by Arthur Andersen & Co. as an Audit Staff Assistant, Audit Senior and Audit Manager with primary responsibilities of auditing and providing financial consulting services to large publicly held corporations. Mr. Doyle functions as the principal accounting officer of the company. Edward M. Gleason, 53, was elected Vice President, Treasurer and Corporate Secretary effective October 3, 1993. He previously served as Vice President-Finance and Treasurer of WP&L since May 1986, Controller and Treasurer of WP&L since October 1985 and Treasurer of WP&L since May 1983. Mr. Gleason functions as the principal financial officer of the company. Steve F. Price, 41, was appointed Assistant Corporate Secretary and Assistant Treasurer on April 15, 1992. He had been Cash Management Supervisor since December 1987. He was also appointed Assistant Corporate Secretary of WP&L on April 15, 1992. NOTE: All ages are as of December 31, 1993. None of the executive officers listed above is related to any director of the Board or nominee for director of the company. Executive officers of the company have no definite terms of office and serve at the pleasure of the Board of Directors. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS At December 31, 1993, there were approximately 38,626 holders of record of the company's Common Stock including underlying holders in the company's Employee Stock Ownership Plan and the company's Dividend Reinvestment and Stock Purchase Plan. Cash dividends paid per share of common stock during 1993 and 1992 were 47.5 cents and 46.5 cents, respectively, for each quarter, for a total of $1.90 and $1.86 per share, respectively for each year. ITEMS 6 and 7. SELECTED FINANCIAL DATA AND MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION WPL HOLDINGS, INC. Management's Discussion and Analysis of Financial Condition and Results of Operations 1993 COMPARED WITH 1992 OVERVIEW Earnings per share of WPL Holdings, Inc. (the "company") common stock increased to $2.11 in 1993 compared with $2.10 in 1992. The increase in earnings primarily reflects an increase in earnings from the company's utility subsidiary, Wisconsin Power and Light Company ("WP&L"). The principle factors leading to increased earnings include warmer summer weather and lower electric fuel costs per kilowatthour ("kWh") which yielded higher electric gross margins for WP&L. These increases were somewhat offset by increased depreciation expense resulting from additional investment in utility plant and property additions, a change in the mix of gas sales from higher margin sales to lower margin sales, the increase in the Federal corporate tax rate from 34% to 35% and a one-time 4-cent-per-share charge associated with a voluntary separation program for the executive management group at the utility. The company's nonregulated subsidiary, Heartland Development Corporation ("HDC"), contributed to earnings through its principal businesses: (1) environmental engineering and consulting, (2) affordable housing and (3) energy products and services. Electric Operations WP&L's electric margin in dollars increased during 1993 compared with 1992 due to increased demand for electricity brought on by warmer summer weather. Residential customers, being the most weather sensitive, experienced the most significant increases. Wisconsin's strong economy kept the Commercial and Industrial classes growing steadily. These increases were coupled with declining electric production fuel costs per kWh. The decrease in electric production fuels is due to WP&L's aggressive pursuit of additional spot coal purchase opportunities as its longer term contracts begin to expire. Additionally, a highly competitive rail transportation environment has significantly reduced the cost of transporting the coal. Also, lower cost purchased power became available due to excess capacity in the bulk power market. Gas Operations WP&L's gas revenues for 1992 were affected by the recognition of a $4.9 million, before-tax refund to its natural gas customers resulting from an adjustment in the calculation of the purchased gas adjustment clause. Without the impact of this revenue adjustment, comparative gas margins would have declined for 1993 compared with 1992. The overall increases in gas revenues and purchased gas costs between years resulted primarily from increased volumes procured on behalf of transportation customers. This had the impact of decreasing margins as a percentage of total revenues. A change in the mix of gas sales from higher margin residential sales to lower margin sales also moved margins downward. Offsetting this decline, Wisconsin's strong economy enabled growth in the Commercial and Industrial classes, and there was also some overall increase in the demand for natural gas due to colder weather. Fees, Rents and Other Operating Revenues ("Other Revenues") and Other Operation Expense Other revenues increased between years as a result of RMT, Inc.'s ("RMT") and HPI's growth in their respective businesses and the result of acquisitions in the environmental and energy businesses. Other operation expense also increased as a result of the above factors. An additional increase resulted from higher WP&L employee benefit expense (See Notes to Consolidated Financial Statements, Note 8). These increases were offset somewhat by decreases in WP&L's conservation program expenditures and decreases in fees associated with the sale of WP&L's accounts receivable due to a decline in interest rates. Additionally, WP&L's cost management efforts have helped control annual inflationary pressures on general and administrative costs. Maintenance and Depreciation and Amortization Maintenance expense increased for 1993 compared with 1992, primarily due to service restoration expenses related to a severe storm in the summer of 1993. Depreciation and amortization expense increased, principally reflecting increased property additions and the commencement of deferred charge amortizations approved in WP&L's last two rate orders received in December 1992 and October 1993. The most significant amortizations include the amortization related to an acquisition adjustment which resulted from the purchase of transmission facilities and the amortization of costs incurred related to the remediation of former manufactured gas plant sites (See Notes to the Consolidated Financial Statements, Note 10). Allowance for Funds Used During Construction ("AFUDC") Total AFUDC increased in 1993 compared with 1992, reflecting the greater amounts of construction work in progress including the costs associated with WP&L's construction of two 86-megawatt combustion-turbine generators. Interest Expense Interest expense on debt increased between years, primarily due to increased capital expenditures related to HPI's investments in affordable housing. 1992 COMPARED WITH 1991 OVERVIEW Earnings per share of the company's common stock decreased 13 percent to $2.11 in 1992 compared with $2.43 in 1991. A combination of an electric rate decrease in March 1992 and significantly cooler summer weather led to lower electric revenues, gross margins and earnings at WP&L. WP&L's earnings were also affected by the recognition of a $4.9 million, before- tax refund to natural gas customers noted previously. HDC's contribution to earnings was slightly lower in 1992 compared with 1991, primarily due to the recognition in 1991 of a $2.8 million after-tax gain on the sale of a telecommunications investment. Exclusive of the sale, HDC's profitability increased in 1992, due to the success of its investments in affordable housing and the continued growth in the profitability of its environmental consulting business. Electric Operations WP&L's electric margin decreased during 1992 compared with 1991 due to decreased demand for electricity brought on by cooler summer weather. Residential customers, being the most weather sensitive, experienced the most significant decreases. However, improved economic conditions in 1992 kept the Industrial customer class growing steadily. Sales to commercial customers remained flat despite the negative weather impact due to increased customer growth in this sector and the improving economy. As a result of significantly lower weather-related peak demands, sales and revenues to other Class A utilities decreased. Electric production fuels expense decreased in response to reduced kWh sales, lower fuel costs and a greater reliance on purchased power. Purchased power expense increased in 1992 due to the greater availability of purchased power at competitive prices. Gas Operations After adjusting 1992 gas revenues for the customer refund noted previously, both gas revenues and gas margins increased during 1992 compared with 1991. Overall increases in gas revenues between years resulted primarily from the recovery of increased purchased gas costs through the purchased gas adjustment clause. Gas margins benefited from an increase in gas customers. The impacts of weather were comparable between years. Fees, Rents and Other Operating Revenues ("Other Revenues") and Other Operation Expense Other revenues increased between years as a result of RMT's and HPI's growth in their respective businesses. Other operation expense also increased as a result of the above factor. These increases were offset somewhat by reduced costs at WP&L. Contributing to the decrease in costs at WP&L was a decrease in WP&L's conservation program expenditures, a decrease in fees associated with the sale of WP&L's accounts receivable due to a decline in interest rates, and reduced employee benefit expenses. Additionally, WP&L's cost management efforts have helped control annual inflationary pressures on general and administrative costs. Maintenance and Depreciation and Amortization Expense Maintenance expense increased for 1992 compared with 1991, primarily due to an increased tree trimming program, increased costs associated with scheduled overhauls at generating units and major service restoration expenses related to three tornados which caused extensive damage to WP&L's service territory during the summer of 1992. Depreciation expense increased, principally reflecting increased property additions. Allowance for Funds Used During Construction ("AFUDC") and Other, net Total AFUDC increased in 1992 compared with 1991, reflecting the greater amounts of construction work in progress which includes the costs associated with WP&L's construction of two 86-megawatt combustion-turbine generators. Other, net decreased between years primarily due to a $2.8 million after-tax gain on the sale of certain nonutility investments that was recorded in 1991. Interest Expense Interest expense on debt increased between years, primarily due to the financing of increased capital expenditures related to HPI's investments in affordable housing and to increased debt outstanding at WP&L to fund construction activity. This increase was somewhat offset by WP&L's refinancing activities during 1992. To take advantage of recent low interest rates, WP&L issued $279 million principal amount of first mortgage bonds, of which $235 million was used to refinance the aggregate principal amount of existing series. The bonds, which had coupon payments ranging from 8 to 10 percent, were replaced with issues having coupons of 6.125 percent to 8.6 percent. Income Taxes Income taxes decreased between years, primarily due to lower taxable income and an increase in tax credits associated with affordable housing investments in 1992 compared with 1991. LIQUIDITY AND CAPITAL RESOURCES Rates and Regulatory Matters On September 30, 1993, WP&L received final decisions from the PSCW on its retail rate application filed in early 1993. The final order authorized an annual retail electric rate increase of $15.6 million, or 3.8 percent; a natural gas rate increase of $1.8 million, or 1.4 percent; and a nominal water rate increase. The new rates became effective October 1, 1993 and will remain effective until January 1, 1995. The regulatory return on common equity for WP&L was reduced from 12.4 percent to 11.6 percent. The allowed rates of return authorized by WP&L's regulators have decreased due to declines in debt capital costs and equity investor rate of return expectations. On August 6, 1993 the Federal Energy Regulatory Commission ("FERC") approved WP&L's request for a $2.1 million, or 2.9 percent increase in wholesale rates. The rates became effective October 1, 1993. Electric and Gas Sales Outlook To deal with competitive pressures arising from regulatory changes, WP&L is forecasting to hold retail rates flat through 1996. This objective arises from the competitive pressures forced by changes in regulation. The National Energy Policy Act contains a provision calling for "open transmission access". WP&L anticipates that retail wheeling will become a reality within a few years. In order to meet these new competitive challenges and maintain a low cost pricing advantage, WP&L's objective is to manage costs to maintain profitability while limiting any rate changes until 1997. These forecasts are subject to a number of assumptions, including the economy and weather. WP&L anticipates that its customer base will remain strong in the electric sectors and that favorable gas prices over alternative fuels prices should result in sales growth in gas sectors. Growth in customers' demand for electric service will require capacity additions. Capacity requirements will be met through increased generating capacity (two combustion-turbines in mid-1994), continuation of existing long-term contracts for purchase of capacity, increased efficiency at existing power plants from capital improvements and continued emphasis on cost effective demand-side management programs such as direct load control rate options including interruptible rates and conservation programs. Financing and Capital Structure The level of short-term borrowings fluctuates based on seasonal corporate needs, the timing of long-term financing and capital market conditions. The company's operating subsidiaries generally issue short-term debt to provide interim financing of construction and capital expenditures in excess of available internally generated funds. The subsidiaries periodically reduce their outstanding short-term debt through the issuance of long-term debt and through the company's additional investment in their common equity. To maintain flexibility in its capital structure and to take advantage of favorable short-term rates, the company, through WP&L, also uses proceeds from the sales of accounts receivable and unbilled revenues to finance a portion of its long-term cash needs. The company also anticipates that short-term debt funds will continue to be available at reasonable costs due to strong ratings by independent utility analysts and rating services. Commercial paper has been rated A-1+ by Standard & Poor's Corp. (S&P) and P-1 by Moody's Investors Service (Moody's). Bank lines of credit of $100 million at December 31, 1993 are available to support these borrowings. The company's capitalization at December 31, 1993, including the current maturities of long-term debt, variable rate demand bonds and short-term debt, consisted of 47.9 percent common equity, 4.9 percent preferred stock and 47.2 percent long-term debt. The common equity to total capitalization ratio at December 31, 1993 increased to 47.9 percent from 44.2 percent at December 31, 1992 due to the issuance of 1.65 million shares of Company common stock. The net proceeds from the public offering of $56.7 million were used to repay the short-term debt of its subsidiaries and for general corporate purposes, including construction. A retail rate order effective October 1, 1993, requires WP&L to maintain a utility common equity level of 50.31 percent of total utility capitalization during the test year August 1, 1993 to July 31, 1994. In addition, the PSCW ordered that it must approve the payment of dividends by WP&L to the company that are in excess of the level forecasted in the projected test year ($56.8 million), if such dividends would reduce WP&L's average common equity ratio below 50.31 percent. Capital Requirements The company's largest subsidiary, WP&L, is capital-intensive and requires large investments in long-lived assets. Therefore, the company's most significant capital requirements relate to WP&L construction expenditures. Estimated capital requirements of WP&L for the next five years are as follows: Included in the construction expenditure estimates, in addition to the recurring additions and improvements to the distribution and transmission systems, are the following: expenditures for managing and controlling electric line losses and for the electric delivery system which will save electric line losses and enhance WP&L's interconnection capability with other utilities; expenditures related to environmental compliance issues including the installation of additional emissions monitoring equipment and coal handling equipment; and expenditures associated with the construction of two 86-megawatt combustion-turbine generators expected to become operational in 1994 through 1996. In addition, the steam generator tubes at the Kewaunee Nuclear Power Plant ("Kewaunee") are susceptible to corrosion characteristics seen throughout the nuclear industry. Annual inspections are performed to identify degraded tubes. Degraded tubes are either repaired by sleeving or are removed with approximately 15 percent heat transfer margin, meaning that full power should be sustainable with the equivalent of 15 percent of the steam generator tubes plugged. Currently, the equivalent of 10 percent of the tubes in the steam generators are plugged. WP&L and the other joint owners continue to evaluate appropriate strategies, including replacement, as well as continued operation of the steam generators without replacement. WP&L and the joint owners intend to operate Kewaunee until at least 2013, the expiration of the present operating license. WP&L and the joint owners are also evaluating initiatives to improve the performance of Kewaunee. These initiatives include funding of the development of welded repair technology for steam generator tubes and numerous cost reduction measures such as the conversion from a 12-month to an 18-month fuel cycle. If the steam generators are not replaced, and excluding the possible affect of the aforementioned repair strategies, a gradual power reduction of approximately 1 percent per year may begin as soon as 1995. HDC has expanded its energy related products and services business and its environmental services through acquisitions during 1993. In addition to increasing its investment in affordable housing, HPI continues to market its affordable housing expertise by expanding its business to provide assistance to other corporate/public investors in their development, consultation and financing of affordable housing projects. Capital Resources One of the company's objectives is to finance construction expenditures through internally generated funds supplemented, when required, by outside financing. With this objective in place, the company has financed an average of 62 percent of its construction expenditures during the last five years from internal sources. However, during the next five years, the company expects this percentage to be reduced primarily due to the continuation of major construction expenditures and the maturity of $64 million of WP&L first mortgage bonds. External financing sources such as the issuance of long-term debt, common stock and short-term borrowings will be used by the company to finance the remaining construction expenditure requirements for this period. Current forecasts are that $71 million of additional equity and $60 million of long-term debt will be issued over the next three years. In 1993, the company increased its dividends by 3.4 percent and issued 451,233 new shares of common stock through its Dividend Reinvestment and Stock Purchase Plan, generating proceeds of $15.3 million. Also in 1993, a public offering of 1.65 million newly issued shares of the company's common stock raised proceeds of approximately $56.7 million. The proceeds were used by the company to refinance the short-term debt of its subsidiaries and for general corporate purposes including construction. Market value per share decreased 3 percent to $32.875 per share at December 31, 1993 compared with $33.875 per share at December 31, 1992. Return on equity for 1993 was 11.5 percent and has averaged 13.0 percent over the last five years. INFLATION Under current ratemaking methodologies prescribed by the various commissions that regulate WP&L, projected or forecasted operating costs, including the impacts of inflation, are incorporated into WP&L revenue requirements. Accordingly, the impacts of inflation on WP&L are currently mitigated. Inflationary impacts on the nonregulated businesses are not anticipated to be material to the company. FINANCIAL ACCOUNTING STANDARDS BOARD (the "FASB") ACCOUNTING STANDARDS ISSUED BUT NOT YET EFFECTIVE In November 1992, the FASB issued Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" ("SFAS 112"). SFAS 112 requires adoption of the new accounting and disclosure rules effective January 1, 1994. The impact on earnings will not be material. OTHER EVENTS In November 1989, the PSCW concluded that WP&L did not properly administer a coal contract, resulting in an assessment to compensate ratepayers for excess fuel costs having been incurred. As a result, WP&L recorded a reserve in 1989 which had an after-tax affect of reducing 1989 net income by $4.9 million. The PSCW decision was found to represent unlawful retroactive ratemaking by both the Dane County Circuit Court and the Wisconsin Court of Appeals. The case was then appealed to the Wisconsin Supreme Court. Subsequent to December 31, 1993, the Wisconsin Supreme Court affirmed the decisions of the Dane County Circuit Court and Wisconsin Court of Appeals. Given the continued uncertainty related to the ultimate method of collection of the assessment from ratepayers to be approved by the PSCW, it is management's opinion that the financial impact of the Wisconsin Supreme Court's decision on the company cannot currently be determined and will require further evaluation. As a result, WP&L does not plan to adjust the reserve. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To WPL Holdings, Inc.: We have audited the accompanying consolidated balance sheets and statements of capitalization of WPL HOLDINGS, INC. (a Wisconsin corporation) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, common shareowners' investment and cash flows for each of the three years in the period ended December 31, 1993. 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 financial statements referred to above present fairly, in all material respects, the financial position of WPL Holdings, Inc. and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Milwaukee, Wisconsin, ARTHUR ANDERSEN & CO. January 28, 1994. The accompanying notes are an integral part of the consolidated financial statements. The accompanying notes are an integral part of the consolidated financial statements. The accompanying notes are an integral part of the consolidated financial statements. The accompanying notes are an integral part of the consolidated financial statements. The accompanying notes are an integral part of the consolidated financial statements. WPL HOLDINGS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING AND REPORTING POLICIES: a. Business and Consolidation: WPL Holdings, Inc. (the "company" or "WPLH") is the parent holding company of Wisconsin Power and Light Company ("WP&L") and Heartland Development Corporation ("HDC"). The consolidated financial statements include the company and its consolidated subsidiaries, WP&L and HDC, along with their respective subsidiaries. All significant intercompany transactions have been eliminated in consolidation. Certain amounts from prior years have been reclassified to conform with the current year presentation. WP&L is a public utility predominantly engaged in the transmission and distribution of electric energy and the generation and bulk purchase of electric energy for sale. WP&L also transports, distributes and sells natural gas purchased from gas suppliers. Nearly all of WP&L's customers are located in south and central Wisconsin. WP&L's principal consolidated subsidiary is South Beloit Water, Gas and Electric Company. HDC and its principal subsidiaries are engaged in business development in three major areas: (1) environmental engineering and consulting through the Environmental Holding Company ("EHC") which is the parent company of RMT, Inc. ("RMT"), Jones and Neuse, Inc., Hydroscience, Inc. and Four Nines, Inc., (2) affordable housing and historic rehabilitation through Heartland Properties, Inc. ("HPI") and (3) energy related products and services which includes, in addition to Enserv, Inc., the recent acquisition of A&C Enercom, EcoGroup and Entec Consulting, Inc.. b. Regulation: WP&L's financial records are maintained in accordance with the uniform system of accounts prescribed by its regulators. The Public Service Commission of Wisconsin ("PSCW") and the Illinois Commerce Commission have jurisdiction over retail rates, which represent approximately 86 percent of electric revenues plus all gas revenues. The Federal Energy Regulatory Commission ("FERC") has jurisdiction over wholesale electric rates representing the balance of electric revenues. Statement of Financial Accounting Standards No. 71, "Accounting for the Effects of Certain Types of Regulation" provides that rate-regulated public utilities such as WP&L record certain costs and credits allowed in the ratemaking process in different periods than for the unregulated entities. These are deferred as regulatory assets or regulatory liabilities and are recognized in the Consolidated Statements of Income at the time they are reflected in rates. c. Utility Plant and Other Property and Equipment: Utility plant and other property and equipment are recorded at original cost and cost, respectively. Utility plant costs include financing costs which are capitalized through the PSCW-approved allowance for funds used during construction ("AFUDC"). The AFUDC capitalization rates approximate WP&L's cost of capital. These capitalized costs are recovered in rates as the cost of the utility plant is depreciated. Normal repairs and maintenance and minor items of utility plant and other property and equipment are expensed. Ordinary utility plant retirements, including removal costs less salvage value, are charged to accumulated depreciation upon removal from utility plant accounts, and no gain or loss is recognized. Upon retirement or sale of other property and equipment, the cost and related accumulated depreciation are removed from the accounts and any gain or loss is included in other income and deductions. d. Nuclear Fuel: Nuclear fuel is recorded at its original cost and is amortized to expense based upon the quantity of heat produced for the generation of electricity. This accumulated amortization assumes spent nuclear fuel will have no residual value. Estimated future disposal costs of such fuel are expensed based on kilowatthours ("Kwh") generated. e. Revenue: WP&L accrues utility revenues for services provided but not yet billed. f. Fuel and Purchased Gas: An automatic fuel adjustment clause for the FERC wholesale portion of WP&L's electric business operates to increase or decrease monthly rates based on changes in fuel costs. The PSCW retail electric rates provide a range from which actual fuel costs may vary in relation to costs forecasted and used in rates. If actual fuel costs fall outside this range, a hearing may be held to determine if a rate change is necessary, and a rate increase or decrease can result. WP&L's base gas cost recovery rates permit the recovery of or refund to all customers for any increases or decreases in the cost of gas purchased from WP&L's suppliers through a monthly purchased gas adjustment clause. g. Cash and Equivalents: The company considers all highly liquid debt instruments purchased with a maturity of three months or less to be cash equivalents. The carrying amount approximates fair value because of the short maturity of these items. h. Income Taxes: The company files a consolidated federal income tax return. Under the terms of an agreement between WPLH and its subsidiaries, WP&L and HDC calculate their respective federal tax provisions and make payments to WPLH as if they were separate taxable entities. Beginning in 1993, the company fully provides deferred income taxes in accordance with Statement of Financial Accounting Standards No.109, "Accounting for Income Taxes" ("SFAS 109"), to reflect tax effects of reporting book and tax items in different periods. NOTE 2. DEPRECIATION: The company uses the straight-line method of depreciation. For utility plant, straight-line depreciation is computed on the average balance of depreciable property at individual straight-line PSCW approved rates as follows: Electric Gas Water Common -------- --- ----- ------ 1993 3.6% 3.7% 2.5% 7.3% 1992 3.4 3.7 2.6 7.1 1991 3.4 3.7 2.6 6.9 Estimated useful lives related to other property and equipment are from three to 12 years for equipment and 31.5 to 40 years for buildings. NOTE 3. NUCLEAR OPERATIONS: Depreciation expense related to the Kewaunee Nuclear Power Plant includes a provision for the decommissioning of the plant which totaled $6.1 million, $3.9 million and $4.1 million in 1993, 1992 and 1991, respectively. Wisconsin utilities with ownership of nuclear generating plants are required by the PSCW to establish external trust funds to provide for plant decommissioning. The market value of the investments in the funds established by WP&L at December 31, 1993 and 1992, totaled $45.1 million and $42.8 million, respectively. WP&L's share of the decommissioning costs is estimated to be $149 million (in 1993 dollars, assuming the plant is operating through 2013) based on a 1992 study, using the immediate dismantlement method of decommissioning. Under the Nuclear Waste Policy Act of 1982, the U.S. Department of Energy ("DOE") is responsible for the ultimate storage and disposal of spent nuclear fuel removed from nuclear reactors. Interim storage space for spent nuclear fuel is currently provided at the Kewaunee Nuclear Power Plant. Currently there is on-site storage capacity for spent fuel through the year 1999. Nuclear fuel, net, at December 31 1993 and 1992, consists of (In Thousands of Dollars): 1993 1992 ---- ---- Original cost of nuclear fuel $147,325 $140,652 Less--Accumulated amortization 129,325 123,729 -------- -------- Nuclear fuel, net $ 18,000 $ 16,923 ======== ======== The Price Anderson Act provides for the payment of funds for public liability claims arising from a nuclear incident. Accordingly, in the event of a nuclear incident, WP&L, as a 41 percent owner of the Kewaunee Nuclear Power Plant, is subject to an overall assessment of approximately $32.5 million per incident for its ownership share of this reactor, not to exceed $4.1 million payable in any given year. Through its membership in Nuclear Electric Insurance Limited, WP&L has obtained property damage and decontamination insurance totaling $1.4 billion for loss from damage at the Kewaunee Nuclear Power Plant. In addition, WP&L maintains outage and replacement power insurance coverage totalling $99 million in the event an outage exceeds 21 weeks. NOTE 4. PROPERTY: a. Jointly Owned Utility Plants: WP&L participates with other Wisconsin utilities in the construction and operation of several jointly owned utility generating plants. The chart below represents WP&L's proportionate share of such plants as reflected in the Consolidated Balance Sheets at December 31, 1993 and 1992 (In Thousands of Dollars): Each of the respective joint owners finances its portion of construction costs. WP&L's share of operations and maintenance expenses is included in the Consolidated Statements of Income. b. Other Property and Equipment: As of December 31, 1993 and 1992, other property and equipment, net includes $100.9 million and $94.4 million, respectively, consisting primarily of rental property and equipment associated with HPI's affordable housing and historic rehabilitation project developments. c. Capital Expenditures: The company's capital expenditures for 1994 are estimated to total $166.7 million. Substantial commitments have been incurred for such expenditures. NOTE 5. NET ACCOUNTS RECEIVABLE: WP&L has a contract with a financial organization to sell, with limited recourse, certain accounts receivable. These receivables include customer receivables resulting from sales to other public utilities as well as from billings to the co-owners of the jointly owned electric generating plants that WP&L operates. The contract allows WP&L to sell up to $100 million of receivables at any time. Consideration paid to the financial organization under this contract includes, along with various other fees, a monthly discount charge on the outstanding balance of receivables sold that approximated a 4.14 percent annual rate during 1993. These costs are recovered in retail utility rates as an operating expense. All billing and collection functions remain the responsibility of WP&L. The contract expires August 19, 1995, unless extended by mutual agreement. As of December 31, 1993 and 1992, proceeds from the sale of accounts receivable totaled $74 million and $69 million, respectively. During 1993, WP&L sold an average of $75.9 million of accounts receivable per month, compared with $68.8 million in 1992. As a result of its diversified customer base and WP&L's sale of receivables, the company does not have any significant concentrations of credit risk in the December 31, 1993 net accounts receivable balance. NOTE 6. DEFERRED CHARGES AND OTHER: Certain costs are deferred and amortized in accordance with authorized or expected rate-making treatment. As of December 31, 1993 and 1992, deferred charges and other include regulatory created assets and other noncurrent items representing the following (In Thousands of Dollars): 1993 1992 ---- ---- Unamortized debt redemption expense $ 13,178 $15,384 Decontamination and decommissioning costs of Federal enrichment facilities 6,181 6,150 Prepaid pension costs 26,128 21,226 Conservation loans to WP&L customers (at cost which approximates market) 12,236 12,257 Goodwill 21,622 - Tax related (see Note 7) 28,608 - Emission allowance credits receivable 5,335 5,335 Other 48,058 27,684 ------- ------ $161,346 $88,036 ======== ======= NOTE 7. INCOME TAXES: The following table reconciles the statutory Federal income tax rate to the effective income tax rate: 1993 1992 1991 ---- ---- ---- Statutory Federal income tax rate 35.0% 34.0% 34.0% State income taxes, net of federal benefit 5.1 7.0 5.0 Investment tax credits restored (2.1) (2.7) (2.2) Amortization of excess deferred taxes (1.7) (1.8) (1.6) Affordable housing and historical tax credits (5.7) (7.5) (1.9) Other differences, net (3.2) (.6) (.4) ---- ---- ---- Effective income tax rate 27.4% 28.4% 32.9% ==== ==== ==== The breakdown of income tax expense as reflected in the Consolidated Statements of Income is as follows (In Thousands of Dollars): 1993 1992 1991 ---- ---- ---- Income taxes: Current Federal $20,725 $19,703 $26,775 Current state 6,500 5,343 5,904 Deferred 5,015 8,124 4,571 Investment tax credit restored (1,967) (2,125) (2,141) Affordable housing and historical tax credits (5,217) (7,788) (2,719) ------- ------- ------- $25,056 $23,257 $32,390 ======= ======= ======= Items which resulted in deferred income tax expense are as follows (In Thousands of Dollars): 1992 1991 ---- ---- Utility plant timing differences $4,104 $4,317 Qualified nuclear decommissioning trust contribution 709 709 Employee benefits 2,081 2,105 Other, net 1,230 (2,560) ------ ------ $8,124 $4,571 ====== ====== The temporary differences that resulted in accumulated deferred income tax assets and liabilities as of December 31, 1993 are as follows (In Thousands of Dollars): Deferred Tax (Assets) Liabilities ------------ Accelerated depreciation and other plant related $171,993 Excess deferred taxes 22,744 Unamortized investment tax credits (22,812) Allowance for equity funds used during construction 13,518 Regulatory liability 19,179 Other 8,222 -------- $212,844 ======== Changes in WP&L's deferred income taxes arising from the adoption of SFAS 109 represent amounts recoverable or refundable through future rates and have been recorded as net regulatory assets totalling approximately $29 million on the Consolidated Balance Sheets. These net regulatory assets are being recovered in rates over the estimated remaining useful lives of the assets to which they pertain. As part of HPI's investments in affordable housing, HPI is eligible to claim affordable housing and historic rehabilitation credits. These tax credits can be recognized to the extent the company has consolidated taxes payable against which the qualifying credits can be benefitted. NOTE 8. EMPLOYEE BENEFIT PLANS: a. Pension Plans: WP&L has noncontributory, defined benefit retirement plans covering substantially all employees. The benefits are based upon years of service and levels of compensation. WP&L's funding policy is to contribute at least the statutory minimum to a trust. The projected unit credit actuarial cost method was used to compute net pension costs and the accumulated and projected benefit obligations. The discount rate used in determining those benefit obligations was 7.25 percent for 1993, and 8 percent for 1992 and 1991. The long-term rate of return on assets used in determining those benefit obligations was 9.75 percent for 1993 and 10 percent for 1992 and 1991. The following table sets forth the funded status of the WP&L plans and amounts recognized in the company's Consolidated Balance Sheets at December 31, 1993 and 1992 (In Thousands of Dollars): 1993 1992 ---- ---- Accumulated benefit obligation-- Vested benefits $(135,303) $(119,883) Nonvested benefits (2,962) (869) --------- --------- $(138,265) $(120,752) ========= ========= Projected benefit obligation $(164,271) $(144,760) Plan assets at fair value, primarily common stocks and fixed income securities 183,881 164,771 --------- --------- Plan assets in excess of projected benefit obligation 19,610 20,011 Unrecognized net transition asset (21,823) (24,270) Unrecognized prior service cost 7,691 9,510 Unrecognized net loss 20,650 15,975 --------- --------- Prepaid pension costs, included in deferred charges and other $ 26,128 $ 21,226 ========= ========= The net pension (benefit) recognized in the Consolidated Statements of Income for 1993, 1992 and 1991 included the following components (In Thousands of Dollars): 1993 1992 1991 ---- ---- ---- Service cost $ 4,263 $ 3,912 $ 3,167 Interest cost on projected benefit obligation 11,614 10,615 9,469 Actual return on assets (24,759) (12,143) (30,035) Amortization and deferral 8,430 (5,317) 14,603 -------- -------- -------- Net pension (benefit) $ (452) $ (2,933) $ (2,796) ======== ======== ======== b. Postretirement Health-care and Life Insurance: Effective January 1, 1993, the company prospectively adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("SFAS 106"). SFAS 106 establishes standards of financial accounting and reporting for the company's postretirement health-care and life insurance benefits. SFAS 106 requires the accrual of the expected cost of such benefits during the employees' years of service based on actuarial methodologies that closely parallel pension accounting requirements. WP&L has elected delayed recognition of the transition obligation and is amortizing the discounted present value of the transition obligation to expense over 20 years. For WP&L, the cost of providing postretirement benefits, including the transition obligation, is being recovered in retail rates and wholesale rates under current regulatory practices. For 1993, the annual net postretirement benefits costs recognized in the Consolidated Statements of Income consist of the following components (In Thousands of Dollars): Service cost $ 1,463 Interest cost on projected benefit obligation 3,151 Actual return on plan assets (696) Amortization of transition obligation 1,560 Amortization and deferral (27) ------- Net postretirement benefits cost $ 5,451 ======= The following table sets forth the plans' funded status (In Thousands of Dollars): ---- Accumulated postretirement benefit obligation-- Retirees $ (27,358) Fully eligible active plan participants (5,429) Other active plan participants (9,980) --------- Accumulated benefit obligation (42,767) Plan assets at fair value 7,073 --------- Accumulated benefit obligation in excess of plan assets $(35,694) Unrecognized transition obligation 29,638 Unrecognized loss 2,025 --------- Accrued postretirement benefits liability $ (4,031) ========= The postretirement benefits cost components for 1993 were calculated assuming health care cost trend rates ranging from 12.5 percent for 1993 and decreasing to 5 percent by the year 2002. The health care cost trend rate considers estimates of health care inflation, changes in utilization or delivery, technological advances, and changes in the health status of the plan participants. Increasing the health care cost trend rate by one percentage point in each year would increase the accumulated postretirement benefit obligation as of December 31, 1993 by $2.54 million and the aggregate of the service and interest cost components of the net periodic postretirement benefit cost for the year by $.4 million. The assumed discount rate used in determining the accumulated postretirement obligation was 7.25 percent. The long-term rate of return on assets was 9.50 percent. Plan assets are primarily invested in common stock,bonds and fixed income securities. The company's funding policy is to contribute the tax advantaged maximum to a trust. The costs for the postretirement health-care and life insurance benefits, based on an actuarial determination, were $1,335,000 and $1,078,000, respectively, for 1992 and 1991. c. Other Postemployment Benefits: In November 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" ("SFAS 112"). SFAS 112 establishes standards of financial accounting and reporting for the estimated cost of benefits provided by an employer to former or inactive employees after employment but before retirement. The effect of adopting SFAS 112, which must be adopted January 1, 1994, will not be material. NOTE 9. CAPITALIZATION: a. Common Shareowners' Investment: During 1993, 1992 and 1991, respectively, the company issued 451,233, 528,142 and 122,110 new shares of common stock through its Dividend Reinvestment and Stock Purchase Plan, generating proceeds of $15.3 million, $17.5 million and $3.3 million, respectively. On April 27, 1993, a public offering of 1.65 million newly issued shares of the company's common stock, priced at $35.50 per share, raised net proceeds of $56.7 million. The proceeds were used by the company to refinance short-term debt and for general corporate purposes including construction. In February 1989, the Board of Directors of the company declared a dividend distribution of one common stock purchase right ("right") on each outstanding share of the company's common stock. Each right would initially entitle shareowners to buy one-half of one share of the company's common stock at an exercise price of $60.00 per share, subject to adjustment. The rights are not currently exercisable, but would become exercisable if certain events occurred related to a person or group acquiring or attempting to acquire 20 percent or more of the outstanding shares of common stock. The rights expire on February 22, 1999, unless the rights are earlier redeemed or exchanged by the company. Authorized shares of common stock total 100,000,000 as of December 31, 1993, and can be categorized as follows: No. Of Shares ------------- Issued and outstanding 30,438,654 Reserved for issuance for Dividend Reinvestment and Stock Purchase Plan 891,874 Common Stock Rights Agreement 15,665,264 Unreserved 53,004,208 ----------- Total authorized 100,000,000 =========== A retail rate order effective October 1, 1993, requires WP&L to maintain a utility common equity level of 50.31 percent of total utility capitalization during the test year August 1, 1993 to July 31, 1994. In addition, the PSCW ordered that it must approve the payment of dividends by WP&L to the company that are in excess of the level forecasted in the projected test year ($56.8 million), if such dividends would reduce WP&L's average common equity ratio below 50.31 percent. b. Preferred Stock: On October 27, 1993, WP&L issued two new series of preferred stock through two separate public offerings. The 6.2% Series is non- redeemable for ten years and the 6.5% Series is non-redeemable for five years. The proceeds from the sale were used to retire 150,000 shares of 7.56% Series and 149,865 shares of 8.48% Series preferred stock. c. Long-term Debt: During 1992, WP&L issued $279 million of first mortgage bonds, of which $235 million was used to refinance the principal of existing series in order to take advantage of lower interest rates. The remaining proceeds were used for the payment of short-term debt and general corporate purposes. Substantially all of WP&L's utility plant is secured by its first mortgage bonds. Current maturities of long-term debt are as follows: $.7 million in 1994, $1.6 million in 1995, $3.3 million in 1996, $56.7 million in 1997 and $11.2 million in 1998. The fair value of the company's long-term debt, including variable rate demand bonds, is estimated at $518,251,000 and $475,909,000 as of December 31, 1993 and 1992, respectively, based on the quoted market prices for similar issues or on the current rates offered to the company for similar debt. NOTE 10. COMMITMENTS AND CONTINGENCIES: a. Coal Contract Commitments: To ensure an adequate supply of coal, WP&L has entered into certain long-term coal contracts. These contracts include a demand or take-or-pay clause under which payments are required if contracted quantities are not purchased. Purchase obligations on these coal and related rail contracts total approximately $263 million through December 31, 2004. WP&L's management believes it will meet minimum coal and rail purchase obligations under the contracts or recover in rates any demand or take-or-pay costs if minimum purchase obligations are not met. Minimum purchase obligations on these contracts over the next five years are estimated to be $67 million in 1994 and $27 million in 1995, 1996, 1997 and 1998, respectively. b. Purchased Power: Under firm purchase power contracts, WP&L is obligated to pay $11 million, $8 million, $5 million, $7 million and $14 million in 1994, 1995, 1996, 1997 and 1998, respectively. For 1994, this represents 2,515 megawatts of capacity. Purchase obligations on these purchase power contracts total approximately $169 million through December 31, 2007. c. Manufactured Gas Plant Sites: Historically, WP&L has owned 11 properties that have been associated with the production of manufactured gas. Currently, WP&L owns five of these sites, three are owned by municipalities, and the remaining three are owned by private companies. In 1989, WP&L initiated investigation of these manufactured gas plant sites. The Wisconsin Department of Natural Resources ("DNR") has been involved in reviewing preliminary investigation plans and has received reports regarding these investigations. Based on the results of WP&L's preliminary investigations, WP&L recorded an estimated liability and corresponding deferred charge of approximately $15 million as of December 31, 1991. In 1992, and into the beginning of 1993, WP&L continued its investigations and studies. WP&L confirmed that there was no contamination at two of the sites and received a close out letter from the DNR related to one of those sites and requested a close out letter for the other site. Additionally, the investigation of historical records at a third site indicated a minimal likelihood of any significant environmental impacts. In February 1993, WP&L completed more current cost estimates for the environmental remediation of the eight remaining sites. The results of this more current analysis indicated that during the next 35 years, WP&L will expend approximately $81 million for feasibility studies, data collection, soil remediation activities, groundwater research and groundwater remediation activities, including construction of slurry containment walls and the installation of groundwater pump and treatment facilities. This estimate was based on various assumptions, and is subject to continuous review and revision by management. Based on the cost estimate set forth above, which assumes a 4 percent average inflation over the 35 year period, WP&L will spend approximately $4.2 million, $1.5 million, $2.1 million, $4.4 million and $4.2 million in 1994 through 1998, respectively. The cost estimate also contemplates that primarily groundwater pump and treatment activities will take place after 1998 through and including 2027. During this time, WP&L estimates that it will incur average annual costs of $2.0 million to complete the planned groundwater remediation activities. With respect to rate recovery of these costs, the PSCW has approved a five year amortization of the unamortized balance of incurred environmental costs deferred to date. Based on the present regulatory record at the PSCW, management believes that future costs of remediating these manufactured gas plant sites will be recovered in rates. d. FERC Order No. 636: In 1992 the FERC issued Order No. 636 and 636-A which requires interstate pipelines to restructure their services. Under these orders, existing pipeline sales service would be "unbundled" such that gas supplies would be sold separately from interstate transportation services (pipelines serving WP&L implemented new services November 1, 1993). Pipelines will, however, seek to recover from their customers certain transition costs associated with restructuring. Any such recovery would be subject to prudence hearings at the FERC and state regulatory commissions. NOTE 11. SHORT-TERM DEBT AND LINES OF CREDIT: The company and its subsidiaries maintain bank lines of credit, most of which are at the bank prime rates, to obtain short-term borrowing flexibility, including pledging lines of credit as security for any commercial paper outstanding. Amounts available under these lines of credit totaled $100 million, $70 million and $52.5 million as of December 31, 1993, 1992 and 1991, respectively. Information regarding short-term debt and lines of credit is as follows (In Thousands of Dollars): NOTE 12. SEGMENT INFORMATION: The following table sets forth certain information relating to the company's consolidated operations (In Thousands of Dollars). NOTE 13. ACQUISITIONS: On August 31, 1993, the company issued 515,993 shares of company common stock in exchange for the outstanding common and preferred stock of Jones and Neuse, Inc. ("JN"), a 250-employee environmental consulting and engineering service firm based in Austin, Texas. This transaction was accounted for as a pooling of interests and all prior periods have been restated accordingly; such restatement was not material. The company intends to position JN as a service region of its own 550-employee environmental consulting and engineering company, RMT, a subsidiary of HDC. In February 1993, HDC acquired A&C Enercom Consultants, Inc. ("A&C"), a Georgia corporation, for cash and new shares of the company's common stock. A&C provides demand side management and energy related consulting services, primarily to public electric and gas utility companies. NOTE 14. CONSOLIDATED QUARTERLY FINANCIAL DATA (Unaudited): Seasonal factors significantly affect WP&L and, therefore, the data presented below should not be expected to be comparable between quarters nor necessarily indicative of the results to be expected for an annual period. The amounts below were not audited by independent public accountants, but reflect all adjustments necessary, in the opinion of the company, for a fair presentation of the data. Operating Operating Earnings Quarter Ended Revenues Income Net Income Per Share -------- --------- ---------- --------- (In Thousands except for Per Share Data) 1993: March 31 (*) $209,250 $36,490 $19,766 $.70 June 30 (*) 173,631 19,872 7,190 .24 September 30 173,869 29,358 13,258 .44 December 31 216,307 40,463 22,309 .73 1992 (*): March 31 $184,346 $36,223 $18,653 $.69 June 30 147,146 17,464 7,268 .26 September 30 156,516 25,624 12,290 .44 December 31 185,265 38,648 19,796 .71 (*) The financial information presented has been restated to reflect the pooling of JN (see Note 13). ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required by Item 10 relating to directors and nominees for election as directors at the company's 1994 Annual Meeting of Shareowners is incorporated herein by reference to the information under the caption "Election of Directors" in the company's Proxy Statement (the "1994 Proxy Statement") filed with the Securities and Exchange Commission. The information required by Item 10 relating to executive officers is set forth in Part I of this Annual Report on Form 10-K. The information required by Item 10 relating to delinquent filers is incorporated herein by reference to the information under the caption "Compliance with Section 16(a) of the Securities Exchange Act of 1934" in the 1994 Proxy Statement. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information required by Item 11 is incorporated herein by reference to the information under the caption "Compensation of Executive Officers" in the 1994 Proxy Statement. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by Item 12 is incorporated herein by reference to the information under the caption "Ownership of Voting Securities" in the 1994 Proxy Statement. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by Item 13 is incorporated herein by reference to the information under the caption "Election of Directors" in the 1994 Proxy Statement. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) (1) Consolidated Financial Statements Included in Part II of this report: Report of Independent Public Accountants on Schedules Consolidated Statements of Income for the Years Ended December 31, 1993, 1992 and 1991 Consolidated Balance Sheets, December 31, 1993 and 1992 Consolidated Statements of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991 Consolidated Statements of Capitalization, December 31, 1993 and 1992 Consolidated Statements of Common Shareowners' Investment Notes to Consolidated Financial Statements (a) (2) Financial Statement Schedules For each of the years ended December 31, 1993, 1992 and 1991 Schedule II. Amounts Receivable from Related Parties Schedule III. Parent Company Financial Statements Schedule V. Property Plant and Equipment Schedule VI. Accumulated Provision for Depreciation and Accumulated Amortization of Nuclear Fuel Schedule VIII. Valuation and Qualifying Accounts and Reserves Schedule X. Supplementary Income Statement Information All other schedules are omitted because they are not applicable or not required, or because that required information is shown either in the consolidated financial statements or in the notes thereto. (a)(3) Exhibits Required by Securities and Exchange Commission Regulation S-K The following Exhibits are filed herewith or incorporated herein by reference. Documents indicated by an asterisk (*) are incorporated herein by reference. 3A* Restated Articles of Incorporation (Exhibit 4.1 to the company's Form S-3 Registration Statement No. 33-59972) 3B* By-Laws of as revised to January 1, 1993 4A* Indenture of Mortgage or Deed of Trust dated August 1, 1941, between WP&L and First Wisconsin Trust Company and George B. Luhman, as Trustees, filed as Exhibit 7(a) in File No. 2-6409, and the indentures supplemental thereto dated, respectively, January 1, 1948, September 1, 1948, June 1, 1950, April 1, 1951, April 1, 1952, September 1, 1953, October 1, 1954, March 1, 1959, May 1, 1962, August 1, 1968, June 1, 1969, October 1, 1970, July 1, 1971, April 1, 1974, December 1, 1975, May 1, 1976, May 15, 1978, August 1, 1980, January 15, 1981, August 1, 1984, January 15, 1986, June 1, 1986, August 1, 1988, December 1, 1990, September 1, 1991, October 1, 1991, March 1, 1992, May 1, 1992, June 1, 1992 and July 1, 1992 (Second Amended Exhibit 7(b) in File No. 2-7361; Amended Exhibit 7(c) in File No. 2-7628; Amended Exhibit 7.02 in File No. 2-8462; Amended Exhibit 7.02 in File No. 2-8882; Second Amendment Exhibit 4.03 in File No. 2-9526; Amended Exhibit 4.03 in File No. 2-10406; Amended Exhibit 2.02 in File No. 2-11130; Amended Exhibit 2.02 in File No. 2-14816; Amended Exhibit 2.02 in File No. 2-20372; Amended Exhibit 2.02 in File No. 2-29738; Amended Exhibit 2.02 in File No. 2-32947; Amended Exhibit 2.02 in File No. 2-38304; Amended Exhibit 2.02 in File No. 2-40802; Amended Exhibit 2.02 in File No. 2-50308; Exhibit 2.01(a) in File No. 2-57775; Amended Exhibit 2.02 in File No. 2-56036; Amended Exhibit 2.02 in File No. 2-61439; Exhibit 4.02 in File No. 2-70534; Amended Exhibit 4.03 File No. 2-70534; Exhibit 4.02 in File No. 33-2579; Amended Exhibit 4.03 in File No. 33-2579; Amended Exhibit 4.02 in File No. 33-4961; Exhibit 4B to WP&L's Form 10-K for the year ended December 31, 1988, Exhibit 4.1 to WP&L's Form 8-K dated December 10, 1990, Amended Exhibit 4.26 in File No. 33-45726, Amended Exhibit 4.27 in File No.33-45726, Exhibit 4.1 to WP&L's Form 8-K dated March 9, 1992, Exhibit 4.1 to WP&L's Form 8-K dated May 12, 1992, Exhibit 4.1 to WP&L's Form 8-K dated June 29, 1992 and Exhibit 4.1 to WP&L's Form 8-K dated July 20, 1992) 10A*# Executive Tenure Compensation Plan as revised November 10B*# Form of Supplemental Retirement Plan, as revised November 10C*# Forms of Deferred Compensation Plans, as amended June, 1990 (Exhibit 10C to the company's Form 10-K for the year ended December 31, 1990) 10C.1*# Officer's Deferred Compensation Plan II, as adopted September 1992 10C.2*# Officer's Deferred Compensation Plan III, as adopted January 1993 10F*# Pre-Retirement Survivor's Income Supplemental Plan, as revised November 1992 10H*# Management Incentive Plan 10I*# Deferred Compensation Plan for Directors, as adopted June 27, 1990 12 Computation of ratio of earnings to fixed charges and preferred dividend requirements after taxes 21 Subsidiaries of the company 23 Consent of Independent Public Accountants 99 1994 Proxy Statement for the Annual Meeting of Shareowners to be held May 18, 1994 Pursuant to Item 601(b)(4)(iii) of Regulation S-K, the company hereby agrees to furnish to the Securities and Exchange Commission, upon request, any instrument defining the rights of holders of unregistered long-term debt not filed as an exhibit to this Form 10-K. No such instrument authorizes securities in excess of 10 percent of the total assets of the company. # - A management contract or compensatory plan or arrangement. (b) Reports on Form 8-K. 1. WP&L filed a report on Form 8-K dated October 20, 1994, which reported, under "Item 5. Other Events", the agreement to sell: (i) 150,000 shares of its 6.2% Preferred Stock, with a stated value of $100, in a public offering through Goldman, Sachs & Co.; and (ii) 599,460 shares of its 6.5% Preferred Stock, with a stated value of $25 in a public offering through Robert W. Baird & Co. Incorporated. 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 on the 23rd day of February 1994. WPL HOLDINGS, INC. By: /s/ Erroll B. Davis, Jr. Erroll B. Davis, Jr. President and Chief Executive 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 indicated on the 23rd day of February 1994. /s/ Erroll B. Davis, Jr. President, Chief Executive Erroll B. Davis, Jr. Officer and Director (principal executive officer) /s/ Edward M. Gleason Vice President, Treasurer and Edward M. Gleason Corporate Secretary (principal financial officer) /s/ Daniel A. Doyle Controller and Treasurer - Daniel A. Doyle Wisconsin Power and Light Company (principal accounting officer) /s/ L. David Carley Director /s/ Milton E. Neshek Director L. David Carley Milton E. Neshek /s/ Rockne G. Flowers Director /s/ Henry C. Prange Director Rockne G. Flowers Henry C. Prange /s/ Donald R. Haldeman Director /s/ Henry F. Scheig Director Donald R. Haldeman Henry F. Scheig /s/ Katharine C. Lyall Director /s/ Carol T. Toussaint Director Katharine C. Lyall Carol T. Toussaint /s/ Arnold M. Nemirow Director Arnold M. Nemirow REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON SCHEDULES To WPL Holdings, Inc.: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements included in the 1993 Form 10-K of WPL Holdings, Inc. and have issued our report thereon dated January 28, 1994. Our audit was made for the purpose of forming an opinion on those statements taken as a whole. Supplemental Schedules II, III, V, VI, VIII and X are the responsibility of the company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic consolidated financial statements. These schedules have been subjected to the auditing procedures applied in the audit of the basic consolidated financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic consolidated financial statements taken as a whole. Milwaukee, Wisconsin, ARTHUR ANDERSEN & CO. January 28, 1994. INDEX TO SCHEDULES WPL HOLDINGS, INC. INDEX TO FINANCIAL STATEMENT SCHEDULES FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 FINANCIAL STATEMENT SCHEDULES: II. Amounts Receivable from Related Parties III. Parent Company Financial Statements V. Property Plant and Equipment VI. Accumulated Provision for Depreciation and Accumulated Amortization of Nuclear Fuel VIII. Valuation and Qualifying Accounts and Reserves X. Supplementary Income Statement Information NOTE: All other schedules are omitted because they are not applicable or not required, or because that required information is shown either in the financial statements or in the notes thereto. The loan between HDC and Mr. Ahearn represents income taxes withheld in connection with shares vesting as a part of an employment agreement. The loan is to be in effect at market rates and is payable on July 1, 1994. The accompanying notes are an integral part of these statements. The accompanying notes are an integral part of this statement. The accompanying notes are an integral part of this statement. SCHEDULE III - CONDENSED PARENT COMPANY FINANCIAL STATEMENTS WPL HOLDINGS, INC. Supplemental Notes to Parent Company Only Financial Statements The following are supplemental notes to the WPL Holdings, Inc. (the "Company") Parent Company Financial Statements and should be read in conjunction with the Consolidated Financial Statements and Notes thereto included in the WPL Holdings, Inc. 1993 Annual Report, which are hereby incorporated herein by reference: Note A. The parent company files a consolidated Federal income tax return with its subsidiaries. Note B. Net amounts due to (due from) affiliates result from intercompany transactions including loans, federal income tax liabilities and an administrative allowance. Note C. Information regarding short-term debt is as follows: 1993 1992 (In Thousands) As of end of year: Notes payable outstanding.......... $32,958 $19,151 Interest rates on notes payable.... 3.58% 3.62% For the year ended: Maximum month-end amount of short-term debt.................. $36,000 $22,600 Average amount of short-term debt.. $25,827 $19,722 Average interest rate on short- term debt......................... 3.37% 3.93% Note D. During 1993, 1992 and 1991, Wisconsin Power and Light Company allocated and billed certain administrative and general expenses to using an allocation method approved by the Public Service Commission of Wisconsin. These expenses totalled $777,000, $867,000 and $886,000 during 1993, 1992 and 1991, respectively. SCHEDULE X WPL HOLDINGS, INC. AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION Year Ended December 31, 1993 1992 1991 (In Thousands) Real estate and personal property $18,523 $18,052 $16,292 Payroll............. 12,602 10,117 9,041 Other............... 1,253 1,092 1,201 ------- ------- ------- $32,378 $29,261 $26,534 ======= ======= ======= The amounts of maintenance and repairs, depreciation and taxes charged to other expense accounts are not significant. The amounts charged to the respective accounts for advertising aggregated less than one percent of total consolidated revenues, and no royalty expenses were incurred. WPL HOLDINGS, INC. AND SUBSIDIARIES Exhibit Index for the Year Ended December 31, 1993 Item Description 12 Computation of ratio of earnings to fixed charges and preferred dividend requirements after taxes 21 Subsidiaries of the Company 23 Consent of Independent Public Accountants 99 1994 Proxy Statement for the Annual Meeting of Shareowners to be held May 18, 1994 (To be filed with the Securities and Exchange Commission under Regulation 14A within 120 days after the end of the Company's fiscal year)

1993 Item 1. Business. Consumers Water Company (Consumers or the Company) is a holding and management company whose principal business is the ownership and operation of water utility subsidiaries. Consumers owns directly or indirectly at least 90% of the voting stock of 11 water companies (the Consumers Water Subsidiaries) which operate 28 separate systems providing water service to approximately 218,000 customers in six states. It also owns 100% of C/P Utility Services (C/P), a provider of technical services to utilities and other enterprises. C/P, headquartered in Hamden, Connecticut, provides services in the areas of meter services, contract operations, mechanical engineering services, corrosion engineering services, environmental engineering services and water conservation to the utility industry and certain industrial clients primarily in the northeastern United States. Consumers also owns Burlington Homes of New England (Burlington), a manufactured housing company located in Oxford, Maine, that formerly sold manufactured housing through developers and an independent dealer network throughout New England and eastern New York. On October 6, 1993, The Company announced its decision to discontinue the operations of Burlington, to offer the Company for sale and to concentrate its efforts on its water resource management business. To date, efforts to sell Burlington have been unsuccessful. The plant has been closed and Burlington has begun the liquidation of its assets. Consumers was incorporated under the laws of Maine in 1926. The address of its executive offices is Three Canal Plaza, Portland, Maine 04101, and the Company's telephone number is (207) 773-6438. The Company had at December 31, 1993, subsidiaries as noted on Exhibit 22 attached hereto, the accounts of which are included in the consolidated financial statements in this report. Consumers Water Subsidiaries The Consumers Water Subsidiaries operate 28 primary systems in six states for the collection, treatment and distribution of water for public use to residential, commercial and industrial customers, to other water utilities for resale and for private and municipal fire protection purposes. In 1993, 65% of the revenue of the Consumers Water Subsidiaries was generated from residential accounts, while sales for commercial users, industrial users and fire protection and miscellaneous uses accounted for 13%, 9% and 13% of revenues, respectively. Water utility revenues for the three years ended December 31, 1993, 1992 and 1991 were $78,171,000, $74,637,000, and $72,427,000, respectively. At December 31, 1993, the Consumers Water Subsidiaries owned in the aggregate 3,084 miles of main line pipe, of which approximately 84% was six inches or larger in diameter. Of the 28 primary systems, twelve have surface supplies (lakes, ponds and streams) as their source of supply; twelve obtain water principally or entirely from wells; two obtain their water supplies from adjacent systems through wells and surface supplies; and two purchase their supplies from adjacent systems, one of which is an affiliated utility. Less than 5% of the Consumers Water Subsidiaries' water usage is purchased from other systems. In general, the Company considers the surface and well supplies at the Consumers Water Subsidiaries to be adequate for anticipated average daily demand and normal peak day demand for the next five years. One division of Garden State Water Company, Blackwood, serving approximately 11,000 customers has water supplies that will need to be supplemented. This work of developing an additional water supply is underway and anticipated to be completed within the next year. All of the systems (except one system serving solely industrial users) provide customers with water which has been subjected to disinfection treatment and some of which has been subjected to additional treatment, such as softening, sedimentation, filtration, chemical stabilization, iron and/or manganese removal and taste and odor control. Eight systems own and operate full scale water treatment plants. In addition, Consumers Illinois Water Company operates four wastewater treatment facilities. The water treatment, pumping and distribution capacities of the systems are generally considered by management to be adequate to meet the present requirements of their residential, commercial and industrial customers. On a continuing basis, the Consumers Water Subsidiaries make system improvements and additions to capacity in response to changing regulatory standards, changing patterns of consumption and increases in the number of customers. See "Environmental Regulation." Operating and capital costs associated with these improvements are normally recognized by the various state regulatory commissions in setting rates. See "Rate Regulation." Consumers' water utility business is seasonal because the demand for water during the warmer months is generally greater than during the cooler months due to additional requirements for industrial and residential cooling systems, private and public swimming pools and lawn sprinklers. The following table indicates, for each of the Consumers Water Subsidiaries, the number of customers at year-end, 1993 revenues and net utility plant as of December 31, 1993: (Dollars in Thousands) Number Number of Utility Net Utility Subsidiary of Systems Customers Revenue Plant (1) Ohio Water Service Company (2) 5 70,020 $27,144 $95,840 Consumers Illinois Water Company 5 42,260 10,741 45,731 Inter-State Water Company 1 16,799 7,055 32,167 Shenango Valley Water Company (3) 2 17,044 6,335 22,544 Roaring Creek Water Company 1 16,671 5,260 21,405 Pennsylvania Water Company 1 4,451 1,370 3,872 Garden State Water Company (4) 4 28,374 9,452 40,345 Southern New Hampshire Water Company 1 7,416 5,273 30,188 Camden and Rockland Water Company 1 7,109 2,879 14,053 Maine Water Company 4 2,732 1,125 4,816 Wanakah Water Company 3 4,903 1,606 6,118 Inter-Company Eliminations - (69) ( 363) ------- ------- -------- 28 217,779 $78,171 $316,716 ======= ======= ======== _________________________________ (1) Includes construction work in progress. (2) Includes the revenue from the Washington Court House Division which was sold on December 16, 1993. (3) Includes Masury Water Company, a wholly-owned subsidiary. (4) Includes Califon Water Company, a 93.2% owned subsidiary. The properties of the Consumers Water Subsidiaries consist of transmission and distribution mains and conduits, purification plants, pumping facilities, wells, tanks, meters, supply lines, dams, reservoirs, buildings, land, easements, rights and other facilities and equipment used for the collection, purification, storage and distribution of water. Substantially all of the property and all rights and franchises of the Consumers Water Subsidiaries are owned by the subsidiaries and are subject to liens of mortgages or indentures. For the most part, such liens are imposed to secure bonds, notes and/or other evidences of long-term indebtedness of the respective companies. Management considers that its water collection, treatment and distribution systems, facilities and properties are well maintained and structurally sound. In addition, Consumers carries replacement cost insurance coverage on substantially all of its and its subsidiaries' above-ground properties, as well as liability coverages for risks incident to their ownership and use, including consequential damage coverage. Rate Regulation The Consumers Water Subsidiaries are subject to regulation by their respective state regulatory bodies. The state regulatory bodies have broad administrative power and authority to regulate water and other public utilities, including the power to regulate rates and charges, service and the issuance of securities. They also establish uniform systems of accounts, develop standards with respect to groundwater withdrawal rights, surface water supply, potability and adequacy of treatment, and approve the terms of contracts and relations with affiliates and customers, purchases and sales of property and loans. Maine and Illinois have laws regulating reorganizations of water and other utilities. The profitability of the operations of the Consumers Water Subsidiaries is influenced to a great extent by the timeliness and magnitude of rate allowances by regulatory authorities in various states. Accordingly, Consumers maintains a rate case management capability to ensure that the tariffs of the Consumers Water Subsidiaries reflect, to the extent possible, current costs of operations, capital, taxes, energy, materials and compliance with environmental regulations. This process also addresses other factors bearing on rate determinations, such as the quantity of rainfall and temperature in a given period of time, system expansion and industrial demand. The approximate amount of annual rate increases allowed for the last three years was $2,880,000 for 1991, $4,698,000 for 1992, and $1,945,000 for 1993 represented by ten, eight, and five rate decisions, respectively. Included in the 1992 total is a $2.2 million rate allowance for Inter-State Water Company, received on January 8, 1992. This increase was due primarily to recovery of, and an allowance of a return on, its new $14 million water treatment plant. The Company currently has five rate filings pending totalling $7.3 million of requested annualized new revenue. Decisions on these cases are expected in 1994. The number and magnitude of rate increases for the next three years is expected to increase due to the large capital expenditure program for the period 1994 to 1996. Rates for some divisions of Ohio Water are fixed by negotiated agreements with the political subdivisions that are served, instead of through a filing with the Public Utility Commission of Ohio. Currently, two of the five regulated divisions of Ohio Water are operating under rate ordinances. Water Utility Competition In general, the Company believes that the Consumers Water Subsidiaries have valid operating rights, free from unduly burdensome restrictions, sufficient to enable them to carry on their businesses as presently conducted. They derive their rights to install and maintain mains in streets, highways and other public places from the acts under which they were incorporated, municipal consents and ordinances, permits granted for an indefinite period of time by states and permits from state highway departments and county and township authorities. In most instances, such operating rights are non-exclusive. In certain cases, permits from state highway departments and county and township authorities have not been received for service in unincorporated areas, but service is being rendered without assertion or lack of authority by the governmental body concerned. Each of the Consumers Water Subsidiaries serves an area or areas in which it is sole operator of the public water supply system. In some instances another water utility provides service to a separate and sometimes contiguous area within the same township or other political subdivision served by one of the Consumers Water Subsidiaries. In the states in which the operations of the Consumers Water Subsidiaries are carried on, there exists the right of municipal acquisition by one or more of the following methods: eminent domain, the right of purchase given or reserved by a municipality or other political subdivision in granting a franchise, and the right of purchase given or reserved under the law of the state in which the subsidiary was incorporated or from which it received its permit. The price to be paid upon acquisition is usually determined in accordance with both federal law and the laws of the state governing the taking of lands or other property under eminent domain statutes; in other instances, the price may be negotiated, fixed by appraisers selected by the parties or computed in accordance with a formula prescribed in the law of the state or in the particular franchise or special charter. Certain communities in areas served by the Consumers Water Subsidiaries have, from time to time, expressed an interest in acquiring the water utility serving those communities. Environmental Regulation The primary federal laws affecting the provision of water and wastewater treatment services by the Consumers Water Subsidiaries are the Clean Water Act (the CWA) and the Safe Drinking Water Act (the SDWA), and the regulations promulgated pursuant thereto by the United States Environmental Protection Agency (the EPA). These laws and regulations establish criteria and standards, including those for drinking water and for discharges into waters of the United States. States have the right to establish criteria and standards stricter than those established by the EPA, and some of the states in which the Consumers Water Subsidiaries operate have done so. The CWA regulates the discharge of effluents from the drinking water and wastewater treatment processes into the lakes, rivers, streams, and ground water. Seven of the systems owned by the Consumers Water Subsidiaries generate water treatment precipitate from operating conventional filtration facilities used for producing drinking water. The water treatment precipitate is a combination of silt and chemicals used in the treatment process and chemicals removed from the raw water. For each of the seven facilities, the water treatment precipitate generated from the treatment facilities is disposed of either in a storage facility such as a lagoon owned by the subsidiary, an off-site facility not owned by the subsidiary, a State approved landfill, municipal sewer system or it is used for agricultural land application. Wastewater precipitate generated from small wastewater treatment facilities in Illinois is used as a solid additive. Additional capital expenditures and operating costs in connection with the management and ultimate disposal of effluent from water and wastewater facilities may be required in the future, particularly if changes are made in the requirements of the CWA or other applicable federal or state laws. A small wastewater plant owned by Consumers Illinois serving the University Park area will require approximately $2.0 to $3.0 million of capital investment over the next three years to correct periodic excursions in discharge permit requirements. A consent decree addressing these excursions and the alleged resulting stream bed contamination is being negotiated with the Illinois Environmental Protection Agency (the IEPA). At Consumers Illinois, a small wastewater plant serving the Candlewick area will require approximately $2.2 to $3.0 million of capital investment due to periodic excursions in discharge permit requirements. The IEPA has restricted Consumers Illinois from extending its sewer lines in the Candlewick service area until the plant capital program is complete. The Poland Filtration Plant, which is operated by Ohio Water, has been disposing of treatment precipitate at an abandoned strip mine. The Ohio Environmental Protection Agency has informed Ohio Water that it must find an alternative method of disposal for the treatment precipitate. This issue is being studied and the cost for the alternative disposal method is estimated at $500,000 to $1.0 million. The SDWA established uniform minimum national quality standards for drinking water. The EPA regulations, promulgated pursuant to the SDWA, set standards on the amount of certain inorganic and organic chemical contaminants, microbials and radionuclides in drinking water. The 1986 amendments to the SDWA require that the EPA promulgate new primary water standards for 83 contaminants. The EPA has not met the timetable established in the amendments but is developing new water quality standards and, to date, has issued regulations on volatile synthetic organic chemicals, inorganic chemicals, surface water treatment, microbials, lead and copper. Reauthorization of the SDWA is scheduled to be taken up by Congress in 1994. Stricter drinking water standards currently under consideration may result in additional capital expenditures being required of the Company. The implications of the 1986 amendments to the SDWA and the EPA regulations for the Company can be analyzed by grouping contaminants into four categories: (i) microbials, (ii) inorganics, (iii) radionuclides and (iv) volatile organics. With respect to microbials, improved disinfection and/or filtration is required under the EPA Surface Water Treatment Rule adopted pursuant to the SDWA. Necessary improvements to comply with the Surface Water Treatment Rule have been completed or are under way at a number of Consumers Water Subsidiaries. The estimated cost for 1994 and beyond for these improvements is $20 million. Other major improvements at two water treatment plants designed to increase capacity and upgrade facilities are estimated to cost $11 million. In addition, open water storage reservoirs may have to be covered or replaced at three subsidiaries at an approximate cost of $4 million. Testing for lead and copper in finished water supplies, as required by the SDWA provisions dealing with inorganics, has been undertaken at a number of Consumers Water Subsidiaries. The most recent test results show that copper and lead levels meet the applicable standards at most of the Consumers Water Subsidiaries. The EPA has not yet established the Maximum Contaminant Level (MCL) for radon gas in drinking water pursuant to the SDWA provisions applicable to radiouclides. The Company anticipates that the EPA will set those levels at not less than 300 pico curies/liter and has budgeted for capital expenditures of $5 million during the 1994 through 1998 period to treat groundwater supplies to comply with this anticipated radon standard. If the standard is set at 1,000 pico curies/liter, as proposed by an industry group, the necessary capital expenditures would be reduced to approximately $1 million. The Consumers Water Subsidiaries have surveillance programs in place to provide early warning of a possible contamination threat to their water supplies from volatile organics and other potential contaminants. Each of the Consumers Water Subsidiaries has adopted contingency plans to respond to such contamination, should it occur. In 1992, Inter-State executed a Consent Decree with the Illinois Environmental Protection Agency to comply with the MCL for nitrates by 1997 and to take additional interim steps to address the problem. Inter-State will be required to add treatment facilities and/or new sources of supply to reduce the level of nitrates in its finished water at certain times of the year for an estimated project cost of $5 million. A small satellite system owned by Consumers Illinois Water Company has identified an organic contaminant in its groundwater supply. The problem can be resolved by interconnecting the system to the core system at a cost of approximately $1 million. It is felt costs associated with this problem will be recovered from a third party. A contractor working at the Lake Erie West water treatment facility, which is operated by Ohio Water, caused the release of a relatively small amount of mercury within a building at the facility. Workers tracked the mercury to various areas of the building, necessitating the clean-up of a relatively large area in and around the building at a cost of approximately $900,000. Clean-up has been completed and Ohio Water is looking to the responsible parties for reimbursement of its costs. See "Management's Discussion and Analysis of Financial Conditions and Results of Operations - Liquidity and Capital Resources." The Consumers Water Subsidiaries own 12 major dams that are subject to the requirements of the Federal Dam Safety Act of 1986. The dams normally undergo a comprehensive engineering evaluation annually. The Company believes the dams are structurally sound and well maintained. One of the dams owned by Ohio Water will require structural improvements which are currently estimated to cost $2.7 million. In addition to the SDWA, the CWA and Federal Dam Safety Act of 1986, numerous federal and state environmental laws affect the operations of the Consumers Water Subsidiaries. In addition to the capital expenditures and costs currently anticipated, changes in environmental regulation, enforcement policies and practices or related matters may result in additional capital expenditures and costs. Capital expenditures and costs required as a result of water quality standards and environmental requirements are normally recognized by state public utility commissions as appropriate plant additions in established rates. Water Subsidiary Information Consumers' five largest water subsidiaries, Ohio Water Service Company (Ohio Water), Consumers Illinois Water Company (Consumers Illinois), Garden State Water Company (Garden State), Shenango Valley Water Company, (Shenango), and Inter-State Water Company (Inter-State) accounted for approximately 78% of consolidated operating revenues of the water subsidiaries in 1993 and 75% of consolidated water utility net property, plant and equipment at December 31, 1993. Consumers' five largest water subsidiaries are discussed separately below. Ohio Water Service Company Ohio Water is the largest of the Consumers Water Subsidiaries, accounting for approximately 35% of the operating revenues of the water subsidiaries in 1993. As of December 31, 1993, Ohio Water operates five separate systems, five of which deliver treated water and one of which delivers partially treated water primarily to industrial customers. Ohio Water serves a number of communities in northeastern and central Ohio. The following indicates the distribution of 1993 year-end customers, revenues and net utility plant among the five districts of Ohio Water. (Dollars in Thousands) Number of Utility Net Utility Customers Revenues Plant Lake Erie East District 7,516 $ 3,211 $ 8,789 Lake Erie West District 25,254 7,098 35,239 Massillon District 23,039 8,330 31,237 Struthers District 14,201 5,640 18,067 Washington Court House District 0 2,326 0 Mahoning Valley District 10 539 2,508 ------- -------- --------- Total 70,020 $ 27,144 $ 95,840 ======= ======== ========= Consumers Illinois Water Company Consumers Illinois serves 32,218 water customers in the City of Kankakee, Village of Bourbonnais, and a portion of the Village of Bradley, as well as unincorporated areas of Kankakee, Bourbonnais, Aroma, Limestone, and Manteno Townships, all in Kankakee County; as well as the Village of University Park and unincorporated areas of Crete and Monee Townships in Will County, and portions of Lee, Boone and Knox Counties, all in the state of Illinois. The Company also serves 10,042 sewer customers in the Village of University Park, portions of Crete and Monee Townships in Will County, and portions of Lee and Boone Counties, all in the state of Illinois. The company sold its Bourbonnais wastewater collection operation on January 13, 1993, for a gain, net of taxes, of approximately $847,000. The operation generated $1.1 million in revenues and had 5,007 customers in 1992. Consumers Illinois obtains its water supply for its customers in Kankakee County from the Kankakee River and satellite wells. In Will, Lee, Boone and Knox counties, its customers are supplied from deep well systems. The economy of the Company's service areas is based on agriculture and diverse light industries. Consumers Illinois' net utility plant at December 31, 1993, and utility revenues for 1993 were $45,731,000 and $10,741,000, respectively. Garden State Water Company Garden State (and its 93.2% owned subsidiary, Califon Water Company) operates three districts in New Jersey which serve 28,374 customers in territories which are not contiguous. Each district draws its water from deep high capacity wells. The Blackwood District serves a growing residential area, primarily in Camden County. The Hamilton District serves a growing residential area that also includes a small amount of light industry and agriculture, primarily in Mercer County. The Phillipsburg District serves an industrial and agricultural community and outlying municipalities, primarily in Warren County, that are experiencing modest growth. Garden State's net utility plant at December 31, 1993, and utility revenues for 1993 were $40,345,000 and $9,452,000 respectively. Shenango Valley Water Company Shenango, which draws its water from the Shenango River, and its wholly-owned Ohio subsidiary, Masury Water Company, serve 17,044 residential, commercial, industrial and wholesale customers in the cities of Sharon and Farrell, the boroughs of Wheatland, New Wilmington and West Middlesex, and portions of Hermitage, Mercer, Pulaski and Shenango Townships, all in Pennsylvania, and Trumbull County, Ohio. The economy of the area is largely based on heavy industrial manufacturing. Shenango's net utility plant at December 31, 1993, and utility revenue for 1993 were $22,544,000 and $6,335,000 respectively. Inter-State Water Company Inter-State serves 16,799 residential, commercial, industrial and wholesale customers in the cities of Danville, Tilton, Westville and Catlin and the Lake Boulevard and Hooton areas in Illinois. Inter-State draws its water from Lake Vermilion. Inter-State's corporate offices are located in Danville, Illinois, a city of approximately 34,000 residents, with an economy based on agriculture and heavy industrial manufacturing. Inter-State's net utility plant at December 31, 1993 and utility revenue for 1993 were $32,167,000 and $7,055,000 respectively. Utility Services C/P Utility Services, Inc. (C/P) provides services primarily in the area of meter services, contract operations, corrosion engineering services, environmental engineering services, and water conservation to the utility industry and certain industrial clients, primarily in the northeastern United States. In 1992, C/P began offering its services in the southeastern United States from a regional office in Orlando, Florida. On December 7, 1993, C/P Utilities acquired the assets of EnviroAudit, an environmental services company, for $260,000. C/P's services in the areas of environmental engineering and contract operations subject it to possible liability in environmentally sensitive areas such as the removal of underground storage tanks, site remediation, and environmental assessments of sites and facilities. C/P maintains professional liability insurance with respect to the services it provides in amounts and subject to deductibles and exclusions believed by C/P's management to be appropriate. Since September of 1987, C/P has managed the operation of the Merrill Creek Reservoir, a pumped storage facility owned by several power companies, for the purpose of augmenting flows in the Delaware River during periods of low flow or to replace water used by the owners for cooling purposes. C/P's contract for the operation of this facility was renewed for an additional five-year period at the end of 1992. In June, 1993, C/P was awarded three contracts to install new water meters in New York City. The total award for these three contracts is $10.7 million. C/P began work on these projects in December. C/P's total revenues for the years ended December 31, 1993, 1992 and 1991 were $11 million, $9.7 million, and $7.6 million, respectively. Approximately $117,000, or approximately 1%, of C/P's 1993 revenue was derived from services provided to the Consumers Water Subsidiaries. Discontinued Operations On October 6, 1993, the Company announced its intention to dispose of its manufactured housing business, Burlington Homes of New England, Inc., and to concentrate its effort on its water resource management business. Burlington was offered for sale. It has had losses aggregating $1.8 million from December 31, 1989, through September 30, 1993, and estimated losses under the disposal equal $4.2 million, net of taxes. To date, efforts to sell Burlington have been unsuccessful, therefore, an additional $1.1 million reserve was recorded in the fourth quarter. The plant has been closed and Burlington has begun the liquidation of its assets. Please see Note 13 to the consolidated Financial Statements for further detail. In 1990, the Company decided to discontinue the operations of The Dartmouth Company. As of this date, Dartmouth has sold, or otherwise disposed of, all of its properties. As a result of the successful resolution of material uncertainties related to the disposition of the Company's real estate operations, the Company reversed a total of $1.8 million of its reserve for losses from discontinued operations during 1991. Please see Note 12 to the Consolidated Financial Statements for further detail. Employees Consumers Water Company and its subsidiaries employed 693 people as of December 31, 1993, of which 504 are employed by the Consumers Water Subsidiaries. Non-supervisory personnel at Ohio, Shenango Valley, Consumers Illinois, Roaring Creek, Inter-State and Pennsylvania water companies were covered by collective bargaining agreements. Employee relations are considered by management to be satisfactory throughout the Company. Foreign Operations The Company had no foreign operations or export sales in 1993. Item 2. Item 2. Properties. (a)Description See Item 1. "Consumers Water Subsidiaries" for description of Consumers' principal properties, and encumbrances thereon. Consumers' properties are located as follows: Illinois (1) Consumers Illinois Water Company with five divisions in Kankakee, University Park, Sublette, Oak Run and Candlewick, Illinois. (2) Inter-State Water Company located in Danville, Illinois. Ohio (3) Ohio Water Service Company with corporate offices in Poland and five operating districts located in Massillon, Struthers, Mahoning Valley, Geneva and Mentor, Ohio. (4) Masury Water Company located in Trumbull County, Ohio. Pennsylvania (5) Pennsylvania Water Company located in Sayre, Pennsylvania (6) Shenango Valley Water Company located in Sharon, Pennsylvania. (7) Roaring Creek Water Company located in Shamokin, Pennsylvania. New Jersey (8) Garden State Water Company with corporate offices in Hamilton and operating districts in Blackwood, Hamilton Square and Phillipsburg, New Jersey. (9) Califon Water Company located in Califon, New Jersey. Connecticut (10) C/P Utility Services Company located in Hamden, Connecticut and Orlando, Florida. (11) EnviroAudit, Ltd. located in Centerbrook, Connecticut. New Hampshire (11) Southern New Hampshire Water Company located in Londonderry, New Hampshire. Maine (12) Maine Water Company with four divisions located in Kezar Falls, Freeport, Damariscotta and Oakland, Maine. (13) Camden and Rockland Water Company located in Rockland, Maine. (14) Wanakah Water Company with three divisions in Skowhegan, Greenville and Millinocket, Maine. (15) Burlington Homes of New England located in Oxford, Maine. (16) Consumers' corporate headquarters located in Portland, Maine. Item 3. Item 3. Legal Proceedings. Various environmental orders and policies affecting the Consumers Water Subsidiaries are described above under the caption "Environmental Regulation." In March, 1993, an outside contractor spilled a small amount of mercury while working one of Ohio Water's water treatment plants. Several areas in and around the plant were contaminated by the spill. Although no mercury has contaminated Ohio Water's water supply, Ohio Water is continuously monitoring the situation to maintain water quality. Ohio Water contacted all appropriate regulatory agencies and the clean up has been completed. The total cost to clean up the spill was approximately $900,000. Ohio Water has received $100,000 from its insurer and is currently seeking recovery of all the clean up costs from the contractor. While there can be no assurance as to the ultimate outcome of Ohio Water's efforts to obtain such recovery, management believes it is probable that Ohio Water will recover clean up costs from the contractor and/or the contractor's insurers and, therefore, has deferred the cost incurred in connection with the spill. On December 20, 1993, A.P. O'Horo Company filed a complaint against Ohio Water in Lake County Court of Common Pleas seeking recovery of the retainage of $250,000 that Ohio is withholding on this project. On December 30, 1993, Ohio Water filed a counter claim against A.P. O'Horo Company seeking recovery of all past and future costs relating to the spill. Ohio Water is also asking the court to dismiss A.P. O'Horo's complaint. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. None. PART II Item 5. Item 5. Market for the Registrant's Common Stock and Related Stockholder Matters. (a) Market Information The common shares of Consumers are listed on the National Market System of NASDAQ (symbol: CONW). The following table sets forth the high and low last sale prices for the common shares for the periods indicated, as reported by NASDAQ, together with cash dividends declared per common share. DIVIDENDS Calendar Year HIGH LOW DECLARED First Quarter 19 17 $0.285 Second Quarter 19 3/4 17 1/4 0.285 Third Quarter 21 1/4 18 1/2 0.29 Fourth Quarter 21 1/4 17 1/4 0.29 ------ $1.15 First Quarter 18 1/2 15 1/2 0.28 Second Quarter 19 3/4 14 1/4 0.28 Third Quarter 19 1/2 16 1/4 0.285 Fourth Quarter 19 1/4 17 1/2 0.285 ----- $1.13 (b) Holders As of March 22, 1994, there were approximately 5,900 shareholders of record of the Registrant's common stock. Item 6. Item 6. Selected Financial Data. (Dollars in Thousands Except Per Share Amounts) 1993 1992 1991 1990 1989 Operating Revenue $ 89,084 $ 84,245 $ 79,965 $75,296 $ 71,574 Net Income from Continuing Operations $ 12,003 $ 8,501 $ 9,791 $ 7,488 $ 7,212 Earnings Per Common Share: Continuing Operations $ 1.63 $ 1.21 $ 1.52 $ 1.23 $ 1.21 Total $ .80 $ 1.14 $ 1.74 $( 0.33) $ 1.15 Dividends Declared Per Common Share $ 1.15 $ 1.13 $ 1.11 $ 1.09 $ 1.06 Total Assets $371,657 $343,033 $315,124 $302,220 $287,404 Long-Term Debt of Continuing Operations (including current maturities, sinking fund requirements and redeemable preferred stock) $ 125,080 $ 131,667 $ 106,666 $ 113,875 $ 93,964 Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. The following discussion and analysis sets forth certain factors relative to the financial condition of the Company at December 31, 1993, and the results of its operations for the three years ended December 31, 1993, as compared to the same period of the prior year. LIQUIDITY AND CAPITAL RESOURCES CONSTRUCTION PROGRAM Capital expenditures for the year ended December 31, 1993, totaled $30.8 million, net of contributions and advances, the majority of which relates to the Consumers Utility subsidiaries. Projects include $2.9 million spent on a water treatment plant expansion in Ohio, $4.9 million on a new water treatment plant in Pennsylvania, $2.0 million spent on a disinfection facility in Maine and other smaller projects throughout the Company. The Company expects capital expenditures for 1994 through 1996 to be approximately $116 million, net of contributions and advances. The high level of expected capital expenditures is in large part due to the Safe Drinking Water Act (SDWA), the Clean Water Act (CWA) and other regulations. Construction has begun for a $16 million water treatment plant and transmission main in Pennsylvania required by state regulations under the SDWA to be completed by the end of 1995. The Company's utility subsidiaries plan to file for recovery of, and return on, capital used to fund their capital expenditure programs. While costs which have been prudently incurred in the judgment of the appropriate public utility commission have been, and are expected to continue to be, recognized in rate setting, no assurance can be given that requested rate increases or any portion thereof will be approved. To support these capital requirements over the next three years, some subsidiaries will be required to file for large percentage rate increases, in large part due to the significant capital expenditures resulting from compliance with the SDWA and the CWA. FINANCING AND CAPITALIZATION The table below shows the cash generated and used by the Company during 1993. Cash was generated from: (Dollars in millions) Operating activities $17.3 Net increase in short-term debt 10.3 Long-term debt issued 19.4 Common stock issued 15.4 Sale of properties including the Bourbonnais wastewater system and the Washington Court House Division of Ohio Water Service 10.2 ------- Total cash generated $ 72.6 ======= Cash was used: Repay long-term debt $26.0 Pay dividends 8.4 Capital expenditures net of CIAC 30.8 Increase in funds restricted for capital projects 4.4 ------ Total cash used $69.6 ====== At December 31, 1993, approximately $9.5 million of tax exempt financing proceeds remained on the balance sheet as restricted funds for specific capital projects including $8.9 million to be used for the $16 million water treatment plant and transmission main in Pennsylvania. Common stock issued includes proceeds from the issuance of 690,000 shares through a public offering in the fourth quarter of 1993. Water utilities will require higher equity ratios to maintain current debt ratings due to recognition by Standard & Poors' rating system of additional risk of the SDWA requirements and uncertainty of future regulatory treatment of the cost of these requirements. This, coupled with the size of the 1994 - 1996 capital expenditure program, makes it likely that the Company will again return to the equity market in the next three years. Any cash flow needs not provided through stock issuance will, as usual, be financed with short-term lines of credit until each subsidiary's short-term debt level is high enough to warrant a placement of long-term debt, generally in the $4-$6 million range. As of December 31, 1993, the Company had unused lines of credit available of over $82 million. In addition, the Company plans to continue to use tax exempt long-term debt financing in appropriate situations. The $16 million project in Pennsylvania mentioned above is being financed, in large part, with $14 million of 6.375% tax exempt bonds issued on behalf of Roaring Creek Water Company in October, 1993. The Company plans to continue to take advantage of the current low interest rates by refinancing long-term debt whenever appropriate. DISCONTINUED OPERATIONS On October 6, 1993, the Company announced its intention to dispose of its manufactured housing business, Burlington Homes of New England, Inc., and to concentrate its effort on its water resource management business. A reserve of $4.2 million was established in the third quarter. Burlington was offered for sale. It had losses aggregating $1.8 million from December 31, 1989, through September 30, 1993. To date, efforts to sell Burlington have been unsuccessful, and an additional $1.1 million reserve was recorded in the fourth quarter. The plant has been closed and Burlington has begun the liquidation of its assets. The operating results of Burlington prior to the date of discontinuance is shown under "Discontinued Operations" in the Company Consolidated Statements of Income. All of the financial statements of prior periods have been restated to reflect the discontinuance of Burlington's operations. ACQUISITIONS AND DISPOSITIONS On December 7, 1993, C/P Utilities acquired the assets of EnviroAudit Ltd., an environmental services company, for $260,000. On January 13, 1993, the Company sold the Bourbonnais wastewater collection operation of Consumers Illinois Water Company to the village of Bourbonnais for a gain, net of taxes, of approximately $847,000. The operation generated approximately $1.1 million in revenues and had 5,007 customers in 1992. On December 16, 1993, the Company sold the Washington Court House Division of Ohio Water Service Company to the City for a gain, net of taxes, of approximately $3.0 million. The Washington Court House Division served approximately 6,000 customers and generated approximately $2.3 million in revenue in 1993. Over the past five years, the Company has acquired eight water systems. Although the Company currently has no material acquisitions pending, management anticipates continuing the acquisition policy of recent years. OTHER In March, 1993, an outside contractor spilled a small amount of mercury while working at one of Ohio Water's water treatment plants. Several areas in and around the plant were contaminated by the spill. Although no mercury has contaminated Ohio Water's water supply, Ohio Water is continuously monitoring the situation to maintain water quality. Ohio Water contacted all appropriate regulatory agencies and the cleanup has been completed. The total cost to cleanup the spill was approximately $900,000. Ohio Water has received $100,000 from its insurer and is currently seeking recovery of all the cleanup costs from the contractor. While there can be no assurance as to the ultimate outcome of Ohio Water's efforts to obtain such recovery, management believes it is probable that Ohio Water will recover cleanup costs from the contractor and/or the contractor's insurers and, therefore, has deferred the cost incurred in connection with the spill. The Company adopted Statement of Financial Accounting Standards (SFAS) 106, Employer's Post Retirement Benefits (other than Pensions), and SFAS 109, Accounting for Income Taxes, in the first quarter, 1993. SFAS 106 requires the expected cost of Post Retirement Benefits (other than Pensions) be expensed in the years employees render service. This is a significant change in the Company's previous policy of recording these costs on a cash basis. The annual expense under the new method was $584,200 compared to $75,000 under the old method in 1992. The Public Utilities Commissions have ruled in generic proceedings in each of the states which the Company operates except Illinois, that they will allow full accrual of SFAS 106 costs. They also ordered that the Company's subsidiaries in those states record the costs as regulatory assets until the next rate case. The Illinois Commerce Commission has concluded that any costs associated with this statement must be expensed until the Company's first rate proceeding. Of the $584,200 total expected 1993 cost, $136,000 is related to the Illinois' utilities. SFAS 109, Accounting for Income Taxes, required the Consumers Water subsidiaries to increase deferred taxes by approximately $2.8 million. This is offset by a corresponding increase in deferred charges. There is no material impact on the income statement. The effect of the new standard on C/P and Consumers Parent is not material to the Consolidated Financial Statements. RESULTS OF OPERATIONS 1993 Compared to 1992 UTILITY REVENUE Utility revenues increased $3.5 million or 4.7% in 1993 compared to 1992 due primarily to $2 million in rate increases, $2.1 million from the inclusion of revenues from the properties acquired in Maine and Pennsylvania in 1992, and increased consumption due to dry weather in some areas served by Consumers Water subsidiaries. These increases were partially offset by the revenue impact of the sale of the Bourbonnais wastewater system, which had revenue in 1992 of $1.1 million. Currently, there are five rate cases pending in which approximately $7.3 million in additional revenues is sought. These cases are timed to seek recovery of, and a return on, funds used to finance the large capital expenditure program. UTILITY OPERATING EXPENSES Water utility operating expenses increased approximately $4.1 million in 1993 compared to 1992. Increased expenses associated with the new acquisitions, increased depreciation and property tax expense due to increased plant balances and normal increases in labor costs accounted for most of the increase. OTHER OPERATIONS - REVENUE AND EXPENSE Other operating revenue increased $1.3 million in 1993 or 13.6% over 1992, while other operating expenses increased by $1.7 million or 17.5%. The revenue increase is due primarily to revenue of C/P's New York City meter installation projects. Expenses are up more than revenue due to a health insurance adjustment recorded at the Parent company and lower profit margins at C/P Utility Services. The Company's self insured health insurance plan incurred an unusual amount of claims and required an additional accrual of $500,000 in 1993 compared to $300,000 in 1992. At C/P, meter installation sales, traditionally a low margin field, increased in 1993 over 1992, while demand for underground storage tank testing, a high margin area, decreased. In June, 1993, C/P was awarded contracts for $10.7 million in additional meter installation projects in New York City. C/P began work on these projects in December 1993. The New York City meter installation projects that C/P was awarded in 1992 are nearing completion. OTHER Interest expense was up $435,000 in 1993 compared to 1992, due primarily to increased debt balances offset by lower interest rates in 1993. Income taxes were down $239,000 due to lower pretax income. Congress recently passed a bill to increase corporate income taxes from a top rate of 34% to 35% for taxable income in excess of $10 million. Management does not expect this increase to have a material impact on the Company's financial results. 1992 Compared to 1991 UTILITY REVENUE Utility revenues for 1992 increased $2.2 million or 3.1% over 1991, due primarily to $4.7 million in rate increases offset by decreased consumption and the revenue impact of the sale of the Marysville Division of Ohio Water Service in June, 1991. At the end of 1992, there were three rate cases pending in which over $2 million in additional revenue was sought. Consumption was down compared to 1991 due to a wetter summer in 1992. UTILITY OPERATING EXPENSES Water utility operating expenses in 1992 showed a nominal increase of approximately $200,000. Increased depreciation and property tax expense associated with higher plant balances were offset by lower operating costs, including a lower pension expense due to favorable investment performance and a change in one subsidiary's vacation policy. OTHER OPERATIONS - REVENUE AND EXPENSE Other operating revenue increased $2.1 million or 27.5%, due primarily to revenue of C/P from two additional New York City meter installation projects. Interest expense was down $905,000 in 1992 compared to 1991, due primarily to lower interest rates in 1992. This reduction was offset by $727,000 less capitalized interest in 1992 due to the completion of the new water treatment plant in Illinois in early 1992. Income taxes were up $1.1 million in 1992 over 1991 due to higher pretax income. The effective rate was 34.1% in 1992 and 34.3% in 1991. In 1992, the Company had a small loss on the sale of a satellite of its New Hampshire subsidiary, which was partially offset by gains from the sale of land in Ohio and Illinois. In 1991, gains from the sales of properties included a gain of $3.1 million (after tax) from the sale of the Marysville Division of Ohio Water, and a net gain of $207,000 (after tax) from the sale of land owned by the Company or its subsidiaries in Ohio, Pennsylvania, and Illinois. Item 8. Item 8. Financial Statements and Supplementary Data. Page Reference Report of Management Report of Independent Public Accountants Consolidated Statements of Income for Years Ended December 31, 1993, 1992 and 1991 Consolidated Balance Sheets at December 31, 1993 and 1992 Consolidated Statements of Capitalization and Interim Financing at December 31, 1993 and 1992 Consolidated Statements of Cash Flow for Years Ended December 31, 1993, 1992 and 1991 Consolidated Statements of Change in Common Shareholders' Investment for Years Ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements Quarterly Information Pertaining to the Results of Operations for the Years Ended December 31, 1993 and 1992 Item 9. Item 9. Disagreements on Accounting and Financial Disclosure. None. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant. Incorporated by reference are the "Nominees for Election as Directors," "Other Executive Officers" and "Compliance with Beneficial Ownership Reporting Rules" sections of the Company's Definitive Proxy Statement filed pursuant to Regulation 14A. Item 11. Item 11. Executive Compensation. Incorporated by reference is the "Executive Compensation" section of the Company's Definitive Proxy Statement filed pursuant to Regulation 14A. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. Incorporated by reference is the "Common Stock Ownership of Certain Beneficial Owners and Management" section of the Company's Definitive Proxy Statement filed pursuant to Regulation 14A. Item 13. Item 13. Certain Relationships and Related Transactions. Incorporated by reference is the "Executive Compensation" section of the Company's Definitive Proxy Statement filed pursuant to Regulation 14A. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. (a) List of financial statements, schedules and exhibits. (1) Consolidated financial statements and notes thereto of Consumers Water Company and its subsidiaries together with the Report of Independent Public Accountants, are listed as part of Item 8 of this Form 10-K. (2) Schedules V Property, Plant and Equipment for the Years Ended December 31, 1993, 1992 and 1991. VI Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment for the Years Ended December 31, 1993, 1992 and 1991. VIII Valuation and Qualifying Accounts for the Years Ended December 31, 1993, 1992 and 1991. X Supplementary Income Statement Information for the Years Ended December 31, 1993, 1992 and 1991. All other schedules have been omitted, since they are not required, not applicable or the information is included in the consolidated financial statements or notes thereto. (3) Exhibits Exhibit 2.1 Assets Purchase and Sale Agreement between Ohio Water Service and the City of Washington, Ohio dated October 28, 1993 is submitted herewith as Exhibit 2.1. 3.1 Conformed Copy of Restated Articles of Incorporation of Consumers Water Company, as amended, incorporated by reference to Exhibit 4.1.6 to Consumers Water Company's Registration Statement on Form S-2 (No. 33-41113), filed with the Securities and Exchange Commission on June 11, 1991. 3.2 Bylaws of Consumers Water Company, as amended March 2, 1994, are submitted herewith as Exhibit 3.2. 4.1 Instruments defining the rights of security holders, including Indentures. The registrant agrees to furnish copies of instruments with respect to long-term debt to the Commission upon request. 10.1 Noncompetition and Consulting Agreement between Consumers Water Company and John H. Schiavi incorporated by reference to Exhibit 10.2 of Consumers Water Company's Annual Report on form 10-K for the year ended December 31, 1992. 10.2* Consumers Water Company 1988 Incentive Stock Option Plan is submitted herewith as Exhibit 10.2. 10.3* Consumers Water Company 1993 Incentive Stock Option Plan is incorporated by reference to Appendix B to definitive proxy statement dated April 5, 1993. 10.4* Consumers Water Company 1992 Deferred Compensation Plan for Directors, Plan A, incorporated by reference to Exhibit 10.5.2 to Consumers Water Company's Annual Report on Form 10K for the year ended December 31, 1991. 10.5* Consumers Water Company 1992 Deferred Compensation Plan for Directors, Plan B, incorporated by reference to Exhibit 10.5.3 to Consumers Water Company's Annual Report on Form 10-K for the year ended December 31, 1991. 10.6 Letter Agreement between Consumers Water Company and Anjou International Company dated February 7, 1986, incorporated by reference to Exhibit 10.6 to Consumers Water Company's Registration Statement on Form S-2 (No. 33-41113), filed with the Securities and Exchange Commission on June 11, 1991. 10.7 Assignment of Rights under February 7, 1986 Agreement between Consumers Water Company and Anjou International Company to Compagnie Generale des Eaux, dated November 12, 1987, incorporated by reference to Exhibit 10.7 to Consumers Water Company's Annual Report on Form 10k for the year ended December 31, 1992. 10.8 Form of Indemnification Agreement entered into between Consumers Water Company and each of its current directors and executive officers, incorporated by reference to Exhibit 10.8 to Consumers Water Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1989. 10.9* Employment Agreement between Peter L. Haynes and Consumers Water Company incorporated by reference to Exhibit 10.11 to Consumers Water Company's Annual Report on Form 10-K for the year ended December 31, 1992. 11. Statement of Computation of Per Share Earnings is submitted herewith as Exhibit 11. 22. List of Subsidiaries of the Registrant is submitted herewith as Exhibit 22. 23. Consent of Arthur Andersen & Co is submitted herewith as Exhibit 23. (b)Reports on Form 8K On November 24, 1993, Consumers Water Company filed a Form 8-K with the Securities and Exchange Commission reporting, under Item 5 thereof, the effectiveness of the Company's Registration Statement on Form S-3, File No. 33-71318, in connection with the public offering of its common shares and incorporating therein the final Prospectus distributed in connection with the offering. - ------------------------------------------ * Management contract or compensatory plan or arrangement required to be filed as an Exhibit pursuant to Item 14(c) of Form 10-K. CONSUMERS WATER COMPANY 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. By: /s/ Peter L. Haynes 03/28/94 _______________________________ _________ Peter L. Haynes Date President and Director (Chief Executive 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 dates indicated. By: /s/ John F. Isacke 03/28/94 _____________________________ _________ John F. Isacke Date Senior Vice President - Development and Administration (Chief Financial Officer) By: /s/ Gary E. Wardwell 03/28/94 _______________________________ _________ Gary E. Wardwell Date Controller (Chief Accounting Officer) By: /s/ David R. Hastings, II 03/28/94 ______________________________ _________ David R. Hastings, II Date Chairman and Director By: /s/ Jack S. Ketchum 03/28/94 ______________________________ _________ Jack S. Ketchum Date Director By: /s/ John E. Menario 03/28/94 ______________________________ _________ John E. Menario Date Director By: /s/ J. Bonnie Newman 03/28/94 ________________________________ _________ J. Bonnie Newman Date Director By: /s/ John E. Palmer, Jr. 03/28/94 ________________________________ _________ John E. Palmer, Jr. Date Director CONSUMERS WATER COMPANY 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 dates indicated. By: /s/ Eliot B. Payson 03/28/94 ________________________________ _________ Eliot B. Payson Date Director By: /s/ Elaine D. Rosen 03/28/94 _______________________________ _________ Elaine D. Rosen Date Director By: -------------------------------- --------- William B. Russell Date Director By: /s/ John H. Schiavi 03/28/94 _______________________________ _________ John H. Schiavi Date Director By: /s/ John W. L. White 03/28/94 _______________________________ _________ John W. L. White Date Director By: /s/ Claudio Elia 03/28/43 _______________________________ _________ Claudio Elia Date Director By: /s/ Peter L. Haynes 03/28/94 ________________________________ _________ Peter L. Haynes Date President and Director (Chief Executive Officer) Consumers Water Company and Subsidiaries Report of Management The accompanying consolidated financial statements of Consumers Water Company and its subsidiaries were prepared by management, which is responsible for the integrity and objectivity of the data presented, including amounts that must necessarily be based on judgments or estimates. The consolidated financial statements were prepared in conformity with generally accepted accounting principles and financial information appearing throughout this annual report is consistent with these statements. In recognition of its responsibility, management maintains and relies upon systems of internal accounting controls, which are reviewed and evaluated on an ongoing basis. The systems are designed to provide reasonable assurance that transactions are executed in accordance with management's authorization and properly recorded to permit preparation of reliable financial statements, and that assets are safeguarded. Management must assess and balance the relative cost and expected benefits of these controls. These financial statements have been audited by Arthur Andersen & Co., the Company's independent public accountants. Their audit, in accordance with generally accepted auditing standards, resulted in the expression of their opinion. Arthur Andersen & Co.'s audit does not limit management's responsibility for the fair presentation of the financial statements and all other information in this annual report. The Audit Committee of the Board of Directors, composed solely of outside directors, meets periodically with management, internal audit, and Arthur Andersen & Co. to review the work of each and to discuss areas relating to internal accounting controls, audits, and financial reporting. Arthur Andersen & Co. and the Company's internal audit personnel have free access to meet individually with the Committee, without management present, at any time, and they periodically do so. /s/ John F. Isacke - -------------------- John F. Isacke Senior Vice President Chief Financial Officer Arthur Andersen & Co. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To The Shareholders and Board of Directors of Consumers Water Company: We have audited the accompanying consolidated balance sheets and the consolidated statements of capitalization and interim financing of CONSUMERS WATER COMPANY (a Maine corporation) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, change in common shareholders' investment and cash flows for each of the three years in the period ended December 31, 1993. These financial statements and the schedules referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules 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 financial statements referred to above present fairly, in all material respects, the financial position of Consumers Water Company and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed in notes 2 and 9 to the Consolidated Financial Statements, effective January 1, 1993, the Company changed its method of accounting for income taxes and other post-retirement benefits. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed in the index of financial statements are presented for purposes of complying with the Securities and Exchange Commission's rules and are not a required part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in our audit of the basic financial statements and, in our opionion, fairly state 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 & Co. -------------------------- ARTHUR ANDERSEN & CO. Boston, Massachusetts February 9, 1994 Consumers Water Company and Subsidiaries Consolidated Statements of Income For the years ended December 31, (In Thousands Except Per Share Amounts) 1993 1992 1991 Revenue and Sales: Water utility operations $78,171 $74,637 $72,427 Other operations 10,913 9,608 7,538 - ------------------------------------------------------------------ Operating revenue 89,084 84,245 79,965 - ------------------------------------------------------------------ Costs and Expenses: Water utility operations 55,127 50,996 50,795 Other operations 11,112 9,454 8,158 - ------------------------------------------------------------------ Operating expenses 66,239 60,450 58,953 - ------------------------------------------------------------------ Operating Income 22,845 23,795 21,012 - ------------------------------------------------------------------ Other Income and (Expense): Interest expense (11,905) (11,470)(12,375) Construction interest capitalized 778 367 1,094 Preferred dividends and minority interest of subsidiaries (147) (143) (146) Other, net (Notes 3 and 11) 692 344 116 - ------------------------------------------------------------------ (10,582) (10,902)(11,311) - ------------------------------------------------------------------ Earnings from Continuing Operations Before Income Taxes and Gains (Losses) from Sales of Properties 12,263 12,893 9,701 Income Taxes (Note 2) 4,128 4,367 3,212 - ------------------------------------------------------------------ Earnings from Continuing Operations: Before Gains (Losses) from Sales of Properties 8,135 8,526 6,489 Gains (Losses) from Sales of Properties, Net (Note 7) 3,868 (25) 3,302 - ------------------------------------------------------------------ Income from Continuing Operations 12,003 8,501 9,791 - ------------------------------------------------------------------ Income (Loss) from Discontinued Operations: Before Discontinuance (784) (479) (373) Provision for Loss on Disposal of Discontinued Operations (5,300) - 1,800 - ------------------------------------------------------------------ Total from Discontinued Operations (Notes 12 and 13) (6,084) (479) 1,427 - ------------------------------------------------------------------ Net Income $5,919 $8,022 $11,218 ================================================================== Weighted Average Shares Outstanding 7,320 7,007 6,429 Earning (Loss) per Common Share: Continuing Operations- Before Gains (Losses) from Sales $1.10 $1.21 $1.00 Total $1.63 $1.21 $1.52 - ------------------------------------------------------------------ Discontinued Operations- Before Discontinuance ($0.11) ($0.07) ($0.06) Earnings (Loss) on Disposal of Discontinued Operations ($0.72) - $0.28 - ------------------------------------------------------------------ Total ($0.83) ($0.07) $0.22 - ------------------------------------------------------------------ Total $0.80 $1.14 $1.74 ================================================================== The accompanying notes are an integral part of these consolidated financial statements. Consumers Water Company and Subsidiarie Consolidated Balance Sheets December 31, (Dollars in Thousands) 1993 1992 Assets Property, Plant and Equipment, at cost: Water utility plant, in service $360,115 $349,156 Less - Accumulated depreciation 63,579 59,705 --------------------- 296,536 289,451 --------------------- Other subsidiaries 1,710 1,482 Less - Accumulated depreciation 881 820 --------------------- 829 662 --------------------- Construction work in progress 20,180 10,252 --------------------- Net property, plant and equipment 317,545 300,365 - -------------------------------------------------------------------- Assets of Discontinued Operations, Net (Notes 12 and 13) 1,308 5,180 Investments, at cost 2,044 1,918 - --------------------------------------------------------------------- Current Assets: Cash and cash equivalents (Note 4) 4,993 1,768 Accounts receivable, net of reserves of $798 in 1993 and $702 in 1992 10,171 7,548 Unbilled revenue 6,649 8,169 Inventories (Note 1) 1,793 1,863 Prepayments and other 6,524 5,311 - -------------------------------------------------------------------- Total current assets 30,130 24,659 - -------------------------------------------------------------------- Other Assets: Funds restricted for construction activity (Note 3) 9,508 5,093 Deferred charges and other assets 11,122 5,818 - -------------------------------------------------------------------- 20,630 10,911 - -------------------------------------------------------------------- $371,657 $343,033 ==================================================================== Shareholders' Investment and Liabilities: Capitalization (See Separate Statement) Common shareholders' investment $96,938 $84,243 Preferred shareholders' investment 1,069 1,078 Minority interest 2,240 2,247 Long-term debt 124,050 119,832 - -------------------------------------------------------------------- Total capitalization 224,297 207,400 - -------------------------------------------------------------------- Contributions in Aid of Construction 54,045 50,064 - -------------------------------------------------------------------- Current Liabilities: Interim Financing (See Separate Statement) 20,606 21,071 Accounts payable 6,052 3,364 Accrued taxes (Note 2) 6,662 6,530 Accrued interest 3,318 2,992 Accrued expenses and other 11,011 8,829 - -------------------------------------------------------------------- Total current liabilities 47,649 42,786 - -------------------------------------------------------------------- Commitments and Contingencies (Note 10) - -------------------------------------------------------------------- Deferred Credits: Customers' advances for construction 21,338 24,544 Deferred income taxes (Note 2) 19,183 12,803 Unamortized investment tax credits 5,145 5,436 - -------------------------------------------------------------------- 45,666 42,783 - -------------------------------------------------------------------- $371,657 $343,033 ==================================================================== The accompanying notes are an integral part of these consolidated financial statements. Consumers Water Company and Subsidiaries Consolidated Statements of Capitalization and Interim Financing December 31, (Dollars in Thousands) 1993 1992 Capitalization (Notes 3 and 5) Common shareholders' investment: Common stock, $1 par value Authorized: 15,000,000 shares in 1993 and 10,000,000 shares in 1992 Issued: 8,041,369 shares in 1993 and 7,129,639 shares in 1992 $8,041 $7,130 Amounts in excess of par value 64,662 50,157 Reinvested earnings 24,235 26,956 - ------------------------------------------------------------------- 96,938 84,243 - ------------------------------------------------------------------- Preferred shareholders' investment: Preferred stock, $100 par value 1,069 1,078 - ------------------------------------------------------------------- Minority interest: Common stock, at equity 562 469 Preferred stock 1,678 1,778 - ------------------------------------------------------------------- 2,240 2,247 - ------------------------------------------------------------------- Long-term debt: First mortgage bonds, debentures and promissory notes- Maturities Interest Rate Range 1993 1.00% to 13.00% - 10,358 1994 69% of Prime to 10.50% 14 710 1995 9.00% to 13.88% 1,624 2,738 1996 6.10% to 11.00% 228 757 1997 5.94% to 7.50% 1,452 3,865 1998 5.94% to 9.38% 573 1,656 1999-2003 70% of Prime to 8.75% 5,637 7,018 2004-2008 8.00% to 10.55% 15,646 17,995 2009-2013 1.00% to 10.54% 14,135 14,193 THEREAFTER 6.10% to 10.40% 85,671 72,277 -------------------- Total first mortgage bonds, debentures and notes 124,980 131,567 Less - Sinking fund requirements and current maturities 930 11,735 -------------------- 124,050 119,832 - ------------------------------------------------------------------- Total capitalization 224,297 207,400 - ------------------------------------------------------------------- Interim financing (Note 4): Notes payable 19,676 9,336 Sinking fund requirements and current maturities 930 11,735 - ------------------------------------------------------------------- Total interim financing 20,606 21,071 - ------------------------------------------------------------------- Total capitalization and interim financing $244,903 $228,471 =================================================================== The accompanying notes are an integral part of these consolidated financial statements. Consumers Water Company and Subsidiaries Consolidated Statements of Cash Flows For the years ended December 31, (Dollars in Thousands) 1993 1992 1991 Operating activities: Net income 5,919 $8,022 $11,218 --------------------------- Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 7,994 7,432 6,125 Deferred income taxes and investment tax credits 6,417 1,072 1,475 (Gains) losses on sales of properties (3,869) 25 (3,302) Changes in assets and liabilities: Increase in accounts receivable and unbilled revenue (1,202) (1,695) (1,027) (Increase) decrease in inventories 70 63 (27) (Increase) decrease in prepaid expenses (1,203) 432 (998) Increase (decrease) in accounts payable and accrued expenses 4,134 (236) 4,821 Change in other assets, net of change in other liabilities of continuing operations (4,847) (1,263) 337 Change in assets, net of change in liabilities of discontinued operations (1,428) 257 (7) (Income) loss on disposal of discontinued operations (Notes 12 and 13) 5,300 (1,800) ----------------------------- Total adjustments 11,366 6,087 5,597 ----------------------------- Net cash provided by operating activities 17,285 14,109 16,815 ----------------------------- Investing activities: Capital expenditures (34,655) (21,877) (30,175) Funds restricted for construction activity (4,415) (5,093) 8,271 Increase (decrease) in construction accounts payable 911 (1,092) 829 Net cash cost of acquisitions (Note 6) (260) (3,524) - Net proceeds from sales of properties (Note 7) 10,239 8 8,494 ----------------------------- Net cash used in investing activities (28,180) (31,578) (12,581) ----------------------------- Financing activities: Net borrowing (repayment) of short-term debt 10,340 (7,673) (2,464) Proceeds from issuance of long-term debt 19,429 39,902 6,429 Repayment of long-term debt (25,989) (15,084) (13,619) Proceeds from issuance of stock 15,408 3,570 12,328 Advances and contributions in aid of construction, net of repayments 3,879 3,070 2,868 Taxes paid by developers on advances and contributions in aid of construction (583) (364) (150) Cash dividends paid (8,364) (7,932) (7,202) ----------------------------- Net cash provided by (used in) financing activities 14,120 15,489 (1,810) ----------------------------- Net increase (decrease) in cash and cash equivalents 3,225 (1,980) 2,424 Cash and cash equivalents at beginning of year 1,768 3,748 1,324 ----------------------------- Cash and cash equivalents at end of year $4,993 $1,768 $3,748 ============================= Supplemental disclosures of cash flow information from continuing operations Cash paid during the year for: Interest (net of amounts capitalized) $10,540 $10,612 $11,123 Income taxes $ 3,570 $ 3,713 $ 2,412 Noncash investing and financing activities for the year: Assets acquired by stock issuance and/or assumption of debt of acquired company - $ 998 - Property advanced or contributed $ 855 $ 3,910 $ 455 Note receivable and water rights in exchange for utility assets - $ 2,085 - The accompanying notes are an integral part of these consolidated financial statements. Consumers Water Company and Subsidiaries Consolidated Statements of Change in Common Shareholders' Investment Number of Shares, $1 par value, (Dollars in Thousands) Issued and Excess of Reinvested For the years ended Outstanding Par Value Earnings December 31, 1993, 1992 and 1991 Balance, December 31, 1990 6,059,761 $34,744 $23,217 Net income 11,218 Cash dividends: Common shares (7,410) Preferred shares (57) Dividend Reinvestment Plan 116,656 1,802 Employee benefit plans 25,116 349 Stock Issue 690,000 9,345 Other (5) - ----------------------------------------------------------------------------- Balance, December 31, 1991 6,891,533 46,235 26,968 Net income 8,022 Cash dividends: Common shares (7,977) Preferred shares (57) Dividend Reinvestment Plan 170,823 2,823 Employee benefit plans 32,957 542 Other 34,326 557 - ----------------------------------------------------------------------------- Balance, December 31, 1992 7,129,639 50,157 26,956 Net income 5,919 Cash dividends: Common shares (8,584) Preferred shares (56) Dividend Reinvestment Plan 187,679 3,280 Employee benefit plans 34,051 569 Stock Issue 690,000 10,652 Other 4 - ----------------------------------------------------------------------------- Balance, December 31, 1993 8,041,369 $64,662 $24,235 ============================================================================= The accompanying notes are an integral part of these consolidated financial statements. Consumers Water Company and Subsidiaries Notes to Consolidated Financial Statements (1) Summary of Significant Accounting Policies Principles of Consolidation The accompanying consolidated financial statements include the accounts of Consumers Water Company (the Company) and its water utility and utility services subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation. The consolidated financial statements and related footnote information have been restated to reflect the Company's real estate subsidiary, The Dartmouth Company, and its manufactured housing subsidiary, Burlington Homes of New England, as discontinued operations. See Notes 12 and 13. Regulation The rates, operations, accounting and certain other practices of the Company's utility subsidiaries are subject to the regulatory authority of state public utility commissions. Property, Plant and Equipment The utility subsidiaries generally capitalize interest at current rates on short-term notes payable used to finance major construction projects. Utility plant construction costs also include payroll, related fringe benefits and other overhead costs associated with construction activity. Depreciation is provided principally at straight-line composite rates. consolidated provision, based on average amounts of depreciable utility plant (which excludes contributions in aid of construction and customers' advances for construction for most subsidiaries), approximated 2.4% in 1993, 2.3% in 1992 and 2.1% in 1991. Under composite depreciation, when property is retired or sold in the normal course of business, the entire cost, including net cost of removal, is charged to accumulated depreciation and no gain or loss is recognized. The utility services subsidiary depreciates property and equipment using the straight-line method over the estimated useful lives of the assets, generally 5 to 10 years. Revenue Recognition All of the utility subsidiaries accrue estimated revenue for water distributed but not yet billed as of the balance sheet date. Unbilled revenue also includes amounts for work performed but not yet billed for C/P Utility Services Company, Inc. C/P accounts for contracts using the percentage-of-completion method for long-term contracts and the completed contract method for short-term contracts. Cash Flows For purposes of the Consolidated Statements of Cash Flows, the Company considers all highly liquid instruments with an original maturity of three months or less, which are not restricted for construction activity to be cash equivalents. Consumers Water Company and Subsidiaries Notes to Consolidated Financial Statements Disclosures about Fair Value of Financial Instruments The carrying amount of cash, temporary investments, notes receivable, and preferred stock approximate their fair value. The fair value of long-term debt based on borrowing rates currently available for loans with similar terms and maturities is approximately $139 million. Inventories Inventories generally consist of materials and supplies. They are stated at the lower of cost (average cost method) or market. Other Assets Deferred charges consist primarily of financing charges, rate case and other expenses, a note receivable of $1,330,000 and the net excess of acquisition cost over book value of the net assets for the utility subsidiaries. Deferred rate case expenses are amortized over periods allowed by the governing regulatory authorities, generally one to three years. The net excess of the acquisition cost over book value or market value of the net assets of subsidiaries acquired is being amortized principally over a period of 40 years. Other assets also include preliminary survey and investigation costs and certain items amortized, subject to regulatory approval, over their anticipated period of recovery. Deferred financing charges are amortized over the lives of the related debt issues. Customers' Advances/Contributions in Aid of Construction The water subsidiaries receive contributions and advances for construction from or on behalf of customers. Advances received are refundable, under certain circumstances, either wholly or in part, over varying periods of time. Amounts no longer refundable are reclassified to contributions in aid of construction. Contributions and advances received after 1986 are treated as taxable income. Amounts that customers are required to contribute to offset the income taxes payable by the Company are normally included in contributions or advances. Income Taxes The Company and its subsidiaries file a consolidated federal income tax return. The rate-making practices followed by most regulatory agencies allow the utility subsidiaries to recover, through customer rates, federal and state income taxes payable currently and deferred taxes related to certain timing differences between pretax accounting income and taxable income. The income tax effects of other timing differences are flowed through for rate-making and accounting purposes. The Company expects that deferred taxes not collected will be recovered through customer rates in the future when such taxes become payable. Investment Tax Credits Investment tax credits of utility subsidiaries are deferred and amortized over the estimated useful lives of the related properties. Effective January 1, 1986, investment tax credits were eliminated by the Tax Reform Act of 1986 except for property meeting the transitional rules. Consumers Water Company and Subsidiaries Notes to Consolidated Financial Statements Earnings (Loss) Per Common Share Earnings (loss) per common share are based on the annual weighted average number of shares outstanding and common share equivalents. The effect of employee stock options, which are included as common share equivalents, is not significant. (2) Income Tax Expense Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109 (SFAS 109), Accounting for Income Taxes, which requires the use of the liability method in accounting for income taxes. Under the liability method, deferred income taxes are recognized at currently enacted income tax rates to reflect the tax effect of temporary differences between the financial reporting and tax bases of assets and liabilities. Such temporary differences are the result of provisions in the income tax law that either require or permit certain items to be reported on the income tax return in a different period than they are reported in the financial statements. To implement SFAS 109, certain adjustments were made to accumulated deferred income taxes. To the extent such income taxes are recoverable or payable through future rates, regulatory assets and liabilities have been recorded in the accompanying Consolidated Balance Sheets. The adoption of SFAS 109 resulted in the recognition of a net regulatory asset of approximately $2.8 million and had no material impact on the Company's results of operations. At December 31, 1993, accumulated deferred taxes consisted of tax assets of $893,000 related to alternative minimum tax offset by liabilities of $19,665,000, which are predominanty related to accumulated depreciation and other plant related differences. The Company believes that all deferred income tax assets will be realized in the future; therefore, a valuation allowance has not been recorded. The net regulatory asset was approximately $3.1 million at December 31, 1993. The components of income tax expense from continuing operations reflected in the Consolidated Statements of Income are as follows: For the Years Ended December 31, (Dollars in Thousands) 1993 1992 1991 Federal: Currently payable $3,077 $3,255 $ 3,345 Deferred 2,827 668 1,566 Investment tax credit, net of amortization ( 291) ( 183) ( 246) -------- -------- -------- $5,613 3,740 4,665 -------- -------- -------- State: Currently payable 134 589 493 Deferred 195 ( 21) ( 63) -------- -------- -------- 329 568 430 -------- -------- -------- Total provision $5,942 $ 4,308 $ 5,095 ======== ======== ======== The provision for income tax expense is reflected in: Income taxes $4,128 $ 4,367 $ 3,212 Gains (Losses) from sales of properties 1,735 ( 89) 1,808 Other income 79 30 75 ------- -------- -------- Total provision $5,942 $ 4,308 $ 5,095 ======= ========= ========= The table below reconciles the federal statutory rate to a rate computed by dividing income tax expense, as shown in the previous table, by income from continuing operations before income tax expense. 1993 1992 1991 Statutory rate 34.0% 34.0% 34.0% State taxes, net of federal benefit 1.2 3.0 1.9 Effect of decrease in statutory rate on reversing timing items (0.1) (0.2) (0.2) Investment tax credit (0.8) (1.6) (1.8) Other (1.2) (1.1) 0.4 ------- ------- ------ 33.1% 34.1% 34.3% ======= ======= ====== The table below was required prior to the adoption of SFAS 109, therefore, it is only presented for years prior to 1993. The major differences in the timing of recognition of income and expense for tax and accounting purposes, for which deferred income taxes are provided, are as follows: (Dollars in Thousands) 1992 1991 Accelerated depreciation $ 2,896 $ 2,565 Contributions and advances ( 2,570) ( 1,151) Gains from sales of properties - 1,893 Alternative minimum tax 526 ( 1,307) Other, net ( 205) ( 497) -------- -------- $ 647 $ 1,503 ======== ======== (3) Long-Term Debt Maturities and sinking fund requirements of the first mortgage bonds, debentures and notes including capitalized leases are $930,000 in 1994, $2,516,000 in 1995, $883,000 in 1996, $2,219,000 in 1997, $812,000 in 1998, and $117,620,000 thereafter. Substantially all of the Company's water utility plant is pledged as security under various indentures or mortgages. The indentures restrict cash dividends and purchases of the companies' common stocks. The various water utility subsidiaries' indentures generally prohibit the payment of dividends on common shares in excess of retained earnings plus a stated dollar amount. Approximately $26.6 million of reinvested earnings were not so restricted at December 31, 1993. In 1993, funds restricted for construction activity of $9.5 million was obtained through the issuance of tax exempt bonds, the use of which is restricted for utility plant construction. Interest income earned is included in Other, net in the accompanying Consolidated Statements of Income. (4) Notes Payable Notes payable are incurred primarily for temporary financing of plant expansion. It is the subsidiaries' intent to repay these borrowings with the proceeds from the issuance of long-term debt or equity securities. Certain information related to the borrowings of the continuing operations is as follows: (Dollars in Thousands) 1993 1992 1991 Unused lines of bank credit $ 82,574 $47,314 $38,566 Borrowings outstanding at year-end 19,676 9,336 16,809 -------- ------- ------- Total lines of bank credit $102,250 $56,650 $55,375 ======== ======= ======= Monthly average borrowings during the year $ 20,660 $17,310 $20,774 ======== ======= ======= Maximum borrowings at any month-end during the year $ 34,619 $21,612 $26,223 ======== ======= ======= Weighted average annual interest rate during the year 4.5% 6.0% 8.5% ======== ======= ======= Weighted average interest rate on borrowings outstanding at year-end 4.7% 5.1% 6.8% ======== ======= ======= The Company and its subsidiaries are required to maintain compensating balances with several banks holding notes. As of December 31, 1992, cash balances of approximately $50,000 were on deposit representing compensating balances. There were no compensating balances in 1993. There are no legal restrictions on the withdrawal of these funds. (5) Shareholders' Investment As of December 31, 1993, the Company reserved issuable common shares for the following purposes: Dividend Reinvestment Plan 317,728 401(k) Savings Plan 243,685 Stock Option Plans 278,377 Employee Stock Bonus Plan 64,019 --------- 903,809 ========= The stock option plans approved by stockholders in 1988 and 1993 provide for the sale of shares to eligible key employees of the Company and its subsidiaries. The plans provide that option prices shall not be less than 100% of the fair market value on the date of the grant. The options expire after five years. During 1993, 34,500 options were granted, 13,091 options were exercised and 13,445 options lapsed and were cancelled. During 1992, 30,700 options were granted, 12,767 options were exercised, and 25,613 options lapsed and were cancelled. During 1991, 30,700 options were granted, no options were excercised, and 12,877 options lapsed and were cancelled. At December 31, 1993, options for 108,739 shares were exercisable at prices of $18.25, $18.50, $17.75, $16.50 and $19.25 per share. 13,091 stock options were exercised in 1993 at $18.25, $17.75, $16.50, $19.25, and $16.75. 12,767 stock options were excercised in 1992 at $16.50 and $16.75. No stock options were exercised in 1991. Information regarding outstanding preferred stock ($100 par value) of the Company and its subsidiaries is as follows: Of the total 30,000 Consumers Water Company preferred shares authorized with voting rights, 15,925 shares have been designated 5-1/4% Cumulative Preferred Stock Series A. The remaining 14,075 shares are undesignated. The difference between par value and acquisition price was credited to amounts in excess of par value. (6) Acquisitions On December 7, 1993, the Company, through its subsidiary C/P Utilities acquired the assets of EnviroAudit, an environmental services company, for $260,000. On December 31, 1992, the Company, through its subsidiary, Roaring Creek Water Company, acquired the assets of Northumberland Utilities in exchange for $590,000 of the Company's common stock and the assumption of $408,000 in debt. On December 31, 1992, the Company, through its subsidiary Wanakah Water Company, acquired the assets of Greenville, Millinocket and Skowhegan Water Companies for $3.5 million. All of these acquisitions were accounted for using the purchase method of accounting, and the results of their operations have been included in the consolidated financial statements since the date of acquisition. (7) Dispositions On December 16, 1993, the Company sold the Washington Court House Division of Ohio Water Service Company to the City of Washington resulting in a gain, net of taxes, of $3.0 million. In 1993, Washington Court House Division generated $2.3 million in revenue and had 6,000 customers. On January 13, 1993, the Company sold the Bourbonnais wastewater collection system of Consumers Illinois Water Company to the Village of Bourbonnais for a gain, net of taxes, of approximately $847,000. The operation generated $1.1 million in revenues and had 5,007 customers in 1992. On December 31, 1992, Southern New Hampshire Water Company sold its Amherst Division for $2.1 million resulting in a loss, net of taxes, of $27,000. On December 30, 1991, the Company closed on the sale of 389 acres of land in University Park, Illinois, for $1.1 million. This sale generated a loss, net of taxes, of approximately $98,000. On October 1, 1991, Roaring Creek Water Company closed on the sale of 220 acres of land to Northumberland County, Pennsylvania, for $550,000. This sale generated a gain, net of taxes, of approximately $294,000. On June 27, 1991, the Company sold the Marysville Division of Ohio Water Service Company to the City of Marysville for $9.5 million resulting in a gain, net of taxes, of $3.1 million. The Marysville Division generated $1.9 million of revenue during 1990 and served 3,328 customers. (8) Retirement Plan The Company has a defined benefit pension plan covering substantially all of its employees. Pension benefits are based on years of service and the employee's average salary during the last five years of employment. The Company's funding policy is to contribute an amount that will provide for benefits attributed to service to date and for those expected to be earned in the future by current participants, to the extent deductible for income tax purposes. Net pension cost for the years ended December 31, 1993, 1992, and 1991, was $501,000, $30,000, and $582,000, respectively. The funded status of the Plan as of December 31 is as follows: (Dollars in Thousands) 1993 1992 Actuarial present value of benefit obligations: Accumulated benefit obligations Vested $20,448 $17,350 Nonvested 2,132 1,809 ------- ------- Total 22,580 19,159 Effect of future salary increases 7,361 7,502 ------- ------- Projected benefit obligations for services provided to date 29,941 26,661 Market value of plan assets, primarily invested in stocks, bonds and short-term funds 30,067 28,395 ------- ------- Plan assets in excess of projected benefit obligations 126 1,734 Unrecognized net asset existing as of January 1, 1987, being amortized over 22 years (3,317) ( 3,526) Unrecognized prior service cost 2,601 2,814 Unrecognized net gain ( 865) (1,975) -------- ------- Accrued pension cost at year-end $(1,455) $( 953) ======== ======== Net pension cost included the following items: (Dollars in Thousands) 1993 1992 1991 Service cost-benefits earned during the year $ 977 $ 934 $ 941 Interest cost on projected benefit obligations 2,022 1,860 1,740 Actual return on plan assets (2,502) (1,955) (6,549) Net amortization and deferral 4 ( 809) 4,450 --------- ------- -------- Net periodic pension cost $ 501 $ 30 $ 582 ========= ======= ======== The expected long-term rate of return on plan assets was 9.0% in 1993 and 9.5% in 1992 and 1991 and the salary increase assumption was 5.0% in 1993 and 6% in 1992 and 1991. The discount rate used to determine the actuarial present value of the projected benefit obligations was 7.5% in 1993, 8.0% in 1992 and 8.5% in 1991. (9) Postretirement Benefits Employees retiring from the Company in accordance with the retirement plan provisions are entitled to postretirement health care and life insurance coverage. These benefits are subject to deductibles, co-payment provisions and other limitations. The Company may amend or change the plan periodically. In December, 1990, the Financial Accounting Standards Board issued Statement No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions (SFAS 106). This new standard, which the Company adopted in the first quarter of 1993, requires that the expected cost of postretirement benefits (other than pensions) be expensed during the years that the employees render service. This is a significant change from the Company's previous policy of recognizing these costs on a cash basis. The Company adopted the new standard using the delayed recognition method. Under this method, the unrecorded SFAS 106 liability as of January 1, 1993, will be amortized to expense on a straight-line basis over a 20-year period. The Company estimates that its SFAS 106 liability related to prior years of service, based upon the current level of benefits, is approximately $3,048,000. The annual expense is $584,200. The utility subsidiaries generally will record some portion of the annual expense as a regulatory asset if full SFAS 106 expense is not included in rates currently and appropriate approval is received from their respective regulators. The public utility commissions have ruled in generic proceedings in each of the states in which the Company operates except Illinois that they will allow full accrual of SFAS 106 costs. They also ordered that the Company's subsidiaries in those states record the costs as regulatory assets until the next rate case. The Illinois Commerce Commission has concluded that any costs associated with this statement must be expensed until the Company's first rate proceeding. Of the $584,200 total 1993 costs, $136,000 is related to the Illinois utilities. The following table sets forth the postretirement health and life insurance plans' combined funded status. (Dollars in Thousands) 1993 Accumulated postretirement benefit obligation ($3,873) Plan assets at fair value - Accumulated postretirement benefit --------- obligation in excess of plan assets ($3,873) Unrecognized net gain from past experience different from that assumed and from changes in assumptions 323 Unrecognized transition obligation 3,048 -------- Accrued postretirement benefit cost $(502) ======== The Company's postretirement health and life insurance plans are unfunded; there are no assets for either plan and the accumulated postretirement benefit obligation for health insurance is $3,371,961 and for life insurance is $501,110. Net periodic postretirement benefit cost for fiscal 1993 included the following components; (Dollars in Thousands) 1993 Service cost-benefits attributed to service during the period $155 Interest cost on accumulated postretirement benefit obligation 269 Amortization of transition obligation over 20 years 160 ------ Net periodic postretirement benefit cost $584 ====== The weighted average discount rate used in determining the accumulated postretirement benefit obligation is 7.5%. A 15% annual rate of increase in the per capita cost of covered health care benefits is assumed for 1993. The health care cost trend rate is assumed to decrease annually through the year 2002 to an ultimate rate of 6%. Increasing the assumed health care cost trend rates by 1% would increase the accumulated postretirement benefit obligation as of December 31, 1993, by $300,000. (10) Commitments and Contingencies The Company is a party in or may be affected by various matters under litigation. The Company expects that some of its operating subsidiaries, in order to comply with the requirements of the Safe Drinking Water Act, may have to invest in significant improvements or additions including, but not limited to, the construction of treatment plants and the modification or replacement of open reservoirs. Management believes that the ultimate treatment of these expenditures and the various matters under litigation will not have a significant adverse effect on either the Company's future results of operations or financial position. The Company has operating leases for buildings, vehicles, water meters and office equipment. Rental expenses relating to these leases for the years ended December 31, 1993, 1992 and 1991 were approximately $1,612,000, $1,684,000 and $1,448,000,respectively. At December 31, 1993, minimum future lease payments under noncancelable operating leases are $1,386,000 in 1994, $916,000 in 1995, $683,000 in 1996, $467,000 in 1997, $127,000 in 1998 and $706,000 thereafter. In March, 1993, an outside contractor spilled a small amount of mercury while working at the Company's subsidiary, Ohio Water Service's (OWS) water treatment plant. Several areas in and around the plant were contaminated by the spill, although no mercury has contaminated OWS's water supply. OWS is continuously monitoring the situation to maintain water quality. The OWS has contacted all the appropriate regulatory agencies and the cleanup has been completed. The total cost to clean up the spill was approximately $900,000. The OWS is currently seeking recovery of these costs from the contractor. Management believes that OWS has a high probability of recovering damages from the contractor and, therefore, has recorded no expenses related to the spill. (11) Other, net In the second quarter of 1991, the Company's New Hampshire utility, Southern New Hampshire Water Company, received a decision and order on its pending rate request, requiring that Southern New Hampshire Water Company reduce its rate base by approximately $616,000. Accordingly, the Company has recorded a write-off of $616,000 ($374,000 after taxes). This write-off is included in Other, net as of December 31, 1991. (12) Discontinuance of Real Estate Operations On July 11, 1990, the Company announced its intention to discontinue and dispose of its real estate business, which includes The Dartmouth Company (Dartmouth) and its wholly owned subsidiary, Arcadia Company (Arcadia). In February 1991, the Company decided to cease any further investment in Dartmouth. This action was in response to increasingly stringent financing requirements for real estate investors, recent bank failures creating a considerable inventory of properties on the market at distressed prices and the inability to forecast a near bottom to the New England real estate market decline. Dartmouth had notes payable to financial institutions aggregating $14.2 million at December 31, 1990, which were secured by its real estate assets and other liabilities of $420,000, consisting primarily of current liabilities. As of December 31, 1991, Dartmouth had sold, or otherwise disposed of, all of its properties. As a result of the successful resolution of material uncertainties related to the disposition of the Company's real estate operations the Company reversed $1.8 million of its reserve for loss on disposal of discontinued operations during 1991. The Dartmouth Company's business is being accounted for as a discontinued operation, and accordingly, operating results to the date of discontinuance are shown separately in the accompanying Consolidated Statements of Income, and all financial statements presented for prior periods have been restated. Total sales for the discontinued real estate operations were $1.7 million in 1991. (13) Discontinuance of Manufactured Housing Operations On October 6, 1993, the Company announced its intention to dispose of its manufactured housing business, Burlington Homes of New England. The business was offered for sale. The estimated loss on the disposal of $4.2 million was recorded in the third quarter of 1993. To date, efforts to sell Burlington have been unsuccessful, and an additional $1.1 million reserve was recorded in the fourth quarter for a total reserve of $5.3 million, net of taxes, of approximately $600,000. The operating results of Burlington Homes prior to the date of discontinuance are shown separately on the accompanying consolidated statements of income, and all financial statements for prior periods have been restated. Total sales for Burlington Homes were $5,486,000, $5,370,000, and $5,240,000 in 1993, 1992, and 1991, respectively. Consumers Water Company and Subsidiaries Unaudited Financial Information Quarterly Financial Data Unaudited quarterly financial data pertaining to the results of operations for 1993 and 1992 are as follows: (Dollars in Thousands Except Per Share Amounts) 1st 2nd 3rd 4th Quarter Quarter Quarter Quarter Operating Revenue --- Continuing Operations $20,937 $22,503 $24,521 $21,123 Operating Income --- Continuing Operations $4,662 $5,444 $8,026 $4,713 Net Income(Loss): Continuing Operations $2,111 $1,738 $3,613 $4,541 Discontinued Operations($ 274) ($ 293) ($4,417) ($1,100) Total $1,837 $1,445 ($ 804) $3,441 Earnings(Loss) Per Share: Continuing Operations $0.29 $0.24 $0.50 $0.60 Discontinued Operations($0.04) ($0.04) ($0.61) ($0.14) Total $0.25 $0.20 ($0.11) $0.46 Operating Revenue --- Continuing Operations $19,195 $21,142 $22,725 $21,183 Operating Income --- Continuing Operations $4,628 $6,367 $7,132 $5,668 Net Income(Loss): Continuing Operations $1,255 $2,331 $2,818 $2,097 Discontinued Operations($ 156) ($ 66) ($ 62) ($ 195) Total $1,099 $2,265 $2,756 $1,902 Earnings Per Share(Loss): Continuing Operations $0.18 $0.33 $0.40 $0.30 Discontinued Operations($0.02) ($0.01) ($0.01) ($0.03) Total $0.16 $0.32 $0.39 $0.27 The fluctuations in revenue and operating income between quarters reflect the seasonal nature of the water utility business, changes in industrial usage and the timing of rate relief. Gains from the sales of properties of continuing operations, net of taxes, were $867,000, $6,000, $(5,000), and $2,999,000 in the four quarters of 1993 as compared with $2,000, $0, $0, and $(27,000) in 1992. Schedule X CONSUMERS WATER COMPANY AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR CONTINUING OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (Dollars in Thousands) Column A Column B Item Charged to Costs and Expenses 1993 1992 1991 Maintenance and repairs $4,806 $5,275 $5,696 ========================= Depreciation and amortization $7,994 $7,432 $6,125 ========================= Taxes other than payroll and income taxes: Municipal property $4,983 $4,521 $4,137 State, franchise and excise $3,098 $2,902 $2,730 Other $291 $298 $281 Total taxes other than payroll and ------------------------- income taxes $8,372 $7,721 $7,148 ========================= The amounts of royalties and advertising expenses are not presented as such amounts are less than one percent of total revenues and sales.

1993 ITEM 1. Business. The trust fund relating to Pooling and Servicing Agreement dated as of July 1, 1993 (the "Pooling and Servicing Agreement") between First Boston Mortgage Securities Corp., depositor (the "Depositor"), Countrywide Funding Corporation as master servicer (the "Master Servicer") and Bankers Trust Company of California, N.A. as trustee (the "Trustee"). The Conduit Mortgage Pass-Through Certificates, Series 1993-5 (the "Certificates") will be comprised of Interest-Only Class X, Principal Only Class P, Classes A-1 through A-15, Class A-R, Class M-1, Class M-2, Class B-1, Class B-2, and the Subordinated Class B-3, Class B-4 and Class B-5 Certificates (collectively with the Class B-1 and Class B-2 Certificates, the "Class B Certificates"). It is a condition to their issuance that the Class X, Class P, Class A-1 through Class A-15 and Class A-R (collectively, the "Class A Certificates") and Class M-1 Certificates be rated "AAA" by Fitch Investors Service, Inc. ("Fitch") and "Aaa" by Moody's Investors Service, Inc. ("Moody's"), that the Class M-2 Certificates be rated "AA" by Fitch, that the Class B-1 Certificates be rated "A" by Fitch and that the Class B-2 Certificates be rated "BBB" by Fitch. Accordingly, the Class B-1 and Class B-2 Certificates will not constitute "mortgage related securities" for purposes of the Secondary Mortgage Market Enhancement Act of 1984, as amended. The Certificates evidence beneficial ownership interests in a trust fund (the "Trust Fund") to be created by First Boston Mortgage Securities Corp. (the "Depositor"), which will consist primarily of a pool of conventional 30-year, fully-amortizing, fixed-rate mortgage loans (the "Mortgage Loans") secured by first liens on one- to four- family, residential real properties. The Mortgage Loans were originated by or acquired by Countrywide Funding Corporation ("Countrywide") and will be purchased by the Depositor from First Boston Mortgage Capital Corp., an affiliate of the Depositor. The Mortgage Loans are more fully described under "Description of the Mortgage Pool and the Underlying Mortgaged Properties" in the Prospectus Supplement dated July 22, 1993. Information with respect to the business of the Trust would not be meaningful because the only "business" of the Trust is the collection on the Mortgage Loans and distribution of payments on the Certificates to Certificateholders. This information is accurately summarized in the Monthly Reports to Certificateholders, which are filed on Form 8-K. There is no additional relevant information to report in response to Item 101 of Regulation S-K. ITEM 2. ITEM 2. Properties. The Depositor owns no property. The First Boston Mortgage Securities Corp., Conduit Mortgage Pass-Through Certificates, Series 1993-5, in the aggregate, represent the beneficial ownership in a Trust consisting primarily of the Mortgage Loans. The Trust will acquire title to real estate only upon default of the mortgagors under the Mortgage Loan. Therefore, this item is inapplicable. ITEM 3. ITEM 3. Legal Proceedings. None. ITEM 4. ITEM 4. Submission of Matters to a Vote of Security Holders. No matters were submitted to a vote of Certificateholders during the fiscal year covered by this report. PART II ITEM 5. ITEM 5. Market for Depositor's Common Equity and Related Stockholder Matters. The First Boston Mortgage Securities Corp., Conduit Mortgage Pass-Through Certificates, Series 1993-5 represent, in the aggregate, the beneficial ownership in a trust fund consisting primarily of the Mortgage Loans. The Certificates are owned by Certificateholders as trust beneficiaries. Strictly speaking, Depositor has no "common equity," but for purposes of this Item only, Depositor's Conduit Mortgage Pass-Through Certificates are treated as "common equity." (a) Market Information. There is no established public trading market for Depositor's Notes. Depositor believes the Notes are traded primarily in intra-dealer markets and non-centralized inter-dealer markets. (b) Holders. The number of registered holders of all classes of Certificates on (for dates see ITEM 12(a)) was 29. (c) Dividends. Not applicable. The information regarding dividend required by sub-paragraph (c) of Item 201 of Regulation S-K is inapplicable because the Trust does not pay dividends. However, information as to distribution to Certificateholders is provided in the Monthly Reports to Certificateholders for each month of the fiscal year in which a distribution to Certificateholders was made. ITEM 6. ITEM 6. Selected Financial Data. Not Applicable. Because of the limited activities of the Trust, the Selected Financial Data required by Item 301 of Regulation S-K does not add relevant information to that provided by the Monthly Reports to Certificateholders, which are filed on a monthly basis on Form 8-K. ITEM 7. ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. Not Applicable. The information required by Item 303 of Regulation S-K is inapplicable because the Trust does not have management per se, but rather the Trust has a Trustee who causes the preparation of the Monthly Reports to Certificateholders. The information provided by the Monthly Reports to Certificateholders, which are filed on a monthly basis on Form 8-K, does provide the relevant financial information regarding the financial status of the Trust. ITEM 8. ITEM 8. Financial Statements and Supplementary Data. Monthly Remittance Statement to the Certificateholders as to distributions made on August 25, 1993, and filed with the Securities and Exchange Commission on Form 8-K on February 10, 1999. Monthly Remittance Statement to the Certificateholders as to distributions made on September 27, 1993, and filed with the Securities and Exchange Commission on Form 8-K on February 10, 1999. Monthly Remittance Statement to the Certificateholders as to distributions made on October 25, 1993, and filed with the Securities and Exchange Commission on Form 8-K on February 10, 1999. Monthly Remittance Statement to the Certificateholders as to distributions made on November 26, 1993, and filed with the Securities and Exchange Commission on Form 8-K on February 10, 1999. Monthly Remittance Statement to the Certificateholders as to distributions made on December 27, 1993, and filed with the Securities and Exchange Commission on Form 8-K on February 10, 1999. Annual Statement of Compliance by the Master Servicer is not currently available and will be subsequently filed on Form 8. Independent Accountant's Report on Servicer's will be subsequently filed on Form 8. ITEM 9. ITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. None. PART III ITEM 10. ITEM 10. Directors and Executive Officers of Depositor. Not Applicable. The Trust does not have officers or directors. Therefore, the information required by items 401 and 405 of Regulation S-K are inapplicable. ITEM 11. ITEM 11. Executive Compensation. Not Applicable. The Trust does not have officers or directors to whom compensation needs to be paid. Therefore, the information required by item 402 of regulation S-K is inapplicable. ITEM 12. ITEM 12. Security Ownership of Certain Beneficial Owners and Management. (a) Security ownership of certain beneficial owners. Under the Pooling and Servicing Agreement governing the Trust, the holders of the Certificates generally do not have the right to vote and are prohibited from taking part in management of the Trust. For purposes of this Item and Item 13 ITEM 13. Certain Relationships and Related Transactions. (a) Transactions with management and others. Depositor knows of no transaction or series of transactions during the fiscal year ended December 31, 1993, or any currently proposed transaction or series of transactions, in an amount exceeding $60,000 involving the Depositor in which the Certificateholders identified in Item 12(a) had or will have a direct or indirect material interest. There are no persons of the types described in Item 404(a)(1),(2) and (4) of Regulation S-K, however, the information required by Item 404(a)(3) of Regulation S-K is hereby incorporated by reference in Item 12 herein. (b) Certain business relationships. None. (c) Indebtedness of management. Not Applicable. The Trust does not have management consisting of any officers or directors. Therefore, the information required by item 404 of Regulation S-K is inapplicable. (d) Transactions with promoters. Not Applicable. The Trust does not use promoters. Therefore, the information required by item 404 of Regulation S-K is inapplicable. PART IV ITEM 14. ITEM 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) The following is a list of documents filed as part of this report: EXHIBITS Monthly Remittance Statement to the Certificateholders as to distributions made on August 25, 1993, and filed with the Securities and Exchange Commission on Form 8-K on February 10, 1999. Monthly Remittance Statement to the Certificateholders as to distributions made on September 27, 1993, and filed with the Securities and Exchange Commission on Form 8-K on February 10, 1999. Monthly Remittance Statement to the Certificateholders as to distributions made on October 25, 1993, and filed with the Securities and Exchange Commission on Form 8-K on February 10, 1999. Monthly Remittance Statement to the Certificateholders as to distributions made on November 26, 1993, and filed with the Securities and Exchange Commission on Form 8-K on February 10, 1999. Monthly Remittance Statement to the Certificateholders as to distributions made on December 27, 1993, and filed with the Securities and Exchange Commission on Form 8-K on February 10, 1999. (c) The exhibits required to be filed by Depositor pursuant to Item 601 of Regulation S-K are listed above and in the Exhibit Index that immediately follows the signature page hereof. (d) Not Applicable. The Trust does not have any subsidiaries or affiliates. Therefore, no financial statements are filed with respect to subsidiaries or affiliates. Supplemental information to be furnished with reports filed pursuant to Section 15(d) by Depositors which have not registered securities pursuant to Section 12 of the Act. No annual report, proxy statement, form of proxy or other soliciting material has been sent to Certificateholders, and the Depositor does not contemplate sending any such materials subsequent to the filing of this report. SIGNATURE Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Depositor has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. By: Bankers Trust Company of California, N.A. not in its individual capacity but solely as a duly authorized agent of the Registrant pursuant to the Pooling and Servicing Agreement, dated as of July 1, 1993. By: /s/Judy L. Gomez Judy L. Gomez Assistant Vice President Date: March 4, 1999 EXHIBIT INDEX Exhibit Document 1.1. Monthly Remittance Statement to the Certificateholders as to distributions made on August 25, 1993, and filed with the Securities and Exchange Commission on Form 8-K on February 10, 1999. 1.2 Monthly Remittance Statement to the Certificateholders as to distributions made on September 27, 1993, and filed with the Securities and Exchange Commission on Form 8-K on February 10, 1999. 1.3 Monthly Remittance Statement to the Certificateholders as to distributions made on October 25, 1993, and filed with the Securities and Exchange Commission on Form 8-K on February 10, 1999. 1.4 Monthly Remittance Statement to the Certificateholders as to distributions made on November 26, 1993, and filed with the Securities and Exchange Commission on Form 8-K on February 10, 1999. 1.5 Monthly Remittance Statement to the Certificateholders as to distributions made on December 27, 1993, and filed with the Securities and Exchange Commission on Form 8-K on February 10, 1999. 1.6 The Pooling and Servicing Agreement of the Registrant dated as of July 1, 1993 (hereby incorporated herein by reference and filed as part of the Registrant's Current Report on Form 8-K filed with Securities and Exchange Commission on February , 1999.

1993 Item 1. Business. The registrant, CBS Inc. ("CBS")*, conducts its domestic and international operations either directly or through subsidiaries and joint ventures. The operations of CBS are carried out primarily by the CBS/Broadcast Group. Other activities of CBS include various activities not directly associated with the Group, i.e., The CBS/FOX Company, Radford Studio Center Inc. and other non-material miscellaneous activities. CBS/Broadcast Group The CBS/Broadcast Group, through the CBS Television Network, distributes a comprehensive schedule of news and public affairs broadcasts, entertainment and sports programming and feature films to 206 independently owned affiliated stations and the seven CBS owned and operated television stations, which in the aggregate serve the 50 states and the District of Columbia, and to certain overseas affiliated stations. The CBS Operations and Administration Division operates the technical facilities used to produce and distribute programs of the CBS News, Sports and Entertainment Divisions. This division is also responsible for providing facilities management, personnel services, management information systems and administrative support services to CBS, including the CBS/Broadcast Group, and to unaffiliated companies for a fee. The CBS/Broadcast Group consists of eight divisions, whose operations are briefly described below: The CBS Entertainment Division produces and otherwise acquires entertainment series and other programs, and acquires feature films, for distribution by the CBS Television Network for broadcast. The CBS Marketing Division is responsible for sales of advertising time for CBS Television Network broadcasts and related marketing research, merchandising and sales promotion activities. The CBS Enterprises Division, operating primarily through the CBS Broadcast International and CBS Video units, is responsible for the worldwide distribution of CBS-owned news and public affairs broadcasts, sports and entertainment programming and feature films to broadcast and other media (including cable, airlines and home video, in the latter case through The CBS/Fox Company) and the acquisition of broadcast and non- broadcast rights in independently produced programs where permitted by law. The CBS Affiliate Relations Division is responsible for the full range of ongoing activities and mutual concerns between the CBS Television Network and the 206 independently owned affiliated stations. The CBS News Division operates a worldwide news organization which produces regularly scheduled news and public affairs broadcasts and special reports for the CBS Television and Radio Networks. This division also produces certain news- _______________ * Except as the context otherwise requires, references to CBS in this Annual Report mean CBS Inc. and include its subsidiaries. - 2 - oriented programming for broadcast in the early morning daypart and in designated hours during prime time. The CBS Sports Division produces and otherwise acquires sports programs for distribution by the CBS Television Network for broadcast. The CBS Television Stations Division operates and serves as sales representative for the seven CBS owned television stations (serving New York, Chicago, Los Angeles, Philadelphia, Minneapolis-St. Paul (which includes two satellite stations), Green Bay-Appleton (which includes a satellite station) and Miami). The division also owns and operates Midwest Sports Channel, a supplier of regional sports programming to cable subscribers in Minnesota, North Dakota, South Dakota, northern Iowa and western Wisconsin, and Teleport Minnesota, which provides programming and technical services to cable operators in the upper Midwest and operates a service enabling broadcast companies and other clients to transmit video signals into and out of Minnesota. The CBS Radio Division operates the eight CBS owned AM radio stations (serving New York, Chicago, Detroit, Los Angeles, Philadelphia, Minneapolis- St. Paul, St. Louis and San Francisco) and 13 CBS owned FM radio stations (serving the same cities named above, as well as Boston, Dallas/Fort Worth (two stations), Houston and Washington, D.C.); serves as broadcast sales representative for the CBS owned radio stations, 14 independently owned AM and 24 independently owned FM radio stations; and operates the CBS Radio Networks, which serve approximately 585 affiliated stations nationwide. Other Activities The CBS/FOX Company is a partnership in which CBS and a wholly-owned subsidiary of Twentieth Century-Fox Film Corporation ("Fox") each own a 50% interest. This partnership is engaged in the acquisition from unrelated third parties of the videocassette rights to feature films and other, non-theatrical product, and provides marketing activities relating to the videocassette distribution (by a subsidiary of Fox) of products produced by CBS and the partnership. It also engages in selling activities to specialized accounts of product of CBS and the partnership. The related partnership agreement expires February 28, 1997. Radford Studio Center Inc., a wholly owned subsidiary of CBS ("Radford"), owns and operates television and film production facilities at its Studio Center facility in Studio City, California. CBS, through Radford, became the sole owner of the Studio Center business and facilities in March 1992 when it acquired the 50 percent partnership interest of MTM Studios, Ltd. in The CBS/MTM Company. Industry Segment Information Since January 1988, CBS has operated predominantly in a single industry - -- broadcasting. Accordingly, there is no requirement for segment reporting. Competition The CBS Television Network and CBS owned television stations compete for audiences with other television networks and television stations, as well as with other video media, including cable television, multipoint distribution services, low power television stations, satellite television services and video cassettes. In the sale of advertising, the CBS Television Network competes with other networks, - 3 - television stations, cable television programmers, and other advertising media. The CBS owned television stations compete for advertising with other television stations and cable television systems, as well as with newspapers, magazines and billboards. The CBS Television Network and CBS owned television stations also compete with other video media for distribution rights to television programming. The CBS owned television stations compete primarily in their individual markets. In addition to competing television broadcast stations, cable television systems and program services represent a significant source of competition for audiences, advertising and program rights to CBS. In individual markets, cable systems provide competition by offering audiences additional signals and by supplying a broad array of advertiser- and subscription-supported video programming not available on conventional stations. Current and future technological developments may affect competition within the television field. Developments in advanced digital technology may enable competitors to provide "high definition" pictures and sound qualitatively superior to what television stations now provide. Development of the technology to compress digital signals may also permit the same broadcast or cable channel or satellite transponder to carry multiple video and data services, and could result in an expanded field of competing services. CBS cannot predict when and to what extent digital technology will be implemented in the various television services, and whether and how television stations will be able to make use of the improvements inherent in it. The Federal Communications Commission (FCC) has initiated proceedings having the ultimate goal of adopting a standard for the use of advanced digital technology in terrestrial television broadcast service. Recent statutory, judicial and regulatory actions may also affect competition. The Cable Consumer Protection and Competition Act of 1992 ("1992 Cable Act") for the first time required cable systems to obtain broadcast stations' consent to retransmit the stations' signals, thereby providing television stations the opportunity to negotiate a fee or other compensation for such retransmission. (In September 1993 CBS granted cable systems carrying the signals of its owned television stations consent to continue to carry those signals, without compensation, until October 6, 1994.) As an alternative, the Cable Act allowed television stations to require cable systems to carry their signals within their television markets without compensation. The cable industry has brought legal challenges to the latter provisions of the 1992 Cable Act (commonly referred to as the "must carry" provisions), and a split lower court decision upholding them has been appealed to the United States Supreme Court, which is expected to render its decision by the end of June 1994. Telephone companies represent another source of potential competition in the television field through their efforts to provide both video services and data transmission services directly to their subscribers' homes. While the Cable Communications Policy Act of 1984 ("1984 Cable Act") prohibits regional Bell operating companies ("RBOCs") from providing video programming directly to subscribers' homes, several recent developments may affect competition. In 1992, the FCC permitted telephone companies, without the necessity of obtaining a municipal cable franchise, to offer "video dialtone" distribution services to programmers on a common carrier basis. In 1993, a federal district court in Virginia ruled that the 1984 Cable Act's prohibition on telephone companies' provision of video programming to subscribers is unconstitutional as applied to the Bell Atlantic Corporation. Other RBOCs have sought similar rulings, and the Bell Atlantic ruling is on appeal. Currently, there are a number of legislative - 4 - proposals that would provide a regulatory framework for telephone company entry into the cable television business and into the provision of future broadband video services in the companies' service areas. Network regulations may also affect competition. In 1991, the FCC modified its Financial Interest and Syndication ("Fin/Syn") rules, which had limited the ability of television networks to acquire any financial interest or syndication rights in television programs and prohibited the networks from themselves syndicating television programs. CBS and other television networks appealed this decision to the United States Court of Appeals for the Seventh Circuit, contending that the rules should have been eliminated rather than modified. The Court affirmed the FCC's decision to abrogate the pre-existing rules, but vacated the FCC's modification of those rules as arbitrary and capricious and remanded the matter to the FCC. In April 1993, the FCC announced new rules which eliminate all restrictions on network acquisition of financial interests and syndication rights in network programming and retain most restrictions on syndication by the networks themselves. Petitions to review the new rules are before the Seventh Circuit Court of Appeals. The television network operations of CBS and other television networks are subject to consent decrees entered by the United States District Court for the Central District of California in 1980. In November 1993, the court modified the consent decrees to eliminate restrictions parallel to the FCC's old Fin/Syn rules, thereby permitting the networks to act to the extent permitted by the FCC's 1993 rules. The FCC has provided that all its Fin/Syn restrictions are to "sunset" two years from the date of the November 1993 modification of the consent decrees. It has also determined that it will review the rules six months before they expire and that the burden of proof in this review will rest on those favoring retention of the rules. The CBS Radio Network and CBS's owned radio stations compete with other radio networks, independent radio stations, suppliers of radio programming, and other advertising media. Competition with CBS's owned radio stations occurs primarily in their individual market areas, although on occasion stations outside a market place signals within that area. While such outside stations may obtain an audience share, they generally do not obtain any significant share of the advertising within the market. Developments in radio technology could affect competition in the radio field. New radio technology, known as "digital audio broadcasting" (DAB), can provide sound of the quality of compact discs, which is significantly higher than that now provided by radio networks and stations using analog technology. CBS, among others, is actively involved in the study and development of this digital technology, but cannot predict when and to what extent existing radio networks and stations will be in a position to utilize it. The FCC has initiated proceedings to consider the development and implementation of DAB services. The FCC is also currently considering an application to establish a nationwide, satellite-delivered DAB service, which, if approved, could constitute an additional source of competition to conventional radio stations and networks. CBS cannot predict the effect on its business or earnings of possible future competitive, economic, technological, international or industrial changes. Nor can CBS generally predict the outcome of administrative and judicial procedures or whether new legislation may be enacted or new regulations adopted that might bear on the broadcast industry or affect CBS's business. - 5 - Material Licenses and Federal Regulation Except as indicated below, all of CBS's television and radio stations operate under currently effective licenses from the Federal Communications Commission ("FCC"), which is empowered by the Communications Act of 1934, as amended, to, inter alia, license and regulate television and radio broadcasting stations. The FCC has authority to grant or renew broadcast licenses for a maximum term of five years for television and seven years for radio if it determines that the "public convenience, interest or necessity" will be served thereby. During a specified period after an application for renewal of a broadcast station license has been filed, competing applications seeking a license to broadcast on the same frequency may be filed with the FCC, and are entitled to consideration by the FCC in a hearing to evaluate the comparative merits of the applications. Persons objecting to the license renewal application may also file petitions to deny during this period. In Item 1 of CBS's Form 10-K for 1992 (under the caption "Material Licenses and Federal Regulation"), CBS reported that, on August 3, 1992, it had filed with the FCC timely applications to renew the television broadcast licenses for WBBM-TV, Chicago, Illinois; WFRV-TV, Green Bay, Wisconsin; and WJMN-TV, Escanaba, Michigan. The applications to renew such licenses for WFRV-TV and WJMN-TV were granted on November 23, 1993. There is no change in the status of CBS's application to renew the license for WBBM-TV. CBS believes that the station has been operated in accordance with all requirements. In Item 1 of Part II of CBS's Form 10-Q for the quarter ended September 30, 1993, CBS reported that, on August 2, 1993, CBS filed with the FCC a timely application to renew the television broadcast license for KCBS-TV, Los Angeles, California. On November 17, 1993, Mark McDermott and Americans for Responsible Media filed with the FCC a petition to deny the KCBS-TV application, to which CBS responded on December 14, 1993. CBS believes that the station has been operated in accordance with all requirements. On February 1, 1994 CBS filed with the FCC a timely application to renew the television license for WCBS-TV, New York, New York. The date by which oppositions or competing applications may be filed is May 2, 1994. The FCC has adopted rules prohibiting common ownership in the same market of radio and VHF television stations and prohibiting common ownership of stations with certain overlapping signals ("duopoly"). When those rules were adopted, existing commonly owned stations, including the VHF/radio combinations and a television duopoly then owned by CBS, were "grandfathered". In addition, in February 1992, CBS acquired from Midwest Communications, Inc., a VHF television station and AM and FM radio stations in Minneapolis, Minnesota, pursuant to an FCC waiver of its rules relating to VHF/radio combinations. As a result, absent an FCC waiver, a transfer of CBS licenses to a third party or a change in control of CBS could result in the loss of the license of either the television station or the radio stations in New York, Philadelphia, Chicago, Los Angeles and Minneapolis, and (as a result of overlapping television signals) the television station in either New York or Philadelphia. Under the FCC's waiver policy, however, the FCC will generally look favorably on waiver applications relating to radio-television station combinations in the top 25 television markets where there would be at least 30 separately owned broadcast stations after the proposed combination. Employees As of December 31, 1993, CBS had approximately 6,500 full-time employees. - 6 - Executive Officers of the Registrant (as of March 1, 1994) Date of Commencement of Service as Executive Officer in Present Position; Other Positions Since Name Age Present Positions January 1, 1989 ____ ___ _________________ ______________________ Laurence A. Tisch 71 Chairman of the Board, December 12, 1990; President President and Chief Exe- and Chief Executive Officer cutive Officer, CBS Inc. since January 1987; Chairman of the Board and Co-chief Executive Officer, Loews Corporation (Chief Executive Officer from August 1986 to February 1988 and a Director since 1959) (insurance, tobacco products, hotels, watches) Edward Grebow 44 Senior Vice President, February 8, 1988; executive Administration, CBS Inc. in charge of CBS Operations and Administration Division since June 1988 Ellen Oran Kaden 42 Senior Vice President, October 13, 1993; Vice General Counsel and President, General Counsel Secretary, CBS Inc. and Secretary, from July 1991 to October 1993; Vice President, Deputy General Counsel and Secretary (Acting General Counsel), from May to July 1991; Deputy General Counsel, from April 1989 to July 1991; Associate General Counsel, from September 1986 to April Peter W. Keegan 49 Senior Vice President, March 9, 1988 Finance, CBS Inc. Howard Stringer 52 Vice President, CBS Inc.; August 1, 1988 President, CBS/Broadcast Group Peter A. Lund 53 Executive Vice President, January 3, 1994; President, CBS/Broadcast Group; CBS Marketing Division, from President, CBS Television October 9, 1990 to December Network 1993; President, Multimedia Entertainment, from March 1987 to October 1990 Anthony C. Malara 57 President, CBS Affiliate May 31, 1988 Relations, a Division of CBS Inc. - 7 - Eric W. Ober 52 President, CBS News, a September 1, 1990; Division of CBS Inc. President, CBS Television Stations Division, from March 1987 to August 1990 Neal H. Pilson 53 President, CBS Sports, December 15, 1986 a Division of CBS Inc. Johnathan Rodgers 48 President, CBS Television September 1, 1990; Vice Stations, a Division of President and General CBS Inc. Manager, WBBM-TV, from March 1986 to August 1990 Jeffrey F. Sagansky 42 President, CBS January 1, 1990; President, Entertainment, a Tri-Star Pictures Inc., Division of from March to December CBS Inc. 1989; President, Production, Tri-Star Pictures Inc., from February 1985 to March James A. Warner 40 President, CBS December 4, 1989; Vice Enterprises, a Division President, HBO Enterprises, of CBS Inc. Home Box Office, Inc., from April 1986 to November 1989 Nancy C. Widmann 51 President, CBS Radio, a August 1, 1988 Division of CBS Inc. - 8 - Item 2. Item 2. Properties. The principal executive offices of CBS are located in its headquarters building at 51 West 52 Street, New York, NY 10019. Major CBS television and/or radio facilities are located at the CBS Broadcast Center at 524 West 57 Street, New York, NY and the headquarters building in New York, NY; CBS Television City and Columbia Square in Los Angeles, CA; and in Chicago, IL; Philadelphia, PA; St. Louis, MO; Boston, MA; San Francisco, CA; a suburb of Washington, D.C.; Miami, FL; Detroit, MI; St. Petersburg, FL; Dallas/Fort Worth and Houston, TX; Minneapolis, MN; and Green Bay, WI. Of the foregoing real estate properties, all are owned by CBS except as described below: CBS Radio Division occupies radio studios and offices in St. Louis, MO (leases expire December 31, 2002); Boston, MA (lease expires December 31, 2006); San Francisco, CA (lease expires December 31, 1995); Dallas, TX (lease expires December 31, 1996); Houston, TX (lease expires March 25, 1994); Detroit, MI (lease expires April 30, 1998); and Minneapolis, MN (month-to-month). Radford owns and operates a television and film production facility lot in Studio City, CA which includes 17 sound stages. Some of these facilities are made available to the CBS Entertainment Division, and the balance is leased to third parties. CBS owns and leases other domestic real properties (including transmitter sites), and leases foreign real properties, used in connection with its business activities. In October 1993, CBS and the City of New York consummated a previously- announced agreement whereby, for a 15-year period, CBS agreed to maintain current principal operations and specified levels of employment in New York City, and in consideration thereof the City of New York granted to CBS annual tax abatements, investment incentives, and certain other concessions. Over such period, the abatements and concessions are expected to aggregate approximately $48.5 million, and will reduce CBS's annual operating costs accordingly. Included among a series of interrelated transactions among CBS, the City and certain of its administrative units, and the New York State Power Authority, was CBS's conveyance of fee title to its Broadcast Center properties, located on West 57th Street in Manhattan, to the New York City Industrial Development Agency for a period of 15 years with a lease of those properties back to CBS. Such conveyance is expressly subject to CBS's retaining a reversionary interest in the properties, so that title in fee will revert to CBS at the end of the 15-year term, or prior thereto in the event of the occurrence of certain contingencies. Also, on March 15, 1993, CBS acquired the Ed Sullivan Theater and an adjacent 13-story office building in New York City. The Ed Sullivan Theater has been designated a landmark theater by the New York City Landmark Preservation Commission. CBS has renovated the theater for use as a television production facility, and the Landmark Commission has granted its approval of the renovation. The Ed Sullivan Theater currently serves as the home of the LATE SHOW with DAVID LETTERMAN, which commenced broadcasting on the CBS Television Network in August, 1993. - 9 - Item 3. Item 3. Legal Proceedings. There are no active pending legal proceedings to which CBS is a party, or to which any of its property is subject, other than (a) routine litigation incidental to the business, and (b) proceedings before the FCC with respect to the renewal of certain radio broadcast and television broadcast licenses reported in Item 1 under the caption "Material Licenses and Federal Regulation". In addition, various other legal actions, governmental proceedings and other claims (including those relating to environmental investigations and remediation resulting from the operations of discontinued businesses) are pending or, with respect to certain claims, unasserted. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. Inapplicable. PART II Item 5. Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters. Incorporated herein by this reference and made a part of this Item 5 are the materials included under the captions "Stock Data" and "Dividends" at page 41 of Item 8 of this Report. There were approximately 11,584 holders of CBS common stock as of February 28, 1994. In May 1993, CBS converted $389.6 million of its outstanding 5% Convertible Subordinated Debentures Due 2002 for 1,947,975 shares of its common stock, issued from its treasury shares. The remaining Debentures of $.9 million were redeemed. In November 1993, CBS issued $100,000,000 of 7-1/8% Senior Notes that are due on November 1, 2023 and may not be redeemed prior to maturity. The net proceeds from the sale of those debt securities were used to fund the cost of implementing a related transaction with the New York City Industrial Development Agency, referred to in Item 2 of this Report. Item 6. Item 6. Selected Financial Data. Incorporated herein by this reference and made a part of this Item 6 is the information set forth for the years 1989 through 1993 in Item 7 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. Incorporated herein by this reference and made a part of this Item 7 are the materials included under the caption "Management's Financial Commentary" at pages 15 through 20 of this Report. Item 8. Item 8. Financial Statements and Supplementary Data. Incorporated herein by this reference and made a part of this Item 8 are the Consolidated Statements of Income, Retained Earnings, Additional Paid-In Capital and Cash Flows for the years ended December 31, 1993, 1992, and 1991; the Consolidated Balance Sheets as of December 31, 1993, 1992, and 1991; the Notes to Consolidated Financial Statements; the Report of Independent Certified Public Accountants thereon; the material set forth under "Quarterly Results of Operations (Unaudited)"; and the material set forth under "Shareholder Reference Information"; all of which are set forth at pages 21 through 41 of this Report. Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. Inapplicable. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant. Incorporated herein by this reference and made a part of this Item 10 are the materials included in CBS's Proxy Statement relating to the 1994 Annual Meeting of Shareholders (the "1994 Proxy Statement") under the captions "Information Concerning the Director-Nominees" and "Board of Directors and Its Committees". Definitive copies of the 1994 Proxy Statement are to be filed with the Commission on or about April 8, 1994. See also, "Executive Officers of the Registrant", included in Item 1 hereof pursuant to Instruction 3 to Item 401(b) of Regulation S-K. Item 11. Item 11. Executive Compensation. Incorporated herein by this reference and made a part of this Item 11 are the materials included under the caption "Executive Compensation" and the sub-headings thereunder, as set forth in the 1994 Proxy Statement. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management. Incorporated herein by this reference and made a part of this Item 12 are the materials included under the caption "Principal Stockholders and Management Ownership of Equity Securities", as set forth in the 1994 Proxy Statement. Item 13. Item 13. Certain Relationships and Related Transactions. Incorporated herein by this reference and made a part of this Item 13 are the materials included under the caption "Certain Relationships and Related Transactions", as set forth in the 1994 Proxy Statement. - 11 - PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) The Index to Financial Statements and Schedules filed as a part of this Report appears on page 14 and the report and consent of the independent certified public accountants thereon appears on page 22. The following compensatory plans and management contracts have been filed (or incorporated by reference) as Exhibits hereunder. (i) Compensatory Plans: CBS Additional Compensation Plan, CBS Stock Rights Plan, CBS Pension Plan, CBS Supplemental Executive Retirement Plan, CBS Supplemental Executive Retirement Plan #2, CBS Excess Benefits Plan, CBS Senior Executive Life Insurance Plan, CBS Deferred Compensation Plan, CBS Employee Investment Fund, CBS Retirement Plan for Outside Directors, Restricted Stock Plan for Eligible Directors. (ii) Management Contracts: The following executive officers of CBS are the only executive officers of CBS who have employment agreements: Messrs. Stringer, Lund, Ober, Sagansky, Grebow, Warner and Rodgers. (b) No reports on Form 8-K were filed during the fourth quarter of 1993. (c) The Index to Exhibits begins on page 46. (d) Not applicable. - 12 - 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. Dated: March 9, 1994 (Registrant) CBS Inc. Peter W. Keegan By:________________________________ Peter W. Keegan Senior Vice President, Finance 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 dates indicated. Laurence A. Tisch Henry B. Schacht _______________________________ _____________________________ Laurence A. Tisch Henry B. Schacht, Director Chairman of the Board, Dated: March 7, 1994 President and Chief Executive Officer (principal executive officer) Dated: March 9, 1994 Peter W. Keegan Edson W. Spencer ________________________________ ______________________________ Peter W. Keegan Edson W. Spencer, Director Senior Vice President, Finance Dated: March 9, 1994 (principal financial and accounting officer) Dated: March 9, 1994 Michel C. Bergerac Franklin A. Thomas ________________________________ ______________________________ Michel C. Bergerac, Director Franklin A. Thomas, Director Dated: March 9, 1994 Dated: March 9, 1994 Harold Brown Preston R. Tisch ________________________________ _____________________________ Harold Brown, Director Preston R. Tisch, Director Dated: March 9, 1994 Dated: March 9, 1994 Ellen V. Futter James D. Wolfensohn ________________________________ _____________________________ Ellen V. Futter, Director James D. Wolfensohn, Director Dated: March 9, 1994 Dated: March 9, 1994 Henry A. Kissinger ________________________________ Henry A. Kissinger, Director Dated: March 9, 1994 - 13 - INDEX TO FINANCIAL STATEMENTS AND SCHEDULES PAGE NO. DESCRIPTION IN 10-K ___________ _______ Management's Financial Commentary 15 Consolidated Financial Statements Management's Responsibility for Financial Statements 21 Report and Consent of Independent Certified Public Accountants 22 Statements of Income 23 Balance Sheets 24 Statements of Retained Earnings and Additional Paid-In Capital 25 Statements of Cash Flows 26 Notes to Financial Statements 27 Quarterly Results of Operations (unaudited) 40 Shareholder Reference Information 41 Schedules Schedule I - Marketable Securities - Other Investments 42 Schedule II - Amounts Receivable from Related Parties and Underwriters, Promoters, and Employees other than Related Parties 44 Schedule X - Supplementary Income Statement Information 45 Schedules other than those listed above have been omitted since they are either not required or not applicable. Financial statements of 50% or less owned persons, the investments in which are carried on an equity basis, are omitted because such persons are not "significant subsidiaries" within the meaning of Rule 1-02(v) of Regulation S-X. - 14 - MANAGEMENT'S FINANCIAL COMMENTARY In 1993, the Company's operating results improved significantly, reflecting both its ratings strength and higher unit pricing. Earnings in 1993 were also enhanced by several special items as well as by capital gains from the sale of marketable securities. The special items, which are not expected to recur in 1994, included a legal settlement with Viacom International Inc. (Viacom), an insurance settlement for hurricane damage to the Company's television station in Miami, a favorable Federal income tax audit settlement, and deferred tax benefits resulting from new Federal tax law. Excluding the effect of the above noted special items and capital gains, the Company anticipates improved operating results in 1994 based on continuing solid audience ratings, improving advertiser demand and active cost control. The Company continually updates its evaluations of environmental liabilities and the adequacy of the provisions made in prior years to cover asserted and unasserted environmental claims arising from the operations of its discontinued businesses. (There are no significant environmental claims known to the Company arising from its continuing operations.) In the Company's opinion, any additional liabilities that may result from such claims are not reasonably likely to have a material adverse effect on its consolidated financial position, results of operations, or liquidity. The impact of inflation on the Company's financial statements in 1993 was not considered sufficient to warrant the inclusion of any additional current cost disclosures in these statements. This Financial Commentary should be read in conjunction with the consolidated financial statements and notes to these financial statements. In addition, although the Commentary's Liquidity and Capital Resources section is based upon the Consolidated Statements of Cash Flows, certain data have been rearranged for purposes of clarification and, therefore, it should be read in conjunction with the Consolidated Statements of Cash Flows. RESULTS OF OPERATIONS Income from Continuing Operations and Net Income The Company's sales in 1993 were essentially the same as in 1992. The Television Network's strong household ratings and better unit prices resulted in increased sales in 1993 from its regularly scheduled programming which largely compensated for the absence of the sales generated from the broadcasts of the Olympic Winter Games and the Super Bowl in 1992. As a result, the Company's operating income improved significantly in 1993 over 1992 from the Television Network's more profitable entertainment and news programs. The Television Stations Division recorded increased sales and profits at all stations except Los Angeles. The Radio Division experienced a significant improvement in earnings, attributable to sales increases at most of its stations and to lower operating costs. Also, in 1993, earnings benefited from a legal settlement with Viacom and an insurance settlement for hurricane damage to the Company's television station in Miami (both of which were included in other income, net); capital gains from the sale of marketable securities; a favorable Federal income tax audit settlement; and deferred tax benefits resulting from new Federal tax law-all of which contributed $5.33 to earnings per share. The Company's sales and operating income improved significantly in 1992. The Television Network's stronger primetime program schedule, as well as the sales generated by the acquisition of Midwest Communications, Inc. (Midwest) (note 2), contributed to the sales and operating income increases. The sales increases due to the broadcasts of the Olympic Winter Games and the Super Bowl were largely offset by their related costs. In 1991 and 1990, the Company recorded operating losses due mainly to the provisions for losses on its Major League Baseball and National Football League television contracts (note 3). Interest income increased slightly in 1993. In 1992 and 1991, it decreased from previous years, largely as a result of the sale of marketable securities to fund the Company's $2 billion repurchase of its common stock in February 1991 (note 12). The decrease in interest expense in 1993 resulted mainly from the conversion of the 5% convertible debt into common stock in 1993 and the refinancing of the 10 7/8% senior notes in 1992. The increase in interest expense in 1992 was due mainly to the issuance of $150.0 million of debt related to the acquisition of Midwest. The decrease in interest expense in 1991 and 1990 was due primarily to the retirement of debt in 1990 and 1989. In 1993, the effective income tax expense rate was reduced by deferred tax benefits of $11.2 million resulting from new Federal tax law and by a favorable Federal tax audit settlement for the years 1988-1990 of $23.0 million. The 1992 effective income tax expense rate was reduced by a favorable Federal tax audit settlement of $17.9 million for the years 1985-1987. Income from tax preference securities increased the effective tax benefit rate in 1991 and reduced the effective tax expense rate in 1990. The Company recorded additional gains in 1991 and 1990 as a result of the final settlement of all disputed items in arbitration related to the sale of its Records Group in 1988. In 1992, the Company adopted certain accounting standards (note 1) that resulted in a one-time charge to net income, shown as cumulative effects of changes in accounting principles. The decreases in 1992 and 1991 of the adjusted weighted average shares outstanding were related mainly to the Company's repurchase of 10.5 million shares of its common stock in February 1991. In connection with this repurchase, the Company reduced its quarterly dividend per share in the first quarter of 1991 from $1.10 to $.25. Based on the Company's improved financial condition, it raised its quarterly dividend per share to $.50 in the fourth quarter of 1993. -16 (Page 1 of 2)- Year ended December 31 1993 1992 1991 1990 1989 (In millions, except per share amounts) Net sales $3,510.1 $3,503.0 $3,035.0 $3,261.2 $2,961.5 Cost of sales (2,688.8) (2,906.5) (2,938.0)(2,925.6) (2,313.2) Selling, general and administrative expenses (461.3) (422.9) (384.6) (409.3) (384.1) Other income, net 51.2 6.5 16.3 23.9 9.6 Operating income (loss) 411.2 180.1 (271.3) (49.8) 273.8 Interest income on investments, net 110.4 107.6 140.1 210.1 246.7 Interest expense on debt, net (42.3) (60.7) (47.4) (57.9) (64.8) Interest, net 68.1 46.9 92.7 152.2 181.9 Income (loss) from continuing operations before income taxes 479.3 227.0 (178.6) 102.4 455.7 Income tax (expense) benefit (153.1) (64.5) 79.9 (10.9) (158.6) Income (loss) from continuing operations 326.2 162.5 (98.7) 91.5 297.1 Discontinued operations 12.9 20.0 Extraordinary items (.7) (.8) Cumulative effects of changes in accounting principles (81.5) Net income (loss) $326.2 $81.0 $(85.8) $110.8 $296.3 Per share of common stock: Continuing operations $20.39 $10.51 $(6.11) $3.55 $11.54 Discontinued operations .79 .78 Extraordinary items (.03) (.03) Cumulative effects of changes in accounting principles (5.28) Net income (loss) $20.39 $5.23 $(5.32) $4.30 $11.51 Dividends per common share $1.25 $1.00 $1.00 $4.40 $4.40 Adjusted weighted average shares outstanding 15.5 15.4 16.2 25.7 25.7 -16 (Page 2 of 2)- LIQUIDITY AND CAPITAL RESOURCES Cash Flows The Company's liquid assets include its cash and cash equivalents and readily marketable securities held in its short-term and long-term portfolios. In 1993, the increase in liquid assets of $123.8 million was attributable primarily to cash flows from operating activities, gain on sale of marketable securities and the issuance of $100.0 million of debt, partially offset by capital expenditures. In 1992, the increase of $46.7 million was due mainly to cash flows from operating activities, partially offset by capital expenditures. The issuance of $150.0 million of debt in 1992 was used to fund major acquisitions. The decrease in liquid assets in 1991 was related principally to the Company's $2 billion repurchase of its common stock (note 12). In 1990, the combination of capital expenditures, retirement of debt and the payment of dividends to shareholders moderately exceeded the Company's cash flows from operating activities. In 1989, the Company retired debt, acquired a television station and two radio stations, and made substantial investments in broadcasting assets. These expenditures more than offset cash flows from operations, after dividend payments, and resulted in negative cash flows. The positive cash flows from asset dispositions in the 1985-1988 period and from normal operations have enabled the Company to accumulate a substantial amount of cash and marketable securities while allowing it to repurchase its common stock and make major investments in program rights, broadcasting assets, and television and radio stations. Additional details on specific cash flows are provided in subsequent sections of this Commentary. Year ended December 31 1993 1992 1991 1990 1989 (In millions) Cash flows: Operating activities $117.6 $144.2 $97.8 $217.7 $180.7 Investing activities (163.0) (374.1) 1,484.3 103.5 203.8 Financing activities 73.4 105.3 (2,033.2) (198.6) (192.1) Net change in cash and cash equivalents 28.0 (124.6) (451.1) 122.6 192.4 Remove net investment in marketable securities (included above)* 95.8 171.3 (1,456.2) (147.6) (404.8) Cash flows before investment in marketable securities** 123.8 46.7 (1,907.3) (25.0) (212.4) Cash and marketable securities at beginning of year** 921.6 874.9 2,782.2 2,807.2 3,019.6 Cash and marketable securities at end of year** $1,045.4 $921.6 $874.9 $2,782.2 $2,807.2 *Includes liabilities for securities sold subject to repurchase agreements (note 1). **Includes cash and cash equivalents and readily marketable securites held in the Company's short-term and long-term portfolios as well as liabilities for securities sold under repurchase agreements. Cash Flows from Operating Activities In accordance with Statement of Financial Accounting Standards (SFAS) No. 95, "Statement of Cash Flows," all cash flows not classified as investing or financing activities, and all interest and income taxes including those related to investing and financing activities, are classified as operating activities. In 1993, cash flows from operating activities were lower than in 1992. This was primarily caused by the excess of payments for baseball and football program rights over their related revenues, the rights fee paid for the 1994 Olympic Winter Games, and a higher level of year-end accounts receivable, due to increased sales in the fourth quarter. In 1992, cash flows from operating activities increased over the preceding year due to improved operating results. The main reasons for this increase were the sales due to the improved primetime ratings and unit pricing, and the operating cash flows related to the acquisition of Midwest (note 2). In 1991, cash flows from operating activities declined from 1990's level, principally as a result of a decline in sales which more than offset cost reductions, and also because of reduced interest income resulting from the sale of marketable securities in February 1991 to fund the Company's $2 billion repurchase of its common stock (note 12). Cash flows from operating activities in 1990 rose over 1989's level, despite a signficant reduction in income in 1990, because of lower year-end accounts receivable in 1990 and the absence of 1989's buildup of program rights. Interest, net, increased in 1993, mainly because of the conversion of the 5% convertible debt into common stock in 1993 and the refinancing of the 10 7/8% senior notes in 1992. In the preceding two years, interest, net, had declined, due primarily to the issuance of debt in 1992 related to the acquisition of Midwest and to the sale of securities in February 1991 to fund the Company's $2 billion repurchase of its common stock. The significant taxes paid in 1993 related primarily to the Company's improved operating results. The small positive cash flows from taxes in 1992 and 1991 were attributable principally to refunds related to prior years, offsetting the current years'tax payments which were small due to tax deductions for timing items. These timing items arose mainly from baseball and football losses (note 3) which were accrued in 1990 and 1991 but which were deducted for tax purposes in 1991, 1992 and 1993. From an overall standpoint, the fluctuations in cash flows from operating activities, over the period covered by the table, were due largely to changes in operating income (exclusive of noncash items) and investments in program rights. Additionally, there were period-to-period changes in year-end levels of accounts receivable and various other assets and liabilities, due largely to the timing of transactions. -18 (Page 1 of 2)- Year ended December 31 1993 1992 1991 1990 1989 (In millions) Net income (loss) $326.2 $81.0 $(85.8) $110.8 $296.3 Adjustments: Depreciation and amortization 71.0 66.7 59.9 58.7 63.6 Gain on sale of marketable securities, net (39.6) (28.9) (38.1) (12.4) (10.5) Cumulative effects of changes in accounting principles 81.5 Gain on discontinued operations (21.2) (33.0) Changes in assets and liabilities: Accounts receivable (37.1) 7.8 (2.7) 32.4 (46.9) Program rights, net (26.0) 23.3 .9 8.1 (160.5) Accounts payable (2.3) (18.1) 4.7 (5.0) 6.6 Accrual on baseball and football television contracts (242.0) (160.0) 233.0 190.0 Recoverable income taxes 88.3 (9.6) (2.6) (88.5) (4.0) Deferred income taxes (27.8) 79.4 (61.9) (26.2) 27.4 Other, net 6.9 21.1 11.6 (17.2) 8.7 Cash flows from operating activities $117.6 $144.2 $97.8 $217.7 $180.7 Cash flows from interest and income taxes included above: Interest, net* $28.5 $18.0 $54.6 $139.8 $171.4 Income taxes (94.2) 2.6 2.4 (143.4) (144.4) *Excludes gain on sale of marketable securities, which was included in cash flows from investing activities. -18 (Page 2 of 2)- Cash Flows from Investing Activities The cash flows from marketable securities in 1991 were used mainly to fund the Company's $2 billion repurchase of shares of its common stock (note 12). Other changes in net investment in marketable securities were due essentially to the cash requirements of the Company. In addition, the increases and decreases in the sales and purchases of these securities, as presented in the Statements of Cash Flows, reflected activity stimulated by market conditions. In 1992, the Company acquired Midwest and the remaining 50 percent interest in television and film production facilities in Los Angeles (note 2). In 1989, it acquired a television station in Miami and two radio stations in Detroit. The Company's principal capital expenditures in 1993, as in previous years, were for broadcasting assets. In 1993, they also included the acquisition and renovation of the Ed Sullivan Theater in New York City from which the Late Show with David Letterman is broadcast. In 1989, the Company also acquired satellite capacity for the distribution of Television Network programs to affiliated stations. The asset dispositions in 1991 represent the cash receipt of the final settlement of all disputed items in arbitration related to the 1988 sale of the Company's Records Group. Interest income on investments, net, excluding gain on sale of marketable securities, was included in operating activities and is presented for informational purposes. -19 (Page 1 of 4)- Year ended December 31 1993 1992 1991 1990 1989 (In millions) Marketable securities: Gain on sale $ 39.6 $ 28.9 $ 38.1 $ 12.4 $ 10.5 Net investment (95.8) (171.3) 1,456.2 147.6 404.8 Cash flows from marketable securities* (56.2) (142.4) 1,494.3 160.0 415.3 Major acquisitions** (160.2) (117.0) Capital expenditures (106.8) (71.5) (64.2) (60.4) (98.7) Asset dispositions 54.2 3.9 4.2 Cash flows from investing activities*** $(163.0) $(374.1) $1,484.3 $ 103.5 $ 203.8 Interest income on investments, net (not included above)*** $ 70.8 $ 78.7 $ 102.0 $ 197.7 $ 236.2 *Includes liabilities for securities sold subject to repurchase agreements (note 1). **The table excludes the noncash items indicated in the footnotes to the Statements of Cash Flows. ***Cash flows related to interest (excluding gain on sale of marketable securities) and taxes are included in operating activities in accordance with SFAS No. 95. -19 (Page 2 of 4)- Cash Flows from Financing Activities In 1993, the Company issued $100.0 million of senior notes. The proceeds from the issuance of these debt securities were used to purchase New York City Industrial Development Agency (IDA) bonds, which were issued by the IDA to establish a trust fund to implement the Company's agreement with the IDA. Under this agreement, the Company is required to invest in production facilities and develop new broadcasting and production technologies in New York City in return for certain tax incentives and low-cost energy. In 1992, the Company issued $150.0 million of senior notes in connection with the acquisition of Midwest. In addition, it issued $125.0 million of senior notes and $125.0 million of senior debentures to refinance the $263.0 million of 10 7/8% senior notes due 1995. During the period 1989-1991, the Company retired debt of $171.5 million. In 1991, the Company repurchased 10.5 million shares of its common stock at a cost of approximately $2 billion. In connection with this repurchase of shares, the Company reduced its quarterly dividend per share in the first quarter of 1991 from $1.10 to $.25. In the fourth quarter of 1993, based on its improved financial condition, the Company increased its quarterly dividend per share to $.50. Interest expense on debt, net, was included in operating activities and is presented for informational purposes. -19 (Page 3 of 4)- Year ended December 31 1993 1992 1991 1990 1989 (In millions) 7 1/8% senior notes due 2023 $100.0 7 5/8% senior notes due 2002 $ 150.0 7 3/4% senior notes due 1999 125.0 8 7/8% senior debentures due 2022 125.0 10 7/8% senior notes due 1995 (263.0) $(3.0) $ (7.7) $ (26.7) 11 3/8% notes due 1992 (75.6) (1.0) 14 1/2% notes due 1992 (50.0) Other debt (.9) (2.5) (2.5) (2.3) (2.7) Debt issued (retired)* 99.1 134.5 (5.5) (85.6) (80.4) Repurchases of common stock (3.0) (2,005.1) Dividends to shareholders (31.3) (25.9) (25.7) (116.6) (116.5) Other, net 5.6 (.3) 3.1 3.6 4.8 Cash flows from financing activities** $ 73.4 $105.3 $(2,033.2) $(198.6) $(192.1) Interest expense on debt, net (not included above)** $(42.3) $(60.7) $ (47.4) $ (57.9) $ (64.8) *The table excludes the noncash items indicated in the footnotes to the Statements of Cash Flows. **Cash flows related to interest and taxes are included in operating activities in accordance with SFAS No. 95. -19 (Page 4 of 4)- Working Capital In 1993, the increase in working capital was due largely to the decrease in other current liabilities caused by the reversal of accrued losses recorded in prior years related to the baseball and football television contracts (note 3), partially offset by the realization of tax benefits related to these losses. The increase in accounts receivable, due to increased sales in the fourth quarter, and the increase in net program rights, due primarily to the 1994 Olympic Winter Games, contributed to the increase in working capital. In 1992, the decrease in working capital was due primarily to the reclassification of certain marketable securities to the Company's long-term portfolio, and to a reclassification from long-term to other current liabilities for the accrued losses related to the baseball and football television contracts. The main reason for the decrease in working capital in 1991 related to the Company's cash outlay for its $2 billion common stock repurchase (note 12). In addition, the increase in other current liabilities was due mainly to accrued losses on the baseball and football television contracts. In 1990, the primary reason for the increased working capital was the reclassification of marketable securities from long-term to short-term in anticipation of their sale to fund the $2 billion common stock repurchase. -20 (Page 1 of 4)- December 31 1993 1992 1991 1990 1989 (In millions) Current assets: Cash and marketable securities* $ 219.4 $169.0 $272.5 $2,318.8 $755.8 Accounts receivable 454.5 417.4 420.3 417.6 450.0 Program rights 581.9 447.4 505.5 403.3 353.5 Recoverable income taxes** 28.8 117.1 90.2 87.6 Other 18.2 20.9 18.2 17.8 19.8 Total current assets 1,302.8 1,171.8 1,306.7 3,245.1 1,579.1 Current liabilities: Accounts payable 33.4 35.7 48.1 43.4 48.4 Liabilities for talent and program rights 317.4 245.5 276.3 236.4 183.9 Debt .9 13.0 3.5 3.4 3.3 Other 312.5 514.4 410.0 251.7 263.1 Total current liabilities 664.2 808.6 737.9 534.9 498.7 Working capital $ 638.6 $363.2 $ 568.8 $2,710.2 $1,080.4 Ratio of current assets to current liabilities 1.96:1 1.45:1 1.77:1 6.07:1 3.17:1 *Includes cash and cash equivalents and liabilities related to securities sold subject to repurchase agreements (note 1). **Primarily related to temporary differences attributable to the Major League Baseball and National Football League television contracts (note 3). -20 (Page 2 of 4)- Capital Structure and Total Assets In 1993, the Company's total debt as a percentage of total capitalization improved, mainly because of the conversion of $389.6 million of the 5% convertible debentures into common stock, and net income $326.2 million. The percentage remained essentially unchanged in 1992 compared with 1991, due mainly to the higher level of debt largely offset by the increase in shareholders' equity. The percentage rose in 1991, primarily as a result of the Company's repurchase of common stock, which reduced shareholders' equity by $2 billion in 1991. The higher level of debt in 1992 was due primarily to the issuance of $150.0 million of senior notes in connection with the acquisition of Midwest (note 2). Also, in 1992, the Company retired its 10 7/8% senior notes due 1995 by refinancing debt with lower interest rates and lengthened maturities. The Company believes that, with a substantial amount of highly liquid assets and a low debt-to-total capitalization ratio, it remains fully capable of funding its current operations and sufficiently flexible with respect to the acquisition of additional broadcast properties should suitable opportunities arise. The principal changes in total assets over the five-year period were related to the Company's $2 billion common stock repurchase in 1991, the acquisitions of Midwest and television and film production facilities in 1992, and increased investment in marketable securities from the issuance of debt and increased program rights in 1993. -20 (Page 3 of 4)- December 31 1993 1992 1991 1990 1989 (In millions) Current debt $ .9 $ 13.0 $ 3.5 $ 3.4 $ 3.3 Long-term debt 590.3 870.0 696.5 712.4 795.5 Total debt 591.2 883.0 700.0 715.8 798.8 Common stock subject to redemption 65.2 65.2 Preference stock subject to redemption 124.7 124.5 124.4 124.2 124.0 Shareholders' equity 1,138.0 446.8 354.8 2,392.7 2,394.0 Total capitalization $1,853.9 $1,454.3 $1,179.2 $3,297.9 $3,382.0 Total debt as a percentage of total capitalization 31.9% 60.7% 59.4% 21.7% 23.6% Total assets $3,418.7 $3,175.0 $2,798.6 $4,691.8 $4,637.9 -20 (Page 4 of 4)- FINANCIAL STATEMENTS Management's Responsibility for Financial Statements The consolidated financial statements presented on the following pages have been prepared by management in conformity with generally accepted accounting principles. The reliability of the financial information, which includes amounts based on judgment, is the responsibility of management. The Company uses systems and procedures for handling routine business activities which seek to prevent or detect unauthorized transactions. The Company's internal control system envisages a segregation of duties among the Company's personnel, a wide dissemination to these personnel of the Company's written policies and procedures, the use of formal approval authorities and the selection and training of qualified people. The design of internal control systems involves a balancing of estimated benefits against estimated costs. The system is monitored by an internal audit program. The scope and results of the internal audit function and the adequacy of the system of internal accounting controls are reviewed regularly by the Audit Committee of the Board of Directors. Management believes that the Company's system provides reasonable assurance that assets are safeguarded against material loss and that the Company's financial records permit the preparation of financial statements that are fairly presented in accordance with generally accepted accounting principles. REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS ____________________ To the Shareholders of CBS Inc.: We have audited the consolidated financial statements and the financial statement schedules of CBS Inc. and subsidiaries listed in the index on page 14 of this Form 10-K. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules 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 financial statements referred to above present fairly, in all material respects, the consolidated financial position of CBS Inc. and subsidiaries as of December 31, 1993, 1992, and 1991, and the consolidated results of their operations and their cash flows for the years then ended in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. As discussed in note 1 to the consolidated financial statements, in 1992 the Company changed its method of accounting for postretirement benefits other than pensions, postemployment benefits and income taxes. COOPERS & LYBRAND New York, New York February 9, 1994 CONSENT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS ____________________ We consent to the incorporation by reference in the registration statements of CBS Inc. and subsidiaries on Form S-8 (File Nos. 2-87270, 2-58540, and 2- 33-2098) and the registration statement of CBS Inc. on Form S-3 (File No. 33- 59462) of our report dated February 9, 1994, on our audits of the consolidated financial statements and financial statement schedules of CBS Inc. and subsidiaries as of December 31, 1993 and 1992, and for the years ended December 31, 1993, 1992 and 1991, which report appears above. COOPERS & LYBRAND New York, New York March 9, 1994 CONSOLIDATED STATEMENTS OF INCOME CBS Inc. and subsidiaries (Dollars in millions, except per share amounts) Year ended December 31 1993 1992 1991 Net sales. . . . . . . . . . . . . . . . . . $3,510.1 $3,503.0 $3,035.0 Cost of sales (note 3) . . . . . . . . . . . (2,688.8) (2,906.5) (2,938.0) Selling, general and administrative expenses . . . . . . . . . . . . . . . . . (461.3) (422.9) (384.6) Other income, net (note 4) . . . . . . . . . 51.2 6.5 16.3 Operating income (loss). . . . . . . . . . . 411.2 180.1 (271.3) Interest income on investments, net. . . . . . . . . . . . . . . . . . . . 110.4 107.6 140.1 Interest expense on debt, net. . . . . . . . (42.3) (60.7) (47.4) Interest, net (note 4) . . . . . . . . . . . 68.1 46.9 92.7 Income (loss) from continuing operations before income taxes . . . . . . . . . . . . 479.3 227.0 (178.6) Income tax (expense) benefit (note 5). . . . (153.1) (64.5) 79.9 Income (loss) from continuing operations . . 326.2 162.5 (98.7) Discontinued operations (note 7) . . . . . . 12.9 Income (loss) before cumulative effects of changes in accounting principles . . . . . 326.2 162.5 (85.8) Cumulative effects of changes in accounting principles (note 1) . . . . . . (81.5) Net income (loss). . . . . . . . . . . . . . $ 326.2 $ 81.0 $ (85.8) Per share of common stock (note 6): Continuing operations . . . . . . . . . . . $ 20.39 $ 10.51 $ (6.11) Discontinued operations . . . . . . . . . . .79 Cumulative effects of changes in accounting principles (note 1) . . . . . (5.28) Net income (loss) . . . . . . . . . . . . . $ 20.39 $ 5.23 $ (5.32) See notes to consolidated financial statements. CONSOLIDATED BALANCE SHEETS CBS Inc. and subsidiaries (Dollars in millions, except per share amounts) ASSETS December 31 1993 1992 1991 Current assets: Cash and cash equivalents (note 1). . . . . . . . $ 173.4 $ 145.4 $ 270.0 Marketable securities (note 1). . . . . . . . . . 420.7 332.3 215.7 Accounts receivable, less allowance for doubtful accounts: 1993, $9.1; 1992, $9.7; 1991, $9.0 . . 454.5 417.4 420.3 Program rights. . . . . . . . . . . . . . . . . . 581.9 447.4 505.5 Recoverable income taxes (note 5) . . . . . . . . 28.8 117.1 90.2 Other . . . . . . . . . . . . . . . . . . . . . . 18.2 20.9 18.2 Total current assets. . . . . . . . . . . . . . . 1,677.5 1,480.5 1,519.9 Marketable securities (note 1). . . . . . . . . . 826.0 752.6 602.4 Property, plant and equipment (note 2): Land. . . . . . . . . . . . . . . . . . . . . . . 81.4 76.8 32.5 Buildings . . . . . . . . . . . . . . . . . . . . 319.0 297.2 218.0 Machinery and equipment . . . . . . . . . . . . . 556.9 542.0 544.2 Leasehold improvements. . . . . . . . . . . . . . 20.8 21.3 21.4 978.1 937.3 816.1 Less accumulated depreciation . . . . . . . . . . 459.0 451.9 437.5 Net property, plant and equipment . . . . . . . . 519.1 485.4 378.6 Other assets: Program rights. . . . . . . . . . . . . . . . . . 90.9 154.1 131.9 Goodwill, less accumulated amortization (note 1): 1993, $33.0; 1992, $28.0; 1991, $20.4; . . . . . 280.6 283.8 144.6 Other . . . . . . . . . . . . . . . . . . . . . . 24.6 18.6 21.2 Total other assets. . . . . . . . . . . . . . . . 396.1 456.5 297.7 $3,418.7 $3,175.0 $2,798.6 -24 (Page 1 of 2)- LIABILITIES AND SHAREHOLDERS' EQUITY December 31 1993 1992 1991 Current liabilities: Accounts payable . . . . . . . . . . . . . . . $ 33.4 $ 35.7 $ 48.1 Accrued salaries, wages and benefits . . . . . 72.6 61.4 53.5 Liabilities for talent and program rights. . . 317.4 245.5 276.3 Liabilities for securities sold under repurchase agreements (note 1). . . . . . . . 374.7 308.7 213.2 Debt (note 8). . . . . . . . . . . . . . . . . .9 13.0 3.5 Other (note 3) . . . . . . . . . . . . . . . . 239.9 453.0 356.5 Total current liabilities. . . . . . . . . . . 1,038.9 1,117.3 951.1 Long-term debt (note 8). . . . . . . . . . . . 590.3 870.0 696.5 Other liabilities (notes 3, 9 and 11). . . . . 406.0 467.8 554.3 Deferred income taxes (note 5) . . . . . . . . 120.8 148.6 117.5 Commitments and contingent liabilities (notes 10 and 16) . . . . . . . . . . . . . . Preference stock, Series B, par value $1.00 per share, subject to redemption (note 14). . 124.7 124.5 124.4 Shareholders' equity (notes 12, 13 and 14): Common stock, par value $2.50 per share; authorized 100,000,000 shares; issued 24,816,623 shares . . . . . . . . . . . . . . 62.0 61.8 61.8 Additional paid-in capital . . . . . . . . . . 318.6 274.7 277.7 Retained earnings. . . . . . . . . . . . . . . 2,441.9 2,147.2 2,092.3 2,822.5 2,483.7 2,431.8 Less shares of common stock in treasury, at cost: 9,332,916 in 1993; 11,284,669 in 1992; 11,504,270 in 1991 . . . . . . . . . . . . . 1,684.5 2,036.9 2,077.0 Total shareholders' equity . . . . . . . . . . 1,138.0 446.8 354.8 $3,418.7 $3,175.0 $2,798.6 See notes to consolidated financial statements. -24 (Page 2 of 2)- CONSOLIDATED STATEMENTS OF RETAINED EARNINGS AND ADDITIONAL PAID-IN CAPITAL CBS Inc. and subsidiaries (Dollars in millions, except per share amounts) Year ended December 31 1993 1992 1991 RETAINED EARNINGS Balance at beginning of year. . . . . . . . $2,147.2 $2,092.3 $2,143.9 Net income (loss) . . . . . . . . . . . . . 326.2 81.0 (85.8) Cash dividends: Common stock (per share - 1993, $1.25; 1992 and 1991, $1.00) . . . . . . . . . (18.8) (13.4) (13.2) Preference stock, Series B ($10.00 per share) . . . . . . . . . . . (12.5) (12.5) (12.5) Accretion of preference stock, Series B (note 14). . . . . . . . . . . . (.2) (.2) (.2) Reclassification of common stock subject to redemption (note 13). . . . . . 60.1 Balance at end of year. . . . . . . . . . . $2,441.9 $2,147.2 $2,092.3 ADDITIONAL PAID-IN CAPITAL Balance at beginning of year. . . . . . . . $ 274.7 $ 277.7 $ 260.9 Exercise of stock options and other items . 12.5 1.8 3.3 Conversion of convertible debentures (note 8) . . . . . . . . . . . 31.4 9.5 Acquisition of Midwest (note 2) . . . . . . (4.8) Reclassification of common stock subject to redemption (note 13). . . . . . 4.0 Balance at end of year. . . . . . . . . . . $ 318.6 $ 274.7 $ 277.7 See notes to consolidated financial statements. CONSOLIDATED STATEMENTS OF CASH FLOWS CBS Inc. and subsidiaries (Dollars in millions) Year ended December 31 1993 1992 1991 Operating activities: Net income (loss). . . . . . . . . . . . . . . $ 326.2 $ 81.0 $ (85.8) Adjustments: Depreciation and amortization. . . . . . . . 71.0 66.7 59.9 Gain on sale of marketable securities, net . (39.6) (28.9) (38.1) Cumulative effects of changes in accounting principles. . . . . . . . . . . 81.5 Gain on discontinued operations. . . . . . . (21.2) Changes in assets and liabilities*: Accounts receivable. . . . . . . . . . . . . (37.1) 7.8 (2.7) Program rights, net. . . . . . . . . . . . . (26.0) 23.3 .9 Accounts payable . . . . . . . . . . . . . . (2.3) (18.1) 4.7 Accrual on baseball and football television contracts . . . . . . . . . . . (242.0) (160.0) 233.0 Recoverable income taxes . . . . . . . . . . 88.3 (9.6) (2.6) Deferred income taxes. . . . . . . . . . . . (27.8) 79.4 (61.9) Other, net . . . . . . . . . . . . . . . . . 6.9 21.1 11.6 117.6 144.2 97.8 Investing activities**: Marketable securities Gross sales . . . . . . . . . . . . . . . . . 2,521.3 1,495.0 3,536.4 Gross purchases . . . . . . . . . . . . . . . (2,643.5) (1,732.9)(1,975.3) Liabilities for securities sold under repurchase agreements . . . . . . . . . . . 66.0 95.5 (66.8) Capital expenditures . . . . . . . . . . . . . (106.8) (71.5) (64.2) Major acquisitions . . . . . . . . . . . . . . (160.2) Discontinued operations. . . . . . . . . . . . 54.2 (163.0) (374.1) 1,484.3 Financing activities**: Issuance of debt . . . . . . . . . . . . . . . 124.0 422.5 Extinguishment of debt . . . . . . . . . . . . (24.9) (288.0) (5.5) Dividends to shareholders. . . . . . . . . . . (31.3) (25.9) (25.7) Repurchases of common stock. . . . . . . . . . (3.0)(2,005.1) Other, net . . . . . . . . . . . . . . . . . . 5.6 (.3) 3.1 73.4 105.3 (2,033.2) Net increase (decrease) in cash and cash equivalents . . . . . . . . . . . . . . . 28.0 (124.6) (451.1) Cash and cash equivalents at beginning of year. 145.4 270.0 721.1 Cash and cash equivalents at end of year. . . . $ 173.4 $ 145.4 $ 270.0 See notes to consolidated financial statements. *Excludes effect of major acquisitions and items included in Adjustments. **Excludes the following noncash items: a) In 1993 and 1991, the conversion of $389.6 and $9.5, respectively, of the Company's 5% convertible debentures into common stock (note 8). b) In 1992, the issuance of $36.8 of the Company's common stock re: Midwest, and the consolidation of a mortgage obligation of $51.0 re: CBS/MTM Partnership (note 2). NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Statement of Significant Accounting Policies Basis of presentation. The consolidated financial statements include the accounts of the Company and its subsidiaries. All significant intercompany transactions and balances have been excluded from the consolidated financial statements. All notes relate to continuing operations unless otherwise indicated. Revenue recognition. The Company's practice is to record revenues from services when performed. Income taxes. The Company provides deferred income taxes for the temporary differences between the financial reporting basis and the tax basis of the Company's assets and liabilities. Cash equivalents and marketable securities. The Company considers all highly liquid debt instruments purchased with a maturity of three months or less, including accrued interest thereon, to be cash equivalents. Marketable securities include U.S. Treasury notes, money market instruments, tax-exempt securities and corporate securities. The Company also enters into agreements to sell and repurchase certain of these securities. Due to the agreements to repurchase, the sales of these securities are not recorded. Instead, the liabilities to repurchase securities sold under these agreements are reported as current liabilities and the investments acquired with the funds received are included in cash equivalents and/or short-term marketable securities. Marketable securities managed for long-term yield and not required for working capital are classified as long-term investments and are carried at cost. At December 31, 1993, these long-term investments included $94.0 million in a trust fund to implement the Company's agreement with the New York City Industrial Development Agency. (Under this agreement, the Company is required to invest in production facilities and develop new broadcasting and production technologies in New York City in return for certain tax incentives and low-cost energy.) Other marketable securities are classified as current assets and are carried at the aggregate of the lower of cost or market value. Marketable securities, in current assets, also included accrued interest on short-term and long-term marketable securities at December 31, 1993, 1992 and 1991 of $20.4 million, $20.1 million and $19.3 million, respectively. The market values of these securities were as follows (in millions): December 31 1993 1992 1991 Marketable securities (current) . . . . . $405.0 $317.4 $198.7 Marketable securities (noncurrent). . . . 878.5 811.2 660.3 -27 (Page 1 of 2)- As of December 31, 1993, securities sold and the corresponding liabilities (both including accrued interest) under repurchase agreements were as follows (in millions): Maturity Carrying Market Repurchase Term Amount Value Liabilities U.S. Treasury notes up to 30 days $281.6 $302.4 $301.4 U.S. Government agency notes up to 30 days 73.0 73.7 73.3 $354.6 $376.1 $374.7 The loan rates on the repurchase liabilities varied between 2.75% and 3.32% for U.S. Treasury notes and between 3.30% and 3.35% for U.S. Government agency notes. Program rights. Costs incurred in connection with the production of, or the purchase of rights to, programs to be broadcast within one year are classified as current assets while costs of those programs to be broadcast subsequently are considered noncurrent. Program costs are charged to expense as the respective programs are broadcast. -27 (Page 2 of 2)- 1. Statement of Significant Accounting Policies (continued) Property, plant and equipment. Land, buildings, machinery and equipment are stated at cost. Major improvements to existing plant and equipment are capitalized. Expenditures for maintenance and repairs which do not extend the life of the assets are charged to expense as incurred. The cost of properties retired or otherwise disposed of and any related accumulated depreciation are generally removed from the accounts and the resulting gain or loss is reflected in income currently. Depreciation is computed using principally the straight-line method over the estimated useful lives of the assets. Depreciation expense, in millions, for 1993, 1992 and 1991 was $63.1, $58.9 and $53.9, respectively. Goodwill. The goodwill at the date of acquisition of net assets of businesses acquired is amortized over 40 years on a straight-line basis. The increase in 1992 was attributable primarily to the acquisition of Midwest (note 2). Other. In 1992, the Company adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" (note 11); SFAS No. 109, "Accounting for Income Taxes"; and SFAS No. 112, "Employers' Accounting for Postemployment Benefits." In accordance with the provisions of SFAS No. 112, the Company recorded a one-time pretax charge of $9.9 million for severance and long-term disability-related benefits. These adoptions resulted in a one-time post-tax charge to net income as follows: (In Millions) Per Share Postretirement benefits other than pensions $(76.1) $(4.94) Postemployment benefits . . . . . . . . (6.1) (.39) Income taxes. . . . . . . . . . . . . . .7 .05 $(81.5) $(5.28) The ongoing costs related to these adoptions do not have a material effect on continuing operations. On January 1, 1994, the Company adopted SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." It classified its marketable securities as available-for-sale and recorded an unrealized post- tax holding gain of $34.2 million, net of a tax effect of $23.0 million, in a separate component of shareholders' equity. There was no effect on net income as a result of this adoption. -28 (Page 1 of 2)- 2. Business Acquisitions (Dollars in millions, except per share amounts) In February 1992, the Company acquired substantially all of the assets of Midwest Communications, Inc. (Midwest), including a television station (with two satellite stations) located in Minneapolis, Minnesota (WCCO-TV); a television station (with one satellite station) located in Green Bay, Wisconsin (WFRV-TV); two radio stations located in Minneapolis, Minnesota (WCCO-AM and WLTE-FM); and Midwest Cable & Satellite, which operates Midwest Sports Channel, a supplier of regional sports programming. This transaction was consummated at a price of $177.0 through the issuance of $36.8 of the Company's common stock, valued at an exchange price of $160 per share (the market value of the Company's common stock on the closing date was $144 per share), and the assumption and immediate pay-down of $140.2 of Midwest's debt and other liabilities. In March 1992, the Company acquired for $27.0 the 50 percent interest of MTM Studios, Ltd. in the CBS/MTM Partnership, which operated television and film production facilities in Los Angeles, California. The acquisition of this interest also included the assumption of MTM's partnership mortgage indebtedness. The Company is the sole owner of these television and film production facilities and is obligated for the entire mortgage indebtedness (note 8). These acquisitions were accounted for by the purchase method and the results of their operations from the respective dates of acquisition are included in the accompanying financial statements. Had the acquisitions occurred on January 1, 1991, consolidated results of operations for 1992 and 1991 would not have been materially different. -28 (Page 2 of 2)- 3. Major League Baseball and National Football League Television Contracts (Dollars in millions) In 1991, the Company recorded a $322.0 pretax provision, reflected in cost of sales, for losses over the remaining lives of its Major League Baseball and National Football League television contracts. This provision was in addition to a $282.0 pretax loss on the baseball contract recorded in 1990 and reflected the severely depressed condition of the television sports marketplace. The remaining balances of the loss accruals, recorded to reduce these contracts to their net realizable value, were as follows: December 31 1993 1992 1991 Included in: Other current liabilities . . $ 21.0 $242.0 $160.0 Other liabilities . . . . . . 21.0 263.0 $ 21.0 $263.0 $423.0 -29 (Page 1 of 2)- 4. Interest and Other Income, net (Dollars in millions) Interest income on investments, net, consisted of the following: Year ended December 31 1993 1992 1991 Interest income. . . . . . . . . . . . . . . .$ 75.6 $ 82.1 $103.6 Dividend income. . . . . . . . . . . . . . . . 6.6 8.7 10.4 Interest expense on repurchase agreements. . . (11.4) (12.1) (12.0) Gain on sale of marketable securities, net: Equity securities. . . . . . . . . . . . . . 8.0 10.5 2.1 Other securities . . . . . . . . . . . . . . 31.6 18.4 36.0 $110.4 $107.6 $140.1 The cost of marketable securities sold was determined by specific identification. As of December 31, 1993, gross unrealized gains and gross unrealized losses on equity securities were $18.1 and $.2, respectively. The aggregate cost and market value of the Company's equity securities, all of which were noncurrent, were as follows: December 31 1993 1992 1991 Aggregate cost . . . . . . . . . . . . . . . $74.2 $70.7 $78.1 Aggregate market value . . . . . . . . . . . 92.1 89.0 92.8 Interest expense on debt, net, was net of amounts capitalized in 1993, 1992 and 1991 of $6.4, $10.2 and $8.4, respectively, as part of the cost of investments in property, plant and equipment, made-for-television movies and mini-series. Interest paid on debt in 1993, 1992 and 1991 was $59.6, $76.3 and $56.3, respectively. Other income, net, in 1993, included a pretax gain of $29.5 from a legal settlement with Viacom International Inc., a portion of which constituted payment for rights granted to Viacom to distribute in the United States and abroad certain television programs owned by the Company, and a pretax gain of $12.4 from insurance settlements for hurricane damage to the Company's television station in Miami. It also included other miscellaneous items of income and expense. -29 (Page 2 of 2)- 5. Income Taxes (Dollars in millions) Income tax expense (benefit) consisted of the following: Year ended December 31 1993 1992 1991 Federal: Current . . . . . . . . . . . . . . . . . . $ 60.0 $ 5.2 $ 14.9 Deferred* . . . . . . . . . . . . . . . . . 54.3 40.4 (81.2) Other: Current . . . . . . . . . . . . . . . . . . 9.3 1.8 2.9 Deferred* . . . . . . . . . . . . . . . . . 29.5 17.1 (16.5) $153.1 $64.5 $(79.9) *Deferred taxes: Accrual on baseball and football television contracts. . . . . . . . . . $ 97.3 $62.9 $(91.6) Federal tax audit settlement. . . . . . . . (23.0) (17.9) Federal tax law changes . . . . . . . . . . (11.2) Write-down of marketable securities . . . . 6.6 11.9 1.4 Amortization of intangibles . . . . . . . . (1.3) 13.9 .4 Other state and local taxes . . . . . . . . 7.9 11.9 (11.9) Other, net. . . . . . . . . . . . . . . . . 7.5 (25.2) 4.0 $ 83.8 $57.5 $(97.7) Income taxes of $94.2 were paid in 1993. In 1992 and 1991, there were net income tax refunds of $2.6 and $2.4, respectively. In 1991, the Company's loss from continuing operations before income taxes reflected significant provisions for future losses over the remaining lives of its Major League Baseball and National Football League television contracts, as explained in note 3. The tax benefits attributable to these charges were included in deferred taxes and are realized as the transactions provided for become taxable events. Reconciliations between the statutory Federal income tax expense (benefit) rate and the Company's effective income tax expense (benefit) rate as a percentage of income (loss) from continuing operations before income taxes were as follows: Year ended December 31 1993 1992 1991 Statutory Federal income tax expense (benefit) rate. . . . . . . . . . . . . . . 35.1% 34.1% (34.1)% Federal tax audit settlement. . . . . . . . (4.8) (7.9) Federal tax law changes . . . . . . . . . . (2.3) Income from tax preference securities . . . (1.9) (4.2) (5.6) State and local taxes . . . . . . . . . . . 5.2 5.3 (5.2) Other, net. . . . . . . . . . . . . . . . . .6 1.1 .1 Effective income tax expense (benefit) rate. 31.9% 28.4% (44.8)% 5. Income Taxes (continued) Deferred tax assets and liabilities consisted of the following*: December 31 1993 1992 Deferred tax assets: Accrual on baseball and football television contracts. . . . . . . . . . . . . . $ 9.0 $110.2 Postretirement benefits other than pensions. . . 67.5 65.0 Employee benefits. . . . . . . . . . . . . . . . 21.6 19.6 Other. . . . . . . . . . . . . . . . . . . . . . 76.3 50.7 $174.4 $245.5 Deferred tax liabilities: Property, plant and equipment. . . . . . . . . . $ 89.6 $ 90.0 Safe harbor leases . . . . . . . . . . . . . . . 97.6 96.5 Other. . . . . . . . . . . . . . . . . . . . . . 79.2 90.5 $266.4 $277.0 *Recoverable income taxes, reflected in the balance sheet at December 31, 1993 and 1992, include current deferred tax assets of $41.2 and $147.1, respectively, reduced by current deferred tax liabilities of $12.4 and $30.0, respectively. The remaining deferred tax liabilities, net of deferred tax assets, were reflected in the balance sheet as deferred income taxes. -31 (Page 1 of 2)- 6. Earnings Per Share Data (In thousands) The data used in the computation of earnings per share were as follows: Year ended December 31 1993 1992 1991 Earnings: Income (loss) from continuing operations . $326,188 $162,479 $(98,634) Add post-tax interest on convertible debentures*. . . . . . . . . . . . . . . 3,288 12,259 12,277 Less dividends on preference stock . . . . (12,688) (12,688) (12,688) Income (loss) from continuing operations applicable to common shares. . . . . . . 316,788 162,050 (99,045) Discontinued operations. . . . . . . . . . 12,871 Cumulative effects of changes in accounting principles. . . . . . . . . . (81,472) Net income (loss) applicable to common shares. . . . . . . . . . . . . . $316,788 $ 80,578 $(86,174) Shares: Weighted average shares outstanding. . . . 14,797 13,423 14,217 Add common stock equivalents: Convertible debentures*. . . . . . . . . 649 1,953 1,953 Other. . . . . . . . . . . . . . . . . . 92 40 35 Adjusted weighted average shares outstanding. . . . . . . . . . . . 15,538 15,416 16,205 *The debentures were converted in May 1993. Conversion was assumed for all prior periods. In 1993, fully diluted earnings per share was considered equal to primary earnings per share because the addition of potentially dilutive securities that were not common stock equivalents would have resulted in immaterial dilution. In 1992 and 1991, the fully diluted earnings per share calculation produced an antidilutive effect. - 31 (Page 2 of 2)- 7. Discontinued Operations As a result of the final settlement of all disputed items in arbitration, the Company recorded an additional gain in 1991 related to the 1988 sale of its Records Group. Income tax expense applicable to this additional gain was $8.3 million. -32 (Page 1 of 2)- 8. Long-Term Debt (Dollars in millions) Long-term debt consisted of the following: December 31 1993 1992 1991 7 5/8% senior notes due 2002. . . . . . . . . $150.0 $150.0 7 3/4% senior notes due 1999. . . . . . . . . 125.0 125.0 8 7/8% senior debentures due 2022 . . . . . . 125.0 125.0 7 1/8% senior notes due 2023. . . . . . . . . 100.0 9.03% mortgage due 1998 . . . . . . . . . . . 27.0 51.0 5% convertible debentures due 2002. . . . . . 390.5 $390.5 10 7/8% senior notes due 1995 . . . . . . . . 263.0 7.85% debentures due 2001 . . . . . . . . . . 25.0 Capital lease obligations . . . . . . . . . . 19.4 20.4 21.5 Other debt. . . . . . . . . . . . . . . . . . 44.8 21.1 Reclassified to current debt. . . . . . . . . (.9) (13.0) (3.5) $590.3 $870.0 $696.5 During 1993, 1992 and 1991, debt was repurchased, redeemed or converted as follows: Year ended December 31 1993 1992 1991 5% convertible debentures due 2002. . . . . . $390.5 $ 9.5 9.03% mortgage due 1998 . . . . . . . . . . . 24.0 10 7/8% senior notes due 1995 . . . . . . . . $263.0 3.0 7.85% debentures due 2001 . . . . . . . . . . 25.0 2.5 $414.5 $288.0 $15.0 In May 1993, the Company converted $389.6 of its 5% convertible debentures into 1,947,975 shares of its common stock, issued from its treasury shares (note 12). The difference between the amount of debt converted, net of unamortized issue costs, and the average cost of the treasury shares issued was credited to additional paid-in-capital. The remaining debentures of $.9 were redeemed. The principal terms of the various long-term issues are as follows: The 7 5/8% senior notes, issued in connection with the acquisition of Midwest (note 2), are due January 1, 2002 and may not be redeemed prior to maturity. The 7 3/4% senior notes are due June 1, 1999 and may not be redeemed prior to maturity. The 8 7/8% senior debentures are due June 1, 2022 and may not be redeemed prior to June 1, 2002. On and after that date they may be redeemed, at the option of the Company, as a whole at any time, or in part from time to time, at specified redemption prices. The net proceeds from the issuance of the 7 3/4% senior notes due June 1, 1999 and the 8 7/8% senior debentures due June 1, 2022 were used to retire the 10 7/8% senior notes due August 1, 1995. -32 (Page 2 of 2)- 8. Long-Term Debt (continued) The 7 1/8% senior notes are due on November 1, 2023 and may not be redeemed prior to maturity. The proceeds from the issuance of these debt securities were used to purchase New York City Industrial Development Agency (IDA) bonds, which were issued by the IDA to establish a trust fund to implement the Company's agreement with the IDA. Under this agreement, the Company is required to invest in production facilities and develop new broadcasting and production technologies in New York City in return for certain tax incentives and low-cost energy. The 9.03% mortgage, which was recorded as a result of the Company's acquisition of the remaining 50 percent interest in the CBS/MTM Partnership (note 2), is due $12.0 on July 15, 1996 and $15.0 on July 15, 1998. The aggregate amounts of maturities of the Company's long-term debt for each of the five years subsequent to December 31, 1993 are as follows: 1994. . . . . . . . . . . . . . . $ .9 1995. . . . . . . . . . . . . . . .6 1996. . . . . . . . . . . . . . . 12.7 1997. . . . . . . . . . . . . . . 23.3 1998. . . . . . . . . . . . . . . 40.2 To meet the disclosure requirements of SFAS No. 107, "Disclosures about Fair Value of Financial Instruments," the Company estimated that, based primarily on quoted market prices for its traded issues, the fair value of its long- term debt at December 31, 1993 exceeded its book value by approximately $38.0. It is anticipated, however, that the debt ultimately will be redeemed at amounts approximating its book value. -33 (Page 1 of 3)- 9. Environmental Liabilities The Company continually evaluates its environmental liabilities and has determined that, as of December 31, 1993, 1992, and 1991, its recorded liabilities were adequate to cover asserted and unasserted claims arising from the operations of its discontinued businesses. These liabilities were not reduced by any potential recoveries from insurance companies or others. There are no significant environmental claims known to the Company arising from its continuing operations. -33 (Page 2 of 3)- 10. Commitments and Contingent Liabilities (Dollars in millions) The Company routinely enters into commitments to purchase the rights to broadcast programs, including feature films and sports events. These contracts permit the broadcast of such properties for various periods ending no later than September 1999. As of December 31, 1993, the Company was committed to make payments of $1,451.5 under such broadcasting contracts. Rent expense, excluding payments of real estate taxes, insurance and other expenses required under some leases, amounted to $50.3, $53.6 and $57.8 in 1993, 1992 and 1991, respectively. At December 31, 1993, minimum future rental payments and receipts under noncancelable leases (including capital leases and subleases, which were not significant) were as follows: Payments Receipts 1994. . . . . . . . . . . $18.4 $ 10.1 1995. . . . . . . . . . . 13.3 9.7 1996. . . . . . . . . . . 11.2 9.6 1997. . . . . . . . . . . 8.1 9.5 1998. . . . . . . . . . . 6.4 9.4 1999 and thereafter . . . 30.0 58.7 $87.4 $107.0 The Company did not have any significant concentrations of credit risk at December 31, 1993. -33 (Page 3 of 3)- 11. Retirement Plans (Dollars in millions) The Company has pension plans covering substantially all of its employees. Benefits are based on formulas that consider years of service and average compensation. The Company's general policy is to fund pension costs accrued over the lives of the plans to the extent the contributions will be tax- deductible. At December 31, 1993, the aggregate market value of all plan assets exceeded the projected benefit obligations of all plans by $91.3. This net amount consisted of $145.8 related to plans whose assets exceeded their projected benefit obligations and $54.5 related to plans whose projected benefit obligations exceeded their assets. Those plans whose projected benefit obligations exceeded their assets are excluded from coverage under Section 4021(b) of the Employee Retirement Income Security Act of 1974 (ERISA). The assets of the funded plans consisted primarily of interest-bearing securities. The net pension costs for 1993, 1992 and 1991 were as follows: Year ended December 31 1993 1992 1991 Service cost . . . . . . . . . . . . $16.8 $ 15.9 $ 15.4 Interest cost. . . . . . . . . . . . 41.6 39.3 38.4 Net amortization and deferral. . . . (2.6) (25.1) 29.4 55.8 30.1 83.2 Less return on plan assets . . . . . 55.5 33.8 84.2 Net pension cost (credit). . . . . . $ .3 $ (3.7) $ (1.0) Reconciliations of the funded status of these plans were as follows: December 31 1993 1992 1991 Plans whose assets exceed accumulated benefits Accumulated pension benefit obligation: Vested . . . . . . . . . . . . . . . . . $391.7 $352.5 $336.0 Nonvested. . . . . . . . . . . . . . . . 20.4 18.0 22.3 $412.1 $370.5 $358.3 Market value of plan assets. . . . . . . . $669.1 $637.4 $636.5 Less projected pension benefit obligation . . . . . . . . . . . . . . . 523.3 473.2 455.0 Assets exceed projected benefit obligation . . . . . . . . . . . . . . . 145.8 164.2 181.5 Less items not yet recognized in net periodic pension cost: Unrecognized net asset . . . . . . . . . 84.3 94.6 105.3 Unrecognized net gain. . . . . . . . . . 31.1 55.6 73.0 Unrecognized prior service cost. . . . . 1.1 (10.0) (10.8) Pension asset excluding unrecognized items*. . . . . . . . . . . . . . . . . $ 29.3 $ 24.0 $ 14.0 * Amounts recognized in the Consolidated Balance Sheets. Unrecognized items, in the aggregate, will be recognized in future years as a net reduction in pension expense and pension liability under the provisions of SFAS No. 87, "Employers' Accounting for Pensions." 11. Retirement Plans (continued) December 31 1993 1992 1991 Plans whose accumulated benefits exceed assets Accumulated pension benefit obligation: Vested . . . . . . . . . . . . . . . . . $ 26.3 $ 20.0 $ 17.4 Nonvested. . . . . . . . . . . . . . . . 2.9 2.3 2.3 $ 29.2 $ 22.3 $ 19.7 Market value of plan assets. . . . . . . . $ - $ - $ - Less projected pension benefit obligation . . . . . . . . . . . . . . 54.5 34.4 31.0 Assets (are less than) projected benefit obligation. . . . . . . . . . . . . . . (54.5) (34.4) (31.0) Additional minimum (liability) . . . . . . (.6) (.6) (.9) (55.1) (35.0) (31.9) Less items not yet recognized in net periodic pension cost: Unrecognized net (liability). . . . . . (5.1) (5.7) (6.4) Unrecognized net (loss) . . . . . . . . (8.7) (1.9) (.9) Unrecognized prior service cost . . . . (10.0) (.3) (.5) Pension (liability) excluding unrecognized items* . . . . . . . . . $(31.3) $(27.1) $(24.1) *Amounts recognized in the Consolidated Balance Sheets. Unrecognized items, in the aggregate, will be recognized in future years as a net increase in pension expense and pension liability under the provisions of SFAS No. 87, "Employers' Accounting for Pensions." The Company also participates in various multi-employer union-administered defined benefit pension plans that cover certain broadcast employees. Pension expense under these plans for 1993, 1992 and 1991 was $10.2, $9.2 and $7.9, respectively. In addition to providing pension benefits, the Company provides medical and life insurance benefits for its retired employees. Substantially all of the Company's nonunion employees may become eligible for these benefits when they retire from the Company. Also included are those union employees covered by a collective bargaining agreement that provides for such benefits. During 1991, the Company made certain revisions to its retiree medical insurance program. Effective January 1, 1992, most current retirees and all future retirees were required to contribute to the cost of this coverage, and a maximum outlay by the Company for this cost was established. In addition, all retirees whose employment started after March 31, 1991 may maintain their coverage only if they pay its full cost. In 1992, the Company implemented, on the immediate recognition basis, SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," and recorded a transition obligation that resulted in a charge to net income of $76.1, net of an income tax benefit of $49.3. 11. Retirement Plans (continued) Under the new guidelines, the costs of the benefits are accrued over a period ending with the date that the qualified employees become eligible to retire, and future inflation of medical costs is considered in the determination of these costs. As a result, the costs of providing these benefits were as follows: Year ended December 31 1993 1992 Service cost . . . . . . . . . . . . . . . . $ 1.9 $ 1.9 Interest cost. . . . . . . . . . . . . . . . 14.1 14.6 Net amortization and deferral. . . . . . . . 1.9 17.9 16.5 Less return on plan assets . . . . . . . . . 5.5 3.4 Net periodic postretirement benefit cost . . $12.4 $13.1 Prior to the implementation of SFAS No. 106, the Company's practice was to determine the costs of these benefits actuarially, without considering future inflation of medical costs, and to accrue these costs over the working lives of those employees expected to qualify for the benefits. The costs of providing these benefits under this method in 1991 were $5.1. The Company's general policy is to fund accrued postretirement medical and life insurance costs to the extent the contributions will be tax- deductible. The funded assets consisted primarily of interest-bearing securities. The funded status of the postretirement medical and life insurance plans were as follows: December 31 1993 1992 Accumulated postretirement benefit obligation (APBO): Retirees. . . . . . . . . . . . . . . . . . . $141.1 $152.6 Fully eligible active plan participants . . . 17.1 16.0 Other active plan participants. . . . . . . . 34.1 30.2 192.3 198.8 Less market value of plan assets . . . . . . . 52.0 46.4 Assets are less than accumulated postretirement benefit obligation . . . . . . 140.3 152.4 Add unrecognized net gain. . . . . . . . . . . 16.9 Postretirement benefit liability recognized in the balance sheet. . . . . . . . . . . . . $157.2 $152.4 The calculations for the postretirement medical and life insurance plans were based on an actuarial assumption of a medical inflation rate of 14.0 percent in 1993, grading down to 7.0 percent in the year 2000. The effect of a one- percentage-point annual increase in the assumed medical inflation rates would increase the APBO by approximately $1.7; the annual service cost would not be materially affected. -36 (Page 1 of 2)- The actuarial assumptions used in computing the funded status of the pension plans and the postretirement medical and life insurance plans were as follows: 1993 1992 1991 Weighted average discount rate . . . . 7.5% 8.0% 8.0% Rate of compensation increase. . . . . 6.0% 6.5% 6.5% Weighted average long-term rate of return on plan assets . . . . . . 8.0% 8.0% 8.0% All costs in this note relate to the covered employees of both the continuing and discontinued operations of the Company. -36 (Page 2 of 2)- 12. Common Stock (Dollars in millions, except per share amounts) As a result of a tender offer in December 1990, the Company purchased 10.5 million of its shares, at $190 per share, in February 1991 and funded the purchase from available cash and the sale of marketable securities. In 1993, the Company converted $389.6 of its 5% convertible debentures into 1,947,975 shares of its common stock, issued from its treasury shares (note 8). Changes in common stock during 1991, 1992 and 1993 were as follows: Issued Treasury Shares Amount Shares Amount (Shares in thousands) Balance - December 31, 1990 . . . . . . . 24,644 $60.5 960 $ 72.6 Conversions of preference stock . . . . . (4) (.3) Issuances under employee benefit plans. . 31 .1 (8) (.4) Repurchases of common stock . . . . . . . 10,556 2,005.1 Conversions of convertible debentures . . 47 .1 Reclassification of common stock subject to redemption (note 13). . . . . . . . . 1.1 Balance - December 31, 1991 . . . . . . . 24,722 61.8 11,504 2,077.0 Conversions of preference stock . . . . . (7) (1.3) Issuances under employee benefit plans. . 17 (4) (.2) Repurchases of common stock . . . . . . . 22 3.0 Acquisition of Midwest (note 2) . . . . . (230) (41.6) Balance - December 31, 1992 . . . . . . . 24,739 61.8 11,285 2,036.9 Issuances under employee benefit plans. . 78 .2 (4) (.2) Conversions of convertible debentures . . (1,948) (352.2) Balance - December 31, 1993 . . . . . . . 24,817 $62.0 9,333 $1,684.5 See notes 8 and 15 for additional information about the Company's common stock. -37 (Page 1 of 2)- 13. Common Stock Subject to Redemption In July 1985, the Company offered to repurchase 6.365 million shares of its common stock. In consideration for not tendering their shares pursuant to the offer, William S. Paley, certain members of his family and other related entities received the right to sell to the Company a maximum of 434,489 shares at $150 per share. Certain of these rights were relinquished in connection with the Company's December 1990 tender offer (note 12) and the remaining rights expired in October 1991. The common stock subject to redemption was therefore reclassified to the appropriate components of shareholders' equity, as indicated in the Consolidated Statements of Retained Earnings and Additional Paid-In Capital and in note 12. -37 (Page 2 of 2)- 14. Preference Stock The Company's certificate of incorporation provides authority for the issuance of 6.0 million shares of preference stock, $1 par value. In 1985, the Company issued 1.25 million shares of preference stock, specifically authorized and designated as $10 Convertible Series B preference stock. The net proceeds of the issuance was $123.1 million. The issue has an aggregate liquidation preference of $125.0 million. The difference between the redemption value and the net proceeds from the issue is being amortized to retained earnings over 10 years. Each share is entitled to receive cumulative cash dividends at the rate of $10 per year, payable in equal quarterly installments, is subject to mandatory redemption on August 1, 1995, and is convertible, at the option of the holder, into .6915 of a share of common stock. At December 31, 1993 there were 1.25 million shares of Series B preference stock outstanding, for which there were 864,375 common shares reserved for issuance upon conversion. Upon redemption, or in the event of voluntary or involuntary liquidation, each shareholder will be entitled to $l00 per share plus any accrued or unpaid dividends. The terms of the Series B preference stock provide that the Company may not take any action that would result in the Company's ratio of total debt to total capitalization exceeding .75 to 1. As of December 31, 1993, this ratio was .32 to 1. -38 (Page 1 of 2)- 15. Stock Rights Plan The Company's 1983 Stock Rights Plan (as amended) has been approved by the Company's shareholders. It is administered by the Compensation Committee of the Board of Directors (the "Committee"), consisting entirely of outside directors, and under the terms of the plan certain key employees (including officers, who may also be directors) of the Company may be granted nonqualified stock options at an exercise price not less than 100 percent of the closing market price of a share of common stock on the date of the grant. These are ten-year options that become exercisable in installments of 25 percent per year, with the first installment commencing one year following the date of grant. The plan also provides that option grants to any one participant in a calendar year may not exceed 15,000 underlying shares of common stock. Prior to May 7, 1991, options granted to officers subject to the "short swing" profit provisions of Section 16 of the Securities and Exchange Act of 1934 (as amended) were coupled with alternative stock appreciation rights (SAR's) which enabled such holder to receive in cash or shares the excess of the common stock price on the date of exercise over the option price (the "spread"). Due to the manner in which the grant of an option to a person subject to the provisions of Section 16 is now treated by the Securities and Exchange Commission, the Committee has taken action to provide that options granted after May 7, 1991 would not be coupled with SAR's. In November 1985, the Plan was amended to provide that then outstanding options not coupled with SAR's would be subject to limited SAR's. (Such limited SAR's provided for treatment of the spread similar to that of alternative SAR's and became exercisable only if certain defined changes in control or concentration of equity ownership of the Company occurred.) The limited SAR feature was not extended to any option grants subsequent to 1986. The Plan provides that the Committee can authorize dividend share credits on outstanding options and on previously issued dividend share credits. Such credits are recorded in shares of common stock based on cash dividends paid to holders of common stock. In 1986, the Committee permanently suspended granting dividend share credits. The Plan provides that a maximum of 1.5 million shares in the aggregate are available for option grants and dividend share credits. Options granted to purchase 171,376 shares of common stock were exercisable at December 31, 1993. The number of shares available for option grants and dividend share credits, should the Committee choose to reintroduce the granting of such credits, was 369,200 shares, 550,745 shares and 634,945 shares at December 31, 1993, 1992 and 1991, respectively. To record the estimated cost of the Plan, in 1993 and 1992, $6.1 and $.7 million, respectively, were charged to income and, in 1991, $.5 million was credited to income (to adjust prior accruals). The Plan also provides that, absent shareholder approval, options may not be granted after 2001, options for more than 15,000 underlying shares may not be granted to any one participant in any calendar year, and options for an aggregate of 1.5 million underlying shares may not be granted. -38 (Page 2 of 2)- 15. Stock Rights Plan (continued) The following table summarizes the activity under the Plan during the years ended December 31, 1991, 1992 and 1993: Options With Stock Appreciation Rights Other* Dividend Common Common Share Shares Exercise Price Shares Exercise Price Credits Outstanding - December 31, 1990 68,050 $72 -$191 1/2 219,618 $56 1/4-$191 1/2 3,201 Granted. . . 85,600 159 7/8 Exercised. . ( 700) 118 3/4 (30,781) 56 1/4- 163 5/8 (1,678) Cancelled. . (4,500) 163 5/8- 191 1/2 (18,450) 159 7/8- 191 1/2 _____ Outstanding - December 31, 1991 62,850 72 - 191 1/2 255,987 56 1/4- 191 1/2 1,523 Granted. . . 91,600 191 1/2 Exercised. . (2,000) 118 3/4- 163 5/8 (16,762) 56 1/4- 191 1/2 (325) Cancelled. . ______ (8,400) 159 7/8- 191 1/2 Outstanding - December 31, 1992 60,850 72 - 191 1/2 322,425 56 1/4- 191 1/2 1,198 Granted. . . 93,000 237 1/8 Exercised. . (20,500) 72 - 191 1/2 (77,550) 56 1/4- 191 1/2 (883) Cancelled. . ______ (5,750) 159 7/8- 237 1/8 _____ Outstanding - December 31, 1993 40,350 $163 5/8-$191 1/2 332,125 $76 3/4-$237 1/8 315 *All grants outstanding which were issued prior to January 1, 1987 contain limited stock appreciation rights as explained above. At December 31, 1993, there were 12,450 options of this type outstanding with exercise prices between $76 3/4 and $136 5/8. -39 (Page 1 of 2)- 16. Litigation Various legal actions, governmental proceedings and other claims (including those relating to environmental investigations and remediation resulting from the operations of discontinued businesses) are pending or, with respect to certain claims, unasserted. The Company believes that the liabilities, if any, which may result from such litigation, proceedings or claims are not reasonably likely to have a material adverse effect on its consolidated financial position, results of operations, or liquidity. -39 (Page 2 of 2)- OTHER FINANCIAL INFORMATION QUARTERLY RESULTS OF OPERATIONS (Unaudited) (Dollars in millions, except per share amounts) The quarterly results of operations for the years ended December 31, 1993 and 1992 were as follows: 1993 1992 1993 1992 Net Sales Operating Income 1st Quarter . . . . . . . $ 878.7 $1,082.6 $ 62.5 $ 17.6 2nd Quarter . . . . . . . 835.7 779.9 153.2 83.7 3rd Quarter . . . . . . . 752.9 672.2 132.8 39.0 4th Quarter . . . . . . . 1,042.8 968.3 62.7 39.8 $3,510.1 $3,503.0 $411.2 $180.1 Income from Continuing Operations Net Income (Loss) 1st Quarter . . . . . . . $ 54.2 $ 17.5 $ 54.2 $(64.0) 2nd Quarter . . . . . . . 107.4 69.0 107.4 69.0 3rd Quarter . . . . . . . 118.2 42.7 118.2 42.7 4th Quarter . . . . . . . 46.4 33.3 46.4 33.3 $ 326.2 $162.5 $326.2 $ 81.0 Income from Continuing Operations Net Income (Loss) Per Common Share Per Common Share 1st Quarter . . . . . . . $ 3.50 $ 1.14 $ 3.50 $(4.18) 2nd Quarter . . . . . . . 6.73 4.46 6.73 4.46 3rd Quarter . . . . . . . 7.39 2.76 7.39 2.76 4th Quarter . . . . . . . 2.77 2.14 2.77 2.14 $20.39 $10.51 $20.39 $ 5.23 The first quarter of 1992 included a net charge of $81.5 ($5.32 per share) to net income for the adoption of SFAS No. 106, SFAS No. 109 and SFAS No. 112 (note 1). Quarterly and full year per share amounts are calculated independently based on the adjusted weighted average number of outstanding common shares applicable to each period. In 1992, because of the issuance of shares in connection with the acquisition of Midwest (note 2), the sum of the four quarters per common share does not equal the full year. SHAREHOLDER REFERENCE INFORMATION Stock Data The principal market for CBS common stock is the New York Stock Exchange. It is also traded on the Pacific Stock Exchange. There were 11,629 holders of record of CBS common stock as of December 31, 1993. The following table indicates the quarterly high and low prices for CBS common stock as reported in the quotations of consolidated trading for issues on the New York Stock Exchange during the past two years: 1993 1992 1993 1992 High Low 1st Quarter . . . . . . . $217 3/4 $176 7/8 $186 1/8 $136 2nd Quarter . . . . . . . 250 1/2 209 7/8 214 164 5/8 3rd Quarter . . . . . . . 277 7/8 217 228 182 1/4 4th Quarter . . . . . . . 326 1/2 220 1/2 268 5/8 176 Dividends Dividends on CBS common stock were paid quarterly at $.25 per share in 1992 and for the first three quarters of 1993, and at $.50 per share for the fourth quarter of 1993. In 1993 and 1992, dividends were paid quarterly at $2.50 per share on CBS Series B preference stock. Transfer Agent and Registrar Independent Certified Public Accountants First Chicago Trust Company Coopers & Lybrand of New York 1301 Avenue of the Americas P.O. Box 2500 New York, New York 10019 Jersey City, New Jersey 07303-2500 Annual Meeting The 1994 annual meeting of shareholders of CBS Inc. will be held at 11 A.M., Wednesday, May 11, 1994, at The Museum of Modern Art, 11 West 53 Street, New York, New York. Form 10-K Annual Report The Form 10-K Annual Report for the Company's 1993 fiscal year, filed with the Securities and Exchange Commission, contains certain financial information and, when appropriate, other matters concerning the Company which are required to be reported to the SEC. Shareholders who wish a copy of this report may obtain one, without charge, upon request to the CBS Shareholder Relations Department, 51 West 52 Street, New York, New York 10019. Schedule I (Page 1 of 4) CBS INC. and SUBSIDIARIES MARKETABLE SECURITIES - OTHER INVESTMENTS As of December 31, 1993 (In Thousands) ____________________ Col. A Col. B Number of Shares or Units - Principal Name of Issuer and Amount of Title of Each Issue Bonds and Notes U.S. Government and its Agencies $122,430 States and their Agencies 2,140 Corporations Bonds: Time Warner 23,985 Other 52,656 Money Markets: Bank of America 18,000 Other 60,478 Asset Backed Securities 41,880 Notes 41,300 Other 36,250 -42 (Page 1 of 2)- Schedule I (Page 2 of 4) CBS INC. and SUBSIDIARIES MARKETABLE SECURITIES - OTHER INVESTMENTS As of December 31, 1993 (In Thousands) ____________________ Col. A Col. C Col. D Col. E Amount at Which Each Portfolio of Equity Security Issues and Each Market Value of Other Security Name of Issuer and Cost of Each Issue at Issue is Carried in Title of Each Issue Each Issue Balance Sheet Date the Balance Sheet U.S. Government and its Agencies $121,998 $123,715 $121,998 States and their Agencies 2,140 2,140 2,140 Corporations Bonds: Time Warner 23,209 24,714 23,209 Other 53,420 54,023 53,420 Money Markets: Bank of America 18,006 18,045 18,006 Other 60,458 60,633 60,458 Asset Backed Securities 41,945 41,967 41,945 Notes 42,921 43,198 42,921 Other 36,221 36,522 36,221 $400,318 $404,957 400,318 Accrued Interest on Short-Term and Long-Term Securities 20,406 TOTAL SHORT-TERM MARKETABLE SECURITIES $420,724 -42 (Page 2 of 2)- Schedule I (Page 3 of 4) CBS INC. and SUBSIDIARIES MARKETABLE SECURITIES - OTHER INVESTMENTS As of December 31, 1993 (In Thousands) ____________________ Col. A Col. B Number of Shares or Units - Principal Name of Issuer and Amount of Title of Each Issue Bonds and Notes Amount Shares U.S. Government and its Agencies $296,000 States and their Agencies 61,365 Political Subdivisions of States, and their Agencies Utah 40,070 Florida 23,675 Georgia 21,525 Washington 20,975 New Mexico 18,395 California 17,530 New York 13,575 Alabama 13,515 Texas 13,495 Illinois 12,935 Other 52,390 Corporations Preferred Stock Banks 1,108 Other 1,326 Time Warner Convertible Bonds 21,592 Asset Backed Securities 30,382 Other 64,657 -43 (Page 1 of 2)- Schedule I (Page 4 of 4) CBS INC. and SUBSIDIARIES MARKETABLE SECURITIES - OTHER INVESTMENTS As of December 31, 1993 (In Thousands) ____________________ Col. A Col. C Col. D Col. E Amount at Which Each Portfolio of Equity Security Issues and Each Market Value of Other Security Name of Issuer and Cost of Each Issue at Issue is Carried in Title of Each Issue Each Issue Balance Sheet Date the Balance Sheet U.S. Government and its Agencies $286,914 $308,306 $286,914 States and their Agencies 66,324 68,324 66,324 (a) Political Subdivisions of States, and their Agencies Utah 42,332 44,400 42,332 Florida 25,708 26,795 25,708 (b) Georgia 22,966 23,887 22,966 Washington 23,384 24,477 23,384 New Mexico 21,005 20,897 21,005 California 19,955 20,441 19,955 (c) New York 14,572 15,434 14,572 (d) Alabama 15,268 15,211 15,268 Texas 14,247 14,762 14,247 (e) Illinois 14,265 14,921 14,265 (f) Other 56,069 59,030 56,069 (g) Corporations Preferred Stock Banks 38,915 53,025 38,915 Other 45,215 49,352 45,215 Time Warner Convertible Bonds 22,475 22,726 22,475 Asset Backed Securities 30,475 30,466 30,475 Other 65,915 66,093 65,915 TOTAL LONG-TERM MARKETABLE SECURITIES $826,004 $878,547 $826,004 (a) Includes $18,596 (Maryland $8,335, New York $5,561, and Massachusetts $4,700) for which insurance exists if the issuer defaults. (b) Includes $16,502 for which insurance exists if the issuer defaults. (c) Includes $7,785 for which insurance exists if the issuer defaults. (d) Includes $4,455 for which insurance exists if the issuer defaults. (e) Includes $14,247 for which insurance exists if the issuer defaults. (f) Includes $2,120 for which insurance exists if the issuer defaults. (g) Includes $7,654 (Maryland $4,000, Washington, D.C. $2,160 and Minnesota $1,494) for which insurance exists if the issuer defaults. -43 (Page 2 of 2)- Schedule II CBS INC. and SUBSIDIARIES AMOUNTS RECEIVABLE from RELATED PARTIES and UNDERWRITERS, PROMOTERS, and EMPLOYEES other than RELATED PARTIES for the years ended December 31, 1993, 1992 and 1991 (Dollars in Thousands) ____________________ Col. A Col. B Col. C Balance at Beginning Name of Debtor of Period Additions Year ended December 31, 1993: Peter Tortorici - $350 (A) Martin Franks $243 $ 19 Year ended December 31, 1992: Martin Franks $ 61 $183 (B) Year ended December 31, 1991: Martin Franks - $ 61 (B) Col. A Col. D Col. E Deductions Amounts Amounts Balance at End of Period Name of Debtor Collected Written Off Current Not Current Year ended December 31, 1993: Peter Tortorici - - $350 - Martin Franks - - $ 87 $175 Year ended December 31, 1992: Martin Franks $ 1 - $ 68 $175 Year ended December 31, 1991: Martin Franks - - $ 61 - (A) A note receivable for $350.0 at 8% dated 12/1/93 and due 11/30/94. (B) Includes a note receivable for $60.0 at 8% dated 9/25/91, a note receivable for $175.0 at 8% dated 10/13/92, and related accrued interest. By agreement dated January 3, 1994, Registrant will forgive 25% of these loans (and accrued interest) in each of January 1994, 1995, 1996 and 1997. Schedule X CBS INC. and SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION For the years ended December 31, 1993, 1992, and 1991 (Dollars in Thousands) ____________________ Col. A Col. B Item Charged to Costs and Expenses 1993 1992 1991 Advertising costs $107,129 $98,781 $93,957 Depreciation and amortization $70,983 $66,689 $59,882 INDEX TO EXHIBITS Number Description ______ ___________ 3-A Restated Certificate of Incorporation of registrant, as amended May 13, 1988 and filed as Exhibit 3 to Form 10-Q for the quarter ended June 30, 1988.* 3-B By-Laws of registrant, as amended to March 11, 1994, is filed herewith. 4-A See Article 3 of Restated Certificate of Incorporation, as amended, filed as Exhibit 3-A to Form 10-K for 1992.* 4-B(i) Indenture dated as of January 2, 1992 between Registrant and The Chase Manhattan Bank (National Association), as Trustee, filed as Exhibit 4-F(i) to Form 10-K for 1991.* (ii) Specimen Form of 7-5/8% Senior Note Due 2002, filed as Exhibit 4-F(ii) to Form 10-K for 1991.* (iii) Specimen Form of 8-7/8% Senior Debenture Due 2022, issued May 21, 1992, filed as Exhibit 4-D(iii) to Form 10-K for 1992.* (iv) Specimen Form of 7-3/4% Senior Note Due 1999, issued May 21, 1992, filed as Exhibit 4-D(iv) to Form 10-K for 1992.* (v) Specimen Form of 7-1/8% Senior Note Due 2023, issued October 28, 1993, is filed herewith. 4-C Pursuant to Regulation S-K Item 601(b)(4), CBS agrees to furnish to the Securities and Exchange Commission, upon request, a copy of other instruments defining the rights of holders of long-term debt of CBS. 10-A CBS Additional Compensation Plan, filed as Exhibit 10-A to Form 10-K for 1980.* 10-B CBS Stock Rights Plan, as amended effective March 13, 1991, filed as Exhibit 10-B to Form 10-K for 1991.* 10-C CBS Pension Plan, dated as of October 1, 1969, and all amendments through March 11, 1992, filed as Exhibit 10-C to Form 10-K for 1992.* Amendment No. 13 to such Plan, dated July 14, 1993 and effective as of April 1, 1992, is filed herewith. 10-D(i) CBS Supplemental Executive Retirement Plan, as amended October 14, 1987, filed as Exhibit 10-C to Registrant's Form 10-K for 1987.* (ii) CBS Supplemental Executive Retirement Plan #2, dated as of January 1, 1989, as amended January 1, 1993, filed as Exhibit 10-D(ii) to Form 10-K for 1992.* 10-E CBS Excess Benefit Plan, dated as of March 9, 1976, effective January 1, 1976, filed as Exhibit 10-E to Form 10-K for 1992.* ____________ * Previously filed as indicated and incorporated herein by reference. - 46 - 10-F Senior Executive Life Insurance Plan, dated July 9, 1990, filed as Exhibit 10-D to Registrant's Form 10-K for 1990.* 10-G CBS Deferred Compensation Plan for Non-Employee Directors, dated as of November 2, 1981, filed as Exhibit 10-G to Form 10-K for 1992.* 10-H CBS Employee Investment Fund, dated as of June 29, 1969, restated to include all amendments through December 30, 1993, is filed herewith. 10-I CBS Retirement Plan for Outside Directors, as amended May 9,1990, filed as Exhibit 10-E to Registrant's Form 10-K for 1990.* 10-J Restricted Stock Plan for Eligible Directors is filed herewith. 10-K Employment Agreement between CBS Inc. and Howard Stringer, dated December 27, 1992, filed as Exhibit 10-J to Form 10-K for 1992.* 10-L Employment Agreement between CBS Inc. and Edward Grebow, dated as of November 8, 1993, is filed herewith. 10-M Employment Agreement between CBS Inc. and Eric W. Ober, dated as of September 1, 1990, filed as Exhibit 10-H to Form 10-K for 1990.* 10-N Employment Agreement between CBS Inc. and Jeffrey F. Sagansky, dated as of July 1, 1992, filed as Exhibit 10-M to Form 10-K for 1992.* 10-O Employment Agreement between CBS Inc. and James A. Warner, dated January 28, 1992, filed as Exhibit 10-J to Form 10-K for 1991.* 10-P Employment Agreement between CBS Inc. and Peter A. Lund, dated as of January 31, 1994, is filed herewith. 10-Q Employment Agreement between CBS Inc. and Johnathan Rodgers, dated as of September 1, 1990, filed as Exhibit 10-O to Form 10-K for 1990.* 11 Computation of per share income is filed herewith. 12 Computation of ratios is filed herewith. 13 Registrant's 1994 Notice of Annual Meeting and Proxy Statement (to be filed on or about April 8, 1994), which except for those portions thereof expressly incorporated by reference elsewhere in this Form 10-K is furnished for the information of the Securities and Exchange Commission and is not to be deemed "filed" as part of the filing. 21 List of registrant's subsidiaries is filed herewith. 23 Consent of Independent Certified Public Accountants is filed herewith (p. 22). 99 Form S-8 Undertakings pursuant to Item 512 of Regulation S-K is filed herewith. ___________________ * Previously filed as indicated and incorporated herein by reference. - 47 - NOTE Copies of the Exhibits filed may be inspected at the Library of the New York Stock Exchange, 11 Wall Street, New York, NY 10005; at the Pacific Stock Exchange, 301 Pine Street, San Francisco, CA 94104; or at the Public Reference Room of the Securities and Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549. - 48 -

1993 ITEM 1. BUSINESS General - ------- As of February 28, 1994, Care Enterprises, Inc. ("Care" or "the Company") operated and managed 52 nursing and rehabilitation, developmentally disabled and retirement centers in California, Ohio, West Virginia and New Mexico, and home health agencies at 14 locations in California and Ohio. The nursing and rehabilitation centers provide skilled nursing, subacute, custodial care and rehabilitative services to patients that do not require acute care hospitalization and the home health operations provide skilled nursing care, rehabilitative and homemaker services to patients outside the institutional setting. Care also has a 26% interest in a pharmacy partnership which provides products and services to California nursing and other institutional facilities, including nursing facilities operated by Care. Recent Development - ------------------ In December, 1993, Care entered into an Agreement and Plan of Merger with Regency Health Services, Inc. ("Regency"), a Delaware corporation, substantially all of whose business operations are conducted in California, pursuant to which Care would merge with a newly-formed, wholly-owned subsidiary of Regency, and shareholders of Care would receive 0.71 shares of Regency common stock for each share of Care. A Special Shareholders Meeting to vote on the merger is scheduled for April 4, 1994 at 11:00 A.M. at the Sheraton Hotel, Newport Beach, California. Definitive proxy information concerning the meeting was mailed to all shareholders of record as of the close of business on March 3, 1994, the record date fixed by Care's Board of Directors. In connection with the execution of the Agreement and Plan of Merger, holders of a majority of Care's outstanding shares agreed with Regency to vote in favor of the proposed merger. Under Delaware law, the affirmative vote of a majority of the outstanding shares is required to approve the merger. No dissenters' rights are available to shareholders of Care in connection with the merger. Care's Board of Directors has recommended that shareholders vote to approve the merger. Recent History - -------------- In 1992 Care initiated a long range strategic business plan under which Care undertakes to provide a continuum of quality care through delivery of specialized medical services from inpatient to in home settings. Care believes there is an inherent synergy that exists between its home health agencies and nursing and rehabilitation centers. By taking advantage of that unique continuum within one company, Care offers an attractive product to the market, particularly in the managed care arena. It currently has ten specialized clinical units in various stages of development at its nursing and rehabilitation centers. These units include ventilator and other complex medical care such as IV therapies, complex infections, pulmonary care, diabetic management, chemotherapy, treatment of AIDS patients and wound care. Care has increased its focus on physical, speech and occupational rehabilitative therapies, which continue to be a strong source of revenue, growing approximately from $26,600,000 in 1991 to $30,900,000 in 1992 and $34,800,000 in 1993. Care now has 16 outpatient therapy units licensed. Revenue from Care's high acuity specialized clinical programs was approximately 27% of total revenue in 1992 and approximately 32% for 1993. Care's home health operations have been extensively involved in program development. New services such as neonatal care, prenatal care and gero- psychiatric care and expanded infusion therapy services, ventilator care and care to AIDS patients were highlights in 1993. Continued development of a wide base of high acuity services and an integrated approach to the market with its nursing and rehabilitation and home care services make clear Care's direction for the future. Long-term Care Operations - ------------------------- Care's nursing and rehabilitation centers provide nursing care and rehabilitative services to persons who do not require the services of an acute care hospital. Each facility is operated by a licensed administrator and a director of nursing services, who are assisted on a part-time contract basis by a physician who acts as a medical director. The services provided at Care's nursing and rehabilitation centers include 24-hour nursing care by registered nurses and licensed practical nurses, room, board, housekeeping and laundry services, dietary planning, the provision of medical supplies and prescription drugs, and the provision for rehabilitative and other ancillary services including speech, occupational, physical and respiratory therapies and contract laboratory and x-ray services. In support of the health care operations, Care maintains executive and regional administrative centers which provide supervisory, administrative and consulting services. Each regional office is staffed by a regional administrator and support personnel specializing in nursing care, rehabilitation and dietary programs, medical bookkeeping and maintenance. Care's executive offices provide centralized management and support services including operations support, marketing, planning and development, human resources, accounting, reimbursement and financial services, cash management, data processing, legal support, risk management, quality control, centralized purchasing, education, training and consulting support services in the area of rehabilitative care. Care's profitability and cash flows are affected by many factors, including (i) the licensed bed capacity of its nursing facilities; (ii) the extent to which that bed capacity is occupied; (iii) the extent of rehabilitative and other ancillary services provided by Care at its skilled nursing facilities; (iv) the mix of private, Medicare and Medicaid patients; (v) the mix and volume of services provided by Care's home health agencies; (vi) the cost reimbursement rates paid by Medicare and Medicaid (see "Health Care Reimbursement Programs"); and (vii) labor and employee benefits and facility maintenance expense. Care, as well as many of its competitors, is affected by many factors that are indigenous to the long-term care industry, including (i) medical reimbursement levels, (ii) increased regulatory control and scrutiny as a result of the implementation of the Omnibus Budget Reconciliation Act of 1987 ("OBRA"); and (iii) alternatives to the institutional long-term care setting, (i.e., home health agencies, residential care facilities and acute hospital based nursing facility distinct parts). These alternatives have increased competition for employees resulting in an escalation in wages, and have also impacted competition for patient census. Facilities are now accepting patients with greater medical needs in order to maximize census and revenue. Care's specialized clinical units are designed to meet the needs of these high acuity patients and further enhance ancillary and routine revenues. The table below shows the number of Care's nursing and rehabilitation centers and licensed beds at year end, average occupancy rates and annual revenues by source during each of the last five years. (1) Data excludes a 248 bed facility which is being managed by Care under a management agreement. Home Health Operations - ---------------------- Care Home Health Services, Inc., a wholly-owned subsidiary of Care, has provided home care services throughout California and Southern Ohio since 1983 and has grown steadily in revenue and visits in every year since its founding. Through two divisions, Care Home Health and Care At Home, patients at home receive technical medical support such as infusion and ventilator care and respite services such as assistance with personal hygiene, cooking and cleaning. Home Health management resides in free-standing offices from where clinical staff is dispatched. One additional office was opened in 1993 for a total of 14 locations as of December 31, 1993. The 1993 revenue mix was approximately 70% Medicare, 17% private, 11% Medicaid and 2% managed care. Home health revenues increased approximately 39% from $14,700,000 in 1992 to $20,500,000 in 1993. The home care industry has experienced growth in the last decade due to the benefits to patients, physicians, hospitals and payors. Patients enjoy the increased comfort of home and the control of the schedule of nursing visits and therapies. They welcome earlier discharge from hospitals and significantly lower costs than hospitalization. Physicians use home care because it helps minimize distress calls to the doctor and provides ongoing communication regarding the patients' progress. Hospitals refer patients to home care to decrease lengths of stay, thereby reducing costs for services that are reimbursed to them by diagnosis versus time in the hospital. Payors support home care for cost savings and for the reduction in re- hospitalizations achieved by home care nurses recognizing clinical problems earlier and preventing misunderstandings on therapies. Internal factors supporting continued growth of Care Home Health Services, Inc. include the steady referral base from Care facilities and the market appeal of a company that provides a continuum of care from inpatient to outpatient rehabilitation to home care. Care Home Health Services, Inc. is well positioned due to its established longevity in this relatively adolescent industry. Care Home Health Services, Inc. is state licensed in California (not required in Ohio), Medicare and Medicaid certified in California and Ohio and accredited in California and Ohio by the independent Joint Commission on the Accreditation of Healthcare Organizations ("JCAHO"). Care Combined Operations - ------------------------ The table below sets forth the approximate percentage of Care's revenues from each of the following sources: Health Care Reimbursement Programs - --------------------------------- All but one of the nursing facilities and all of the home health agencies operated by Care are certified for participation in Medicare and all of the facilities and home health agencies operated by Care are Medicaid certified. Payments under the Medicare program received by Care are currently sufficient to cover all of the operating and fixed costs allocable to Medicare patients. Payments received by Care under Medicaid programs currently cover a substantial portion, but not all, of the operating and fixed costs of furnishing services to Medicaid patients. There is no assurance that payments under these programs will remain at levels comparable to present levels or will, in the future, be sufficient to cover the operating and fixed costs allocable to patients participating in such programs. Care has made a strategic commitment and has pledged resources to provide managed care organization members with services ranging from subacute care to home health care. The scope of care which Care offers along with the talents of new staff sets Care apart from its competitors in the market. Contracts have been negotiated with managed care organizations, such as health maintenance organizations ("HMO's"), preferred provider organizations ("PPO's") and independent provider associations ("IPA's"), including major medical groups, for care to their members. Numerous contracts have also been entered into with hospice providers and with the Veterans Administration for care to eligible veterans. The last audit of Care with respect to Medicare and Medicaid payments was for the year ended December 31, 1991. Care believes that its reserves for potential adjustments related to fiscal years 1992 and 1993 are adequate and that any future adjustments proposed by these agencies will not have a material effect on the consolidated financial position or liquidity of Care. Managed care is playing a larger role in the industry, with HMO's, PPO's, IPA's and insurance companies creating relationships with long-term care companies and home health agencies. Managed care reimbursement is predicated on different levels of services. Care has made a strategic commitment to develop new payor sources in this growing area. Regulations - ----------- Care's nursing and rehabilitation and home health operations are subject to extensive federal and state regulatory, licensing and inspection requirements. These requirements relate to, among other things, the adequacy of physical buildings and equipment, the qualifications of administrative personnel and nursing staff, the quality of nursing care provided and continuing compliance with the laws and regulations applicable to the operations of the facilities. OBRA contains provisions related to nursing care which are more stringent than those effective prior to its enactment. Care has implemented the provisions of OBRA applicable to its business through the support of its Corporate Professional Services Department, which includes quality improvement programs. In addition, before the acquisition of any existing nursing facility can be consummated, approval of the local state health care licensing authority must be obtained, together with certification for participation in its respective Medicaid and Medicare programs. The nursing and rehabilitation facilities and home health agencies operated by Care are licensed and certified by various governmental agencies. Care's Corporate Professional Services Department sets standards for patient care, provides training and education, assists in development of specialized clinical units, investigates patient complaints, reviews citations or deficiency notices issued by regulatory agencies, consults with facility management and conducts periodic site inspections to ensure that quality care is provided and deficiencies are corrected. Peer reviews are also conducted by teams, whose members are employees of Care's nursing and rehabilitation facilities, to ensure that Care's standards of quality are upheld. In the ordinary course of business, Care, like others in the long-term care industry, receives statements of deficiency for failure to comply with various federal and state regulatory requirements. Fines may be assessed and regulatory authorities have the ability to delicense or decertify facilities operated by any nursing care operator at which there has been failure to comply with the various regulatory requirements. Care believes that its present reserves for potential fines and decertification actions are adequate and that any future actions will not have a material effect on the consolidated financial position of Care. Competition - ----------- Care's approach to revenue enhancement is based on the philosophy that its facilities must strategically identify the needs of the local market and develop programs to meet those needs through a diversification of medical services in order to meet the challenge of a more competitive market. Care is developing specialized clinical units in its facilities to enhance its reputation as a high-end provider. Care has historically emphasized rehabilitation programs (physical, speech and occupational therapies) and has recently expanded its inpatient programs and is developing new outpatient therapy units. Currently, 31% of Care's facilities have outpatient therapy units. Care's specialized clinical units address hospice care, AIDS, wound care, pulmonary and respiratory, ventilator units, Alzheimers units and others currently in development. Care's infusion therapy programs have shown substantial growth in 1993. Increased revenue from these programs comes primarily through the Medicare program and managed care providers. Competition from home health agencies has been partially offset by the continued development of Care's home health operations and the recognition that Care's facilities can operate in conjunction with the home health agencies in their local communities. Employees - --------- At February 28, 1994, Care had approximately 5,900 full-time and part-time employees, of whom approximately 4,850 were employed at Care's nursing and rehabilitation facilities, approximately 900 at its home health agencies, and approximately 150 at its administrative, regional and corporate offices. Approximately 1,100 of the employees were covered by eight collective bargaining agreements. Care believes that its relations with its employees in general and the eight collective bargaining units remain very good. Tax Audits - ---------- An Internal Revenue Service audit of the Care federal income tax returns for the years 1987 through 1990 and the Care federal payroll tax returns for the year 1990 is presently pending, which raises issues concerning the amount of the net operating loss claimed by Care and certain other issues. Although it is not possible to predict with certainty the outcome of the audit, in the opinion of Care management, adequate provision for the audit has been made and the audit is not expected to have a material adverse effect on Care's financial position. Insurance - --------- Care maintains general and professional liability insurance for its operations, subject to a self-insurance retention, in amounts which it believes to be adequate. Property insurance is maintained to protect against all perils, including earthquake and flood, subject to deductibles. For workers' compensation, Care is self-insured in California and Ohio and purchases insurance for this risk in West Virginia and New Mexico. The cost of insurance is based on market conditions, claims history and number and type of company operations. As these factors vary, the cost of insurance can vary. To secure its obligations to pay benefits under its self-insured workers' compensation programs, Care has caused various surety bonds and letters of credit to be issued. Health Care Reform - ------------------ On October 27, 1993, President Clinton submitted to the United States Congress his proposed Health Security Act. As proposed by the Clinton Administration, the Health Security Act would guarantee comprehensive health care coverage for all Americans regardless of health or employment status. The Health Security Act would reduce certain Medicare and Medicaid programs, and permit greater flexibility in the administration of Medicaid. Changes in reimbursement levels under Medicare or Medicaid and changes in applicable government regulations could significantly affect the Company's results of operations. Several U.S. Senators and Representatives have submitted bills that could approach the reform of the United States healthcare system in different ways. In addition to federal initiatives, California, where the Company conducts a substantial portion of its business, has already enacted various healthcare reform measures that are expected to have an effect on the business of the Company. The Company is not able to predict whether the Health Security Act or any of such other healthcare legislation will be enacted and implemented or the precise effects of any such legislation. Management of the Company believes that health services organizations with specialized and diverse services, such as Care, are likely to be well positioned under any of the proposed legislative reforms. Recent Financing - ---------------- On December 30, 1993, Care entered into a note agreement with a number of institutional purchasers pursuant to which it issued $30,000,000 of its 8.10% Senior Secured Notes due December 15, 2000 (the "Notes"). The Notes have an average maturity of five years and provide for semi-annual interest payments commencing January 15, 1994. Principal payments of $6,000,000 are due annually commencing January 15, 1997. The Notes are secured by mortgages on 11 of Care's facilities. Proceeds from the financing were used to retire $18,851,000 of existing indebtedness, to pay the $495,000 remaining balance of a capitalized lease obligation and purchase the related facility, and to pay $1,848,000 of certain other costs and expenses. Net proceeds from the financing totalled $8,806,000, which, combined with the resulting reduction in current maturities of long-term debt, has created a working capital surplus of $5,769,000 at December 31, 1993. On March 3, 1994, Care entered into an $8,000,000 letter of credit facility with the Bank of America secured by Care's accounts and notes receivable and the shares of Care's subsidiary, Healthcare Network, which is a partner in the pharmacy partnership. These letters of credit are used by Care in connection with its self-insured workers' compensation programs in California and Ohio. ITEM 2. ITEM 2. PROPERTIES As of February 28, 1994, Care operated and managed 52 nursing and rehabilitation, developmentally disabled and retirement centers in California, Ohio, West Virginia and New Mexico, and home health agencies in 14 locations in California and Ohio through its subsidiary, Care Home Health Services, Inc. Long-Term Care - -------------- The following table sets forth information regarding the nursing and rehabilitation centers owned or leased by Care as of February 28, 1994: In addition, a 248-bed facility is being managed by the Company under a management agreement and, effective January 1, 1994, Care assumed the operation of a 64-bed residential facility in Pasadena, California. During 1993 Care exercised options to purchase three previously leased nursing facilities with a total of 278 beds. Home Health - ----------- Care's subsidiary, Care Home Health Services, Inc., leases facilities occupying approximately 33,000 square feet for its 14 home health locations. General Lease Information - ------------------------- Care leases a 52,000 square foot facility for its corporate offices in Tustin, California and 7,400 square feet at two regional offices in Suisun, California and Worthington, Ohio. Substantially all of the leases for its operating units require Care to pay all taxes, insurance and maintenance costs. The leases expire at various dates (inclusive of renewal periods) to October 2010. Care has options to purchase five of the leased facilities. See Note 7 to the Consolidated Financial Statements for additional information regarding facility leases. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company is not a party to any material pending legal proceedings other than ordinary routine litigation incidental to its business. See Note 7 to the Consolidated Financial Statements for additional information regarding legal proceedings. ITEM 4. ITEM 4. RESULTS OF VOTES OF SECURITY HOLDERS None. ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED MATTERS Care's capital structure consists of one class of common stock ("Common Stock") issued effective December 31, 1990, in accordance with the Joint Plan of Reorganization (the "Plan"). The previous two classes of common stock, Class A Common Stock and Class B Common Stock (collectively known as "Old Common Stock"), were retired in accordance with the Plan. Holders of Common Stock do not have pre-emptive rights or other rights to subscribe for additional shares. The Common Stock is not subject to conversion or redemption and is fully paid and non-assessable. Price of Common Stock - --------------------- The Common Stock commenced trading over-the-counter on January 7, 1991 and is being quoted on the National Market System of the National Association of Securities Dealers Automated Quotation System ("NASDAQ NMS") under the symbol CREI. The last reported sales price per share for the Common Stock as of March 22, 1994 was $13.00. As of March 22, 1994 Care had approximately 1,100 holders of record. Dividends and Dividends Policy - ------------------------------ Dividends were not paid on the Old Common Stock shares during 1989 and 1990. Covenants in the Company's loan agreement with its secured lenders prohibit the payment of cash dividends on the Common Stock. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The summary consolidated financial information set forth below should be read in conjunction with the Consolidated Financial Statements of the Company and Notes thereto and "Management's Discussion and Analysis of Financial Condition and Results of Operations" included elsewhere in this Annual Report on Form 10-K. (a) The pre-reorganization periods are not comparable with 1991, 1992 and 1993 due to the effects of the implementation of "Fresh-Start Reporting" resulting from the Company's emergence from Chapter 11 reorganization. (b) Represents an extraordinary gain from discharge of debt in connection with the reorganization proceedings. (c) Per share amounts are not meaningful due to Chapter 11 reorganization. (d) Includes charges related to Care's Share Appreciation Rights Plan of $2,157,000, $323,000, and $293,000 for 1993, 1992 and 1991, respectively. (e) The December 31, 1990 balance sheet was restated to record the Plan of Reorganization and reflect "Fresh-Start Reporting." Accordingly, the Company's financial position at December 31, 1990 and subsequent thereto is not comparable to prior periods. (f) Average occupancy is calculated based on all facilities operated during the respective years and is not necessarily representative of occupancy for facilities operated at year end. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Financial Condition, Capital Resources and Liquidity - ---------------------------------------------------- During most of 1993 Care relied on operations to meet its liquidity needs. Cash provided by operations totalling $10,570,000 for the year was used to make principal payments of $9,338,000 on long-term debt, including payments of $7,180,000 on the Term Notes. Cash used in investing activities totalled $5,074,000, including routine capital expenditures of $3,884,000 and payments of an additional $1,542,000 to exercise options to purchase two previously leased facilities, offset slightly by collections on notes receivable. On December 30, 1993 Care sold $30,000,000 of its 8.1% Senior Secured Notes to a number of institutional investors in a private transaction. The notes have an average maturity of five years and provide for semiannual interest payments, with annual principal payments of $6,000,000 commencing in January, 1997. The proceeds of the notes were used to pay $18,851,000 of existing debt, including the remaining balance of $11,569,000 on the Term Notes. An additional $495,000 was used to pay the outstanding balance of a capitalized lease obligation and purchase the related facility. Proceeds of the borrowing were also used to pay costs and expenses of the issuance of the notes totalling $1,139,000, and $709,000 was used to establish cash escrows with a title company pending the resolution of certain title and debt payoff related issues and to pay certain other costs. The $8,806,000 net cash proceeds from the sale of the Senior Secured Notes, combined with the reduction in current maturities of long-term debt, has created a working capital surplus of $5,769,000 at December 31, 1993, including cash of $12,985,000. Management believes the Company's liquidity, including cash provided by operating activities, is adequate to finance planned 1994 capital expenditures of approximately $5,000,000 and other known operating needs. In March 1994 Care entered into an $8,000,000 letter of credit facility with the Bank of America to replace $6,238,000 letters of credit previously issued by another bank to be used in connection with its self-insured workers' compensation programs in California and Ohio. The new letter of credit facility will allow Care to further improve liquidity by substituting an additional $1,762,000 in letters of credit for cash collateral currently held by certain regulatory agencies. Accordingly, these deposits have been included in receivables in the Company's balance sheet as of December 31, 1993. Comparison of operating results 1993 to 1992 - -------------------------------------------- Revenues for the year ended December 31, 1993 increased by $8,306,000 compared to 1992. The change consisted of increases of $16,180,000 for nursing and rehabilitation centers and $5,832,000 for home health, offset by a decrease of $13,706,000 for operations discontinued in 1992. The increase in nursing and rehabilitation center revenues is attributable to several factors. Medicare revenues increased by $11,849,000 due to the continued growth of therapy, subacute, and other specialized clinical services and a 13% increase in Medicare utilization. Medicaid revenues increased by $3,642,000 primarily due to rate increases, offset slightly by lower Medicaid utilization. Home health revenues increased due to the development of new clinical services and increased visits resulting from marketing efforts. The increase in salaries and employee benefits is the result of wage rate increases, increased labor hours and the resulting increase in payroll-related costs for nursing and rehabilitation centers and home health, partially offset by a decrease of $7,153,000 related to operations discontinued in 1992. The increase in labor hours is primarily the result of growth of the home health business. Share appreciation rights ("SARs") expense increased $1,834,000 due to the increase in the market price of shares of Care's Common Stock from $2.75 per share at December 31, 1992 to $9.625 per share at December 31, 1993. Depending on the future performance of Care's Common Stock, Care may incur substantial additional charges related to the SARs in future periods, through December 1995, which will aggregate approximately $333,000 for each one dollar increase in the market price of Care's Common Stock. Supplies and other expenses consist of food, routine supplies, costs related to therapy services, utilities, maintenance and other general and administrative expenses. The increase in supplies and other expenses is primarily the result of higher therapy-related costs in the nursing and rehabilitation centers and home health due to Care's increased provision of those services, offset by a decrease of $2,588,000 related to operations discontinued in 1992. The increased emphasis on the provision of therapy services also resulted in an increase in the cost for contract therapists, which accounts for most of the increase in purchased services and professional fees. Other costs and expenses increased due to the imposition of a health care provider tax in West Virginia. The decrease in interest expense is primarily due to the lower outstanding debt balances. The outstanding debt balances were increased on December 30, 1993 and interest expense for 1994 is expected to be substantially higher than for 1993. Lease and rent expense and depreciation decreased due to the discontinuance of certain operations in 1992. Comparison of operating results 1992 to 1991 - -------------------------------------------- During 1992 revenues increased by $6,372,000, consisting of increases of $11,976,000 for nursing and rehabilitation centers and $3,010,000 for home health partially offset by a $8,614,000 decrease for pharmacies. The decrease in pharmacy revenues resulted from the contribution of the pharmacies to an unconsolidated partnership on April 1, 1992. The increase in nursing and rehabilitation center revenues is attributable to several factors. The fastest growing revenue source was occupational, speech, and physical therapies which increased by approximately $4,300,000. Medicare and Medicaid revenues increased by $2,553,000 and $6,212,000, respectively, due primarily to rate increases. Medicaid revenues for 1992 include approximately $865,000 of favorable rate increases related to 1990 and favorable cost report settlements of $381,000. Medicare revenues for 1992 and 1991 include favorable settlements on prior years' cost reports of $670,000 and $743,000, respectively. The increase in salaries and employee benefits of $2,990,000 is primarily the result of wage rate increases, increased labor hours, and increases in the cost of vacation and other employee benefits provided by the Company totalling $6,724,000. This was offset by a reduction of $3,069,000 for pharmacies and a $665,000 decrease in the provision for workers' compensation insurance resulting from favorable loss experience on prior years' claims. The increase in wage rates was primarily due to nursing salaries which, unlike other staff salaries, are being driven upwards by increased market competition. The increase in labor hours is the result of enforcement of OBRA regulations, increased acuity levels of patients in the nursing and rehabilitation centers and increases in home health due to growth in that business. Supplies and other costs and expenses consist of food, routine supplies, costs relating to therapy services, utilities, maintenance and other general and administrative expenses. The decrease in supplies and other expenses was the result of decreased pharmacy cost of sales, offset by higher therapy-related costs in the nursing and rehabilitation centers due to Care's increased provision of therapy services and inflation. Care's increased emphasis on the provision of therapy services, as discussed above, resulted in an increase in the cost for contract therapists, which accounts for most of the increase in purchased services. The professional fee reduction was the result of the discontinuance of the services of certain management consultants. The decrease in the provision for doubtful accounts and losses is the result of an increased provision in 1991 for losses on mortgage notes receivable offset by a reduced provision in 1992 resulting from substantial recoveries of accounts previously written off as uncollectible. Lease and rent expense decreased due to the contribution of the pharmacies to a partnership, offset by an increase in rent under a short-term lease of a formerly owned facility. Depreciation expense decreased due to the disposal of two nursing and rehabilitation centers in 1991, combined with the elimination of the expense related to assets contributed to the pharmacy partnership. Interest expense declined due to lower interest rates on variable rate debt and a decrease in outstanding debt balances of approximately $7,700,000 during 1992. Additional financial data for fiscal 1992 - ----------------------------------------- In 1992, Care recognized a gain of $1,007,000 on a nursing facility disposal which occurred in 1991. The gain represents the difference between the book value of the nursing facility assets which were acquired in 1991 by a bank in a non-judicial foreclosure and management's estimate of the value of the assets surrendered. Care reduced its reserve for losses on discontinuance of certain operations by $461,000 and reduced its reserve for fees and expenses in connection with Chapter 11 proceedings by $75,000. Impact of Inflation - ------------------- Care's principal costs are salaries and wages (and related employee benefit costs) and payments to third parties for services rendered, all of which are generally sensitive to inflation. A principal source of Care's revenues is derived from the Medi-Cal program which is not a cost reimbursement type program. Adjustments to Medi-Cal reimbursement rates are typically made only on an annual basis and such adjustments may not be sufficient to fully cover all inflationary cost increases. ITEM 8. ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA PAGE Report of Independent Auditors 18 Consolidated Balance Sheets as of December 31, 1993 and 1992 19 Consolidated Statements of Operations, Years Ended December 31, 1993, 1992 and 1991 20 Consolidated Statements of Shareholders' Equity, Years Ended December 31, 1993, 1992 and 1991 21 Consolidated Statements of Cash Flows, Years Ended December 31, 1993, 1992 and 1991 22 Notes to Consolidated Financial Statements 24 Report of Independent Auditors Shareholders and Board of Directors Care Enterprises, Inc. We have audited the accompanying consolidated balance sheets of Care Enterprises, Inc. and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, shareholders' equity and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the index at Item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules 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 consolidated financial position of Care Enterprises, Inc. and subsidiaries at December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in notes to the consolidated financial statements, in 1992 the Company changed its method of accounting for income taxes. ERNST & YOUNG Orange County, California March 10, 1994 CARE ENTERPRISES, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (in thousands, except number of shares and par values) See Independent Auditors' Report and Notes to Consolidated Financial Statements CARE ENTERPRISES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands, except per share amounts) See Independent Auditors' Report and Notes to Consolidated Financial Statements CARE ENTERPRISES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (in thousands) See Independent Auditors' Report and Notes to Consolidated Financial Statements. CARE ENTERPRISES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) See Independent Auditors' Report and Notes to Consolidated Financial Statements CARE ENTERPRISES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands, except facility data) (Continued) In 1992 Care contributed the net assets of five pharmacies and four distribution centers having a net book value of $1,400,000 to a partnership formed with another long-term provider. During 1991 Care disposed of two facilities, one of which the Company continued to operate under a short term lease agreement through November 1992. See Independent Auditors' Report and Notes to Consolidated Financial Statements NOTE 1 - MERGER AGREEMENT - ------------------------- On December 20, 1993, Care Enterprises, Inc. ("Care" or "the Company") and Regency Health Services, Inc., a Delaware corporation ("Regency"), entered into an Agreement and Plan of Merger (the "Merger Agreement"). Regency currently operates 43 long-term care facilities with 4,215 beds and one pharmacy, all located in California. Pursuant to the Merger Agreement, Care will be merged with and into Regency with Regency as the surviving corporation (the "Merger") and each share of Care's Common Stock will be converted into 0.71 shares of Regency's Common Stock, par value $0.01 per share in a tax-free transaction. The Company anticipates that the Merger will be accounted for as a pooling of interests. The Merger has been approved by the Board of Directors of both companies and its completion is subject to, among other things, the approval of regulatory agencies and the shareholders of each of Care and Regency. In connection with the Merger Agreement, shareholders holding a majority of Care's Common Stock and shareholders holding approximately 22% of Regency's Common Stock have agreed to vote in favor of the Merger under certain circumstances. Care anticipates that the Merger will be consummated in the second calendar quarter of 1994. NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - --------------------------------------------------- Nature of Business - ------------------ Care provides skilled and intermediate nursing, rehabilitative services, subacute and other specialized medical services. Services are provided in the Company's owned, leased or managed nursing and rehabilitation facilities located in California, Ohio, West Virginia and New Mexico. Care, through its wholly-owned subsidiary Care Home Health Services, Inc., provides patients at home with technical medical support such as infusion therapy and ventilator care, and respite services such as assistance with personal hygiene, cooking and cleaning. Principles of Consolidation - --------------------------- The consolidated financial statements include the accounts of Care and its wholly-owned subsidiaries. All material intercompany balances have been eliminated. Reclassifications - ----------------- The Company has reclassified the presentation of certain prior year information to conform with the current year presentation. Cash - ---- Cash consists of cash balances held in banks and petty cash funds. The cash balance at December 31, 1993 includes $6,238,000 temporarily placed with Wells Fargo Bank to collateralize letters of credit issued in conjunction with Care's self-insured workers' compensation programs. An agreement in principle was reached in December 1993, and a definitive agreement was signed in March 1994 with the Bank of America to provide an $8,000,000 letter of credit facility (Note 7) and new letters of credit were obtained to secure the workers' compensation obligations. At December 31, 1993 and 1992 the Company held personal funds in trust for patients approximating $425,000 and $400,000, respectively, which are not reflected on the accompanying balance sheets. Supplies Inventory - ------------------ Supplies inventory is stated at the lower of cost or market using the first- in, first-out method. Property and Equipment - ---------------------- Property and equipment owned by the Company at the time of its emergence from bankruptcy on December 31, 1990 was adjusted to its then current fair market value. All other property and equipment is stated at cost. Depreciation and amortization is provided on the straight-line method over the following estimated useful lives or, if applicable, over the terms of the leases. Buildings 20 to 40 years Leasehold interests and improvements 7 to 30 years Equipment 5 to 10 years Assets under capitalized leases 10 to 25 years Betterments, renewals and extraordinary repairs that extend the life of the asset are capitalized; other repairs and maintenance are expensed. The cost and accumulated depreciation applicable to assets retired are removed from the accounts and any gain or loss on disposition is recognized in income. Health Care Revenues and Reimbursement Programs - ----------------------------------------------- Long-term care facilities receive payments for services to certain patients under Medicare and state Medicaid programs and from the Veterans Administration. Revenues are recorded at the estimated net realizable amounts from patients and third party payors in the period in which the service is provided. Approximately 83% (1993), 82% (1992), and 83% (1991) of total revenue was derived from federal and state medical assistance programs. Revenues under these programs are based in part on cost reimbursement principles which govern reimbursement of current year costs. These revenues and costs are subject to audit and, in the opinion of management, adequate provision has been made for any adjustments that may result from such audits. Differences between estimated provisions and final settlements are reflected in operations in the year finalized. Approximately 75% (1993) and 78% (1992) of the Company's accounts receivable were related to federal and state medical assistance programs including approximately 26% (1993) and 33% (1992) related to the California Medicaid program. Interest Expense - ---------------- Interest expense is reflected net of $712,000, $752,000 and $1,280,000 of interest income for the years ending December 31, 1993, 1992 and 1991, respectively. Income Taxes - ------------ During 1991, the Company accounted for income taxes under the provisions of Statement of Financial Accounting Standards No. 96 ("SFAS 96"). Effective December 31, 1992, the Company adopted (on a cumulative basis from January 1, 1992) the provisions of Statement of Financial Accounting Standards No. 109 ("SFAS 109"), "Accounting for Income Taxes" (Note 3). In accordance with AICPA Statement of Position 90-7, "Financial Reporting by Entities in Reorganization Under the Bankruptcy Code" ("SOP 90-7"), SFAS 96 and SFAS 109 tax benefits recognized in periods subsequent to bankruptcy reorganization, resulting from utilization of pre-reorganization financial reporting Net Operating Losses ("financial reporting NOL"), are recorded by the Company as direct additions to additional capital with a corresponding charge in lieu of taxes included in the provision for income taxes in the Statement of Operations. Income Per Share - ---------------- Income per share for 1993, 1992 and 1991 has been computed on the basis of the weighted average shares of Common Stock outstanding plus, for 1993, common equivalent shares arising from dilutive stock options, using the treasury stock method. For 1992, common equivalent shares arising from dilutive stock options have been excluded from the determination of income per share due to immateriality. No such options were outstanding during 1991. For the computation of fully diluted income per share for 1991, shares issued in November 1991 for the conversion of the $3,000,000 secured convertible exchangeable notes are included in the weighted average shares outstanding from the beginning of 1991 and, accordingly, net income for 1991 has not been reduced by interest expense on the notes. The weighted average number of common and common equivalent shares outstanding for the calculation of primary income per share was 13,312,000 in 1993, 11,667,000 in 1992, and 9,294,000 in 1991. The weighted average number of shares used to compute income per share, assuming full dilution, was 13,388,000 in 1993, 11,667,000 in 1992, and 11,635,000 in 1991. All common shares issued pursuant to the Plan of Reorganization have been treated as outstanding as of December 31, 1990. The income per share calculation does not include the shares reserved for issuance in connection with the Company's Share Appreciation Rights Plan (Note 8), which provides for settlement of the rights in cash or stock. The Company's Board of Directors does not presently plan to issue any shares in settlement of the rights. Workers' Compensation Self-Insurance - ------------------------------------ The Company maintains self-insurance programs for workers' compensation in California and Ohio. The self-insurance liability under these programs is based on claims filed and estimates of claims incurred but not reported. The self-insurance liability is discounted at a rate of 10%, which management believes to be its appropriate market rate of interest based on its current financial circumstances. Professional Liability Insurance - -------------------------------- The Company maintains approximately $30,000,000 of professional liability insurance covering substantially all of its operations on a claims-made basis, with a $10,000 deductible for operations in the states of New Mexico and West Virginia and a $250,000 self-insurance retention for all other locations. The estimated amount payable for claims, including unasserted claims, under the Company's self-insurance retention is recorded as a liability, without discounting. NOTE 3 - INCOME TAXES - --------------------- During 1991, the Company accounted for income taxes under the provisions of SFAS 96. Effective December 31, 1992, the Company adopted (on a cumulative basis from January 1, 1992) the provisions of SFAS 109, which mandates the liability method of accounting for deferred income taxes and permits the recognition of net deferred tax assets subject to an ongoing assessment of realizability. The change in accounting for income taxes did not have a material effect on the Company's financial statements. For federal tax return purposes, Care Enterprises, Inc. files a consolidated tax return with its subsidiaries. As of December 31, 1993, the Company had claimed a federal net operating loss carryforward for tax purposes ("Tax NOL") of approximately $93,200,000 and credit carryforwards of approximately $4,021,000. However, when the Company's Plan of Reorganization was confirmed, an ownership change as defined in Internal Revenue Code ("IRC") Section 382 occurred. As a result, use of Tax NOL and credit carryforwards accumulated on or before April 20, 1990 ("pre-confirmation") may be subject to an annual limitation of approximately $300,000. Tax losses and credits generated after April 20, 1990 ("post-confirmation") are not subject to the above limitation. Because a portion of the Company's Tax NOL was generated as early as 1985, it will begin to expire in the year 2000. Considering the annual limitation, it is currently estimated that as of December 31, 1993, a maximum of $3,300,000 of Tax NOL in the aggregate will be available for use prior to expiration. Management is pursuing the possibility that the Company may qualify for the special provisions of IRC Section 382(l)(5), which could reduce the aggregate Tax NOL and credit carryforwards available but would not limit their annual use. Should circumstances permit the Company to qualify for this section of the IRC, a significant portion of the pre-confirmation Tax NOL and credit carryforwards could become available for use. However, the Merger (discussed in Note 1) may also result in a limitation on the use of the Company's post- confirmation Tax NOL and credit carryforwards and, if Section 382(l)(5) applies, pre-confirmation Tax NOL and carryforwards. The Internal Revenue Service ("IRS") is examining the Company's income tax returns for the years 1987 through 1990. Management believes that the outcome of this examination will not have a material impact on the financial position or liquidity of the Company, although it may reduce the Tax NOL. In March 1994 the IRS issued final regulations relating to net operating losses, and specifically relating to the determination of eligibility for the use of Section 382(l)(5). Based on the new regulations, management believes the Company will qualify for use of this section. After applying its provisions, the amount of Tax NOL would be approximately $53,000,000, usable without annual limitation, before the effect of any audit adjustments. Deferred income tax assets and liabilities originate from differences between accounting principles and procedures used for book and tax purposes, principally related to depreciation, contingencies and legal settlements, workers' compensation, share appreciation rights, bankruptcy costs and fees, doubtful accounts and reserves for losses on discontinuance of certain operations. The provision for income taxes consists of the following: A reconciliation of the federal statutory income tax rate with the Company's effective tax rate follows: The tax effect of the temporary differences giving rise to the Company's deferred tax assets and liabilities are shown on the following table: NOTE 4 - PROPERTY AND EQUIPMENT - ------------------------------- A summary of property and equipment follows: NOTE 5 - DETAIL OF CERTAIN BALANCE SHEET ACCOUNTS - -------------------------------------------------- Other assets consist of deposits (primarily related to the Company's self- insured workers' compensation plans and facility leases), debt service reserves related to the Industrial Development Bonds, a 26% interest in a pharmacy partnership, deferred charges and other. Accrued liabilities consist of the following (in thousands): NOTE 6 - LONG-TERM DEBT AND CREDIT FACILITIES - --------------------------------------------- Long-term debt consists of the following: The repayment of the remaining balances of the Term Notes and the working capital loan and the reduction of the outstanding balances of IDB's, mortgage notes payable, and capitalized lease obligations was primarily accomplished with the proceeds of the Senior Secured Notes, as discussed below. The aggregate maturities of long-term debt and capitalized lease obligations for the ensuing five years and thereafter are as follows (in thousands): On December 30, 1993, Care entered into a Note Agreement with a number of institutional purchasers pursuant to which it issued $30,000,000 of its 8.10% Senior Secured Notes due December 15, 2000 ("Notes"). The Notes have an average maturity of five years and provide for interest payments on each of January 15 and July 15, commencing January 15, 1994. Principal payments of $6,000,000 are due annually commencing on January 15, 1997, with the final payment due on maturity. The Notes are secured by mortgages on eleven nursing facilities having an aggregate carrying value of $30,374,000. The Notes contain covenants which require the maintenance of certain financial ratios and levels of tangible net worth, restrict the incurrence of new debt, and limit the payment of dividends on Care's Common Stock. The proceeds of the Notes were used to pay $18,851,000 of existing debt, including the remaining balance of $11,569,000 on the Term Notes, the $1,000,000 working capital loan from a shareholder, and $6,282,000 in other debt. An additional $495,000 was used to pay the outstanding balance of a capitalized lease obligation and purchase the related facility. Proceeds of the borrowing were also used to pay costs and expenses of the issuance of the notes totalling $1,139,000, and $709,000 was used to establish cash escrows with a title company pending the resolution of certain title and debt payoff related issues and to pay certain other costs. Each of the mortgage notes and IDBs is secured by a first deed of trust on the related facility. One of the IDBs requires the maintenance of debt service reserve funds and all of the IDBs contain affirmative and negative covenants and reporting requirements. NOTE 7 - COMMITMENTS AND CONTINGENCIES - -------------------------------------- Letters of Credit - ----------------- The Company is contingently liable under letters of credit principally related to deposit requirements on its self-insured workers' compensation plans. State regulations require the maintenance of deposits at specified percentages of estimated future claim payments which can be satisfied through a combination of cash deposits, surety bonds and letters of credit. The total amount of letters of credit outstanding at December 31, 1993 and 1992 were $6,238,000 and $6,250,000, respectively. An agreement in principle was reached in December 1993, and a definitive agreement was signed in March 1994 with the Bank of America to provide an $8,000,000 letter of credit facility secured by Care's accounts and notes receivable and the shares of Care's subsidiary, Healthcare Network, which is a partner in the pharmacy partnership. Leases - ------ The Company leases certain facilities and offices under cancelable and noncancelable agreements expiring at various dates through October 2010. The leases are generally triple-net leases and provide for the Company's payment of property taxes, insurance and repairs. Certain leases contain renewal options and rent escalation clauses. Rent escalation clauses require either fixed increases or increases tied to the Consumer Price Index. Five leases include purchase options at fixed or market prices at various dates. Three leases include put options in the year 2000 at 100% of fair market value. Rent and lease expenses aggregated $6,897,000 for 1993, $7,682,000 for 1992, and $7,785,000 for 1991. Future minimum lease payments (in thousands) for operating leases at December 31, 1993 are as follows: Guarantees of Leases - -------------------- The Company is contingently liable for certain operating leases assumed by the purchasers of the Company's leasehold interests in facilities. The Company is not aware of any failure on the part of these purchasers to meet the terms of their obligations, and does not anticipate any expenditures to be incurred in connection with its guarantees. If a default were to occur, the Company generally would be able to assume operations of the facility and use the net revenues thereof to defray the Company's expenditures on these guarantees. The following is a schedule of future minimum lease payments (in thousands) for the operating leases for which the Company is contingently liable: Litigation - ---------- The Company is also subject to various claims and lawsuits which arise in the normal course of business. In the opinion of management, adequate provision has been made and such claims or actions are not expected to have a material adverse effect on the Company's financial position. NOTE 8 - CAPITAL STRUCTURE - -------------------------- The Company has authorized capital stock of 26,000,000 shares consisting of 1,000,000 shares of Series A Preferred Stock, $1.00 par value per share, and 25,000,000 shares of Common Stock, $.01 par value per share. Preferred Stock - --------------- The Preferred Stock, none of which has been issued, has certain preferences upon liquidation or redemption and has voting rights similar to the Common Stock. Common Stock - ------------ On December 21, 1992, the Company sold 1,633,000 shares of Common Stock to affiliates of Smith Management Company and Foothill Group, Inc., its two largest shareholders for $4,000,000 (Note 9). In 1992, Care retired 46,000 shares of Common Stock which had been acquired by the Company through settlement of certain claims. Stock Option Plan - ----------------- In 1992, the Board of Directors and the shareholders of the Company approved a stock option plan providing for the grant of options to employees and certain consultants to purchase an aggregate of 550,000 shares of the Company's Common Stock. Under this plan, full-time employees are eligible to receive grants of either incentive stock options structured to qualify under Section 422 of the IRC of 1986, or nonqualified stock options which are not intended to meet the requirements of the IRC. Consultants and certain eligible directors may be granted only nonqualified stock options. The options vest over a four year period and have an exercise price equal to the market price of the Company's common stock on the date of grant. Outstanding options expire on various dates through December 15, 1998. Stock option activity (in shares): Share Appreciation Rights Plan - ------------------------------ In January 1991, Care's Board of Directors adopted a Share Appreciation Rights Plan (the "SAR Plan") which provided for the award of 1,000,000 units to certain key executives. The SAR Plan was amended by the Board of Directors and shareholders in May 1992. The SAR Plan provides that upon award, 25% of the units vest on each of the first four anniversaries of the award date and vested units must be exercised before the fifth anniversary of the award. Upon exercise, the awardee is entitled to receive in cash or stock, at the Company's option, the difference between the base value awarded and the market value on the date units are exercised. As indicated below, of the 900,000 units which were awarded in 1991 at the base price of $1 per unit, 36,000 were exercised, 531,000 were forfeited and 333,000 remain outstanding, of which 166,500 are vested as of December 31, 1993. The Board of Directors has decided not to award additional rights under the SAR Plan. During 1993, 1992 and 1991, the Company accrued $2,157,000, $323,000 and $293,000, respectively, in benefits associated with this plan and 450,000 shares of Common Stock have been reserved for possible issuance in settlement of the appreciation due awardees. Share appreciation rights activity (in units): NOTE 9 - RELATED PARTY TRANSACTIONS - ------------------------------------ Smith Management Company and its affiliated companies ("Smith") and Foothill Capital Corporation, Foothill Group, Inc. and affiliates ("Foothill") are significant shareholders of the Company. In January 1992, Foothill acquired from Wells Fargo Bank, N.A. a 50% interest in the Company's Term Note obligation. Their portion of the Term Notes amounted to $9,375,000 at December 31, 1992. As part of the transaction, Foothill also acquired a contingent letter of credit obligation with a principal amount of $4,316,000. The remaining balance of the Term Notes was paid on December 30, 1993. In December, 1992, the Company sold 1,633,000 shares of Common Stock to Smith and Foothill for $4,000,000. In connection with this transaction, Smith and Foothill have registration rights whereby they can join the Company in a registration if the Company chooses to register other shares of its Common Stock with the Securities and Exchange Commission. In 1990 and 1991 the Company sold $3,000,000 in secured convertible exchangeable notes to Smith and Foothill. The notes, which had a maturity date of December 31, 1993, bore interest at a rate approximating the Citibank, N.A. prime rate plus 1% payable quarterly, were secured by two of the Company's nursing facilities. The notes were convertible at any time, at the option of the holder, into shares of Preferred Stock or Common Stock and would automatically convert into shares of Common Stock upon the occurrence of certain events. On November 14, 1991, the requirements for automatic conversion were met and the notes were converted into 2,679,000 shares of Common Stock. The holders of these shares have registration rights whereby they can request, at the Company's expense, that the Common Stock issued be registered with the Securities and Exchange Commission. Foothill also provided the Company with a $1,000,000 revolving credit working capital facility which was terminated, and the outstanding balance paid, in December 1993. In April 1991, the Company engaged Smith to assist in the development and implementation of a program which would improve the Company's liquidity. Under this agreement, the Company paid Smith an aggregate of $218,000 for 1992 and $100,000 for 1991. This agreement expired on December 31, 1992. The Company has a 26% interest in the pharmacy partnership formed in April 1992. The partnership continues to provide products and services to the nursing and rehabilitation centers operated by the Company. For 1993 and 1992 these purchases totalled approximately $5,900,000 and $4,200,000, respectively. NOTE 10 - DISPOSAL OF FACILITY - ------------------------------ In 1992, Care recognized a gain of $1,007,000 on a nursing facility disposal which occurred in 1991. The gain represents the difference between the book value of the nursing facility assets which were acquired in 1991 by a bank in a non-judicial foreclosure and management's estimate of the value of the assets surrendered. NOTE 11 - RETIREMENT SAVINGS PLAN - --------------------------------- Effective January 1, 1992, the Company began accepting the entry of new participants and began accepting participant contributions to the Care Enterprises, Inc. Retirement Savings Plan, which is a qualified cash or deferred arrangement under Section 401(k) of the Internal Revenue Code. All employees with at least one year of employment who have attained the age of 21 are eligible to participate. Participants may contribute, on a pretax basis, up to 15% of their earnings to the plan (subject to certain limitations), for which the Company matches 15% of the first 3% of contributions for persons with less than three years of service and 25% of the first 5% for all others. The Company's contributions are subject to a four-year vesting period. Matching contributions made by the Company for 1993 and 1992 were $186,000 and $155,000, respectively. NOTE 12 - QUARTERLY FINANCIAL DATA - ---------------------------------- During the fourth quarter of 1993 the Company recorded a charge of $1,694,000 for compensation payable under the Share Appreciation Rights Plan. This charge is the result of an increase in the market price of Care's Common Stock from $4.00 per share at September 30, 1993 to $9.625 at December 31, 1993. During the fourth quarter of 1992 the Company recognized gains resulting from the reversal of reserves for losses on the discontinuance of certain operations of $461,000, the reversal of reserves for expenses and fees resulting from Chapter 11 proceedings of $75,000 and recognized a gain on the sale of a facility disposed of in 1991 of $1,007,000. During the second quarter of 1991 Care disposed of one facility and recognized a loss of $653,000 that was charged against reserves for losses on discontinuance of certain operations. During the third quarter of 1991 the Company recognized gains resulting from the reversal of reserves for losses on the discontinuance of certain operations of $882,000. During the fourth quarter of 1991 the Company recognized gains resulting from the reversal of reserves for losses on the discontinuance of certain operations of $374,000 and reversal of reserves for expenses and fees resulting from Chapter 11 proceedings of $464,000. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF REGISTRANT John W. Adams, 50, has been Chairman of the Board of Directors since May 1990 and was Chief Executive Officer of the Company from September 1991 through December 1993. He has been President of Smith Management Company, a New York- based investment firm since January 1984. Mr. Adams served as Co-Chairman of the Official Creditors' Committee during the Company's reorganization proceedings from March 1988 to December 1990. From 1975 to 1983, Mr. Adams was a partner with the law firm of Dillon, Bitar and Luther in New Jersey. Corley R. Barnes, 42, has been a director of the Company since May 1990. He is a private investor and a financial consultant to various publicly and privately held companies, including certain companies in the health care industry. Mr. Barnes served on the Official Creditors' Committee during the Company's reorganization proceedings from March 1988 through December 1990. Laraine K. Beck, 43, has been a director of the Company since May 1990. Since December 1992, Ms. Beck has been the Senior Credit Manager at Rykoff/Sexton, a food service distribution company based in Los Angeles, California. Prior to joining Rykoff, Ms. Beck was the Regional Credit Manager of Kraft Food Service, a food production and distribution company from 1978 to 1992 and served as Co-Chairman of the Official Creditors' Committee during the Company's reorganization proceedings from March 1988 through December 1990. From 1975 to 1978, Ms. Beck was employed as Credit Manager of White Motor Credit, a truck manufacturing company, located in Dallas, Texas. Robert G. Coo, 52, has been a director of the Company since January 1991. Also since January 1991, Mr. Coo has been Vice President, Chief Financial Officer and Secretary of Pengo Industries, Inc., the parent company of two manufacturing companies - Pengo Corporation and Goex, Inc. From 1987 to 1990, Mr. Coo was Vice President, Finance and Secretary of Renewable Resource Systems, Inc., a privately owned, diversified venture capital company. Mr. Coo has been a director of First National Bank, whose headquarters are located in San Diego, California, since October 1993. Mr. Coo is the brother-in-law of Mr. Adams. John F. Nickoll, 59, has been a director of the Company since November 1991. Since 1970, he has been Vice Chairman, Co-Chief Executive Officer, Chief Operating Officer and President of The Foothill Group, Inc. and Chairman and Chief Executive Officer of Foothill Capital Corporation, a subsidiary of The Foothill Group. Mr. Nickoll is also a director of Carson Pirie Scott & Co., Inc.; a director of CIM-High Yield Securities, Inc., a closed-end investment company; and a director of American Healthcare Management, Inc., an owner and manager of acute care hospitals. Arthur J. Pasmas, 59, has been a director of Care since December 1993, when he was elected to fill the vacancy created by the death of a board member. Since 1987, Mr. Pasmas has served as a Vice President of Smith Management Company. Prior thereto, he was founder, President, and Chief Executive Officer of Energy Management Corporation (acquired by Smith Management Company in 1987). He presently serves as Chairman of the Board of Pengo Industries, Inc. and of Goex International, Inc., and is a director of Liberty National Bank, Austin, Texas. Richard K. Matros, 40, has been a director of the Company since November 1991, President and Chief Operating Officer of the Company since September 1991 and Chief Executive Officer of the Company since January 1994. Prior to September 1991, Mr. Matros was Executive Vice President, Operations of the Company from March 1988. Before joining the Company, Mr. Matros served as Vice President of Operations, from 1985 to 1987, and Regional Administrator, from 1983 to 1985, for Beverly Enterprises, the nation's largest long-term care company. He has over 17 years of experience in the long-term care industry and is President-elect of the California Association of Health Facilities. Gary L. Massimino, 57, was appointed Chief Financial Officer of the Company in March 1990 and Executive Vice President in September 1991. For the previous eight years, Mr. Massimino was a financial consultant to companies in the health care, real estate and entertainment industries in various specialized financial projects. He has also served as Chief Financial Officer, Treasurer and a Director of Flagg Industries, Inc., a major California-based operator of nursing homes and real estate ventures. Barbara A. Garner, 39, was appointed Vice President of Professional Services in January 1988. Ms. Garner has been an Administrator and Southern Division Quality Assurance Coordinator since joining Care in 1983. From 1978 to 1983, she held nursing and administrator responsibilities with National Health Enterprises and Hillhaven; both companies are providers of skilled nursing care. Janet M. Turner, 62, was appointed Vice President of Nursing and Rehabilitation Centers in July 1992. Prior to her appointment, Ms. Turner was the Company's Director of Operations from September 1991 to June 1992 and a Regional Administrator from 1983 to 1988 and again from 1989 to 1991. From 1988 through 1989, Ms. Turner served as a Regional Administrator for ARA Living Centers, a nationwide long-term care company based in Houston, Texas. Ms. Turner joined Care Enterprises in 1983 in conjunction with the Company's acquisition of Casa Blanca Convalescent Homes, Inc., a long-term care company for which she was then Vice President of Operations for Northern California. She has over 25 years experience in the long-term care industry including serving as a statewide Officer for the California Association of Health Facilities from 1976 through 1980. Steven C. Ronilo, 44, was appointed Vice President of Human Resources in March 1990. Prior to his appointment, from 1984 to 1990, Mr. Ronilo was the Corporate Director of Industrial Relations for Beverly Enterprises, Inc., the nation's largest long-term care company. Prior to joining Beverly Enterprises, Mr. Ronilo held a variety of positions in upper management specializing in labor relations, employee relations and industrial relations for various manufacturing companies. Mr. Ronilo has over 21 years experience in the field of human resources, including personnel development and administration and union negotiation. One report to the Securities and Exchange Commission on Form 5, due February 14, 1994, was filed on March 21, 1994 by Janet M. Turner. The report covered one transaction in December, 1993. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION (1) The Company has no restricted stock awards outstanding. (2) The Company has no long term incentive payout plans. (3) All compensation is reported in columns c, d, & e. (4) SARs granted January 1, 1991. (5) Options granted April 9, 1992. (6) Options granted February 26, 1993. (7) Includes $26,000, $23,000, and $14,000 in Director's fees for 1993, 1992, and 1991, respectively. (8) Includes $9,688 of compensation resulting from December 20, 1993 exercise of nonqualified stock options. Options/Stock Appreciation Rights (SAR) Grants in Last Fiscal Year ------------------------------------------------------------------ Aggregated Option/SAR Exercises in Fiscal Year ended December 31, 1993 and - -------------------------------------------------------------------------- December 31, 1993 Option/SAR Value ---------------------------------- ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT PRINCIPAL SHAREHOLDERS The following table sets forth certain information, as of March 22, 1994, with respect to all those known by the Company to be the beneficial owners of more than 5% of its outstanding Common Stock, each director who owns shares of Common Stock, and all directors and executive officers of the Company as a group. Except as otherwise indicated, the address of each individual director is in care of the Company at 2742 Dow Avenue, Tustin, California, 92680. (1) Common Stock consists of 13,243,168 shares issued and outstanding as of March 22, 1994. (2) According to reports filed with the Securities and Exchange Commission and Company records, the aggregate number of shares reported for the Smith Group is beneficially owned by a group comprised of SOLVation Inc., d/b/a/ Smith Management Company, Randall D. Smith, Gary M. Smith, Energy Management Corporation, Woodstead Associates, L.P., The Durian Trust and SEGA Associates, L.P. (3) According to the most recent reports filed with the Commission and Care records, the aggregate number of shares reported for The Foothill Group was 3,161,729 and includes shares beneficially owned by The Foothill Group, Inc., a Delaware corporation, The Foothill Fund, a California limited partnership, Foothill Capital Corporation, a California corporation, Foothill Partners L.P., a Delaware Limited Partnership, as well as 35,803 shares owned directly by John F. Nickoll. On March 3, 1994, The Foothill Fund distributed 1,663,857 shares of Care Common Stock in connection with the liquidation of the partnership following the expiration of the partnership term. Of such amount, 1,928 shares were distributed to John F. Nickoll and 108,161 shares were distributed to The Foothill Group. (4) Mr. Adams is the sole general partner of SEGA Associates, L.P. and accordingly has voting control and beneficial ownership of 64,175 shares of Care Common Stock held by SEGA Associates, L.P. Mr. Adams is also the President of Smith Management Company and indirectly owns 4.2% of Smith Management Company. (5) Mr. Coo is the brother-in-law of John W. Adams. (6) John F. Nickoll is the President, Co-Chief Executive Officer and a Director of The Foothill Group, Inc. (7) Richard K. Matros is President and Chief Executive Officer of the Company. Beneficial ownership includes 31,250 shares that could be purchased within 60 days of March 22, 1994 upon exercise of stock options, but does not include SARs. (8) Arthur J. Pasmas is Vice President of Smith Management Company. (9) Includes 64,500 shares that could be purchased within 60 days of March 22, 1994 upon exercise of stock options, including 31,250 shares that could be purchased by Mr. Matros, and 22,000 shares that could be purchased by Mr. Massimino. Does not include SARs. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Smith Management Company and its affiliated companies ("Smith") and Foothill Capital Corporation ("Foothill Capital"), Foothill Group, Inc. and its affiliates ("Foothill") are significant shareholders of Care. John W. Adams, Chairman of the Board of Directors of Care (and, until January 1994, Care's Chief Executive Officer), is President of Smith Management Company. Arthur J. Pasmas, a director of Care, is also employed by Smith. Mr. Adams received a fee for services as chief executive officer of Care at the rate of $50,000 per annum until December 31, 1992 and at the rate of $100,000 per annum for fiscal year 1993. John F. Nickoll, a director of Care, is President and Co-Chief Executive Officer and a director of The Foothill Group, Inc. In December 1990 and January 1991, Care issued to Smith and Foothill an aggregate of $3,000,000 of Convertible Exchangeable Notes. These notes were converted by their terms into 2,679,000 shares of Common Stock in November 1991. In April 1991, Care engaged Smith to assist in the development and implementation of a program that would improve Care's liquidity. Under this agreement, Care paid Smith an aggregate of $218,000 for 1992 and $100,000 for 1991. This agreement expired on December 31, 1992. In December 1992, Care sold 1,633,000 shares of Common Stock to Smith and Foothill Capital for $4,000,000. In connection with this transaction, Smith and Foothill Capital have registration rights whereby they can join Care in a registration if Care chooses to register other shares of Common Stock with the Commission. In January 1992, Foothill Capital purchased from Wells Fargo Bank, N.A. a Term Note obligation of Care, which had a principal amount of $13,212,722 and which was scheduled to mature on April 20, 1995, and accrued interest at the rate of Prime plus 2%. As part of the Term Note purchase, Foothill Capital also acquired a standby letter of credit obligation of Care with a principal amount of $4,316,000. The Term Note obligation was repaid in full by Care on December 30, 1993. In March 1993, Care obtained a commitment for a $3,500,000 increase in its working capital facility provided by Foothill Capital. This facility was secured by certain of Care's nursing and rehabilitation centers and certain accounts receivable, and was to bear interest at a rate of Prime plus 3%. The facility was terminated and the collateral released on December 30, 1993. Until December 30, 1993, Care had a $1,000,000 working capital facility made available by Foothill Capital. This facility bore interest at a rate approximating Citibank N.A.'s prime rate plus 3%, payable quarterly, and was secured by one of Care's properties. This facility was terminated, all outstanding indebtedness was retired and the collateral was released on December 30, 1993. ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8K (a) Set forth below is a list of Financial Statements and Financial Statement Schedules filed as part of this Report: AND FINANCIAL STATEMENT SCHEDULES 1. Financial Statements: Page ---- Report of Independent Auditors 18 Consolidated Balance Sheets at December 31, 1993 and 1992 19 Consolidated Statements of Operations, Years Ended December 31, 1993, 1992 and 1991 20 Consolidated Statements of Shareholders' Equity, Years Ended December 31, 1993, 1992 and 1991 21 Consolidated Statements of Cash Flows, Years Ended December 31, 1993, 1992 and 1991 22 Notes to Consolidated Financial Statements 24 2. Financial Statement Schedules: Schedule IV - Indebtedness of and to related parties - not current 55 Schedule V - Property and equipment 56 Schedule VI - Accumulated depreciation and amortization 57 Schedule VIII - Valuation and qualifying accounts 58 All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable and therefore have been omitted. 3. Exhibits: Reference is made to the Exhibit Index which is filed as part of this annual report. (b) Reports on Form 8-K: The Company filed the following reports on Form 8-K during the quarter ended December 31, 1993: Date Item Reported - ------------------------ -------------------------- December 20, 1993 Merger Agreement with Regency Health Services, Inc. December 30, 1993 Sale of Senior Secured Notes 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. CARE ENTERPRISES, INC. (Registrant) March 24, 1994 /S/ John W. Adams - ---------------------- ------------------------------ Date John W. Adams Chairman of the Board March 24, 1994 /S/ Gary L. Massimino - ---------------------- ------------------------------ Date Gary L. Massimino Executive Vice President Chief Financial Officer SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed on the date or dates indicated below, by the following persons on behalf of the registrant in the capacities indicated. CARE ENTERPRISES, INC. (Registrant) March 24, 1994 /S/ John W. Adams - ---------------------- ------------------------------ Date John W. Adams, Chairman March 24, 1994 /S/ Corley R. Barnes - ---------------------- ------------------------------ Date Corley R. Barnes, Director March 24, 1994 /S/ Laraine K. Beck - ---------------------- ------------------------------ Date Laraine K. Beck, Director March 24, 1994 /S/ Robert G. Coo - ---------------------- ------------------------------ Date Robert G. Coo, Director March 24, 1994 /S/ Richard K. Matros - ---------------------- ------------------------------ Date Richard K. Matros, Director March 24, 1994 /S/ John F. Nickoll - ---------------------- ------------------------------ Date John F. Nickoll, Director March 24, 1994 /S/ Arthur J. Pasmas - ---------------------- ------------------------------ Date Arthur J. Pasmas, Director INDEX TO EXHIBITS (ITEM 14(a) (3)) Sequential Exhibit Numbered Number Description Page - ---------- ------------------------------------------------ ------ 2.1 Debtors' and Official Creditors Committee's (A) Joint Plan of Reorganization. 2.2 Order confirming Debtors' and Creditors' (B) Committee's Joint Consolidated Plan of Reorganization. 2.5 Agreement and Plan of Merger, dated as of (M) December 20, 1993, between Regency Health Services, Inc. and Care Enterprises, Inc. 2.6 Amendment to Agreement and Plan of Merger, (O) dated as of January 7, 1994, between Regency Health Services, Inc. and Care Enterprises, Inc. 3.1 Restated Certificate of Incorporation of (C) Care Enterprises, Inc., a Delaware corporation. 3.2 Restated By-Laws of Care Enterprises, Inc. (C) 3.3 Certificate of Amendment of Restated (D) Certificate of Incorporation of Care Enterprises, Inc. 4.1 Form of Transfer Restriction Agreement (D) 4.2 Certificate of Designations, Preferences (D) and Relative, Participating, Optional or Other Special Rights of Series A Convertible Preferred Stock of CARE ENTERPRISES, INC. 4.3 1992 Stock Option Plan of the Registrant. (F) 4.4 Form of Incentive Stock Option Agreement for (G) Employees of the Registrant. 4.5 Form of Nonqualified Stock Option Agreement for (H) Employees and Consultants of the Registrant. 4.6 Registrant's Share Appreciation Rights Plan, (I) as amended. 4.7 Form of Agreement Regarding Allocation of Units (J) Under Registrant's Share Appreciation Rights Plan. 10.14 Stock Purchase Agreement dated as of (K) December 15, 1992 between Care Enterprises, Inc., Foothill Group Inc., Foothill Partners and Energy Management Corporation 10.15 Partnership agreement dated April 1, 1992 between (L) Medisave Pharmacies, Inc. and HealthCare Network, Incorporated. 10.16 Voting Agreement, dated December 27, 1993 between (M) Care Enterprises, Inc. and certain shareholders of Regency Health Services, Inc. named therein. 10.17 Voting Agreement, dated December 27, 1993 between (M) Regency Health Services, Inc. and certain shareholders of Care Enterprises, Inc. named therein. 10.18 Note Agreement dated as of December 15, 1993 between (N) Care Enterprises, Inc. and the Purchasers named on Schedule I to the Note Agreement. 10.19 Indenture of Trust dated as of December 15, 1993 (N) between Care Enterprises, Inc. and State Street Bank and Trust Company of Connecticut, National Association, as Indenture Trustee. 10.20 Guaranty Agreement dated as of December 15, 1993 in (N) favor of Note Holders by certain subsidiaries of Care Enterprises, Inc. 10.21 Letter Agreement dated December 29, 1993 (N) between Wells Fargo Bank, National Association and Care Enterprises, Inc. 10.22 Form of Deeds of Trust relating to the 8.1% (O) Senior Secured Notes with a corresponding schedule pursuant to Regulation S-K Item 601 instruction 2. 10.23 Form of Open-End Mortgage and Security Agreement (O) relating to the 8.1% Senior Secured Notes with a corresponding schedule pursuant to Regulation S-K Item 601 instruction 2. 10.24 Agreement dated as of December 30, 1993 (O) between Care Enterprises, Inc. and the Purchasers of the 8.1% Senior Secured Notes. 10.25 Agreement dated July 1, 1993 between (O) Mabon Securities Corp. and Care Enterprises, Inc. to provide investment banking services. 10.26 Agreement dated November 15, 1993 between (O) Merrill Lynch & Co. and Care Enterprises, Inc. to provide advisory services. 10.27 Business loan agreement dated as of (O) March 1, 1994, between Care Enterprises, Inc. and Bank of America National Trust and Savings Association. 10.28 Third Amendment to Lease, dated as of (O) October 22, 1992, by and among certain lessors and Care Enterprises, West. 10.29 Amendment to Agreement of Lease re: (O) Calistoga Convalescent Hospital dated August 21, 1992 between certain lessors and Care Enterprises, West. 10.30 Employment Agreement dated January 1, 1993 (O) between Care Enterprises, Inc. and Richard K. Matros. 10.31 Employment Agreement dated January 1, 1993 (O) between Care Enterprises, Inc. and Gary L. Massimino. 10.32 Form of Deeds of Trust relating to the 8.1% (O) Senior Secured Notes with a corresponding schedule pursuant to Regulation S-K Item 601 instruction 2. 21 Subsidiaries of Registrant. (O) 23 Consent of Ernst & Young (O) 99.2 8.10% Senior Secured Note from (N) Care Enterprises, Inc. to John Hancock Life Insurance Company of America in the original principal amount of $1,000,000, dated December 30, 1993. 99.3 8.10% Senior Secured Note from (N) Care Enterprises, Inc. to Mellon Bank, N.A., Trustee under Master Trust Agreement of NYNEX Corporation dated January 1, 1984 for Employee Pension Plans - NYNEX - John Hancock - Private Placement in the original principal amount of $2,000,000, dated December 30, 1993. 99.4 8.10% Senior Secured Note from (N) Care Enterprises, Inc. to Anchor National Life Insurance Company in the original principal amount of $15,000,000, dated December 30, 1993. 99.5 8.10% Senior Secured Note from (O) Care Enterprises, Inc. to John Hancock Mutual Life Insurance Company in the original principal amount of $7,000,000, dated December 30, 1993. 99.6 8.10% Senior Secured Note from (O) Care Enterprises, Inc. to John Hancock Mutual Life Insurance Company in the original principal amount of $5,000,000, dated December 30, 1993. 99.7 Annual Report on Form 11-K for (E) Employee Retirement Savings Plan for the year ended December 31, 1992. (A) Incorporated by reference from Exhibit 28.1 to Care's Current Report on Form 8-K dated December 29, 1989. (B) Incorporated by reference from the same numbered exhibit to Care's Annual Report on Form 10-K for the fiscal year ended December 31, 1989. (C) Incorporated by reference from the same numbered exhibit to Care's Current Report on Form 8-K dated April 20, 1990. (D) Incorporated by reference from the same numbered exhibit to Care's 8-A filed on December 28, 1990. (E) Incorporated by reference. (F) Incorporated by reference from Exhibit 4.1 to Care's Registration Statement on Form S-8 dated March 16, 1992. (G) Incorporated by reference from Exhibit 4.2 to Care's Registration Statement on Form S-8 dated March 16, 1992. (H) Incorporated by reference from Exhibit 4.3 to Care's Registration Statement on Form S-8 dated March 16, 1992. (I) Incorporated by reference from Exhibit 4.4 to Care's Registration Statement on Form S-8 dated March 16, 1992. (J) Incorporated by reference from Exhibit 4.5 to Care's Registration Statement on Form S-8 dated March 16, 1992. (K) Incorporated by reference from Exhibit 10.1 to Care's Current Report on Form 8-K filed on December 22, 1992. (L) Incorporated by reference from the same numbered exhibit to Care's Annual Report on Form 10-K for the fiscal year ended December 31, 1992. (M) Incorporated by reference from the same numbered exhibit to Care's Current Report on Form 8-K filed on December 20, 1993. (N) Incorporated by reference from the same numbered exhibit to Care's Current Report on Form 8-K filed on December 30, 1993. (O) Filed with this report. CARE ENTERPRISES, INC. AND SUBSIDIARIES SCHEDULE IV - INDEBTEDNESS OF AND TO RELATED PARTIES CARE ENTERPRISES, INC. AND SUBSIDIARIES SCHEDULE V - PROPERTY AND EQUIPMENT (in thousands) (a) Reclassification of previously leased assets to owned assets. (b) Restoration of assets previously classified as held for sale. CARE ENTERPRISES, INC. AND SUBSIDIARIES SCHEDULE VI - ACCUMULATED DEPRECIATION AND AMORTIZATION (in thousands) (a) Reclassification of previously leased assets to owned assets. CARE ENTERPRISES, INC. AND SUBSIDIARIES SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS (in thousands)

1993 ITEM 1. BUSINESS. General Westinghouse Electric Corporation was founded in 1886 and since 1889 has operated under a corporate charter granted by the Commonwealth of Pennsylvania in 1872. Today, Westinghouse is a diversified, global, technology-based corporation. The Corporation's key operations include television and radio broadcasting, advanced electronics systems, environmental services, management services at government-owned facilities, services and equipment for utility markets and transport temperature control. For management reporting purposes, Westinghouse applies a business unit concept to its operating organizations, with each business unit consisting of one or more divisions or subsidiaries that meet certain internal criteria for profit center decentralization. In November 1992, the Board of Directors of Westinghouse adopted a plan (the Plan) that included exiting the financial services and other non-strategic businesses. The Corporation classified the operations of Distribution and Control Business Unit (DCBU), Westinghouse Electric Supply Company (WESCO) (collectively, Other Operations) and Financial Services as discontinued operations in accordance with Accounting Principles Board Opinion No. 30, "Reporting the Results of Operations--Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions" (APB 30). Under the Plan, the disposition of The Knoll Group (Knoll) was scheduled to occur by the end of 1994 and WCI Communities, Inc. (WCI) by the end of 1995. Financial Services was comprised primarily of Westinghouse Credit Corporation (WCC) and Westinghouse Savings Corporation (WSAV), each subsidiaries of Westinghouse Financial Services, Inc. (WFSI) and the Corporation's leasing portfolio. On May 3, 1993, WFSI and WCC were merged into Westinghouse. See notes 2 and 20 to the financial statements included in Part II, Item 8 of this report. In January 1994, the Corporation announced that the sale of WCI will be accelerated from 1995 into 1994 and Knoll is no longer for sale. WCI will continue to be reported as part of Continuing Operations until the requirements of APB 30 are met. At that time, WCI will be classified as a discontinued operation and appropriate restatements will be made to the Corporation's financial statements. For financial reporting purposes, the Corporation's Continuing Operations are aligned into the following segments: Broadcasting, Electronic Systems, Environmental, Industries, Power Systems, Knoll and WCI. Engineering and repair services, previously included in the Industries segment, has been transferred to the Power Systems segment where these businesses have been consolidated with the power generation service organization. The Environmental segment now includes the U.S. naval nuclear reactors programs previously reported in Power Systems. The Longines-Wittnauer Watch Company and Westinghouse Communications have been transferred from the Broadcasting segment to the Industries segment as part of the Industrial Products and Services business unit. The financial results of manufacturing entities located outside the United States, and export sales and foreign licensee income are included in the financial information of the reporting segment that had operating responsibility for such activity. Financial and other information by segment and geographic area is included in note 21 to the financial statements included in Part II, Item 8 of this report. For information about principal acquisitions and divestitures during the three years ended December 31, 1993, see note 20 to the financial statements included in Part II, Item 8 of this report. During 1993, the largest single customer of Westinghouse was the United States government and its agencies, whose purchases accounted for 30% of 1993 consolidated sales of products and services. No material portion of the Corporation's business was seasonal in nature. REPORTING SEGMENTS BROADCASTING Westinghouse Broadcasting Company, Inc. (Group W), a wholly-owned subsidiary of the Corporation, provides a variety of communications services consisting primarily of commercial broadcasting, program production and distribution. It sells advertising time to radio, television and cable advertisers through national and local sales organizations. Group W currently owns and operates five network affiliated television broadcasting stations and 14 radio stations. Group W's television stations are located in Baltimore, Boston, Philadelphia, Pittsburgh and San Francisco and their signals reach approximately ten percent of the United States viewing audience. Four of the five Group W television stations are currently rated either first or second in prime time and in news among adult viewers. Group W's radio stations form the largest non-network radio group in the United States. They are located in Boston, Chicago, Detroit, Houston, Los Angeles, New York City, Philadelphia and Pittsburgh--seven of the top ten radio markets in the nation. In addition, WINS, Group W's all-news radio station in New York City, currently has more listeners over the age of 18 than any other radio station in the United States. Group W Satellite Communications provides sports programming and the marketing and advertising sales for two country music entertainment channels. Group W Satellite Communications is also the industry leader providing technical services to broadcast and cable television networks. The Broadcasting segment also includes Group W's program production and distribution business, Group W Productions, which supplies television series and special programs through national syndication to broadcast television stations and cable networks throughout the United States. Group W's broadcast stations have many competitors, both large and small, and compete principally on the basis of audience ratings, price and service. Group W's commercial broadcast television business experiences competition from cable television which provides program diversification in addition to improved reception. Broadcast television stations and cable television systems are also in competition in varying degrees with other communications and entertainment media, including movie theaters, videocassette distributors and over-the-air pay television. Due to the rapid pace of technological advancement, broadcast television stations can expect to face continued strong competition in the future. Still, after years of such intense competition, these broadcast television stations remain, by a wide margin, the dominant distributors of news and entertainment programming in their geographical markets. ELECTRONIC SYSTEMS Electronic Systems is a world leader in the research, development, production and support of advanced electronic systems for defense, government, and commercial customers. Products provided to the Department of Defense (DoD) and foreign governments include surveillance and fire control radars, command and control systems, electronic countermeasures equipment, electro-optical systems, satellite-based sensors, missile launching and handling equipment, marine propulsion systems, torpedoes, anti-submarine warfare systems and communications equipment. Purchases by DoD, directly and through subcontractors, accounted for 70% of Electronic Systems' sales in 1993. In 1991, Electronic Systems' DoD business began to experience a shift from high margin production to lower margin development programs. These high priority development programs, such as the Air Force Advanced Tactical Fighter and Army Comanche Helicopter, are expected to transition to high margin production in the late '90s. The termination of the Airborne Self Protection Jammer and reduced torpedo production options will impact near-term sales. Electronic Systems is pursuing growth of its core businesses and expansion of its DoD product and customer base. Strong growth opportunities also exist internationally for capitalizing on strong product positions in markets such as air traffic control and airborne sensor systems. Electronic Systems has been successful in using its technology leadership position to develop a broad spectrum of electronic products for domestic and international markets. International sales were 18% of Electronic Systems' total sales in 1993 and its products have a presence in over 100 countries. In general, sales to the United States government and foreign military sales through the United States government, are subject to termination procedures prescribed by statute. Government contracts vary from fixed-price contracts on production programs and some development programs, to cost-type contracts on development activities. Reliability, performance and competitive costs are the main criteria in the award of contracts of this type. This segment's business is influenced by changes in the budgetary plans and procurement policies of the United States government, as well as changes in its diplomatic posture. This segment encounters significant competition, primarily from large electronics companies, on the basis of technology, price, service, warranty and product performance. On any DoD weapons system platform, Electronic Systems might be a prime bidder, or teamed or in competition with any one of the major aerospace companies doing business within the United States or allied countries. ENVIRONMENTAL The Westinghouse Government & Environmental Services Company includes Environmental Services, the management of certain government-owned facilities and the U.S. naval nuclear reactors programs. Environmental Services provides a variety of environmental remediation and toxic, hazardous and radioactive waste treatment services. Through Aptus, Inc., the Corporation offers toxic and hazardous waste incineration, treatment, transportation, storage and analysis services. Facilities performing these services are located in Kansas, Utah and Minnesota. Westinghouse Remediation Services, Inc. provides comprehensive toxic and hazardous waste remediation services, including mobile, on-site environmental treatment technologies. The Scientific Ecology Group, Inc. offers a broad range of on-and off-site services to manage radioactive materials and mixed wastes, including the only commercially-licensed radioactive waste incinerator and the only recycling facility for radioactively contaminated metals in the United States. Through subsidiaries, Resource Energy Systems operates four waste-to-energy plants that convert municipal solid waste into clean electrical energy. Controlmatic, a group of affiliated indirect subsidiaries having principal operations in Germany, Switzerland, Austria and Italy, offers products and services relating to control, monitoring and industrial automation and instrumentation. Through the Westinghouse Savannah River Company and certain subsidiaries and divisions of Westinghouse Government & Environmental Services Company, the Corporation manages five government-owned facilities under contracts with the United States Department of Energy (DoE). These DoE facilities are involved in the production of uranium metal products, fuel reprocessing, nuclear waste disposal and environmental restoration. The mission at the defense facilities has been evolving in recent years to waste management and environmental cleanup. These businesses are under contracts with the federal government, which reserves the right to terminate these contracts for convenience. The U.S. naval nuclear reactors programs consist of the Corporation's Navy nuclear and technical support businesses. These businesses include the Bettis Atomic Power Laboratory, the Plant Apparatus Division, Machinery Apparatus Operation and the Machinery Technology Division, which provides technical engineering services to the Naval Sea Systems Command. Certain businesses within this segment have been identified for sale in connection with the Corporation's planned disposition of certain non-strategic businesses announced in January 1994. See Management's Discussion and Analysis--Restructuring and Other Actions included in Part II, Item 7 of this report. Competition for services provided by businesses in the Environmental segment is based on price, technology preference, environmental experience, performance reputation and, with respect to certain businesses, availability of permitted treatment or disposal facilities. INDUSTRIES The Industries segment is comprised of the transport temperature control business and the Industrial Products and Services business unit. Thermo King Corporation (Thermo King), the world leader in its primary businesses, manufactures a complete line of transport temperature control equipment, including units for trucks, truck trailers, container ships, buses and railway cars and service parts to support these units. The transport refrigeration units are powered by diesel fuel, gasoline, propane or electricity. Thermo King maintains international manufacturing facilities in Ireland, Brazil, Spain, the Dominican Republic, the United Kingdom, the Czech Republic and the People's Republic of China. It has dealerships throughout the world, and its equipment is used in virtually every country. Industrial Products and Services is a diverse group of businesses located primarily in the United States, providing products and services to commercial, industrial, utility, and government customers. These products and services include: wide area and local area voice and data communications services; watches; process rectifiers and associated renewal parts, electro-mechanical parts, and maintenance and repair of continuous casting machines within the steel industry; copper rod and magnet wire, liquid insulation and resins, and flexible insulation; decorative and industrial high-pressure laminates; large industrial motors; and commercial printing. Certain businesses within this business unit have been identified for sale in connection with the Corporation's planned disposition of certain non-strategic businesses announced in January 1994. See Management's Discussion and Analysis--Restructuring and Other Actions included in Part II, Item 7 of this report. Thermo King is subject to competition worldwide for all of its products. Its products compete on the basis of service, technology, warranty, product performance, and cost. In addition, Thermo King's customers and end users are concerned about environmental issues, especially chloroflourocarbons, noise pollution and engine emissions. Thermo King designs its products to meet or exceed all environmental requirements. Industry Products and Services competes in local geographic markets based on price, performance reputation, technology preference and experience. POWER SYSTEMS The Power Systems segment includes the Power Generation and Energy Systems business units which serve the worldwide market for electrical power generation. The Power Generation business unit designs, manufactures and services steam turbine-generators for commercial nuclear and fossil-fueled power plants, as well as combustion turbine-generators for natural gas and oil-fired power plants. In addition to serving the regulated electric utility industry, the business unit supplies, services and operates power plants for independent power producers and other non-utility customers. Growing demand for electrical energy has contributed to the business unit's growth. In 1993, the business unit was awarded orders for approximately 3,200 megawatts of new power generating capacity. The domestic market for new generating equipment from 1994 through the year 2002 is approximately 132 gigawatts; the international market is expected to be over five times the size of the domestic market. With more than 2,800 operating units worldwide based on Westinghouse power generation technology, the business unit has a substantial service business. The Power Generation business unit is a participant in the development of emerging technologies which could shape the future of power generation and place the business unit in a strong position for continued growth. The Energy Systems business unit primarily serves the worldwide nuclear energy market. It also designs and develops solar-based energy systems and process control systems for nuclear and fossil-fueled power plants and industrial facilities. About 40% of the world's operating commercial nuclear power plants incorporate Westinghouse technology. With virtually all of Westinghouse's worldwide nuclear power plant projects now in operation, the business unit focuses on supplying a wide range of operating plant services, ranging from performance-based maintenance programs to new products and services that enhance plant performance. The business unit also has complete capabilities for supplying customers with nuclear fuel. The annual market for operating plant services and fuel is over $10 billion in the United States and $30 billion globally. The business unit is also working with government agencies and industry leaders to revitalize the nuclear energy option, and is developing a simplified nuclear power plant design that incorporates passive safety systems. The Power Generation and Energy Systems business units have a number of domestic and foreign competitors in the electric utility industry where Westinghouse is recognized as a significant supplier. Positive factors with respect to competitive position are technology, service and worldwide presence. Negative factors are an increasing number of foreign competitors and small competitors, particularly in the service area. The principal methods of competition are technology, product performance, customer service, pricing and financing. KNOLL The Knoll Group is comprised of the Corporation's office furniture businesses. Knoll provides a wide range of furniture products ranging from designer-oriented individual pieces to systems designed to improve work environments and contribute to productivity. Products include individually hand-crafted furniture, executive furniture, general office furniture, furniture-grade textiles, office accessories and furniture systems. Knoll is subject to a high degree of competition (including price, service, design and product performance) for sales of products to the interior design, construction, industrial and consumer markets from both large and small competitors. WCI WCI develops land into master planned luxury communities located primarily in Florida and California. Among WCI's major community developments are Coral Springs, Parkland, Bermuda Bay, Pelican Bay, Pelican Marsh, Pelican Landing, Gateway and Bay Colony, all in Florida, Tortolita Mountain Properties in Arizona and Bighorn in Palm Springs, California. DISCONTINUED OPERATIONS Discontinued Operations consists of Financial Services and Other Operations. Other Operations is comprised of DCBU and WESCO. FINANCIAL SERVICES Financial Services was comprised primarily of WCC and WSAV, WFSI and the Corporation's leasing portfolio. WSAV sold Westinghouse Federal Bank, whose assets represented the substantial majority of WSAV's assets, in January 1993. On May 3, 1993, WFSI and WCC were merged into Westinghouse and, as a consequence, ceased to exist as separate legal entities and their debt was assumed by the Corporation. This merger gave management greater flexibility to liquidate the assets of Financial Services and execute the strategy of exiting the financial services business. During 1993, Financial Services disposed of assets ahead of schedule at prices more favorable than anticipated in the Plan. Financial Services disposed of real estate, corporate and leasing assets for approximately $4,150 million in cash during 1993, and significantly reduced debt. These dispositions included the sale of over half of the commercial real estate portfolio to LW Real Estate Investments, L.P. (LW) in several transactions. LW was formed in April 1993 between Westinghouse, the limited partner, and an affiliate of Lehman Brothers, an investment banking firm. The Lehman Brothers affiliate is the general partner. At December 31, 1993, the Corporation had a 44% limited partnership interest in LW. Financial Services portfolio investments are comprised of the remaining real estate and corporate assets, and the Corporation's leasing portfolio, which is expected to run-off in accordance with contractual terms. The remaining real estate assets are primarily comprised of real estate properties, receivables and the Corporation's investment in LW. The Corporation expects a significant portion of its investment in LW to be liquidated during 1994 and the remaining real estate assets by the end of 1995. The remaining corporate assets are expected to be liquidated during 1994. DISTRIBUTION AND CONTROL On August 11, 1993, the Corporation announced an agreement to sell the majority of DCBU to Eaton Corporation for a purchase price of $1.1 billion and the assumption by the buyer of certain liabilities. The Corporation completed this sale on January 31, 1994. WESTINGHOUSE ELECTRIC SUPPLY COMPANY On February 16, 1994, the Corporation announced an agreement to sell WESCO to an affiliate of Clayton Dubilier & Rice, Inc., a private investment firm, for a purchase price of approximately $340 million. The Corporation completed this sale on February 28, 1994. RAW MATERIALS The Corporation has experienced no significant difficulty with respect to sources and availability of raw materials essential to the business. PATENTS Westinghouse owns or is licensed under a large number of patents and patent applications in the United States and other countries that, taken together, are of material importance to its business. Such patent rights are, in the judgment of the Corporation, adequate for the conduct of its business. None of its important products, however, are covered by exclusive controlling patent rights that preclude the manufacture of competitive products by others. BACKLOG The backlog of firm orders of the Corporation from Continuing Operations was $9,925 million at the end of 1993 and $9,617 million at the end of 1992, excluding amounts associated with uranium supply contract settlements. Of the 1993 backlog, $5,686 million is expected to be liquidated after 1994. In addition to the reported backlog, the Corporation provides certain non-Westinghouse products primarily for nuclear steam supply systems customers. Backlog for the Corporation is as follows: Electronic Systems backlog at year-end 1993 and 1992 was $3,841 million and $3,969 million. Backlog of $2,118 million is expected to be liquidated after 1994. Environmental backlog at year-end 1993 and 1992 was $797 million and $778 million. Backlog of $645 million is expected to be liquidated after 1994. Industries backlog at year-end 1993 and 1992 was $215 million and $196 million. Backlog of $36 million is expected to be liquidated after 1994. Power Systems backlog at year-end 1993 and 1992 was $4,901 million and $4,518 million. Backlog of $2,850 million is expected to be liquidated after 1994. Knoll backlog at year-end 1993 and 1992 was $108 million and $106 million. Backlog of $24 million is expected to be liquidated after 1994. Also included in backlog at year-end of 1993 and 1992 was $63 million and $50 million attributable to Corporate-Other, of which $13 million is expected to be liquidated after 1994. ENVIRONMENTAL MATTERS Information with respect to Environmental Matters is incorporated herein by reference to Management's Discussion and Analysis--Environmental Matters included in Part II, Item 7 and note 17 to the financial statements included in Part II, Item 8 of this report. RESEARCH AND DEVELOPMENT Data with respect to research and development is incorporated herein by reference to note 21 to the financial statements included in Part II, Item 8 of this report. EMPLOYEE RELATIONS During 1993, Westinghouse employed an average of 103,063 people of whom approximately 79,000 were located in the United States. During the same period, approximately 14,000 domestic employees were represented in collective bargaining by 24 labor organizations. Two-thirds of these represented employees were represented by unions that are affiliated with, and/or bargain in conjunction with, one of three national unions, namely, the International Brotherhood of Electrical Workers, International Union of Electronic, Electrical, Salaried, Machine and Furniture Workers and the Federation of Independent Salaried Unions. The current three-year agreements for these national unions which were negotiated in August 1991 expire on August 27, 1994. The current agreements provide a balanced and competitive package of pay and benefits which were particularly well suited for Westinghouse and its employees. In 1994 negotiations, management will place particular emphasis on achieving an economic settlement and other provisions that are appropriate for and supportive of current business conditions. At December 31, 1993, the Corporation employed 101,654 people, of which 16,812 were employees of DCBU and WESCO. The Corporation completed the sales of DCBU and WESCO in January 1994 and February 1994, respectively. FOREIGN AND DOMESTIC OPERATIONS Data with respect to foreign and domestic operations and export sales is incorporated herein by reference to note 21 to the financial statements included in Part II, Item 8 of this report. ITEM 2. ITEM 2. PROPERTIES. At December 31, 1993, Westinghouse Continuing Operations owned or leased 791 locations totalling 40 million square feet of floor area in the United States and 32 foreign countries. Domestic operations of Continuing Operations comprised approximately 84% of the total space. Facilities leased in the United States accounted for approximately 23% of the total space occupied by Continuing Operations and facilities leased in foreign countries accounted for approximately 7% of the total space occupied by Continuing Operations. No individual lease was material. A number of manufacturing plants and other facilities formerly used in operations are either vacant, partially utilized, or leased to others. All of these plants are expected to be sold, leased, or otherwise utilized. Except for these facilities, the Corporation's physical properties are adequate and suitable, with an appropriate level of utilization, for the conduct of its business in the future. ITEM 3. ITEM 3. LEGAL PROCEEDINGS. (a) On December 1, 1988, the Republic of the Philippines (Republic) and National Power Corporation (NPC) filed a lawsuit in the United States District Court (USDC) for the District of New Jersey asserting claims against the Corporation, Westinghouse International Projects Company and Burns and Roe Enterprises, Inc. (Burns and Roe) relating to a contract between NPC and Westinghouse for the construction of a nuclear power plant in the Philippines as well as an earlier consulting contract between NPC and Burns and Roe relating to the same project. This action seeks recision of the Westinghouse and Burns and Roe contracts and restitution of all money and other property paid to Westinghouse and Burns and Roe or, alternatively, reformation of the NPC-Westinghouse contract. Plaintiffs requested compensatory, punitive and treble damages, costs and expenses of the lawsuit, and such other relief as the USDC deems just and proper. The complaint alleges, among other things, bribery and other fraudulent conduct, tortious interference with the fiduciary duty owed by Ferdinand E. Marcos to the Republic and the people of the Philippines, common law fraud, and violations of various New Jersey and federal statutes, including the Federal Racketeer Influenced and Corrupt Organizations Act (RICO) statute. Plaintiffs demanded a jury trial. Also on December 1, 1988, Westinghouse filed a request for arbitration with the International Chamber of Commerce Court of Arbitration (ICC) pursuant to the NPC-Westinghouse contract, setting forth certain claims Westinghouse has against NPC and the Republic and asking for arbitration of the anticipated claims of the Republic and NPC related to the Philippines nuclear power plant. The Republic and NPC challenged the jurisdiction of the ICC, arguing that the contract between the parties, including its arbitration provision, was invalid due to alleged bribery in the procurement of the contract. In December 1991, the ICC arbitration panel issued its award finding that the Republic and NPC had failed to carry their burden of proving the alleged bribery by the Corporation. The panel thereby concluded that the arbitration clause and contract were valid and that the panel has jurisdiction over the remaining disputes between NPC and the Corporation. In January 1992, NPC filed an action for annulment of the award by the ICC arbitration panel in the Swiss Federal Supreme Court. In September 1993, the Swiss Federal Supreme Court issued an order dismissing NPC's annulment action and assessing cost against NPC. Arbitration before the ICC is ongoing. An evidentiary hearing is scheduled to begin in the first quarter of 1994, and a final award is anticipated before the end of 1994. With respect to the suit filed in the USDC, Westinghouse filed a motion requesting that the action filed there be stayed in its entirety pending arbitration of the Republic's claims. In 1989, the Court granted a motion brought by the Corporation and ordered 14 of the 15 counts in the lawsuit stayed pending arbitration. The Court retained jurisdiction over the remaining count involving an alleged intentional interference with a fiduciary relationship. Trial commenced with respect to this one count in March 1993. In May 1993, a jury verdict was rendered in favor of the Corporation with respect to all claims relating to the alleged intentional interference with a fiduciary relationship. NPC and the Republic have indicated that they intend to appeal this decision. (b) Duke Power Company (Duke) filed a lawsuit against the Corporation in March 1990 in the USDC for the District of South Carolina, Charleston Division, for an unspecified amount of damages, including treble and punitive damages, based on 1970 and 1975 contracts for Westinghouse's supply of nuclear steam supply systems at Duke's McGuire and Catawba plants. Subsequently, Duke disclosed that it is seeking approximately $655 million for estimated past and future damages for the four nuclear steam supply systems. Duke asserted counts for negligence, promissory estoppel, fraud, negligent misrepresentation, violation of the RICO statute, and violation of North Carolina and South Carolina unfair trade practices statutes, and alleged that the steam generators delivered by the Corporation were defectively designed and manufactured. Alleged co-owners of the plants intervened in the litigation as additional plaintiffs. In February 1993, the USDC granted the Corporation's motion to dismiss Duke's negligent misrepresentation, negligent design and fabrication claims and portions of its RICO claims. A motion to dismiss the remaining counts is pending. Trial is scheduled for March 14, 1994. (c) In March 1990, South Carolina Electric and Gas (SCE&G) filed a lawsuit against the Corporation in the USDC for the District of South Carolina, Charleston Division, for an unspecified amount of damages, including treble and punitive damages, based on a 1970 contract for the Corporation's supply of a nuclear steam supply system at the Summer plant. Subsequently, plaintiff disclosed that it is seeking approximately $175 million for past damages and for estimated future replacement of the nuclear supply system. SCE&G asserted counts for breach of warranty, breach of contract, negligence, negligent misrepresentation, promissory estoppel, fraud, violation of the RICO statute and violation of a South Carolina unfair trade practices statute. SCE&G alleged that the steam generators delivered by the Corporation were defectively designed and manufactured. In February 1993, the court granted the Corporation's motion to dismiss with respect to SCE&G's negligent misrepresentation, negligent design and fabrication claim and portions of its RICO claims. On January 12, 1994, the Corporation and SCE&G entered into a settlement agreement resolving all claims asserted in this action and entered into a stipulated order dismissing the action with prejudice. (d) In October 1990, Commonwealth Edison Company (Commonwealth Edison) filed a lawsuit against the Corporation and four individual defendants (all employees of the Corporation or a Corporation subsidiary company) in Circuit Court in Cook County, Illinois, for an unspecified amount of damages, including treble and punitive damages, based on the Corporation's supply of nuclear steam supply systems for Commonwealth Edison's Zion, Byron and Braidwood plants. The complaint sets forth counts of common law fraud against the Corporation and the employees, and violation of the Illinois Consumer Fraud and Deceptive Practices Act and violations of the RICO statute against the Corporation. In November 1991 Commonwealth Edison dismissed the individual defendants and the parties are currently engaged in discovery. (e) In October 1990, Houston Lighting and Power Company and its co-owners filed a lawsuit against the Corporation and two individual defendants (one current and one retired employee of the Corporation) in the District Court of Matagorda County, Texas, for an unspecified amount of damages. The claims arise out of the Corporation's supply of nuclear steam supply systems for the South Texas Project. The petition alleges breach of contract warranty, misrepresentation, negligent misrepresentation and violation of the Texas Deceptive Trade Practices Act. Plaintiffs later alleged $14 million plus, for past damages. In January 1991, the parties reached agreement to dismiss the individual defendants and to stay the litigation for the purpose of discussing resolution of the issues between them. In November 1991, however, the plaintiffs gave notice that they were activating the litigation. In March 1993, plaintiffs filed an amended complaint seeking an unspecified amount of future damages for replacement of the steam generator. The parties are continuing discovery and a trial date is set for the third quarter of 1994. (f) In April 1991, Duquesne Light Company (Duquesne) and its co-owners filed a lawsuit against the Corporation in the USDC for the Western District of Pennsylvania for an undetermined amount of damages, including treble and punitive damages. Subsequently Duquesne disclosed that it is seeking approximately $320 million in damages. The claims arise out of the Corporation's supply of nuclear steam supply systems for the Beaver Valley plants. Duquesne asserts counts for breach of contract, fraud, negligent misrepresentation, and violations of the RICO statute. Pre-trial statements have been filed by all parties and this case could go to trial in 1994. (g) In February 1993, Portland General Electric Company (Portland) filed a lawsuit against the Corporation in the USDC for the Western District of Pennsylvania seeking unspecified damages based on claims for breach of contract, negligence, fraud, negligent misrepresentation, and violations of the RICO statute and the Oregon RICO statute relating to the Corporation's design, manufacture and installation of steam generators at the Trojan Nuclear Plant, an electric generating facility located in Ranier, Oregon. Portland also seeks a declaratory judgment that the steam generators are defective and that the Corporation is liable to plaintiff for expenses, including replacement power, incurred as a result of the alleged defects. In April 1993, Portland filed a motion to consolidate its case with a similar action filed by The Eugene Water & Electric Board relating to the Trojan Nuclear Plant. This motion was subsequently granted. In June 1993, the court granted the Corporation's motion to dismiss plaintiff's claims for negligence and negligent misrepresentation. The court also dismissed, in part, the plaintiff's claims under Section 1962(b) of the federal RICO statute relating to the Trojan project enterprise. The parties continue to engage in discovery. This case could go to trial in 1994. (h) In February 1993, the City of Eugene, Oregon, acting by and through The Eugene Water & Electric Board (the Board), filed a lawsuit against the Corporation in the USDC for the District of Oregon seeking unspecified damages based on claims for breach of contract, negligence, fraud, negligent misrepresentation, and violations of the RICO statute and the Oregon RICO statute relating to the Corporation's design, manufacture and installation of steam generators at the Trojan Nuclear Plant, an electric generating facility located in Ranier, Oregon. The Board is a 30% owner of the Trojan Nuclear Plant. The Board also seeks a declaratory judgment that the steam generators are defective and that the Corporation is liable to plaintiff for expenses incurred as a result of the alleged defects. Also in February 1993, the Board filed a motion to change venue from the USDC for the District of Oregon to the USDC for the Western District of Pennsylvania. The Board's motion was subsequently granted. This case was consolidated with the Portland case described in item (g) above. The parties in both actions are seeking total damages of approximately $350 million. In June 1993, the court granted the Corporation's motion to dismiss plaintiff's claims for negligence and negligent misrepresentation. The court also dismissed, in part, the plaintiff's claims under Section 1962(b) of the federal RICO statute relating to the Trojan project enterprise. The parties continue to engage in discovery. This case could go to trial in 1994. (i) In July 1993, Northern States Power Company (NSP) filed a lawsuit against the Corporation in the USDC for the District of Minnesota for an unspecified amount of damages, including treble and punitive damages, based on the Corporation's supply of steam generators at NSP's Prairie Island Nuclear Plant. The complaint sets forth counts for breach of contract, fraud, negligent misrepresentation, violations of RICO and violations of the Minnesota Prevention of Consumer Fraud Act. (j) In August 1988, the Pennsylvania Department of Environmental Resources (DER) filed a complaint against the Corporation alleging violations of the Pennsylvania Clean Streams Law at the Corporation's Gettysburg, Pennsylvania, elevator plant. The DER requested that the Environmental Hearing Board assess a penalty in the amount of $9 million. The Corporation has denied these allegations. The parties completed discovery and a portion of the hearing on the complaint began in 1991. The hearing resumed in 1992 and concluded in February 1993. All post-trial briefs have been filed and the parties await a decision. (k) The Corporation has been defending a consolidated class action, a consolidated derivative action and certain individual lawsuits that have been brought by shareholders of the Corporation against the Corporation, WFSI and WCC, previously subsidiaries of the Corporation and/or certain present and former directors and officers of the Corporation, as well as other unrelated parties. Together, these actions allege various federal securities law and common law violations arising out of alleged misstatements or omissions contained in the Corporation's public filings concerning the financial condition of the Corporation, WFSI and WCC in connection with a $975 million charge to earnings announced on February 27, 1991, a public offering of Westinghouse common stock in May 1991, a $1,680 million charge to earnings announced on October 7, 1991, and alleged misrepresentations regarding the adequacy of internal controls at the Corporation, WFSI and WCC. In July 1993, the USDC for the Western District of Pennsylvania dismissed in its entirety the derivative claim and dismissed most of the class action claims set forth above, with leave to replead both actions. In August 1993, the plaintiffs refiled, in its entirety, the derivative action. In September 1993, the plaintiffs refiled all dismissed claims in the class-action suit. In September 1993, the Corporation moved to strike and dismiss the refiled derivative action. In December 1993, the Corporation filed a motion to dismiss the refiled class action claims. The parties await a decision on both motions. (l) In June 1990, a suit was filed against WCC in the USDC for the Western District of Missouri by three affiliated entities (collectively American Carriers) for the alleged breach of a commitment letter issued by WCC to lend up to $65 million to American Carriers. American Carriers claims the alleged breach caused it to file bankruptcy. The complaint alleged counts for breach of contract, breach of implied duty of good faith, promissory estoppel and negligent misrepresentation, and sought compensatory and punitive damages. By agreement of the parties, in January 1992, the action in the USDC was dismissed and an action was filed in the Circuit Court of Jackson County, Missouri with substantially the same claims made, except allegations relating to negligent misrepresentation and punitive damages were dropped by stipulation of the parties. WCC counterclaimed alleging, among other things, fraud in the inducement, which if proven would defeat plaintiffs' claims in their entirety. In February 1993, the jury in this case returned a verdict in favor of the plaintiffs in the amount of $70 million. In April 1993, the Corporation appealed the decision of the court. A decision on the appeal is expected soon. (m) In February 1993, the Corporation was sued by 108 former employees who were laid off subsequent to the cancellation by the federal government of all contracts pertaining to the carrier based A-12 aircraft program. The complaint alleges age discrimination on the part of the Corporation. The suit was filed in the USDC for the District of Maryland. The plaintiffs seek back pay with benefits and reinstatement of jobs or front pay. Also, in April 1993, the Equal Employment Opportunity Commission (EEOC) filed a class-action, age discrimination suit against Westinghouse in the USDC for the District of Maryland on behalf of 388 former Westinghouse employees who were laid off or involuntarily terminated from employment subsequent to the federal government's cancellation of all contracts pertaining to the carrier based A-12 aircraft program. The suit alleges age discrimination and discriminatory employment practices. The suit seeks back pay, interest, liquidated damages, reinstatement of jobs, court costs and other appropriate relief. These two cases have been consolidated by the court. Presently, the EEOC is reviewing various discrimination charges relating to other involuntary terminations which have occurred at the Corporation's Electronic Systems business unit. In October 1993, EEOC issued a determination letter regarding age discrimination associated with certain layoffs at the Corporation's Electronic Systems business unit. The letter invited the Corporation to conciliate the issues. If the conciliation is unsuccessful, the EEOC may file another lawsuit in federal court. (n) Beginning in early 1990 and continuing into 1993, numerous asbestos lawsuits have been filed against the Corporation and numerous other defendants in the Circuit Court of Jackson County, Mississippi. The plaintiffs allege personal injury, wrongful death and loss of consortium claims arising out of exposure to products containing asbestos that were manufactured, supplied or installed by the defendants. In April 1993, trial commenced in the Circuit Court with respect to the claims of nine plaintiffs against a number of defendants, including the Corporation. In August 1993, a jury awarded a verdict in favor of five of the plaintiffs against the Corporation and certain other defendants and awarded a defense verdict in favor of the Corporation against the four other plaintiffs. The jury found Westinghouse approximately 38% liable on the aggregate damage verdict of some $8.75 million awarded the five plaintiffs, with punitive damages at 10% of compensatory damages. The Corporation is entitled to offsets on these verdicts from settlements previously paid by certain defendants and will also apply its insurance coverage to these verdicts. The judge has previously ruled that the jury's findings on certain questions may apply to approximately 6,400 other cases pending which, however, would still have to be tried on issues of exposure, causation and the amount of compensatory damages, if any. The Corporation, along with the other defendants who were found liable, have filed post-trial motions seeking a judgment notwithstanding the verdict on a new trial. The Corporation intends to appeal if the court denies its post-trial motions. (o) The Corporation is currently a defendant in approximately 7,400 out of more than 12,000 asbestos cases pending in the Circuit Court of Kanawha County, West Virginia. The plaintiffs allege personal injury, wrongful death and loss of consortium claims arising out of alleged exposure to asbestos-containing products that were manufactured, supplied or installed by the defendants, including the Corporation. On March 24 1994, a trial is scheduled to begin on the plaintiffs' claims generally, although no individual plaintiffs will be asserting their claims at that time. Rather, the trial will focus on whether the various defendants' asbestos-containing products were hazardous, and whether the defendants had and/or breached a duty to warn of the alleged hazards associated with those products. The trial will also determine whether the defendants are liable for punitive damages arising from a failure to warn of alleged hazards associated with their asbestos-containing products. The findings made in this phase of trial regarding "duty to warn" and punitive damages may be applied in future trials involving the individual plaintiffs. (p) The Corporation is a direct defendant in approximately 527 of 2,100 consolidated cases alleging personal injury, wrongful death and loss of consortium claims arising from exposure to asbestos-containing products manufactured, supplied or installed by various defendants, including the Corporation. Although pending in Baltimore County Circuit Court, Westinghouse has removed 508 of the cases to Federal Court, and has thus far successfully defended plaintiffs' attempts to remand the cases to state court. If the cases are remanded, they will become part of a trial scheduled for March 1994, which will adjudicate all issues raised by the claims of ten representative plaintiffs, including the issue of punitive damages. Certain findings made with respect to the representative plaintiffs will be applied to future trials of the remaining plaintiffs. The March 1994 trial will also address cross-claims and third-party claims filed by various defendants against the Corporation in an earlier consolidated proceeding in which the Corporation was not a direct defendant. (q) On March 10, 1993, the State of Washington Department of Ecology issued to the DoE and to Westinghouse Hanford Company (WHC) an administrative penalty in the amount of $100,000 for violation of the Washington Dangerous Waste regulations. Specifically, the penalty was assessed for failure to designate certain waste at the tank farms at the DoE's Hanford, Washington facility, which is managed by WHC. On November 1, 1993, the parties agreed to fund certain projects in lieu of paying this amount directly to the State. The Corporation believes that the penalty will be an allowable cost under WHC's contract with the DoE. (r) A description of the derivative litigation involving certain of the Corporation's current and past directors is incorporated herein by reference to "Litigation Involving Derivative Claims Against Directors" in the Proxy Statement. Management believes that the Corporation has meritorious defenses to all of the proceedings described above. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. None during the fourth quarter of 1993. EXECUTIVE OFFICERS The name, offices, and positions held during the past five years by each of the executive officers of the Corporation as of March 1, 1994 are listed below. Officers are elected annually. There are no family relationships among any of the executive officers of the Corporation. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The principal markets for the Corporation's common stock are identified on page 1 of this report. The remaining information required by this item appears on page 58 of this report and is incorporated herein by reference. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. The information required by this item appears on page 58 of this report and is incorporated herein by reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The information required by this item appears on pages 16 through 28 of this report and is incorporated herein by reference. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The information required by this item, together with the report of Price Waterhouse dated January 26, 1994, except as to the matter discussed in paragraph 9 of note 2 which is as of February 28, 1994, appears on pages 29 through 57 of this report and is incorporated herein by reference. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. FINANCIAL REVIEW MANAGEMENT'S DISCUSSION AND ANALYSIS OVERVIEW In November 1992, the Corporation adopted a plan which included the disposition of Distribution and Control Business Unit (DCBU), Westinghouse Electric Supply Company (WESCO) and exiting Financial Services. These businesses comprise the Corporation's Discontinued Operations. The Corporation's Continuing Operations consist of its Broadcasting, Electronic Systems, Environmental, Transport Temperature Control and Power Systems businesses, as well as The Knoll Group (Knoll), its furniture business, and WCI Communities, Inc. (WCI). The Corporation reported a net loss of $326 million, or $1.07 per share, for 1993. Net losses in 1992 and 1991 were $1,394 million and $1,086 million, or $4.11 and $3.46 per share, respectively. Included in 1993 results was a pre-tax provision of $750 million for restructuring, the disposition of certain non-strategic businesses and certain litigation and environmental contingencies. The 1993 results also included an after-tax charge of $95 million for Discontinued Operations to reflect management's current estimates of proceeds and costs associated with the plan adopted in November 1992. See notes 1 and 2 to the financial statements for a description of the plan. Included in 1992 results was an after-tax charge of $1,383 million to record the estimated loss on disposal of Discontinued Operations. See note 2 to the financial statements. The Corporation reported a loss from Continuing Operations of $175 million or $.64 per share for 1993. Excluding the pre-tax provision of $750 million recorded in the fourth quarter of 1993, income from Continuing Operations was $318 million or $.76 per share. Income from Continuing Operations was $357 million or $.95 per share for 1992 and $335 million or $1.07 per share for 1991. The loss from Discontinued Operations was $95 million or $.27 per share in 1993, $1,413 million or $4.08 per share in 1992 and $1,421 million or $4.53 per share in 1991. Included in 1993 results is the adoption, retroactive to January 1, 1993, of Statement of Financial Accounting Standards (SFAS) No. 112, "Employers' Accounting for Postemployment Benefits," which resulted in an after-tax charge of $56 million or $.16 per share. The Corporation's results for the first quarter of 1993 have been restated to reflect the implementation of SFAS No. 112. See notes 1 and 4 to the financial statements. The Corporation's 1992 results included the adoption of SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," concurrent with the adoption of SFAS No. 109, "Accounting for Income Taxes," which resulted in a net charge of $338 million or $.98 per share. See notes 1, 4, and 5 to the financial statements. The 1991 results included a pre-tax valuation provision at Financial Services of $1,680 million and a $160 million pre-tax charge for a corporate-wide workforce reduction, $22 million of which related to Discontinued Operations. In 1992, a $36 million pre-tax charge for corporate restructuring was recorded in Continuing Operations in connection with the November 1992 plan. The Corporation's goals during 1994 include improving the operating performance of the continuing businesses, continuing to pay down debt, rebuilding equity, and accelerating the pursuit of international opportunities by certain of its businesses. Operating profit and results of operations will, however, continue to be negatively impacted in 1994 by interest and litigation costs and increased pension expense. The Corporation's objective is to reduce these earnings constraints over the next several years. Sales for the first quarter of 1994 are expected to be down compared to the first quarter of 1993. Operating profit for the first quarter of 1994 is expected to be down approximately 10% compared to the same period of 1993, after considering the effects of higher pension expense and reduced licensee income in 1994, and a change in accounting for nuclear fuel revenues that favorably impacted the first quarter of 1993. The decline in the first quarter of 1994 operating profit is expected to be caused primarily by the nuclear energy business of the Power Systems segment and two businesses within the Environmental segment, Resource Energy Systems and Controlmatic, both scheduled to be sold. Reported earnings per share for the first quarter of 1994 are anticipated to be down approximately $.10 per share from the same period of 1993. RESTRUCTURING AND OTHER ACTIONS On January 11, 1994, the Corporation announced a restructuring of its continuing businesses, the disposition of certain non-strategic businesses and provisions for certain litigation and environmental contingencies. These actions resulted from an extensive review led by Chairman and Chief Executive Officer Michael Jordan of all of the Corporation's Continuing and Discontinued Operations and are designed to improve operating performance, accelerate the divestiture of non-strategic businesses and improve financial flexibility. The benefits of these actions are expected to be realized over the next several years. In addition to the charges resulting from restructuring and other actions, certain other charges were recorded related to Discontinued Operations and the adoption of SFAS No. 112. Restructuring of continuing businesses--$350 million: The $350 million charge includes costs directly related to employment reductions which are comprised of approximately $225 million related to separation costs for 3,400 employees, approximately $35 million associated with asset writedowns, and approximately $45 million for facility closedown and rationalization costs. The remaining portion of the $350 million charge is approximately $45 million related to asset writedowns for process and product redesign or reengineering. The Corporation anticipates that actions resulting from implementation of its restructuring plan, directed to improving productivity and operating performance, will result in the reduction of approximately 6,000 employees, which includes the previously- discussed 3,400 separations and an additional 2,600 reductions expected to result from normal attrition. The 3,400 employee separations that are included as part of the restructuring charge are expected to result in annual pre-tax savings of approximately $100 million primarily through reduced employment costs. A substantial portion of this annual savings is expected to be realized in 1994 and approximately $300 million over the next three-year period. Additional savings will be realized as the anticipated reductions resulting from normal attritions occur over the next two years. Total cash expenditures for restructuring over the next three years are expected to approximate $270 million with expenditures of approximately $180 million in 1994, $55 million in 1995 and $35 million in 1996. Net cash expenditures in excess of savings are expected to be funded through cash flows from operations of Continuing Operations. See Liquidity and Capital Resources--Other Actions. Disposition of non-strategic businesses--$215 million: The Corporation plans to dispose of certain non-strategic businesses including parts of the Environmental Services business unit and certain businesses in the Industrial Products and Services business unit. This charge includes all associated costs anticipated to be incurred in disposing of these businesses, including estimates for the cost of certain possible environmental remediation which may result from the selling process. Estimated sales proceeds for these businesses of approximately $175 million were determined from various sources, including offers contained in bona fide letters of interest received from third parties, estimates from investment banking firms retained by the Corporation or certain internal sources. Also included in the $215 million charge is approximately $20 million for the writedown of certain assets related to discontinued projects. Litigation provision--$125 million: As a result of a change in strategy with respect to certain litigation, the Corporation has determined to provide for the possible settlement of these matters when it is in the best interests of the Corporation and its shareholders. See Legal Matters for a description of certain pending litigation. Environmental provision--$60 million: The Corporation is a party to a 1985 Consent Decree to remediate toxic waste resulting from its former manufacturing operations in Bloomington, Indiana. In the Consent Decree, the Corporation agreed to construct and operate an incinerator, which would be permitted under federal and state law to burn excavated materials. Community opposition to the construction of the incinerator has continued. Further, the State of Indiana has enacted legislation that has resulted in indefinite delays in granting permits to construct and operate toxic waste incinerators. Finally, the parties to the Consent Decree have filed a status report with the court overseeing the Consent Decree which outlines a plan to investigate alternative remedial measures which would replace the incineration remedy. In light of these developments, the Corporation no longer believes that it is probable that the Consent Decree will be implemented under its present terms and has chosen to recognize and provide for what it has determined to be the most likely alternative environmental cleanup strategy if the Consent Decree is modified. Timing with respect to the expenditure of the $60 million is entirely dependent on the outcome of discussions between the parties and any resulting modifications to the Consent Decree. However, the Corporation believes that should a modification to the Consent Decree be agreed upon, the majority of these costs would be expended during the 1994 to 1996 time period. See also Environmental Matters. Estimated loss on disposal of Discontinued Operations-- $95 million, after-tax: In the fourth quarter of 1993, the Corporation recorded an additional provision for the estimated loss on disposal of Discontinued Operations of $95 million, after-tax. This change in the estimated loss resulted from additional information, obtained through negotiation activity, regarding the expected selling prices of WESCO and the Australian subsidiary of DCBU. Also contributing to this provision was a decision to bulk sell a Financial Services residential development that the Corporation, upon adoption of the November 1992 plan, had intended to transfer to WCI for development. These matters and a revision to the estimated interest costs expected to be incurred by the Discontinued Operations during the disposal period resulted in the additional fourth quarter provision. See note 2 to the financial statements. In January 1994, the Corporation announced that the planned sale of WCI will be accelerated from 1995 into 1994, and Knoll is no longer for sale. With respect to Knoll, the Corporation's strategy will now be directed to create shareholder value by continuing to operate this business. EQUITY AND DIVIDEND ACTIONS On January 11, 1994, the Corporation also announced its intention to take actions to rebuild its equity base. These actions include a reduction in the annual dividend on the Corporation's common stock from $.40 per share to $.20 per share and the issuance during 1994 of $700 million of new equity securities. Approximately $200 million of the equity securities, proceeds from the sale of such securities or a combination thereof, will be contributed to the Corporation's pension plans during 1994. As a result of the trend of declining long-term interest rates, the Corporation remeasured its pension obligation as of June 30, 1993 and December 31, 1993. SFAS No. 87, "Employers' Accounting for Pensions," requires that discount rates used to measure pension obligations reflect current and expected to be available interest rates on high quality fixed-income investments. The Corporation reduced its assumed discount rate from 9%, which was used at December 31, 1992, to 8% at June 30, 1993 and 7.25% at December 31, 1993. The Corporation also reduced its expected long-term rate of return on plan assets and the expected rate of increase in future compensation levels. See note 3 to the financial statements. These changes resulted in an increase in the Corporation's accumulated benefit obligation at June 30, 1993 and December 31, 1993 of $551 million and $389 million, respectively. Shareholders' equity was reduced after consideration of tax effects at June 30, 1993 and December 31, 1993 by $459 million and $260 million, respectively, or a total of $719 million for the year. RESULTS OF OPERATIONS--CONTINUING OPERATIONS In 1993, the Corporation's reporting segments were realigned to more closely reflect the ongoing businesses. Engineering and repair services, previously included in the Industries segment, have been transferred to the Power Systems segment, where these businesses have been consolidated with the power generation service organization. The Environmental segment now includes the U.S. naval nuclear reactors programs previously reported in Power Systems. The Longines-Wittnauer Watch Company and Westinghouse Communications have been transferred from the Broadcasting segment to the Industries segment as part of the Industrial Products and Services business unit. Segment information for 1992 and 1991 has been restated to reflect these changes. 1993 VERSUS 1992 The 1993 results for Continuing Operations included a $750 million charge for the restructuring and other actions announced on January 11, 1994 of which $555 million was charged to operating profit. The charges to operating profit were allocated to each of the Corporation's segments with the exception of the $60 million environmental provision which was included in Other. The 1992 results for Continuing Operations included a $36 million charge for corporate restructuring related to the previous strategy to sell Knoll and WCI. See Results of Operations--Discontinued Operations for a discussion of the November 1992 plan. Revenues for Broadcasting decreased 2% in 1993 compared to 1992 due to poor performance in a weak west coast television market and lower volume at Group W Productions, which was partially offset by stronger performance in radio and Group W Satellite Communications. In addition, 1992 benefitted from advertising revenues from the Olympics and political campaigns. Included in 1993 operating profit was $12 million of the charge for restructuring. Excluding that charge, operating profit decreased 7% in 1993 compared to 1992 due to lower revenues and an unfavorable mix of sales. Revenues for Electronic Systems decreased 9% in 1993 compared to 1992 due to lower revenues from Department of Defense (DoD) contracts and the 1992 divestitures of the Electrical Systems and Copper Laminates divisions. Included in 1993 operating profit was $136 million of the charge for restructuring. Included in 1992 operating profit was $35 million for a workforce reduction. Excluding the charges in both years, operating profit decreased 15% in 1993 compared to 1992 primarily due to the decrease in DoD revenues. Electronic Systems' business is influenced by changes in the budgetary plans and procurement policies of the U.S. government. Reductions in defense spending and program cancellations in recent years have adversely affected and are likely to continue to affect the results of this segment. DoD revenues are expected to be lower in 1994 than in 1993. However, the Corporation intends to maintain a strong focus on DoD opportunities and believes that it is well positioned, over the long-term, to benefit from the supply of advanced electronic systems to the United States and foreign governments. Revenues for Environmental decreased 10% in 1993 compared to 1992 due to lower volume and reduced prices in the remediation services and hazardous waste incineration businesses and the continued weak economic conditions in Europe. Included in 1993 operating profit was $32 million of the charge for restructuring and other actions. Excluding that charge, operating profit decreased 92% in 1993 compared to 1992 due to project cost overruns at a German subsidiary and the lower volume. Certain operations within this segment have been identified for sale. In addition, the Corporation is reviewing the remainder of the businesses in the Environmental segment to determine how best to reposition these businesses. The Corporation does not anticipate that the markets served by the businesses in the Environmental segment will improve in the near-term. Revenues for Industries increased 3% in 1993 compared to 1992. Thermo King's continued strong performance in North American truck and trailer and service parts was partially offset by its lower revenues in Europe, which continues to be impacted by a weak economy. Westinghouse Communications continues to experience revenue growth. Lower production and delayed deliveries contributed to lower revenues at Westinghouse Motor Company. Included in 1993 operating profit was $6 million of the charge for restructuring. Excluding that charge, operating profit increased 11% in 1993 compared to 1992 due to a favorable mix of sales and cost improvements, partially offset by the lower production and delayed deliveries at Westinghouse Motor Company. Certain operations within this segment have been identified for sale in connection with the Corporation's planned disposition of certain non-strategic businesses announced in January 1994. Revenues for Power Systems decreased 1% in 1993 compared to 1992 due to reduced shipments, lower sales in power generation services and projects partially offset by the recognition of revenues on a percentage of completion basis in the nuclear fuel business. Included in 1993 operating profit was $296 million of the charge for restructuring and other actions. Excluding that charge, operating profit decreased 8% in 1993 compared to 1992 due to the volume decreases, lower margin on power generation services and an unfavorable mix of power generation sales partially offset by the revenue recognition change in nuclear fuel. Revenues for Knoll decreased 12% in 1993 compared to 1992 due to lower shipments and reduced prices in the domestic market and poor economic conditions in Europe. Included in 1993 operating loss was $9 million of the charge for restructuring. Included in 1992 operating loss was $26 million of the charge for corporate restructuring related to the November 1992 plan. Excluding the charges in both years, the operating loss increased by $16 million due to the lower revenues. Revenues for WCI increased 8% in 1993 compared to 1992 as strong sales in South Florida were partially offset by the weak Southern California real estate market. Included in 1993 operating profit was $4 million of the charge for restructuring. Included in 1992 operating profit was $10 million of the charge for corporate restructuring related to the November 1992 plan. Excluding the charges in both years, the operating profit decreased 33% in 1993 compared to 1992 due to an unfavorable mix of sales. 1992 VERSUS 1991 The 1992 results for Continuing Operations included a $36 million charge for corporate restructuring related to the previous strategy to sell Knoll and WCI. The 1991 results for Continuing Operations included a charge of $138 million for the corporate-wide workforce reduction. Revenues for Broadcasting increased 2% in 1992 compared to 1991 primarily due to increased revenues in Group W Satellite Communications. Included in 1991 operating profit was $8 million of workforce reduction costs. Excluding that amount, operating profit increased 10% in 1992 compared to 1991 primarily due to cost reductions in television and radio and volume increases in Group W Satellite Communications. Revenues for Electronic Systems decreased 11% in 1992 compared to 1991 due to the termination settlement received in 1991 for the A-12 program cancellation, the 1992 divestitures of Electrical Systems and Copper Laminates divisions and lower DoD volume. In October 1992, Electronic Systems announced a workforce reduction to adjust for the DoD budget decline. Operating profit for 1992 included a $35 million charge for that workforce reduction, compared to a $69 million charge included in 1991 for the Electronic Systems portion of the corporate workforce reduction. Excluding the workforce reduction charges in both years, operating profit decreased 7% in 1992 compared to 1991 due to the lower DoD volume partially offset by cost improvements. Environmental revenues increased 8% in 1992 compared to 1991 due to increased volume in the incineration business. Included in 1991 was $9 million of workforce reduction costs. Excluding that amount, operating profit was up $71 million in 1992 compared to 1991 due to the absence of cost overruns in the waste-to-energy business, increased revenues in the incineration business and higher operating results at the government-owned facilities. Revenues for Industries increased 6% in 1992 compared to 1991 as higher revenues from a stronger domestic truck and trailer market were partially offset by lower revenues in industrial products and services, which continued to be impacted by weak markets. Included in 1991 operating profit was $8 million of workforce reduction costs. Excluding that amount, operating profit increased 1% in 1992 compared to 1991 as improvements in transport refrigeration were partially offset by continued weak performance in industrial products and services. Power Systems revenues increased 6% in 1992 compared to 1991 as power generation projects sales increased. These increases were partially offset by lower licensee income, reduced shipments of manufactured products and lower engineering and repair service revenues which continued to be impacted by weak markets. Included in 1991 operating profit was $29 million of workforce reduction costs. Excluding that amount, operating profit decreased 4% in 1992 compared to 1991 due to an unfavorable mix of products sold and lower engineering and repair revenues. Knoll revenues decreased 14% in 1992 compared to 1991 due to continued weak European markets and weak domestic demand for Knoll products. Included in 1992 operating loss was $26 million of the charge for corporate restructuring related to the November 1992 plan. Excluding that charge, the $14 million operating loss in 1992, compared to a $26 million operating profit in 1991, was due to reduced volume. WCI revenues decreased 9% in 1992 compared to 1991 due to lower levels of commercial and residential land sales. Included in 1992 operating profit was $10 million of the charge for corporate restructuring related to the November 1992 plan. Excluding that charge, operating profit decreased 20% in 1992 compared to 1991 due to lower volume and the shift from land to building sales. RESULTS OF OPERATIONS--DISCONTINUED OPERATIONS The Corporation adopted a plan in November 1992 (the Plan) to sell DCBU, WESCO (collectively, Other Operations), Knoll and WCI, exit the financial services business and pay down debt. The Corporation's financial services business (Financial Services) was comprised primarily of Westinghouse Credit Corporation (WCC) and Westinghouse Savings Corporation (WSAV), each subsidiaries of Westinghouse Financial Services, Inc. (WFSI) and the Corporation's leasing portfolio. On May 3, 1993, WFSI and WCC were merged into Westinghouse. Other Operations and Financial Services were classified as discontinued operations in accordance with Accounting Principles Board Opinion No. 30. Since adoption of the Plan, the Corporation has made significant progress in disposing of Financial Services assets. On August 11, 1993, the Corporation announced an agreement to sell the majority of DCBU to Eaton Corporation for a purchase price of $1.1 billion and the assumption by the buyer of certain liabilities. The Corporation completed this sale on January 31, 1994. On February 16, 1994, the Corporation announced an agreement to sell WESCO to an affiliate of Clayton Dubilier & Rice, Inc., a private investment firm, for a purchase price of approximately $340 million. The Corporation completed this sale on February 28, 1994. The reserve for the estimated loss on disposal of Discontinued Operations established in November 1992 consisted of an addition to the valuation allowance for Financial Services portfolios, estimated future results of operations and sales proceeds to be obtained from Discontinued Operations, as well as estimates as to the timing of the divestitures and assumptions regarding other relevant factors. During 1993, the Corporation reviewed its estimates of proceeds from the disposal of Discontinued Operations and the operating income or loss that would be generated by these businesses during their disposal periods. Through the third quarter of 1993, the Corporation had favorable experience with the sale of Financial Services assets, selling them at prices in excess of original estimates and on a more accelerated schedule than was anticipated at the time the Plan was developed. The more rapid liquidation of the assets had the effect of reducing the earned income from the Financial Services assets during the disposal period, which, to a large degree, offset the favorable price experience from the asset sales. In addition, the marketing process for Other Operations indicated that expected proceeds would be less than the initial forecast. Through the third quarter of 1993, all of these factors were reviewed and considered to be largely offsetting. During the fourth quarter of 1993, the Corporation recorded an additional provision for the estimated loss on disposal of Discontinued Operations of $95 million, after-tax. See Overview--Restructuring and Other Actions and note 2 to the financial statements. The reserve for the estimated loss on disposal of Discontinued Operations may require adjustment in future periods to reflect changes in any of the above constituent elements, which may be affected by adverse economic, market or other factors beyond what was anticipated at December 31, 1993. Management has considered all of the above factors and believes that the reserve for the estimated loss on disposal of Discontinued Operations should be adequate. The adequacy of the reserve is evaluated each quarter and the actual experience and any changes in expectations will be considered in determining whether adjustment to the reserve is required. 1993 VERSUS 1992 Revenues for Other Operations decreased 2% in 1993 compared to 1992 primarily due to lower Canadian sales in a continued weak Canadian economy. Operating profit decreased 35% in 1993 compared to 1992 due to lower revenues, an unfavorable mix of sales and non-recurring costs for strategic initiatives at WESCO partially offset by lower corporate support costs. 1992 VERSUS 1991 Other Operations revenues were flat in 1992 compared to 1991. Increased revenues resulting from the consolidation of a joint venture previously accounted for by the equity method for which the Corporation gained control in 1992, were offset by lower revenues due to weak U.S. and Canadian markets and price competition. Included in 1991 operating profit was $22 million of workforce reduction costs. Excluding that amount, operating profit increased 51% in 1992 compared to 1991 primarily due to cost reductions. Included in 1992 are $198 million of revenues from Other Operations and $11 million of operating profit realized after the Board of Directors adopted the Plan in November 1992. See notes 1 and 2 to the financial statements for additional information about results of Other Operations. FINANCIAL SERVICES During 1993, the Corporation continued to downsize Financial Services, resulting in a reduction in assets and debt. Financial Services revenues of $305 million for 1993 decreased 59% compared to 1992, reflecting the significant reduction in assets through dispositions. Revenues of $745 million for 1992 decreased 30% compared to 1991 due primarily to a reduction in assets through dispositions and reduced volume, and an increase in underperforming assets. The Financial Services pre-tax losses of $2,831 million and $1,660 million in 1992 and 1991, respectively, were due primarily to the valuation provisions recorded in each year. At December 31, 1993 and 1992, Financial Services portfolio investments totalled $1,551 million and $8,967 million, respectively. Portfolio investments include receivables, real estate properties, investments in partnerships and other entities and nonmarketable securities. In 1992, portfolio investments also included marketable securities and equipment on operating leases. Financial Services portfolio investments at December 31, 1993 are comprised of the remaining real estate and corporate assets, and the Corporation's leasing portfolio. In November 1992, the Financial Services real estate portfolio was valued using the Derived Investment Value (DIV) method. DIV is the process developed by the Resolution Trust Corporation for use in measuring the values of real estate owned and loans secured by income-producing assets and land. Likewise, the Financial Services corporate and leasing portfolios were valued using various techniques which consider a number of factors, including trading desk values with respect to the corporate portfolio and information provided by independent consultants. Trading desk values arise from actual or proposed current trades of identical or similar assets. See note 2 to the financial statements. Financial Services remaining real estate assets totalled $399 million at December 31, 1993 and included $212 million of investments in partnerships, $141 million of real estate properties and $46 million of receivables. At December 31, 1992 real estate assets totalled $4,748 million and included $3,442 million of receivables, $663 million of real estate properties, $402 million of investments in partnerships and $241 million of marketable securities. Of the real estate assets at December 31, 1992, $341 million of receivables and real estate properties and all of the marketable securities were assets of Westinghouse Federal Bank, WSAV's Illinois-based thrift, and were sold to First Financial Bank, F.S.B., in January 1993. Real estate investments in partnerships at December 31, 1993 were comprised primarily of the Corporation's investment in LW Real Estate Investments, L.P., discussed below. Real estate properties were acquired through foreclosure proceedings or represent "in-substance" foreclosures and are being operated by Financial Services or contracted professional management until sold. Real estate receivables consist of loans for commercial and residential real estate properties. At December 31, 1993, the remaining real estate receivables were primarily residential loans. Management expects a significant portion of the Corporation's investment in LW Real Estate Investments, L.P. to be liquidated during 1994, and the remaining real estate properties and real estate receivables by the end of 1995. On April 8, 1993, Westinghouse agreed to sell $1.7 billion, book value before reserves, of the remaining commercial real estate assets for in excess of $878 million after closing adjustments. The sale was completed in May 1993. Additionally, during the remainder of 1993, the Corporation sold additional commercial real estate assets totalling $349 million, book value before reserves, for $122 million after closing adjustments. The assets in these transactions were sold to LW Real Estate Investments, L.P., a partnership formed in April 1993. An affiliate of the investment banking firm, Lehman Brothers, is the general partner. Additionally, LW Real Estate Investments, L.P. assumed certain off-balance-sheet financing commitments related to the assets. Westinghouse initially invested a total of $141 million for a 49% limited partnership interest. At December 31, 1993, the Corporation's investment in the partnership totalled $133 million which represented a 44% interest. Financial Services entered into participation agreements with lending institutions which provided for the recourse sale of a senior interest in certain real estate loans. During 1993, Financial Services sold its subordinated interest in the remaining loans subject to certain servicing obligations. At December 31, 1992, the outstanding balance of receivables previously sold under participation agreements totalled $57 million. Financial Services remaining corporate portfolio assets totalled $144 million at December 31, 1993 and included $82 million of investments in partnerships and other entities, $47 million of receivables and $15 million of nonmarketable equity securities. Management expects the remaining corporate assets to be liquidated during 1994. At December 31, 1992, corporate assets totalled $2,929 million and included $2,140 million of receivables, $457 million of investments in partnerships and other entities and $332 million of nonmarketable equity securities. Corporate investments in partnerships and other entities represent investments in limited partnerships engaged in subordinated lending to, and investing in, highly leveraged borrowers. Corporate receivables are generally considered highly leveraged financing that involves a buyout, acquisition, or recapitalization of an existing business with a high debt-to-equity ratio. Borrowers in the corporate portfolio generally are middle market companies and located throughout the U.S. Industry concentrations included manufacturing, retail trade, media and financial services. The Corporation's leasing portfolio totalled $1,008 million at December 31, 1993 and included $969 million of receivables and $39 million of investments in partnerships. The Plan calls for the run-off of the leasing portfolio in accordance with contractual terms. At December 31, 1992, the leasing portfolio totalled $1,290 million and included $1,146 million of receivables, $101 million of equipment on operating leases and $43 million of investments in partnerships and other assets. The equipment on operating lease portfolio was sold during 1993. Leasing receivables consist of direct financing and leveraged leases. At December 31, 1993 and 1992, 77% and 66%, respectively, related to aircraft and 19% and 22%, respectively, related to cogeneration facilities. Leasing receivables at December 31, 1992 also included leases for railcars, marine vessels and trucking equipment. Certain leasing receivables classified as performing and totalling $162 million at December 31, 1993, have been identified by management as potential problem receivables. Management believes that the characterization of receivables as potential problems is mitigated by the valuation allowance attributed to such receivables at December 31, 1993. Nonearning receivables at December 31, 1993 totalled $30 million, a decrease of $1,893 million from year-end 1992. At December 31, 1993 there were no reduced earning receivables, compared to $881 million at year-end 1992. These decreases were primarily the result of dispositions and the write-off of receivables. The difference between the income for 1993 that would have been earned under original contractual terms on nonearning receivables at December 31, 1993, and the income that was actually earned, was not significant. The income for 1992 that would have been earned under original contractual terms on nonearning and reduced earning receivables at December 31, 1992 totalled $268 million, and the income actually earned was $98 million. Financial Services had issued various loan or investment commitments, guarantees, standby letters of credit and standby commitments. These commitments totalled $111 million at December 31, 1993, compared to $1,418 million at year-end 1992. The Corporation's efforts to reduce assets and debt were impacted by these commitments. However, management expects the remaining commitments to either expire unfunded, be assumed by the purchaser in asset dispositions or be funded with the resulting assets being sold shortly after funding. The primary reasons for the $1,307 million reduction in commitments during 1993 were that Financial Services was released from $959 million of commitments through asset sales, restructurings and commitment expirations, funded $340 million of commitments and transferred $76 million of guarantees to Continuing Operations. These decreases were partially offset by $68 million of new commitments. At December 31, 1993, the valuation allowance for portfolio investments totalled $424 million. Management believes that under current economic conditions, the valuation allowance at Financial Services should be adequate to cover losses that are expected from the disposal of the remaining portfolios. OTHER INCOME AND EXPENSES Other income and expenses was a net expense of $18 million in 1992 and a net expense of $165 million in 1993 and changed primarily due to a $195 million charge recorded for the disposition of certain non-strategic businesses in connection with the actions announced on January 11, 1994. Other income and expenses was a net expense of $19 million in 1991 and a net expense of $18 million in 1992 and changed due to lower interest income, partially offset by improved operating results from affiliates. In addition, 1991 included a provision for the loss on investment in an affiliate. Interest expense decreased $8 million in 1993 compared to 1992 due to lower effective interest rates on average outstanding debt, partially offset by higher fees associated with the revolving credit facility (see Liquidity and Capital Resources--Revolving Credit Facility) and the replacement of short-term floating-rate debt with higher coupon long-term fixed-rate debt. Interest expense decreased $6 million in 1992 compared to 1991 due to lower effective interest rates on average outstanding debt, partially offset by fees associated with the revolving credit facility. INCOME TAXES The Corporation's 1993 benefit for income taxes was 32.6% of the net losses from all sources. The 1993 benefit totalled $153 million and was comprised of a $70 million tax benefit from Continuing Operations, a benefit of $53 million from the estimated loss on disposal of Discontinued Operations, and a benefit of $30 million from the cumulative effect of the change in accounting principle for postemployment benefits. The Corporation's 1992 benefit for income taxes was 52.7% of the net losses from all sources. The 1992 benefit totalled $1,530 million and was comprised of $187 million tax expense on income from Continuing Operations, a benefit of $882 million on losses from Discontinued Operations, and a benefit of $835 million on the cumulative effect of changes in accounting principles for postretirement benefits other than pensions and for the adoption of SFAS No. 109. The consolidated net loss before taxes, minority interest in income of consolidated subsidiaries and provision for postretirement benefits other than pensions totalled $2,905 million and was comprised of income from Continuing Operations of $550 million, the loss from Discontinued Operations of $2,282 million and pre-tax charge for the adoption of SFAS No. 106 of $1,173 million. The net deferred tax asset at December 31, 1993 was $2,505 million as shown in the Consolidated Deferred Income Tax Sources table in note 5 to the financial statements. There are three significant components of the deferred tax asset balance: (i) the tax effect of net operating loss carryforwards of $3,437 million, $922 million of which will expire by the year 2007 and the balance by 2008, (ii) the tax effect of cumulative net temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes of $2,667 million that represents future net income tax deductions. Of this net temporary difference, approximately $1,100 million represents a net pension obligation and approximately $1,300 million represents an obligation for postretirement and postemployment benefits, and (iii) alternative minimum tax credit carryforwards of $257 million which have no expiration date. Management believes that the Corporation will have sufficient future taxable income to make it more likely than not that the net deferred tax asset will be realized. In making this assessment, management considered the net losses generated in recent years as aberrations caused by liquidation of a substantial portion of Financial Services assets and not recurring conditions; further that the Corporation's Continuing Operations have been consistently profitable and that the loss from Continuing Operations in 1993 is due to the decision to reduce the workforce and dispose of underperforming businesses. Management further considered the actual historic operating performance and taxable income generated by the Continuing Operations. Certain of the tax losses will not occur until future years. Each tax loss year would receive a new 15 year carryforward period. Under the most conservative assumption, however, that all net cumulative temporary differences reversed in 1993, the Corporation would have through the year 2008 to recover the tax asset. This would require the Corporation to generate a minimum of approximately $400 million of annual taxable income. Management believes that average annual future taxable income will exceed this minimum amount. In addition, there are certain tax planning strategies that could be employed to utilize a net operating loss carryforward that would otherwise expire. Some of the strategies that would be most feasible are sale and leaseback of facilities, adjustment of tax deductible depreciation, purchase of leases that would generate taxable income and capitalization of research and development expense. The following table shows a reconciliation of income or loss from Continuing Operations before income taxes to taxable income from Continuing Operations. Income from Continuing Operations in 1992 included a $36 million pre-tax charge for corporate restructuring related to the previous strategy to sell Knoll and WCI. Included in income from Continuing Operations for 1991 was a pre-tax provision for the corporate-wide workforce reduction totalling $138 million. LIQUIDITY AND CAPITAL RESOURCES OVERVIEW The Corporation's liquidity has improved through the disposition of Financial Services assets ahead of schedule and the sale of DCBU and WESCO. Management believes that the net proceeds anticipated from the disposition of assets of Discontinued Operations, WCI and certain identified and to be identified non-strategic businesses, as well as cash flow from Discontinued Operations until sold, will be sufficient but not in excess of the liquidity required to fund Discontinued Operations, including the repayment of its debt. Other sources of liquidity generally available to the Corporation include significant levels of cash and cash equivalents, unused borrowing capacity under the Corporation's revolving credit facility, cash flow from the operations of Continuing Operations and borrowings from other sources, including funds from the capital markets, subject to then existing market conditions and other considerations. Significant progress was made during 1993 in reducing net debt (total debt less cash and cash equivalents) due to the disposition of Financial Services assets ahead of schedule at prices more favorable than anticipated in the Plan. The Corporation's net debt was $5,102 million at December 31, 1993, a reduction of $3,277 million from $8,379 million at December 31, 1992. The principal source of cash for this reduction was the disposal of Financial Services assets for $4,150 million, partially offset by Financial Services commitment fundings of $340 million and investments totalling $141 million in LW Real Estate Investments, L.P. Funding of Financial Services commitments has slowed the Corporation's efforts to reduce debt. However, the level of remaining unfunded commitments has substantially declined. Unfunded commitments were $111 million at December 31, 1993 compared to $1,418 million at December 31, 1992, a decrease of $1,307 million. Management anticipates that the remaining commitments will either expire unfunded, be assumed by the purchaser in asset dispositions or be funded with the resulting assets being sold shortly after funding. See note 17 to the financial statements. On August 11, 1993, the Corporation announced an agreement to sell DCBU for a purchase price of approximately $1.1 billion. See note 2 to the financial statements. The proceeds of $1.1 billion were received on January 31, 1994 and were used primarily to reduce debt of Discontinued Operations. On February 16, 1994, the Corporation announced an agreement to sell WESCO for approximately $340 million. See note 2 to the financial statements. This sale was completed on February 28, 1994. The proceeds of approximately $340 million were comprised of approximately $275 million in cash, approximately $50 million in first mortgage notes and the remainder in stock and options in the new company. Cash proceeds were used primarily to reduce debt of Discontinued Operations. On October 8, 1993, the Corporation redeemed at par value $100 million of outstanding 8 3/8% senior notes due March 1, 1996 and the remaining $45 million of outstanding 7.60% debentures due October 15, 1997. These notes and debentures were originally issued by WCC, which until May 1993, was a subsidiary of the Corporation. Additionally, on November 30, 1993, the Corporation redeemed the remaining $41 million of its 9% convertible subordinated debentures due August 15, 2009. The notes, debentures and subordinated debentures were redeemed with a portion of the net proceeds received from the sale of $600 million principal amount of notes and debentures on September 1, 1993. This sale included $275 million principal amount of 6 7/8% notes due September 1, 2003 and $325 million principal amount of 7 7/8% debentures due September 1, 2023. SECURITIES RATINGS On March 9, 1993, Standard and Poor's (S&P) lowered its ratings on the Corporation's senior debt from A- to BBB; subordinated debt and preferred stock from BBB+ to BBB-; and commercial paper from A-2 to A-3. S&P cited the Corporation's weakened financial profile caused by the high level of impaired assets at Financial Services as the reason for the downgrades. On January 11, 1994, S&P affirmed its ratings of the Corporation's securities with a negative outlook. S&P cited that the ratings reflect an above average business profile, as a major diversified manufacturing firm, and a temporarily weakened financial profile. The affirmation was partially conditioned upon the completion by the Corporation of an equity financing plan announced on January 11, 1994 (see Overview--Equity and Dividend Actions) and the Corporation's progress in completing the Plan. On March 10, 1993, Fitch Investor's Service, Inc. (Fitch) lowered its ratings on the Corporation's senior debt from A to BBB+ and commercial paper from to. Fitch cited the Corporation's diminished financial flexibility resulting from large losses at Financial Services, lower than expected operating results from Continuing Operations and a less than favorable intermediate term outlook as reasons for the downgrades. On January 11, 1994, Fitch lowered its ratings on the senior debt from BBB+ to BBB and has placed the debt on FitchAlert with negative implications. Fitch cited the Corporation's continued operating difficulties and its announcement to take a substantial charge to its fourth quarter 1993 earnings as reasons for the downgrade. Fitch also noted that a further downgrade could occur if the Corporation fails to raise additional equity. On March 23, 1993, Moody's Investors Service (Moody's) affirmed its ratings of the Corporation's senior debt at Baa3 and commercial paper at Prime-3. Moody's cited its assessment that reserves taken for Financial Services' assets are adequate and the expected future benefits of restructuring activities as reasons for the affirmation. On January 7, 1994, Moody's lowered its ratings on the Corporation's senior debt from Baa3 to Ba1; its preferred stock from ba1 to ba3; and its commercial paper from Prime-3 to Not-Prime. Moody's downgrades were based on an expectation that the Corporation's efforts to rebuild its depleted capital structure will take longer than previously believed. The Corporation does not believe that the recent actions by the rating agencies will materially impact its operations or financial condition or its ability to borrow in the capital markets. REVOLVING CREDIT FACILITY In December 1991, the Corporation entered into a $6 billion revolving credit agreement (revolver) with a syndicate of domestic and international banks. This facility expires in December 1994. The revolver is available for use by the Corporation subject to the maintenance of certain financial ratios and compliance with other covenants and subject to there being no material adverse change with respect to the Corporation taken as a whole. Among other things, the covenants place restrictions on the incurrence of liens, the amount of debt on a consolidated basis and at the subsidiary level, and the amount of contingent liabilities. The covenants also require the maintenance of a maximum leverage ratio, minimum interest coverage ratios and a minimum consolidated net worth. Certain of the covenants become more restrictive over the term of the revolver. At December 31, 1993, the Corporation was in compliance with these covenants. See Financing Activities for a discussion of interest costs and fees related to this facility. The borrowing status of this facility at December 31, 1993 and 1992 is presented in the following table: During 1993, the Corporation made repayments of borrowings under this facility totalling $2,640 million and increased its use of the letter of credit portion of the facility by $149 million. Also during 1993, the Corporation and the bank syndicate negotiated certain amendments to the revolver wherein the Corporation agreed to reduce the commitment level by a total of $2 billion in 1993, and by an additional $500 million upon completion of the sale of DCBU. The Corporation decided to reduce the commitment level by an additional $500 million, to $3 billion in February 1994. Amendments to the revolver negotiated during 1993 also included changes which affect various covenants and calculations, as well as certain costs paid by the Corporation. These changes included a one-year delay of a scheduled increase in the minimum consolidated net worth covenant, additional provisions for increased costs in the event of certain rating agency downgrades, and an exclusion of certain of the provisions for restructuring and other actions announced on January 11, 1994 from the calculation of certain ratios until, in certain cases, such time as the Corporation expends cash for these charges. As a result of the January 7, 1994 downgrade by Moody's, discussed above, the margin paid by the Corporation under the revolver increased by an additional .125% per annum. The downgrade by Fitch on January 11, 1994 had no effect on the margin. The Corporation made several repayments of borrowings under the revolver during the first two months of 1994 totalling $1,565 million. The primary source of cash for these repayments was the $1.1 billion of cash proceeds received by the Corporation in January 1994 from the sale of DCBU and the $275 million of cash received from the sale of WESCO. Of the $1,565 million of total repayments, $1,355 million related to Discontinued Operations and the remainder related to Continuing Operations. The Corporation intends to negotiate a revolving credit facility during 1994 to replace its existing facility upon expiration. The new facility is expected to have a commitment level of $2 billion to $3 billion with terms and conditions based upon market conditions existing at the time of negotiation. OPERATING ACTIVITIES Cash provided by operating activities of Continuing Operations was $735 million for 1993, an increase of $118 million from the amount provided in 1992. Cash provided by operating activities of Discontinued Operations was $45 million for 1993, a decrease of $420 million from the amount provided in 1992. INVESTING ACTIVITIES Excluding cash provided to Discontinued Operations, investing activities of Continuing Operations used $164 million of cash in 1993, compared to $69 million of cash used in 1992. The principal reason for this additional use of cash was lower cash proceeds received in 1993 from business dispositions. In addition, during 1993, Continuing Operations purchased assets from Discontinued Operations for $233 million primarily for contribution to the Corporation's pension plans. Investing activities of Discontinued Operations provided $3,065 million of cash during 1993, primarily as a result of the sale of Financial Services assets, an increase of $2,800 million from 1992. Capital expenditures of Continuing Operations were $237 million in 1993 compared to $259 million in 1992. Management expects that capital expenditures for Continuing Operations in 1994 will exceed the 1993 level. Capital expenditures of Discontinued Operations were $35 million in 1993 compared to $45 million in 1992. FINANCING ACTIVITIES Total debt of the Corporation was $6,350 million at December 31, 1993, a decrease of $3,583 million from $9,933 million at December 31, 1992. Cash and cash equivalents of the Corporation were $1,248 million at December 31, 1993, a decrease of $306 million from $1,554 million at December 31, 1992, primarily related to the sale of Westinghouse Federal Bank in January 1993. Short-term debt, including current maturities of long-term debt, of the Corporation totalled $3,818 million at December 31, 1993 compared to $6,990 million at December 31, 1992. See notes 11 and 13 to the financial statements. Short-term debt, including current maturities of long-term debt, of Continuing Operations was $671 million at December 31, 1993 compared to $1,554 million at December 31, 1992. The decrease of $883 million was due primarily to the repayment of $600 million of revolver borrowings. Short-term debt, including current maturities of long-term debt, of Discontinued Operations totalled $3,147 million at December 31, 1993 compared to $5,436 million at December 31, 1992, a decrease of $2,289 million. This decrease is primarily attributed to repayment of $2,040 million of revolver borrowings. Total borrowings outstanding under the revolver were $2,855 million at December 31, 1993 (excluding $149 million of letters of credit), of which $500 million was attributable to Continuing Operations and $2,355 million to Discontinued Operations. These borrowings carried a composite interest rate of 4.0% for Continuing Operations and 4.1% for Discontinued Operations. The current interest rate for borrowings under the revolver is based on the London Interbank Offer Rate (LIBOR) plus an interest rate margin based upon the Corporation's debt ratings and interest coverage ratio, and utilization of the facility. An increase or decrease in LIBOR will result in higher or lower interest expense to the Corporation. The Corporation's interest rate margin increased .125% upon Moody's downgrade on January 7, 1994. The utilization fee has decreased from .25% to .125% as a result of a lower average revolver balance outstanding during the second half of 1993. The revolver is also subject to facility fees. The facility fee, also based on the Corporation's debt ratings and interest coverage ratio, increased .125% per annum upon the S&P downgrade on March 9, 1993. However, the commitment level on which the facility fee is based has declined (see Liquidity and Capital Resources--Revolving Credit Facility). Long-term debt of the Corporation totalled $2,532 million at December 31, 1993, a $411 million decrease from December 31, 1992. See note 13 to the financial statements. Long-term debt of Continuing Operations was $1,885 million at December 31, 1993 compared to $1,341 million at December 31, 1992. The $544 million increase was primarily due to the sale of notes and debentures as discussed in Liquidity and Capital Resources--Overview. Long-term debt of Discontinued Operations was $647 million at December 31, 1993, a decrease of $955 million since year-end 1992. The Corporation's net debt-to-capital ratio for Continuing Operations was 65% at December 31, 1993 compared to 49% at December 31, 1992. For this ratio, the reduction of net debt during 1993 was more than offset by non-cash charges to shareholders' equity. See notes 1, 4 and 5 to the financial statements. The Corporation's foreign exchange exposure policy includes selling in national currencies where possible, and hedging those transactions in excess of $250,000 which occur in currencies other than those of the originating country. In addition, the Corporation's accounting policies require translation of local currency financial statements of subsidiaries in highly inflationary and unstable economies into U.S. dollars in accordance with SFAS No. 52, "Foreign Currency Translation," in order to minimize foreign exchange rate risks and provide for appropriate accounting treatment where exchange rates are most volatile. With respect to the Corporation's operations in highly inflationary and unstable economies that are accounted for in accordance with SFAS No. 52, the combined total sales for those operations were less than 0.5% of the Corporation's sales for 1993. Any translation adjustments resulting from converting the local currency balance sheets and income statements of designated hyperinflationary subsidiaries into U.S. dollars are recorded as period costs in accordance with SFAS No. 52. OTHER ACTIONS The restructuring of the Corporation's continuing businesses, announced on January 11, 1994 (see Overview--Restructuring and Other Actions), is expected to require total cash expenditures over the next three years of approximately $270 million, with expenditures of approximately $180 million in 1994, $55 million in 1995 and $35 million in 1996. These expenditures are expected to be funded through cash flows from operations of the Continuing Operations and will be offset by savings, resulting in an expected net cash outflow of approximately $85 million in 1994, and net cash inflows of approximately $55 million and $70 million for 1995 and 1996, respectively. The disposition of certain non-strategic businesses is expected to generate, over the next two years, total cash proceeds of approximately $175 million as these businesses are sold. On January 11, 1994, the Corporation also announced its intention to take actions to rebuild its equity base. These actions include a reduction in the annual dividend on the Corporation's common stock from $.40 per share to $.20 per share and the issuance during 1994 of $700 million of new equity securities. Approximately $200 million of the equity securities, proceeds from the sale of such securities or a combination thereof, will be contributed to the Corporation's pension plans during 1994. The reduction in the common stock dividend became effective with the quarterly dividend declared by the Board of Directors in January 1994, which is payable on March 1, 1994. On August 26, 1992, Westinghouse filed a registration statement on Form S-3 for the issuance of up to $1 billion of Westinghouse debt securities. At December 31, 1993, $400 million of this shelf registration was unused. On May 3, 1993, WFSI and WCC were merged into Westinghouse and, as a consequence, WFSI and WCC ceased to exist as separate legal entities and their debt was assumed by the Corporation. This merger gave management greater flexibility to liquidate the assets of Financial Services and execute the strategy of exiting the financial services business. Prior to the merger, a support agreement existed between Westinghouse and WCC that required the Corporation to provide financial support necessary to maintain WCC's total debt-to-equity ratio at not more than 6.5 to 1 and maintain WCC's equity at a minimum of $1 billion. On December 31, 1992, Westinghouse assumed $1,800 million of WCC's revolver debt to satisfy its obligation under the support agreement. No payments were required under the support agreement during 1993. Payments of $73 million and $1,405 million were made under the support agreement during 1992 and 1991, respectively. The support agreement terminated on May 3, 1993, the effective date of the merger. ENVIRONMENTAL MATTERS Compliance with federal, state and local regulations relating to the discharge of substances into the environment, the disposal of hazardous wastes and other related activities affecting the environment have had and will continue to have an impact on the Corporation. While it is difficult to estimate the timing and ultimate costs to be incurred in the future due to uncertainties about the status of laws, regulations, technology and information available for individual sites, management estimates the total probable and reasonably possible remediation costs that could be incurred by the Corporation based on the facts and circumstances currently known. Such estimates include the Corporation's experience to date with investigating and evaluating site cleanup costs, the professional judgment of the Corporation's environmental experts, outside environmental specialists and other experts and, when necessary, counsel. In addition, the likelihood that other parties which have been named as potentially responsible parties (PRPs) will have the financial resources to fulfill their obligations at Superfund sites where they and the Corporation may be jointly and severally liable has been considered. These estimates have been used to assess materiality for financial statement disclosure purposes and in the following discussion. MANAGEMENT'S DISCUSSION AND ANALYSIS PRP SITES With regard to remedial actions under federal and state superfund laws, the Corporation has been named as a PRP at numerous sites located throughout the country. At many of these sites, the Corporation is either not a responsible party or its site involvement is very limited or de minimus. However, the Corporation may have varying degrees of cleanup responsibilities at 52 of these sites, excluding those discussed in the preceding sentence. With regard to cleanup costs at these sites, in many cases the Corporation will share these costs with other responsible parties and the Corporation believes that any liability incurred will be satisfied over a number of years. Management believes the total remaining probable costs which the Corporation could incur for remediation of these sites as of December 31, 1993 are approximately $69 million, all of which has been accrued. These remediation actions are expected to occur over a period of several years. As the remediation activities progress, additional information may be obtained which may require additional investigations or an expansion of the remediation activities. This may result in an increase in site remediation costs; however, until such time as additional requirements are identified during the remediation process, the Corporation is unable to reasonably estimate what those costs might be. BLOOMINGTON CONSENT DECREE The Corporation is a party to a 1985 Consent Decree relating to remediation of six sites in Bloomington, Indiana. The Corporation has additional responsibility for two other sites in Bloomington not included as part of the Consent Decree. In the Consent Decree, the Corporation agreed to construct and operate an incinerator, which would be permitted under federal and state law to burn excavated materials. The incinerator would also burn municipal solid waste provided by the City of Bloomington (City) and Monroe County. Applications for permits to build an incinerator are pending with the United States Environmental Protection Agency, the State of Indiana and other local permitting agencies. There is continuing community opposition to the construction of the incinerator and the State of Indiana has enacted legislation that has resulted in indefinite delays in granting permits. As a result, the parties to the Consent Decree have met several times on a cooperative basis and have decided to explore whether alternative remedial measures should be used to replace the incineration remedy set forth in the Consent Decree. On February 8, 1994 the parties filed a status report with the United States District Court for the Southern District of Indiana, which is responsible for overseeing the implementation of the Consent Decree. This report advised the court of the parties' intention to investigate alternatives and provided the court with operating principles for this process. It is the goal of the parties to reach a consensus on an alternative which is acceptable to all parties and to the Bloomington public. However, the parties recognize that at the end of the process they may conclude that the remedy currently provided in the Consent Decree is the most appropriate. The parties also recognize that the Consent Decree shall remain in full force during this process. These actions have resulted in the Corporation's belief that it no longer is probable that the Consent Decree will be implemented under its present terms. The Corporation and the other parties may have claims against each other under the Consent Decree if a mutually agreeable alternative is not reached. The Corporation may be required to post security for 125% of the net cost to complete remediation in the event certain requirements of the Consent Decree are not met. The Corporation believes it has met all of these requirements. If necessary permits were to be granted and the Consent Decree fully implemented in its present form, the Corporation estimates that its total remaining cost would be approximately $300 million at December 31, 1993. As part of the Consent Decree, and in addition to burning contaminated materials, the incinerator would also be used to burn municipal solid waste and generate electricity which would be purchased by various public utilities. The Corporation would receive revenues from tipping fees and sale of electricity which are estimated to be approximately $210 million. The Consent Decree also provides the City with an option to purchase the incinerator after the remediation is completed. The Corporation has assumed that proceeds from the sale of the incinerator would be in the range of $100 million to $160 million. Based on the above estimates, the Corporation continues to believe that the ultimate net cost of the environmental remediation under the present terms of the Consent Decree would not result in a material adverse effect on its future financial condition or results of operation. However, because the Corporation believes it is probable the Consent Decree will be modified to an alternate remediation action, the Corporation estimates that its cost to implement the most reasonable and likely alternative would be approximately $60 million, all of which has been accrued. Approximately $16 million of this estimate represents operating and maintenance costs which will be incurred over an approximate 30 year period. These costs are expected to be distributed equally over this period and, based on the Corporation's experience with similar operating and maintenance costs, have been determined to be reliably determinable on a year to year basis. Accordingly, the estimated $44 million gross cost of operating and maintenance has been discounted at a rate of 5% per year which results in the above described $16 million charge. The remaining portion of the $60 million charge represents site construction and other related costs and is valued as of the year of expenditure. Analyses of internal experts and outside consultants have been used in forecasting construction and other related costs. The estimates of future period costs include an assumed inflation rate of 5% per year. This estimate of $60 million is within a range of reasonably possible alternatives and one which the Corporation believes to be the most likely outcome. This alternative includes a combination of containment, treatment, remediation and monitoring. Other alternatives, while considered less likely, could cause such costs to be as much as $100 million. OTHER SITES The Corporation is involved with several administrative actions alleging violations of federal, state or local environmental regulations. For these matters the Corporation has estimated that its potential total remaining reasonably possible costs are insignificant. The Corporation currently manages under contract several government-owned facilities, which among other things are engaged in the remediation of hazardous and nuclear wastes. To date, under the terms of the contracts, the Corporation is not responsible for costs associated with environmental liabilities, including environmental cleanup costs, except under certain circumstances associated with negligence and willful misconduct. There are currently no known claims for which the Corporation believes it is responsible. In 1994, the U.S. Department of Energy (DoE) announced its intention to renegotiate its existing contracts for maintenance and operation of DoE facilities to address environmental issues. The Corporation has or will have responsibilities for environmental remediation such as dismantling incinerators, decommissioning nuclear licensed sites, and other similar commitments at various sites. The Corporation has estimated total potential cost to be incurred for these actions to be approximately $133 million, of which $35 million had been accrued at December 31, 1993. The Corporation's policy is to accrue these costs over the estimated lives of the individual facilities which in most cases is approximately 20 years. The anticipated annual costs currently being accrued are $6 million. As part of the agreement for the sale of DCBU to Eaton Corporation, the Corporation agreed to a cost sharing arrangement if future, but as yet unidentified, remediation is required as a result of any contamination caused during the Corporation's operation of DCBU prior to its sale. Under the terms of the agreement, the Corporation's share of any such environmental remediation costs, on an annual basis, will be at the rate of $2.5 million of the first $6 million expended, and 100% of such costs in excess of $6 million. The Corporation has provided for all known environmental liabilities related to DCBU. These estimated costs and related reserves are included in the discussion of PRP sites above. Environmental liabilities related to the sale of WESCO are insignificant. CAPITAL EXPENDITURES Capital expenditures related to environmental remediation activities in 1993 totalled $5 million. Management believes that the total estimated capital expenditures related to current operations necessary to comply with present governmental regulations will not have a material adverse effect on capital resources, liquidity, financial condition and results of operations. INSURANCE RECOVERIES In 1987, the Corporation filed an action in New Jersey against over 100 insurance companies seeking recovery for these and other environmental liabilities and litigation involving personal injury and property damage. The Corporation has received certain recoveries from insurance companies related to environmental costs. The Corporation has not accrued for any future insurance recoveries. Based on the above discussion and including all information presently known to the Corporation, management believes that the environmental matters described above will not have a material adverse effect on the Corporation's capital resources, liquidity, financial condition and results of operations. LEGAL MATTERS At present, there are seven pending actions brought by utilities claiming a substantial amount of damages in connection with alleged tube degradation in steam generators sold by the Corporation as components for nuclear steam supply systems. One previous action, which was pending in 1991 and was resolved in 1992 after a full arbitration hearing before the International Chamber of Commerce, found that no damages were warranted on any of the steam generator claims against the Corporation. Two other previous actions which were pending in 1992 were resolved, one in 1993 and the other in January 1994, through settlements with the respective utilities. The Corporation is also a party to six agreements with utilities or utility plant owners' groups which toll the statute of limitations regarding their steam generator tube degradation claims and permit the parties time to engage in discussions. The parties have agreed that no litigation will be initiated for agreed upon periods of time as set forth in the respective tolling agreements. The term of each tolling agreement varies. The Corporation has notified its insurance carriers of the pending steam generator actions and claims. While some of the carriers have denied coverage in whole or in part, most have reserved their rights with respect to obligations to defend and indemnify the Corporation. The coverage is the subject of litigation between the Corporation and these carriers. The Corporation has been defending a consolidated class action, a consolidated derivative action and certain individual lawsuits brought against the Corporation, WFSI and WCC, both previously subsidiaries of the Corporation, and/or certain present and former directors and officers of the Corporation, as well as other unrelated parties. Together, these actions allege various federal securities law and common law violations arising out of alleged misstatements or omissions contained in the Corporation's public filings concerning the financial condition of the Corporation, WFSI and WCC in connection with a $975 million charge to earnings announced on February 27, 1991, a public offering of Westinghouse common stock in May 1991, a $1,680 million charge to earnings announced on October 7, 1991, and alleged misrepresentations regarding the adequacy of internal controls at the Corporation, WFSI and WCC. Litigation is inherently uncertain and always difficult to predict. Substantial damages are sought in each of the foregoing cases and although management believes a significant adverse judgment is unlikely, any such judgment could have a material adverse effect upon the Corporation's results of operations for a quarter or a year. However, based on its understanding and evaluation of the relevant facts and circumstances, management believes the Corporation has meritorious defenses to the litigation described above and management believes that the litigation should not have a material adverse effect on the financial condition of the Corporation. CONSOLIDATED STATEMENT OF INCOME The Notes to the Financial Statements are an integral part of these financial statements. CONSOLIDATED BALANCE SHEET The Notes to the Financial Statements are an integral part of these financial statements. (a) Certain amounts have been reclassified for comparative purposes. CONSOLIDATED STATEMENT OF CASH FLOWS The Notes to the Financial Statements are an integral part of these financial statements. For a description of noncash transactions, see notes 1, 3, 4, 5 and 7. NOTES TO THE FINANCIAL STATEMENTS NOTE 1: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES CONSOLIDATION The consolidated financial statements include the accounts of Westinghouse Electric Corporation (Westinghouse) and its subsidiary companies (together, the Corporation) after elimination of intercompany accounts and transactions. Investments in joint ventures and in other companies in which the Corporation does not have control, but has the ability to exercise significant management influence over operating and financial policies, are accounted for by the equity method. Certain previously reported amounts have been reclassified to conform to the 1993 presentation. DISCONTINUED OPERATIONS In November 1992, the Corporation's Board of Directors adopted a plan (the Plan) that included exiting the financial services and other non-strategic businesses. The Corporation classified the operations of Distribution and Control Business Unit (DCBU), Westinghouse Electric Supply Company (WESCO) (collectively, Other Operations) and Financial Services as discontinued operations in accordance with Accounting Principles Board Opinion No. 30, "Reporting the Results of Operations--Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions" (APB 30). Under this Plan, the disposition of The Knoll Group (Knoll) was scheduled to occur by the end of 1994 and WCI Communities, Inc. (WCI) by the end of 1995. Financial Services was comprised primarily of Westinghouse Credit Corporation (WCC) and Westinghouse Savings Corporation (WSAV), each subsidiaries of Westinghouse Financial Services, Inc. (WFSI) and the Corporation's leasing portfolio. On May 3, 1993, WFSI and WCC were merged into Westinghouse. See note 20 to the financial statements. In January 1994, the Corporation announced that the sale of WCI will be accelerated from 1995 into 1994 and Knoll is no longer for sale. WCI will continue to be reported as part of Continuing Operations until the requirements of APB 30 are met. At that time, WCI will be classified as a discontinued operation and appropriate restatements will be made to the Corporation's financial statements. See note 2 to the financial statements. REVENUE RECOGNITION Sales are recorded primarily as products are shipped and services are rendered. The percentage-of-completion method of accounting is used for nuclear steam supply system and related equipment orders with delivery schedules generally in excess of five years, major power generation systems with a cycle time in excess of one year, and certain construction projects where this method of accounting is consistent with industry practice. For certain long-term contracts in which development and production are combined, revenue is recognized as development milestones are completed or units are delivered. AMORTIZATION OF INTANGIBLE ASSETS Goodwill and other acquired intangible assets are amortized under the straight-line method over their estimated lives, but not in excess of 40 years. CASH AND CASH EQUIVALENTS The Corporation considers all investment securities with a maturity of three months or less when acquired to be cash equivalents. All cash and temporary investments are placed with high credit-quality financial institutions and the amount of credit exposure to any one financial institution is limited. At December 31, 1993 and 1992, cash and cash equivalents includes restricted funds of $73 million and $48 million, respectively. Cash and cash equivalents in the Consolidated Statement of Cash Flows includes those items from Continuing Operations, Financial Services and Other Operations. See note 2 to the financial statements. INVENTORIES Inventories are stated at the lower of standard cost, which approximates actual cost on a first-in, first-out (FIFO) basis, or market. The elements of cost included in inventories are direct labor, direct material and certain overheads. Prior to 1992, a portion of the value of the Corporation's domestic inventories were determined using the last-in, first-out (LIFO) method of inventory valuation. See note 7 to the financial statements. Long-term contracts in process include costs incurred plus estimated profits on contracts accounted for according to the percentage-of-completion method. PLANT AND EQUIPMENT Plant and equipment assets are recorded at cost and depreciated generally under the straight-line method over their estimated useful lives. Expenditures for additions and improvements are capitalized, and costs for repairs and maintenance are charged to operations as incurred. The Corporation limits capitalization of newly acquired assets to those assets with cost in excess of $1,000. ENVIRONMENTAL COSTS The Corporation expenses or capitalizes as appropriate environmental expenditures that relate to current operations. Expenditures that relate to an existing condition caused by past operations, and which do not contribute to current or future revenue generation, are expensed. The Corporation will record reserves when environmental assessments or remedial efforts are probable and the costs can be reasonably estimated. Such reserves are adjusted if necessary based upon the completion of a formal study or the Corporation's commitment to a formal plan of action. The Corporation accrues over their estimated remaining useful lives, the anticipated future costs of dismantling incinerators, decommissioning nuclear licensed sites and other such future commitments. CHANGES IN ACCOUNTING PRINCIPLES In December 1993, the Corporation adopted, retroactive to January 1, 1993, Statement of Financial Accounting Standards (SFAS) No. 112 "Employers' Accounting for Postemployment Benefits." This statement requires employers to adopt accrual accounting for workers' compensation, salary continuation, medical and life insurance continuation, severance benefits and disability benefits provided to former or inactive employees after employment but before retirement. See note 4 to the financial statements. Effective January 1, 1992, the Corporation adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," on the immediate recognition basis. This statement requires that the expected costs of providing postretirement health care and life insurance benefits be accrued during the employees' service with the Corporation. The Corporation's previous practice was to expense these costs as incurred. See note 4 to the financial statements. In the first quarter of 1992, the Corporation adopted the provisions of SFAS No. 109, "Accounting for Income Taxes." This statement replaced SFAS No. 96, which the Corporation previously used to account for income taxes. SFAS No. 109 permitted the Corporation to recognize certain deferred tax benefits not recognized under SFAS No. 96. See note 5 to the financial statements. In December 1992, the Corporation adopted SFAS No. 107, "Disclosures about Fair Value of Financial Instruments." This statement is an extension of SFAS No. 105, "Disclosure of Information about Financial Instruments with Off-Balance-Sheet Risk and Financial Instruments with Concentrations of Credit Risk," adopted in a prior year, and requires the disclosure of the fair value of certain financial instruments. See note 22 to the financial statements. NOTE 2: DISCONTINUED OPERATIONS In November 1992, the Corporation announced the Plan that included exiting the financial services business through the disposition of its asset portfolios and the sale of other non-strategic businesses. The Plan provided for the sale of real estate and corporate finance portfolios over a three-year period and the run-off of the leasing portfolio over a longer period of time in accordance with contractual terms. Also, as part of the Plan, the Corporation was to divest the following other non-strategic operations: DCBU and WESCO; Knoll; and WCI. Financial Services and Other Operations have been accounted for as discontinued operations in accordance with APB 30. In January 1994, the Corporation announced that the planned sale of WCI will be accelerated from 1995 into 1994 and Knoll is no longer for sale. With respect to Knoll, the Corporation's strategy will now be directed to create shareholder value by continuing to operate this business. As a result of the adoption of the Plan, the Corporation recorded in Discontinued Operations, during the fourth quarter of 1992, a pre-tax charge of $2,201 million. This pre-tax charge consisted of $2,350 million for an addition to the valuation allowance for Financial Services portfolios, $300 million for estimated losses from operations for Financial Services during the phase-out period and $144 million for restructuring charges related to the change in corporate strategy. These charges were partially offset by an estimated $449 million gain from the disposition of Other Operations and an estimated $144 million of earnings from those operations during the phase-out period. Income tax benefits totalling $818 million were recorded in connection with the Plan. The after-tax estimated loss on the disposal of Discontinued Operations was $1,383 million. A $36 million charge for corporate restructuring was recorded in Continuing Operations in connection with the Plan. In November 1992, in determining the valuation provision for Financial Services real estate portfolio, management used the Derived Investment Value (DIV) method. DIV is the process developed by the Resolution Trust Corporation for use in measuring the values of real estate owned and loans secured by income-producing assets and land. In developing the provision for Financial Services corporate and leasing portfolios, management used various techniques which considered a number of factors, including trading desk values with respect to the corporate portfolio, and information provided by independent consultants. Trading desk values arise from actual or proposed current trades of identical or similar assets. These valuation processes provided portfolio valuations that reflect the strategy of exiting the financial services business. Under the Corporation's previous strategy of downsizing Financial Services over a period of up to five years and holding certain assets for the long term, the methods used to value assets resulted in higher asset values net of valuation allowances. The estimated gain from the disposition of Other Operations was determined by management using various techniques and assumptions which considered, among other factors, index multiples derived for comparable businesses as appropriately adjusted to reflect the characteristics of the businesses within Other Operations. Variances from estimates which may occur will be considered in determining if an adjustment of the estimated loss on disposal of Discontinued Operations is necessary. Since adoption of the Plan, the Corporation has made significant progress in disposing of Financial Services assets. On August 11, 1993, the Corporation announced an agreement to sell the majority of DCBU to Eaton Corporation for a purchase price of $1.1 billion and the assumption by the buyer of certain liabilities. The Corporation completed this sale on January 31, 1994. On February 16, 1994, the Corporation announced an agreement to sell WESCO to an affiliate of Clayton, Dubilier & Rice, Inc., a private investment firm, for a purchase price of approximately $340 million. The Corporation completed this sale on February 28, 1994. The reserve for the estimated loss on the disposal of Discontinued Operations established in November 1992 consisted of an addition to the valuation allowance for Financial Services portfolios, estimated future results of operations and sales proceeds to be obtained from Discontinued Operations, as well as estimates as to the timing of the divestitures and assumptions regarding other relevant factors. During 1993, the Corporation reviewed its estimates of proceeds from the disposal of Discontinued Operations and the operating income or loss that would be generated by these businesses during their disposal periods. Through the third quarter of 1993, the Corporation had favorable experience with the sale of Financial Services assets, selling them at prices in excess of original estimates and on a more accelerated schedule than was anticipated at the time the Plan was developed. The more rapid liquidation of the assets had the effect of reducing the earned income from the Financial Services assets during the disposal period, which, to a large degree, offset the favorable price experience from the asset sales. In addition, the marketing process for Other Operations indicated that expected proceeds would be less than the initial forecast. Through the third quarter of 1993, all of these factors were reviewed and considered to be largely offsetting. In the fourth quarter of 1993, the Corporation recorded an additional provision for loss on disposal of Discontinued Operations of $148 million, pre-tax or $95 million, after-tax. This change in the estimated loss resulted from additional information, obtained through negotiation activity, regarding the expected selling prices of WESCO and the Australian subsidiary of DCBU. Also contributing to this provision was a decision to bulk sell a Financial Services residential development that the Corporation, upon adoption of the Plan, had intended to transfer to WCI for development. These matters and a revision to the estimated interest costs expected to be incurred by the Discontinued Operations during the disposal period resulted in the additional fourth quarter provision. The reserve for the estimated loss on the disposal of Discontinued Operations may require adjustment in future periods to reflect changes in any of the above constituent elements, which may be affected by adverse economic, market or other factors beyond what was anticipated at December 31, 1993. Management has considered all of the above factors and believes that the reserve for the estimated loss on disposal of Discontinued Operations should be adequate. The adequacy of this reserve is evaluated each quarter, and the actual experience and any changes in expectations will be considered in determining whether adjustment to the reserve is required. In accordance with APB 30, the consolidated financial statements reflect the operating results of Discontinued Operations separately from Continuing Operations. Prior periods have been restated. Summarized operating results of Discontinued Operations follow: The composition of the estimated loss on disposal of Discontinued Operations recorded in the fourth quarter of 1992 follows: The assets and liabilities of Discontinued Operations have been separately classified on the balance sheet as net liabilities of Discontinued Operations. A summary of these assets and liabilities and additional information pertaining to Financial Services follows: FINANCIAL SERVICES Revenue Recognition Financial Services revenues are recognized generally on the accrual method, except that revenues for real estate accounts are being recognized only as payments are received. When accrual method accounts become delinquent for more than two payment periods, usually 60 days, income is recognized only as payments are received. Such delinquent accounts and all real estate accounts for which no payments are received in the current month, and other accounts on which income is not being recognized because the receipt of either principal or interest is questionable, are classified as nonearning receivables. Investment Tax Credit The investment tax credit earned prior to its repeal on property leased to others has been deferred and is recognized as income over the contractual terms of the respective leases. Portfolio Investments Portfolio investments by category of investment and financing at December 31, 1993 and 1992, are summarized in the table below. Real estate receivables consist of loans for commercial and residential real estate properties. At December 31, 1993, the remaining real estate receivables were primarily residential loans. Real estate properties were acquired through foreclosure proceedings or represent "in-substance" foreclosures and are being operated by Financial Services or contracted professional management until sold. Real estate investments in partnerships at December 31, 1993 was comprised primarily of the Corporation's investment in LW Real Estate Investments, L.P., which totalled $133 million at year-end. At December 31, 1993, there were no significant investment-type, individual borrower, or geographic concentrations in the remaining real estate receivables. At December 31, 1992, first mortgages on real estate properties, the majority of which were income-producing, comprised 84% of real estate receivables. Hotels and motels secured 29% of the receivables at December 31, 1992, apartments secured 18%, shopping centers and land each secured 8% and office buildings secured 7%. Of these properties, 18% were located in California, 12% in Illinois, 9% in Pennsylvania and 8% in Florida. No other significant geographic concentrations existed. The largest borrower exposure in the real estate portfolio totalled $299 million at December 31, 1992; average borrower exposure, excluding small-balance borrowers, was $20 million. Financial Services entered into participation agreements with lending institutions which provided for the recourse sale of a senior interest in certain real estate loans. During 1993, Financial Services sold its subordinated interest in the remaining loans subject to certain servicing obligations. At December 31, 1992, the outstanding balance of receivables previously sold under participation agreements totalled $57 million. Corporate receivables are generally considered highly leveraged financing that involves a buyout, acquisition, or recapitalization of an existing business with a high debt-to-equity ratio. Borrowers in the corporate portfolio generally are middle market companies and located throughout the U.S. Manufacturing, retail trade, media and financial services represented the significant industry concentrations in this portfolio. Corporate investments in partnerships and other entities represent investments in limited partnerships engaged in subordinated lending to, and investing in, highly leveraged borrowers. Nonmarketable equity securities relate to corporate financing transactions. Originally, corporate investments in partnerships and other entities and nonmarketable securities generally were acquired with the intent to realize appreciation upon disposition, reflecting an increase in the value of the underlying entity. However, many of these investments are now the result of debtor account restructurings. At December 31, 1993, there were no significant industry, subordinated or unsecured positions, or individual borrower exposures in the remaining corporate receivables. At December 31, 1992, 58% of corporate receivables were senior obligations of the borrower and 42% were subordinated. Variable-amount commercial line-of-credit loans secured by the borrowers' inventory or receivables represented 25% of the corporate receivables at December 31, 1992. An additional 33% of corporate receivables represented fixed-amount loans secured by specified assets, general assets, stock or other tangible assets of the borrower. The remaining corporate receivables were unsecured. Exposure to the largest borrower totalled $165 million at December 31, 1992; average borrower exposure was $15 million. Investments in partnerships or other entities are accounted for by either the equity or cost methods in those cases where the Corporation gains majority ownership of entities of a temporary nature or in those cases where the Corporation is legally prevented from exercising control even though it has majority ownership. Ownership is considered of a temporary nature if the entity is acquired through foreclosure and the Corporation expects to maximize its investment through near-term disposal or liquidation. At December 31, 1993 and 1992, the total carrying value of such non-consolidated entities related to Financial Services was $73 million and $147 million, respectively. Leasing receivables consist of direct financing and leveraged leases. At December 31, 1993 and 1992, 77% and 66%, respectively, related to aircraft and 19% and 22%, respectively, related to cogeneration facilities. Leasing receivables at December 31, 1992, also included leases for railcars, marine vessels and trucking equipment. These leasing receivables were sold during 1993. The components of the Corporation's net investment in leases at December 31, 1993 and 1992 are as follows: *Investment in leases for 1992 included lease receivables in both the leasing and real estate categories of financing. Contractual maturities for the Corporation's leasing receivables at December 31, 1993 are as follows: Nonearning receivables at December 31, 1993 totalled $30 million, a decrease of $1,893 million from year-end 1992. At December 31, 1993 there were no reduced earning receivables, compared to $881 million at year-end 1992. These decreases were primarily the result of dispositions and the write-off of receivables. The difference between the income for 1993 that would have been earned under original contractual terms on nonearning receivables at December 31, 1993 and the income that was actually earned, was not significant. The income for 1992 that would have been earned under original contractual terms on nonearning and reduced earning receivables at December 31, 1992 totalled $268 million, and the income actually earned was $98 million. The following table is a reconciliation of the valuation allowance for portfolio investments for the years ended December 31, 1993, 1992, and 1991. During 1993, portfolio investments written off represented 71.4% of average outstanding portfolio investments. The comparable percentages for 1992 and 1991 were 12.7% and 7.1%, respectively. Portfolio investments written off during 1993 reflects management's strategy to liquidate portfolios and exit the financial services business. Portfolio investments written off during 1992 and 1991 reflect management's strategy to liquidate or downsize portfolios. Marketable and nonmarketable securities written off usually resulted from the disposition of the securities for cash. Receivables and real estate properties written off generally resulted from the disposition of the investments for cash or management's determination of the recoverability of the receivable balance or property value in accordance with management's disposition strategy. The provision added during 1993 represents an allocation of the $148 million pre-tax charge recorded in the fourth quarter of 1993 and relates to a residential development that the Corporation had previously intended to transfer to WCI for development. During December 1993, the Corporation's intent regarding this asset changed to one of bulk sale out of the Financial Services real estate portfolio. The $38 million provision reduces the carrying value of the asset to its DIV. The increase in the provision added during 1992 compared to 1991 reflects management's current strategy to exit the financial services business, compared to management's prior strategy to downsize portfolios over a period of up to five years. The valuation allowance at December 31, 1992, adjusted by adding back amounts written off since January 1, 1991, totalling $988 million related to investments remaining in the portfolio at year-end 1992, represented 46.4% of the value of portfolio investments, with such investments similarly adjusted. The valuation allowance at December 31, 1991, comparably adjusted for amounts written off since January 1, 1991, totalling $375 million, represented 24.7% of the value of portfolio investments. Due to the significantly reduced levels of portfolio investments and the valuation allowance at December 31, 1993, management believes that this calculation would produce results of limited usefulness and, therefore, is not presented at December 31, 1993. Management believes under current economic conditions, the valuation allowance at Financial Services at December 31, 1993 should be adequate to cover losses that are expected from the disposal of the remaining portfolios. At December 31, 1992, the marketable securities of $241 million were assets of WSAV's Illinois-based thrift, Westinghouse Federal Bank, and thrift deposits of $693 million were obligations of the thrift. On January 4, 1993, Westinghouse Federal Bank was sold to First Financial Bank, F.S.B., and the thrift's assets and obligations were transferred. Marketable securities at December 31, 1992 were primarily comprised of U.S. and other government obligations, and mortgage-backed securities. At December 31, 1992, these marketable securities had gross unrealized gains of $8 million and no gross unrealized losses. During 1992, proceeds from sales of investments in debt securities totalled $367 million. Gross gains on such sales were $7 million and gross losses were $19 million. NOTE 3: PENSIONS The Corporation has various pension arrangements covering substantially all employees. Most plan benefits are based on either years of service and compensation levels at the time of retirement or a formula based on career earnings. Pension benefits are paid from trusts funded by contributions from employees and the Corporation. The pension funding policy for qualified plans is consistent with the funding requirements of U.S. federal and other government laws and regulations. Plan assets consist primarily of listed stocks, fixed income securities and real estate investments. The projected benefit obligation is the actuarial present value of that portion of the projected benefits attributable to employee service rendered to date. Service cost is the actuarial present value of that portion of the projected benefits attributable to employee service rendered during the year. As a result of the trend of declining long-term interest rates, the Corporation remeasured its pension obligation as of June 30, 1993 and December 31, 1993. The requirement of SFAS No. 87 to adjust the discount rate to reflect current and expected to be available interest rates on high quality fixed-income investments resulted in a decision by the Corporation to reduce its assumed discount rate from 9%, which was used at December 31, 1992, to 8% at June 30, 1993 and 7.25% at December 31, 1993. In addition, the Corporation has reduced its expected long-term rate of return on plan assets from 11% at December 31, 1992, to 10.5% at June 30, 1993, and 9.75% at December 31, 1993. The expected rate of increase in future compensation levels was also adjusted from 6% at December 31, 1992, to 5% at June 30, 1993, and 4% at December 31, 1993. The expected long-term rate of return on pension plan assets has been reduced to more closely reflect the plan's recent performance. The five-year average increase in compensation levels at the Corporation has, in recent years, approximated 5%; however, wage trends indicate that a 4% rate is more indicative of future compensation levels. For financial reporting purposes, a pension plan is considered underfunded when the fair value of plan assets is less than the accumulated benefit obligation. When that is the case, a minimum pension liability must be recognized for the sum of the underfunded amount plus any prepaid pension contributions. In recognizing such a liability, an intangible asset is usually recorded. However, the amount of the intangible asset may not be greater than the sum of the prior service cost not yet recognized and the unrecognized transition obligation as shown in the Funding Status table. When the liability to be recognized is greater than the intangible asset limit, a charge must be made to shareholders' equity for the difference, net of any tax effects which could be recognized in the future. At December 31, 1992, a minimum pension liability of $1,099 million was recognized for the sum of the underfunded amount of $303 million plus the prepaid pension contribution of $796 million. An intangible asset of $348 million and a charge to shareholders' equity of $751 million, which was reduced to $496 million due to tax deferrals of $255 million, offset the pension liability. At June 30, 1993, a minimum pension liability of $1,771 million was recognized for the sum of the underfunded amount of $940 million plus the prepaid pension contribution of $831 million. An intangible asset of $325 million and a charge to shareholders' equity of $1,446 million, which was reduced to $955 million due to tax deferrals of $491 million, offset the pension liability. As a result of this remeasurement, shareholders' equity was reduced by an additional $459 million from December 31, 1992. At December 31, 1993, a minimum pension liability of $2,143 million was recognized for the sum of the underfunded amount of $1,282 million plus the prepaid pension contribution of $861 million. An intangible asset of $295 million and a charge to shareholders' equity of $1,848 million, which was reduced to $1,215 million due to tax deferrals of $633 million, offset the pension liability. As a result of this remeasurement, shareholders' equity was reduced by an additional $260 million from June 30, 1993. During 1993, the Corporation contributed $273 million to its pension plans. As a result of the restructuring actions announced in January 1994 and the Plan announced in November 1992 (see notes 2 and 20 to the financial statements), a curtailment charge of $22 million was included in the loss from Continuing Operations for the year ended December 31, 1993, and $54 million was included in the estimated loss on disposal of Discontinued Operations for the year ended December 31, 1992 in accordance with the provisions of SFAS No. 88, "Employers' Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits." These curtailment charges have reduced, by the same amount, the total of the unrecognized transition obligation and prior service costs not yet recognized in net periodic pension costs. NOTE 4: POSTRETIREMENT BENEFITS OTHER THAN PENSIONS AND POSTEMPLOYMENT BENEFITS The Corporation has defined benefit postretirement plans that provide medical, dental and life insurance for eligible retirees and dependents. The components of net periodic postretirement benefit cost follow. The adoption of SFAS No. 106 on the immediate recognition basis, concurrent with the adoption of SFAS No. 109, as of January 1, 1992, resulted in a net charge to first quarter 1992 earnings of $742 million, or $2.14 per share, net of $431 million of deferred income tax effects. *Decreasing 1/2% annually to 7.0% each year thereafter The Corporation's accumulated postretirement benefit obligation consists of the following: The accumulated postretirement benefit obligation was calculated using the terms of medical, dental, and life insurance plans, including the effects of established maximums on covered costs. SFAS No. 106 requires the discount rate used to measure the accumulated postretirement benefit obligation to be determined in a manner consistent with the method previously described for SFAS No. 87 in note 3 to the financial statements. As a result of the decline in long-term interest rates, the Corporation reduced its discount rate from 9%, which was used at December 31, 1992, to 8% at June 30, 1993 and 7.25% at December 31, 1993. These discount rates are consistent with the discount rate assumptions applied for measurement of the Corporation's pension obligation, since the duration of pension and postretirement benefit expected payments are both approximately 11 years. The actuarial loss resulting from the discount rate reduction will be considered in the determination of postretirement benefit costs in future periods. The effect of a 1% annual increase in the assumed cost trend rates would increase the accumulated postretirement benefit obligation by approximately $63 million and would increase net periodic postretirement benefit costs by approximately $8 million. Certain of the Corporation's non-U.S. subsidiaries have private and government-sponsored plans for retirees. The cost of these plans is not significant to the Corporation. The Corporation provides certain postemployment benefits to former or inactive employees and their dependents during the time period following employment but before retirement. In December 1993, the Corporation adopted, retroactive to January 1, 1993, SFAS No. 112, "Employers' Accounting for Postemployment Benefits." Prior to 1993, postemployment benefit expenses were recognized primarily as they were paid. The Corporation's charge for postemployment benefits at January 1, 1993 was $56 million, net of $30 million of deferred taxes, and was immediately recognized as the cumulative effect of a change in accounting for postemployment benefits. The effect of this change on 1993 operating results was an increase in pre-tax postemployment benefit expense of $5 million. At December 31, 1993, the Corporation's liability for postemployment benefits totalled $91 million and is included in other noncurrent liabilities. See note 14 to the financial statements. NOTE 5: INCOME TAXES Deferred federal income taxes for 1993 include a benefit of $62 million resulting from the enactment of an increase in the statutory federal income tax rate from 34% to 35%. Income tax expense (benefit) included in the consolidated financial statements follows: In addition to the amounts in the table above, during 1993, 1992 and 1991, $378 million of income tax benefit, $255 million of income tax benefit and $71 million of income tax expense, respectively, were recorded against shareholders' equity as a result of the pension liability adjustment. See note 3 to the financial statements. In January 1992, the Corporation adopted SFAS No. 109. This statement replaced SFAS No. 96 which the Corporation had used to account for income taxes since 1988. The effect of adopting SFAS No. 109 on the Corporation was to permit the recognition of deferred tax benefits as shown in the following table. The foreign portion of income or loss before income taxes and minority interest in income of consolidated subsidiaries in the consolidated statement of income consisted of a loss of $6 million in 1993 and income of $61 million in 1992 and $32 million in 1991. Such income or loss consists of profits and losses generated from foreign operations and can be subject to both U.S. and foreign income taxes. Deferred federal income taxes have not been provided on cumulative undistributed earnings from foreign subsidiaries, totalling $474 million at December 31, 1993, in which the earnings have been reinvested for an indefinite time. It is not practicable to determine the income tax liability that would result had such earnings been repatriated. The amount of withholding taxes that would be payable upon such repatriation is estimated to be $30 million. Income from Continuing Operations includes income of certain manufacturing operations in Puerto Rico which are exempt from U.S. federal income tax and partially exempt from Puerto Rican income tax under grants of industrial tax exemptions. These tax exemptions provided net tax benefits of $21 million or $.06 per share in 1993, $21 million or $.06 per share in 1992, and $22 million or $.07 per share in 1991. The exemptions will expire at various dates from 2002 through 2007. Deferred income taxes result from temporary differences in the financial bases and tax bases of assets and liabilities. The type of differences that give rise to significant portions of deferred income tax liabilities or assets are shown in the accompanying table. *Certain amounts have been reclassified for comparative purposes. The valuation allowance for deferred taxes represents foreign tax credits not anticipated to be utilized and operating loss carryforwards of certain foreign subsidiaries. The net balance of deferred income taxes is intended to offset income taxes on future taxable income expected to be earned by the Corporation's continuing businesses. See Management's Discussion and Analysis--Income Taxes. During 1992, federal income tax assessments were settled which reduced deferred income taxes by $70 million. At December 31, 1993, for federal income tax purposes, there were regular tax net operating loss carryforwards of $922 million which expire by the year 2007, $2,515 million which expire by the year 2008, alternative minimum tax operating loss carryforwards of $565 million which expire by the year 2007, $2,444 million which expire by the year 2008 and alternative minimum tax credit carryforwards of $257 million which have no expiration date. At December 31, 1993, there were $100 million of net operating loss carryforwards attributable to foreign subsidiaries. Of this total, approximately $35 million has no expiration date. The remaining amount will expire not later than 2000. A valuation allowance for the $38 million of deferred tax benefit related to these losses has been established since it is considered more likely than not that the benefit will not be realized. *Certain amounts have been reclassified for comparative purposes. The federal income tax returns of the Corporation and its wholly-owned subsidiaries are settled through the year ended December 31, 1986. The Corporation has reached a tentative agreement with the Internal Revenue Service regarding intercompany pricing adjustments applicable to operations in Puerto Rico for the years 1987 through 1992. Management believes that adequate provisions for taxes have been made through December 31, 1993. NOTE 6: CUSTOMER RECEIVABLES Customer receivables at December 31, 1993 included $273 million which represented the sales value of material shipped under long-term contracts but not billed to the customer. Billing will occur upon shipment of major components of the contract, and collection of these receivables is expected to be substantially completed within one year. Allowance for doubtful accounts of $54 million and $50 million at December 31, 1993 and 1992, respectively, were deducted from customer receivables. At December 31, 1993 and 1992, approximately 8% and 15%, respectively, of the Corporation's customer receivables were from sales on open account with various agencies of the U.S. government, which is the Corporation's largest single customer. The Corporation performs ongoing credit evaluations of its customers and generally does not require collateral. NOTE 7: INVENTORIES AND COSTS AND BILLINGS ON UNCOMPLETED CONTRACTS During the fourth quarter of 1992, the Corporation changed its method of determining the cost of a portion of its inventories from the LIFO method to the FIFO method. Previously, a substantial portion of the inventories of Continuing Operations had been valued using the FIFO method. The change to the FIFO method for all of Continuing Operations' inventories conforms such inventories to the same method of valuation. The Corporation believes that the FIFO method of inventory valuation provides a more meaningful presentation of the financial position of the Corporation since it reflects more recent inventory acquisition costs in the balance sheet. Under the current economic environment of low inflation, the Corporation believes that the FIFO method also results in a better matching of current costs with current revenues. The change in the method of valuing inventories was not applied retroactively to prior periods as the effect on the Corporation's financial position and its results of operations was not material. Raw materials, work in process and finished goods included contract-related costs of approximately $770 million at December 31, 1993, and $866 million at December 31, 1992. All costs in long-term contracts in process, progress payments to subcontractors, and recoverable engineering and development costs were contract-related. Inventories other than those related to long-term contracts are generally realized within one year. Inventoried costs do not exceed realizable values. NOTE 8: PREPAID AND OTHER CURRENT ASSETS NOTE 9: PLANT AND EQUIPMENT NOTE 10: INTANGIBLE AND OTHER NONCURRENT ASSETS Goodwill and other acquired intangible assets are shown net of accumulated amortization of $139 million and $102 million at December 31, 1993 and 1992, respectively. Joint ventures and other affiliates include investments in companies where the Corporation does not have the ability to exercise control. Uranium settlement assets relate to uranium inventory awaiting delivery and settlement items being produced under uranium supply contract settlement agreements. Inventory and other settlement items expected to be delivered within one year are included in other current assets. NOTE 11: SHORT-TERM DEBT In December 1991, the Corporation entered into a three-year $6 billion revolving credit facility agreement (revolver) with a syndicate of domestic and international banks. By December 31, 1993, the commitment level of the revolver had been reduced to $4 billion. The largest commitment from any one bank is less than 5% of the total facility. The revolver is available for use by the Corporation subject to the maintenance of certain ratios and compliance with other covenants and subject to there being no material adverse change with respect to the Corporation taken as a whole. Among other things, these covenants place restrictions on the incurrence of liens, the amount of debt on a consolidated basis and at the subsidiary level, and the amount of contingent liabilities. The covenants also require the maintenance of a maximum leverage ratio, minimum interest coverage ratios, and minimum consolidated net worth. Certain of the covenants become more restrictive over the term of the revolver. The interest rate for revolver borrowings is determined at the time of each borrowing and may be based on one of a variety of indices plus a margin based on the Corporation's debt ratings and interest coverage ratio, and utilization of the facility. The indices include the following: London Interbank Offer Rate (LIBOR), certificate of deposit, prime, and federal funds. A fee is also paid on letters of credit. The interest rates for the borrowings under the revolver at December 31, 1993 and 1992, were based on LIBOR. The utilization fee has decreased from .25% to .125% as a result of a lower average revolver balance outstanding during the second half of 1993. A utilization fee is charged if average revolver borrowings and outstanding letters of credit are $2,000 million or more. At December 31, 1993, consolidated borrowings under the revolver totalled $2,855 million, of which $500 million was attributed to Continuing Operations and $2,355 million was attributed to Discontinued Operations. There are no compensating balance requirements under the revolver. Origination fees of $91 million are being amortized and charged to Discontinued Operations over the term of the revolver. Facility fees averaged approximately .50% of the commitment level during 1993 and were charged to Continuing and Discontinued Operations on a pro-rata basis. As a result of rating agency actions and management's assessment of the capital markets, in October 1992, the Corporation discontinued the sale of commercial paper and replaced this debt with borrowings under the revolver. Average outstanding borrowings for Continuing Operations were determined based on daily amounts outstanding for commercial paper and the revolver, and on monthly balances outstanding for short-term foreign bank loans. The average rates for those bank loans compared to commercial paper reflect the impact of higher interest costs on local currency borrowings of subsidiaries. Average outstanding borrowings for Discontinued Operations were determined based on daily amounts outstanding for commercial paper and revolving credit facilities, and on monthly balances outstanding for variable-rate trust master notes. To manage interest costs on its debt, Financial Services has entered into various types of interest rate and currency exchange agreements. Interest rate exchange agreements generally involve the exchange of interest payments without the exchange of the underlying principal amounts. The notional amounts of the interest rate and currency exchange agreements totalled $1,326 million and $2,218 million at December 31, 1993 and 1992, respectively. The $892 million decrease in the notional amount during 1993 was due to the maturity of certain of the agreements. At December 31, 1993, interest rate swap agreements in which Financial Services paid a fixed interest rate totalled $575 million and had a weighted average rate of 8.7% with an average maturity of 1.31 years. In addition, those interest rate swap agreements in which Financial Services received a fixed interest rate totalled $430 million and had a weighted average rate of 8.1% with an average maturity of approximately 10 months. The remaining notional amount of $321 million at December 31, 1993 included forward interest rate exchange agreements, interest rate floor agreements, currency exchange agreements and basis swap agreements. Certain of these agreements are associated with long-term debt of Discontinued Operations. See note 13 to the financial statements. NOTE 12: OTHER CURRENT LIABILITIES NOTE 13: LONG-TERM DEBT During 1993, the 8.60% notes due 1993 and $29 million of medium-term notes were paid at maturity. Medium-term notes carry interest rates ranging from 7.5% to 9.4%. At December 31, 1992, $25 million of the medium-term notes and all of the 8 7/8% notes were subject to interest rate swap agreements. These agreements have effectively changed the fixed interest rate for the first two years of the notes' terms to a variable rate based on the 30-day commercial paper rate. At December 31, 1992, the effective interest rate on all of the medium-term notes was 7.8% and the effective interest rate on the 8 7/8% notes was 5.1%. Both interest rate swap agreements matured in June 1993. In June 1992, the Corporation issued $350 million of 8 3/8% notes due June 15, 2002. These notes were offered at a discount. In August 1992, the Corporation issued $275 million of 8 5/8% debentures due August 1, 2012. These debentures were offered at a discount. The 8 3/8% notes due 2002 and the 8 5/8% debentures due 2012 were issued under a shelf registration statement filed in 1991. In August 1992, the Corporation filed an additional debt shelf registration statement for $1 billion. In September 1993, the Corporation issued $275 million of 6 7/8% notes due September 1, 2003 and $325 million of 7 7/8% debentures due September 1, 2023. These notes and debentures were offered at a discount and were issued under the $1 billion shelf registration, of which $400 million was unused as of December 31, 1993. The 6 7/8% notes, the medium-term notes, the 7 3/4% notes, the 8 7/8% notes, the 8 3/8% notes, the 8 5/8% debentures, and the 7 7/8% debentures may not be redeemed prior to maturity. At December 31, 1993, Continuing Operations long-term debt maturing in each of the following years is: 1994--$9 million, 1995--$9 million, 1996--$322 million, 1997--$2 million, and 1998--$58 million. During 1993, $779 million of medium-term notes were paid at maturity. During 1992, $1,313 million of medium-term notes were paid at maturity and $55 million of new notes were issued. At December 31, 1993 and 1992, $291 million and $565 million, respectively, of medium-term notes had been issued either on a variable-rate basis or swapped to a variable-rate through interest rate swap agreements. After the effects of any interest rate swap agreements, the average interest rates on variable-rate medium-term notes outstanding at December 31, 1993 and 1992 were 3.7% and 4.4%, respectively. At December 31, 1993 and 1992, $756 million and $1,261 million, respectively, of medium-term notes had been issued either on a fixed-rate basis or swapped to a fixed rate through interest rate swap agreements. After the effects of any interest rate swap agreements, the average interest rate on fixed-rate medium-term notes outstanding at December 31, 1993 and 1992 was 8.6%. At December 31, 1993, the average interest rate, after the effects of the interest rate swap agreements, and average remaining maturity for all medium-term notes were 7.2% and 1.58 years, compared to 7.3% and 1.65 years at year-end 1992. At December 31, 1993, all of the 8-7/8% notes due 1995 were subject to an interest rate swap agreement as well as an interest rate floor agreement. The net effect of these agreements reduced the effective interest rate on these notes to 7.4% at December 31, 1993. In October 1993, the Corporation redeemed at par value $100 million of outstanding 8 3/8% senior notes due March 1, 1996. At December 31, 1993, Discontinued Operations long-term debt maturing in each of the following years is: 1994--$774 million, 1995--$230 million, 1996--$262 million, 1997--$2 million, and 1998--$96 million. Current maturities of $774 million at December 31, 1993 include the $150 million of 8 7/8% senior notes due 2014 as the noteholders have the right, during the sixty-day period ending June 14, 1994, to request that their notes be redeemed. These notes will be included in current maturities of long-term debt until such time as the request is made and the notes are redeemed, or the right to request redemption period expires. Management does not anticipate that the noteholders will exercise their right to redemption during the 1994 request period. The next right to request redemption period is the sixty days ending June 14, 1999. NOTE 14: OTHER NONCURRENT LIABILITIES NOTE 15: SHAREHOLDERS' EQUITY In June 1992, Westinghouse sold 32,890,000 Depositary Shares at $17 per share. Each of the Depositary Shares represents ownership of one quarter of a share of Westinghouse's $1 par value Series B Conversion Preferred Stock (B Preferred) deposited with Mellon Bank, N.A., as Depositary, and entitles the owner to all of the proportionate rights, preferences and privileges of the B Preferred. A total of 8,222,500 B Preferred shares were deposited. The Depositary Shares are listed on the New York Stock Exchange (NYSE) under the symbol "WXPrP." Since the Depositary Shares are claims against the Depositary which in turn holds all the shares of B Preferred in trust, only the B Preferred are shown as equity on the Corporation's balance sheet. Holders of Depositary Shares may redeem them for the B Preferred shares at the Depositary; however, only the Depositary Shares are listed for trading on the NYSE. The net proceeds to the Corporation from the sale of the Depositary Shares, after commissions, fees and out-of-pocket expenses, totalled $543 million which was used to reduce short-term debt of Continuing Operations. As a result of the transaction, par value of B Preferred was established for $8 million, and capital in excess of par value was increased by $535 million. Annual dividends are $1.53 per Depositary Share (equivalent to $6.12 for each B Preferred) and are payable quarterly in arrears on the first day of March, June, September and December. Dividends are cumulative and must be declared by the Board of Directors to be payable. Payments commenced September 1, 1992. On September 1, 1995 (the Mandatory Conversion Date), each of the outstanding Depositary Shares will automatically convert into (i) one share of common stock (equivalent to four shares for each B Preferred) subject to adjustment if certain events occur, and (ii) the right to receive on such date an amount in cash equal to all accrued and unpaid dividends thereon, or, in certain circumstances, a number of shares of common stock equal to 110% of such cash amount divided by the market value of the common stock. Conversion of the outstanding Depositary Shares (and the B Preferred) will also occur upon certain mergers, consolidations or similar extraordinary transactions involving the Corporation or in connection with certain other events, as described in the prospectus. At any time and from time to time prior to the Mandatory Conversion Date, Westinghouse may call the outstanding B Preferred (and thereby the Depositary Shares), in whole or in part, for redemption. Upon any such redemption, each owner of Depositary Shares will receive, in exchange for each Depositary Share so called, shares of common stock having a market value initially equal to $26.23 (equivalent to $104.92 for each B Preferred), declining by $0.002095 (equivalent to $0.008380 for each B Preferred) on each day following the date of issue of the B Preferred to $23.93 (equivalent to $95.72 for each B Preferred) on July 1, 1995, and equal to $23.80 (equivalent to $95.20 for each B Preferred) thereafter (the Call Price), plus an amount in cash equal to all proportionate accrued and unpaid dividends thereon. On September 1, 1995, the outstanding B Preferred shares mandatorily convert to one share of common stock at the then existing market price. The B Preferred shares are considered common stock equivalents, at a rate of four to one, for the calculation of primary and fully diluted earnings per share, unless such treatment would result in a lower net loss per share or higher net income per share. If common stock equivalency is not appropriate, the B Preferred shares are considered preferred stock for earnings per share purposes. At December 31, 1993 and 1992, 8,222,500 shares of B Preferred stock were issued and outstanding. During May 1991, Westinghouse issued 21,500,000 shares of its common stock in a public offering, the net proceeds of which totalled $551 million. The proceeds of the offering were used to reduce the Corporation's short-term debt. Beginning in the third quarter of 1991, the Corporation offered a Dividend Reinvestment and Common Stock Purchase Plan whereby shareholders may elect to reinvest cash dividends, and may optionally invest additional cash, in shares of Westinghouse common stock without paying commissions or service charges. Proceeds received from participants in this plan are used for general corporate purposes. During October 1991, the Corporation contributed 22,645,000 shares of common stock held in treasury to the Westinghouse Pension Plan. The contribution at that time was valued at $375 million by the pension plan trustee. See note 3 to the financial statements. At December 31, 1993, common shares outstanding totalled 352,175,746. On January 11, 1994, the Corporation announced its intention to take actions to rebuild its equity base. These actions include a reduction in the annual dividend on the Corporation's common stock from $.40 per share to $.20 per share and the issuance during 1994 of $700 million of new equity securities. Approximately $200 million of the equity securities, proceeds from the sale of such securities or a combination thereof, will be contributed to the Corporation's pension plans during 1994. The reduction in the common stock dividend became effective with the quarterly dividend declared by the Board of Directors in January 1994, which is to be payable on March 1, 1994. Earnings (loss) per common share is computed by dividing income, after deducting the preferred dividend requirements, by the weighted average number of common shares outstanding during the year plus the weighted average common stock equivalents. Common stock equivalents consist of shares subject to stock options and shares potentially issuable under deferred compensation programs. For this computation, net income or loss was adjusted for the after-tax interest expense applicable to the deferred compensation programs. The B Preferred shares may be treated as common stock equivalents or preferred stock depending on the effect as previously discussed. When treated as preferred stock, the B Preferred dividends are deducted for computing earnings available to common shareholders. During 1993, the B Preferred shares for earnings per share calculations were treated as preferred stock. During 1992, the B Preferred shares for earnings per share calculations were treated as common stock equivalents in the first and second quarters, and as preferred stock for the third and fourth quarters and the total year. No preferred shares were outstanding in 1991. The weighted average number of common shares used for computing earnings or loss per share was 352,902,000 in 1993, 346,103,000 in 1992 and 313,984,000 in 1991. In 1988, the Board of Directors adopted a shareholder rights plan pursuant to which one right was attached to each share of common stock outstanding on December 17, 1988, and to each share issued thereafter. In accordance with plan provisions, in December 1992, the Board of Directors elected to redeem the rights at a redemption price of $0.005 per share. The Corporation paid approximately $2 million to shareholders of record as of December 2, 1992, as the total redemption price for the rights. NOTE 16: STOCK OPTIONS AND OTHER LONG-TERM INCENTIVE COMPENSATION AWARDS The 1993, 1991 and 1984 Long-Term Incentive Plans provide for the granting of stock options and other performance awards to employees of the Corporation. The 1993 and 1991 Plans are similar in all material respects to the 1984 Plan. At December 31, 1993, four million shares have been authorized, subject to shareholder approval, for awards under the 1993 Plan. Unoptioned shares available under the 1993 Plan at December 31, 1993 totalled 1,787,500. At December 31, 1993 and 1992, an aggregate of 19.2 million and 16 million shares, respectively, have been authorized for awarding under the 1991 and 1984 Plans. Unoptioned shares available under the 1991 and 1984 Plans at December 31, 1993 and 1992, totalled 2,141,708 and 1,371,292, respectively. The option price under the Plans may not be less than the fair market value of the shares on the date the option is granted. The options were granted for terms of 10 years and generally become exercisable in whole or in part after the commencement of the second year of the term. All options outstanding under the 1984 and 1991 Plans, except those granted during 1993, were exercisable at December 31, 1993. Options outstanding under the 1993 Plan will not be exercisable until 1994. Outstanding options have expiration dates ranging from 1994 through 2003. During 1992 and 1993, Equity Plus dollar grants totalling approximately $17 million for the 1992-94 measurement period were granted to employees of the Corporation. Equity Plus dollar grants have the potential to increase in value through both financial performance and stock price appreciation. Payment of these grants is approved by a committee of the Board of Directors and is contingent upon achieving performance targets over the measurement period. If minimum levels of financial performance are not achieved, the grants will not be paid. Certain of these grants have been or will be prorated or terminated upon termination of employment. Payments are generally made in stock. In February 1994, 244,747 shares of Westinghouse common stock were issued to employees for Equity Plus grants made in 1991. NOTE 17: CONTINGENT LIABILITIES AND COMMITMENTS URANIUM SETTLEMENTS The Corporation had previously provided for all estimated future costs associated with the resolution of all uranium supply contract suits and related litigation. The remaining uranium reserve balance includes uranium settlement assets (see note 10 to the financial statements) and reserves for estimated future costs. The remaining balance at December 31, 1993, is deemed adequate considering all facts and circumstances known to management. The future obligations require providing specific quantities of uranium and products and services over a period extending beyond the year 2010. Variances from estimates which may occur will be considered in determining if an adjustment of the liability is necessary. LITIGATION Republic of the Philippines and National Power Corporation In December 1988, the Republic of the Philippines (Philippines) and National Power Corporation of the Philippines (NPC) (collectively, the Republic) filed a 15 count lawsuit against the Corporation in connection with the construction of a nuclear power plant in the Philippines. In 1989, the U.S. District Court (USDC) for the District of New Jersey stayed substantially all of the complaint pending arbitration by the International Chamber of Commerce (ICC) in Geneva, Switzerland. The USDC did not grant a stay with respect to the one count in the complaint alleging intentional interference with a fiduciary relationship. A jury verdict with respect to this count was rendered in favor of the Corporation on May 18, 1993. The Republic has stated its intention to appeal this verdict. In December 1991, the ICC arbitration panel issued an award finding that the NPC had failed to carry its burden of proving an alleged bribery by the Corporation. The panel thereby concluded that the arbitration clauses and the contracts were valid and the panel had jurisdiction over the disputes remaining before it with respect to NPC; the panel also concluded that it did not have jurisdiction over the Philippines. The NPC, in an attempt to attack the ICC decision regarding jurisdiction and contract validity, filed an action for annulment with the Swiss Federal Supreme Court which was not successful. Arbitration with respect to the remaining disputes before the ICC is ongoing. An evidentiary hearing is scheduled to begin during the first quarter of 1994, and a final award is anticipated before the end of 1994. Steam Generators At present, there are seven pending actions brought by utilities claiming a substantial amount of damages in connection with alleged tube degradation in steam generators sold by the Corporation as components for nuclear steam supply systems. One previous action, which was pending in 1991 and was resolved in 1992 after a full arbitration hearing before the ICC, found that no damages were warranted on any of the steam generator claims against the Corporation. Two other previous actions which were pending in 1992 were resolved, one in 1993 and the other in January 1994, through settlements with the respective utilities. The Corporation is also a party to six agreements with utilities or utility plant owners' groups which toll the statute of limitations regarding their steam generator tube degradation claims and permit the parties time to engage in discussions. The parties have agreed that no litigation will be initiated for agreed upon periods of time as set forth in the respective tolling agreements. The term of each tolling agreement varies. The Corporation has notified its insurance carriers of the pending steam generator actions and claims. While some of the carriers have denied coverage in whole or in part, most have reserved their rights with respect to obligations to defend and indemnify the Corporation. The coverage is the subject of litigation between the Corporation and these carriers. Securities Class Actions--Financial Services The Corporation has been defending a consolidated class action, a consolidated derivative action and certain individual lawsuits brought against the Corporation, WFSI and WCC, both previously subsidiaries of the Corporation, and/or certain present and former directors and officers of the Corporation, as well as other unrelated parties. Together, these actions allege various federal securities law and common law violations arising out of alleged misstatements or omissions contained in the Corporation's public filings concerning the financial condition of the Corporation, WFSI and WCC in connection with a $975 million charge to earnings announced on February 27, 1991, a public offering of Westinghouse common stock in May 1991, a $1,680 million charge to earnings announced on October 7, 1991, and alleged misrepresentations regarding the adequacy of internal controls at the Corporation, WFSI and WCC. Litigation is inherently uncertain and always difficult to predict. Substantial damages are sought in each of the foregoing cases and although management believes a significant adverse judgment is unlikely, any such judgment could have a material adverse effect upon the Corporation's results of operations for a quarter or a year. However, based on its understanding and evaluation of the relevant facts and circumstances, management believes the Corporation has meritorious defenses to the litigation described above and management believes that the litigation should not have a material adverse effect on the financial condition of the Corporation. ENVIRONMENTAL MATTERS Compliance with federal, state and local regulations relating to the discharge of substances into the environment, the disposal of hazardous wastes and other related activities affecting the environment have had and will continue to have an impact on the Corporation. While it is difficult to estimate the timing and ultimate costs to be incurred in the future due to uncertainties about the status of laws, regulations, technology and information available for individual sites, management estimates the total probable and reasonably possible remediation costs that could be incurred by the Corporation based on the facts and circumstances currently known. Such estimates include the Corporation's experience to date with investigating and evaluating site cleanup costs, the professional judgment of the Corporation's environmental experts, outside environmental specialists and other experts and, when necessary, counsel. In addition, the likelihood that other parties which have been named as potentially responsible parties (PRPs) will have the financial resources to fulfill their obligations at Superfund sites where they and the Corporation may be jointly and severally liable has been considered. These estimates have been used to assess materiality for financial statement disclosure purposes as follows. PRP Sites With regard to remedial actions under federal and state superfund laws, the Corporation has been named as a PRP at numerous sites located throughout the country. At many of these sites, the Corporation is either not a responsible party or its site involvement is very limited or de minimus. However, the Corporation may have varying degrees of cleanup responsibilities at 52 of these sites, excluding those discussed in the preceding sentence. With regard to cleanup costs at these sites, in many cases the Corporation will share these costs with other responsible parties and the Corporation believes that any liability incurred will be satisfied over a number of years. Management believes the total remaining probable costs which the Corporation could incur for remediation of these sites as of December 31, 1993 are approximately $69 million, all of which has been accrued. These remediation actions are expected to occur over a period of several years. As the remediation activities progress, additional information may be obtained which may require additional investigations or an expansion of the remediation activities. This may result in an increase in site remediation costs; however, until such time as additional requirements are identified during the remediation process, the Corporation is unable to reasonably estimate what those costs might be. Bloomington Consent Decree The Corporation is a party to a 1985 Consent Decree relating to remediation of six sites in Bloomington, Indiana. The Corporation has additional responsibility for two other sites in Bloomington not included as part of the Consent Decree. In the Consent Decree, the Corporation agreed to construct and operate an incinerator, which would be permitted under federal and state law to burn excavated materials. The incinerator would also burn municipal solid waste provided by the City of Bloomington (City) and Monroe County. Applications for permits to build an incinerator are pending with the United States Environmental Protection Agency, the State of Indiana and other local permitting agencies. There is continuing community opposition to the construction of the incinerator and the State of Indiana has enacted legislation that has resulted in indefinite delays in granting permits. As a result, the parties to the Consent Decree have met several times on a cooperative basis and have decided to explore whether alternative remedial measures should be used to replace the incineration remedy set forth in the Consent Decree. On February 8, 1994 the parties filed a status report with the United States District Court for the Southern District of Indiana, which is responsible for overseeing the implementation of the Consent Decree. This report advised the court of the parties' intention to investigate alternatives and provided the court with operating principles for this process. It is the goal of the parties to reach a consensus on an alternative which is acceptable to all parties and to the Bloomington public. However, the parties recognize that at the end of the process they may conclude that the remedy currently provided in the Consent Decree is the most appropriate. The parties also recognize that the Consent Decree shall remain in full force during this process. These actions have resulted in the Corporation's belief that it no longer is probable that the Consent Decree will be implemented under its present terms. The Corporation and the other parties may have claims against each other under the Consent Decree if a mutually agreeable alternative is not reached. The Corporation may be required to post security for 125% of the net cost to complete remediation in the event certain requirements of the Consent Decree are not met. The Corporation believes it has met all of these requirements. If necessary permits were to be granted and the Consent Decree fully implemented in its present form, the Corporation estimates that its total remaining cost would be approximately $300 million at December 31, 1993. As part of the Consent Decree, and in addition to burning contaminated materials, the incinerator would also be used to burn municipal solid waste and generate electricity which would be purchased by various public utilities. The Corporation would receive revenues from tipping fees and sale of electricity which are estimated to be approximately $210 million. The Consent Decree also provides the City with an option to purchase the incinerator after the remediation is completed. The Corporation has assumed that proceeds from the sale of the incinerator would be in the range of $100 million to $160 million. Based on the above estimates, the Corporation continues to believe that the ultimate net cost of the environmental remediation under the present terms of the Consent Decree would not result in a material adverse effect on its future financial condition or results of operations. However, because the Corporation believes it is probable the Consent Decree will be modified to an alternate remediation action, the Corporation estimates that its cost to implement the most reasonable and likely alternative would be approximately $60 million, all of which has been accrued. Approximately $16 million of this estimate represents operating and maintenance costs which will be incurred over an approximate 30 year period. These costs are expected to be distributed equally over this period and, based on the Corporation's experience with similar operating and maintenance costs, have been determined to be reliably determinable on a year-to-year basis. Accordingly, the estimated $44 million gross cost of operating and maintenance has been discounted at a rate of 5% per year which results in the above described $16 million charge. The remaining portion of the $60 million charge represents site construction and other related costs and is valued as of the year of expenditure. Analyses of internal experts and outside consultants have been used in forecasting construction and other related costs. The estimates of future period costs include an assumed inflation rate of 5% per year. This estimate of $60 million is within a range of reasonably possible alternatives and one which the Corporation believes to be the most likely outcome. This alternative includes a combination of containment, treatment, remediation and monitoring. Other alternatives, while considered less likely, could cause such costs to be as much as $100 million. Other Sites The Corporation is involved with several administrative actions alleging violations of federal, state or local environmental regulations. For these matters the Corporation has estimated that its potential total remaining reasonably possible costs are insignificant. The Corporation currently manages under contract several government-owned facilities, which among other things are engaged in the remediation of hazardous and nuclear wastes. To date, under the terms of the contracts, the Corporation is not responsible for costs associated with environmental liabilities, including environmental cleanup costs, except under certain circumstances associated with negligence and willful misconduct. There are currently no known claims for which the Corporation believes it is responsible. In 1994, the U.S. Department of Energy (DoE) announced its intention to renegotiate its existing contracts for maintenance and operation of DoE facilities to address environmental issues. The Corporation has or will have responsibilities for environmental remediation such as dismantling incinerators, decommissioning nuclear licensed sites, and other similar commitments at various sites. The Corporation has estimated total potential cost to be incurred for these actions to be approximately $133 million, of which $35 million had been accrued at December 31, 1993. The Corporation's policy is to accrue these costs over the estimated lives of the individual facilities which in most cases is approximately 20 years. The anticipated annual costs currently being accrued are $6 million. As part of the agreement for the sale of DCBU to Eaton Corporation, the Corporation agreed to a cost sharing arrangement if future, but as yet unidentified, remediation is required as a result of any contamination caused during the Corporation's operation of DCBU prior to its sale. Under the terms of the agreement, the Corporation's share of any such environmental remediation costs, on an annual basis, will be at the rate of $2.5 million of the first $6 million expended, and 100% of such costs in excess of $6 million. The Corporation has provided for all known environmental liabilities related to DCBU. These estimated costs and related reserves are included in the discussion above of PRP sites. Environmental liabilities related to the sale of WESCO are insignificant. Capital Expenditures Capital expenditures related to environmental remediation activities in 1993 totalled $5 million. Management believes that the total estimated capital expenditures related to current operations necessary to comply with present governmental regulations will not have a material adverse effect on capital resources, liquidity, financial condition and results of operations. Insurance Recoveries In 1987, the Corporation filed an action in New Jersey against over 100 insurance companies seeking recovery for these and other environmental liabilities and litigation involving personal injury and property damage. The Corporation has received certain recoveries from insurance companies related to environmental costs. The Corporation has not accrued for any future insurance recoveries. Based on the above discussion and including all information presently known to the Corporation, management believes that the environmental matters described above will not have a material adverse effect on the Corporation's capital resources, liquidity, financial condition and results of operations. FINANCING COMMITMENTS Discontinued Operations Financial Services commitments with off-balance-sheet credit risk represent financing commitments to provide funds, including loan or investment commitments, guarantees, standby letters of credit and standby commitments, generally in exchange for fees. The remaining commitments have fixed expiration dates from 1994 through 2002. At December 31, 1993, Financial Services commitments with off-balance-sheet credit risk totalled $111 million, compared to $1,418 million at year-end 1992. Of the $111 million of commitments at December 31, 1993, $90 million were guarantees, credit enhancements and other standby agreements, and $21 million were commitments to extend credit. Of the $1,418 million of commitments at year-end 1992, $619 million were guarantees, credit enhancements and other standby agreements, $575 million were commitments to extend credit, and $224 million were partnership calls and other investment commitments. Management expects the remaining commitments to either expire unfunded, be assumed by the purchaser in asset dispositions or be funded with the resulting assets being sold shortly after funding. The primary reasons for the $1,307 million reduction in commitments during 1993 were that Financial Services was released from $959 million of commitments through asset sales, restructurings and commitment expirations, funded $340 million of commitments and transferred $76 million of guarantees to Continuing Operations. These decreases were partially offset by $68 million of new commitments. Continuing Operations As discussed above, during 1993, $76 million of guarantees were transferred from Financial Services to Continuing Operations. These guarantees were issued primarily to improve the salability of securities of Financial Services corporate customers and are collateralized by the assets of the customer. Management does not expect the Corporation to be required to fund these guarantees. WCI was contingently liable at December 31, 1993 under guarantees for $54 million of sewer and water district borrowings. The proceeds of the borrowings were used for sewer and water improvements on residential and commercial real estate projects of WCI. Management expects these borrowings to be repaid as the projects are completed and sold, and the guarantees for such borrowings to expire unfunded. OTHER COMMITMENTS The Corporation's other commitments consisting primarily of those for the purchase of plant and equipment are not material. NOTE 18: LEASES The Corporation has commitments under operating leases for certain machinery and equipment and facilities used in various operations. Rental expense for Continuing Operations in 1993, 1992 and 1991 was $220 million, $225 million and $183 million, respectively. These amounts include immaterial amounts for contingent rentals and sublease income. NOTE 19: OTHER INCOME AND EXPENSES, NET The expected losses on disposition of non-strategic businesses of $195 million were recorded to reflect the Corporation's announced plan to dispose of certain of these businesses. Gain on disposition of other assets in 1993 includes a gain of $21 million on the sale of an equity participation in a production company. Loss on disposition of other assets in 1991 includes a $17 million provision for the loss on investment in an affiliate. All items in the other category are less than $10 million each. NOTE 20: RESTRUCTURING, MERGERS, ACQUISITIONS AND DIVESTITURES On January 11, 1994, the Corporation announced a restructuring of its continuing businesses resulting in a one-time charge of $350 million. The Corporation anticipates that actions resulting from its restructuring plan, directed to improving productivity and operating performance, will result in a reduction of approximately 6,000 employees, comprised of approximately 3,400 employee separations and expected reductions of 2,600 employees through normal attrition. These employment reductions will cause the Corporation to incur various other costs related to the rationalization and closedown of facilities which are included in the charge. The restructuring actions are expected to occur over a two to three year period. On May 3, 1993, WFSI and WCC were merged into Westinghouse and, as a consequence, WFSI and WCC ceased to exist as separate legal entities and their debt was assumed by the Corporation. This merger gave management greater flexibility to execute its liquidation of all assets of Financial Services and implement the strategy of exiting the financial services business. During 1992, WSAV executed a definitive agreement with First Financial Bank, F.S.B., to sell its Illinois-based thrift, Westinghouse Federal Bank. The sale was completed in January 1993. In August 1992, the Corporation sold the Copper Laminates Division (formerly part of the Electronic Systems segment) for $97 million in cash. In May 1992, the Corporation sold the Electrical Systems Division (formerly part of the Electronic Systems segment) for $125 million in cash. During 1991, there were no significant acquisitions or divestitures. NOTE 21: SEGMENT INFORMATION Westinghouse is a diversified, global, technology-based corporation operating in the principal business arenas of television and radio broadcasting, defense electronics, environmental services, transport refrigeration and the electric utility markets. The Corporation's continuing businesses are aligned for reporting purposes into the following segments: Broadcasting, Electronic Systems, Environmental, Industries, Power Systems, Knoll and WCI. Engineering and repair services, previously included in the Industries segment, have been transferred to the Power Systems segment where these businesses have been consolidated with the power generation service organization. The Environmental segment now includes the U.S. naval nuclear reactors programs previously reported in Power Systems. The Longines-Wittnauer Watch Company and Westinghouse Communications have been transferred from the Broadcasting segment to the Industries segment as part of the Industrial Products and Services business unit. Segment information for 1992 and 1991 has been restated to reflect these changes. Results of international manufacturing entities, export sales and foreign licensee income are included in the financial information of the segment that has operating responsibility. Broadcasting provides a variety of communications services consisting primarily of commercial broadcasting, program production and distribution. It sells advertising time to radio, television and cable advertisers through national and local sales organizations. Within Broadcasting, Group W currently owns and operates five network affiliated television broadcasting stations and 14 radio stations. Group W also provides programming and distribution services to the cable television industry. Group W Satellite Communications provides sports programming and the marketing and advertising sales for two country music entertainment channels. The Electronic Systems segment is a world leader in the research, development, production and support of advanced electronic systems for the Department of Defense (DoD), Federal Aviation Administration, National Aeronautics and Space Administration, other government agencies and U.S. allies. Products include surveillance and fire control radars, command and control systems, electronic countermeasures equipment, electro-optical systems, spaceborne sensors, missile launching and handling equipment, torpedoes, sonar and communications equipment. The group also engages in technologically complementary non-DoD markets such as air traffic control, security systems and drug traffic interdiction. The Environmental segment combines the Corporation's environmental businesses: toxic, hazardous and radioactive waste services, waste-to-energy plants and management and operation of several government-owned facilities and the U.S. naval nuclear reactors program. The Industries segment is comprised of a leading supplier of transport temperature control equipment for trucks, trailers, ships, fishing vessels and railway cars. The segment also includes the Industrial Products and Services business unit which is a diverse group of businesses providing a wide range of goods and services to consumer, industrial, utility and governmental customers. The Power Systems segment designs, develops, manufactures and services nuclear and fossil-fueled power generation systems and is a leading supplier of reload nuclear fuel to the global electric utility market. Knoll designs, manufactures and distributes office furniture to an expanding global market. WCI develops land into master planned luxury communities primarily in Florida and California. SALES OF PRODUCTS AND SERVICES AND SEGMENT OPERATING PROFIT FROM CONTINUING OPERATIONS (in millions) Segment sales of products and services include products that are transferred between segments generally at inventory cost plus a margin. Segment operating profit or loss consists of sales of products and services less segment operating expenses that include costs of products and services, marketing, administrative and general expenses, depreciation and amortization, and restructuring provisions. A provision for costs associated with the Corporation's 1991 workforce reduction was recorded in the third quarter of 1991 and totalled $138 million for Continuing Operations. Prior to that provision, operating profit totalled $145 million for Broadcasting, $276 million for Electronic Systems, $22 million for Environmental, $107 million for Industries, and $247 million for Power Systems. In 1992, a $36 million charge was recorded in Continuing Operations for corporate restructuring related to the previous strategy to sell Knoll and WCI. Prior to that charge, the operating loss for Knoll was $14 million and the operating profit for WCI was $97 million. In 1993, a $750 million charge was recorded in the fourth quarter for restructuring and other actions of which $555 million was charged to operating profit. Prior to that provision operating profit totalled $148 million for Broadcasting, $217 million for Electronic Systems, $7 million for Environmental, $120 million for Industries, $217 million for Power Systems, $65 million for WCI and a loss of $30 million for Knoll. Identifiable assets, depreciation and amortization, and capital expenditures are presented below. Assets not identified to segments principally include cash and marketable securities, deferred income taxes, prepaid pension contributions and unrecognized pension costs. OTHER FINANCIAL INFORMATION (in millions) Included in income from Continuing Operations is income of subsidiaries located outside the U.S. These subsidiaries reported a loss of $21 million in 1993, and income of $32 million and $48 million in 1992 and 1991, respectively. Subsidiaries located outside the U.S. comprised 6% of total assets of Continuing Operations in 1993, 5% in 1992 and 6% in 1991. Subsidiaries located outside the U.S. comprised 2% of total liabilities of Continuing Operations in 1993, 1992 and 1991. FINANCIAL INFORMATION BY GEOGRAPHIC AREA (in millions) The Corporation sells products manufactured domestically to customers throughout the world using domestic divisions and subsidiaries doing business primarily outside the U.S. Generally, products manufactured outside the U.S. are sold outside the U.S. SALES FROM PRODUCTS AND SERVICES SOLD OUTSIDE THE U.S. FROM CONTINUING OPERATIONS (in millions) The largest single customer of the Corporation is the U.S. government and its agencies, whose purchases accounted for 30% of sales of products and services from Continuing Operations in 1993 and 1992 and 32% in 1991. Of the 1993 purchases, 82% were from the Electronic Systems segment. No other customer made purchases totalling 10% or more of sales of products and services. RESEARCH AND DEVELOPMENT FROM CONTINUING OPERATIONS (in millions) Note 22: FAIR VALUE OF FINANCIAL INSTRUMENTS The estimated fair value of financial instruments has been determined by the Corporation using the best available market information and appropriate valuation methodologies. However, considerable judgment was necessary in interpreting market data to develop the estimates of fair value. Accordingly, the estimates presented are not necessarily indicative of the amounts that the Corporation could realize in a current market exchange or the value that ultimately will be realized by the Corporation upon maturity or disposition. Additionally, because of the variety of valuation techniques permitted under SFAS No. 107, comparability of fair values between entities may not be meaningful. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts. FAIR VALUE OF FINANCIAL INSTRUMENTS--CONTINUING OPERATIONS (in millions) FAIR VALUE OF FINANCIAL INSTRUMENTS--DISCONTINUED OPERATIONS (in millions) *Carrying amount refers to the amount included in net liabilities of Discontinued Operations at December 31, 1993 and 1992, after giving effect to the valuation allowances associated with each portfolio, exclusive of any recoveries or proceeds from the sale of assets that exceeded their initial reserved values. (a)Certain amounts have been reclassified for comparative purposes. The following methods and assumptions were used to estimate the fair value of financial instruments for which it was practicable to estimate that value. CASH AND CASH EQUIVALENTS The carrying amount for cash and cash equivalents approximates fair value. NONCURRENT CUSTOMER AND OTHER RECEIVABLES The fair value of noncurrent customer and other receivables is estimated by discounting the expected future cash flows at interest rates commensurate with the creditworthiness of the customers and other third parties. PORTFOLIO INVESTMENTS The carrying amount of financial instruments included in portfolio investments at Financial Services approximates their fair value. The fair value for marketable securities is determined by quoted market prices, if available, or estimated using quoted market prices for similar securities. Except for the Corporation's investment in LW Real Estate Investments, L.P., which is valued at cost, the real estate portfolio, including receivables, real estate properties and real estate investments in partnerships and other entities, was valued using the Resolution Trust Corporation's DIV method. The corporate portfolio, including receivables, investments in partnerships and other entities and nonmarketable equity securities, was valued using various valuation techniques, including trading desk values, which arise from actual or proposed current trades of identical or similar assets, plus other factors. SHORT-TERM DEBT The carrying amount of the Corporation's borrowings under the revolving credit facility and other arrangements approximate fair value. LONG-TERM DEBT The fair value of long-term debt has been estimated using quoted market prices or discounted cash flow analyses based on the Corporation's incremental borrowing rates for similar types of borrowing arrangements with comparable terms and maturities. THRIFT DEPOSITS The thrift deposits were assumed by the purchaser of Westinghouse Federal Bank on January 4, 1993, at their carrying amount. INTEREST RATE AND CURRENCY EXCHANGE AGREEMENTS The fair value of interest rate and currency exchange agreements (used for hedging purposes) is the amount that the Corporation would receive or pay to terminate the exchange agreements, considering interest rates, currency exchange rates and remaining maturities. FINANCIAL GUARANTEES The fair value of guarantees is based on the estimated cost to terminate or otherwise settle the obligations with the counterparties. FINANCING COMMITMENTS Most of the unfunded commitments relate to, and are inseparable from, specific portfolio investments. When establishing the fair value for those portfolio investments, consideration was given to the related financing commitments. REPORT OF MANAGEMENT The Corporation has prepared the consolidated financial statements and related financial information included in this report. Management has the primary responsibility for the financial statements and other financial information and for ascertaining that the data fairly reflect the financial position, results of operations and cash flows of the Corporation. The financial statements were prepared in accordance with generally accepted accounting principles appropriate in the circumstances, and necessarily include amounts that are based on best estimates and judgments with appropriate consideration given to materiality. Financial information included elsewhere in this report is presented on a basis consistent with the financial statements. The Corporation maintains a system of internal accounting controls, supported by adequate documentation, to provide reasonable assurance that assets are safeguarded and that the books and records reflect the authorized transactions of the Corporation. Limitations exist in any system of internal accounting controls based upon the recognition that the cost of the system should not exceed the benefits derived. Westinghouse believes its system of internal accounting controls, augmented by its corporate auditing function, appropriately balances the cost/benefit relationship. The independent accountants provide an objective assessment of the degree to which management meets its responsibility for fair financial reporting. They regularly evaluate the system of internal accounting controls and perform such tests and procedures as they deem necessary to express an opinion on the fairness of the financial statements. The Board of Directors pursues its responsibility for the Corporation's financial statements through its Audit Review Committee composed of directors who are not officers or employees of the Corporation. The Audit Review Committee meets regularly with the independent accountants, management and the corporate auditors. The independent accountants and the corporate auditors have direct access to the Audit Review Committee, with and without the presence of management representatives, to discuss the scope and results of their audit work and their comments on the adequacy of internal accounting controls and the quality of financial reporting. We believe that the Corporation's policies and procedures, including its system of internal accounting controls, provide reasonable assurance that the financial statements are prepared in accordance with the applicable securities laws and with a corresponding standard of business conduct. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Shareholders of Westinghouse Electric Corporation In our opinion, the accompanying consolidated financial statements appearing on pages 29 through 56 of this Form 10-K present fairly, in all material respects, the financial position of Westinghouse Electric Corporation and its subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Corporation's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which 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, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. As discussed in note 1 to these financial statements, the Corporation adopted Statement of Financial Accounting Standards (SFAS) No. 112, "Employers' Accounting for Postemployment Benefits," in 1993 and SFAS No. 106, "Employers Accounting for Postretirement Benefits Other Than Pensions," and SFAS No. 109, "Accounting for Income Taxes," in 1992. /s/ Price Waterhouse Price Waterhouse 600 Grant Street Pittsburgh, Pennsylvania 15219-9954 January 26, 1994, except as to the matter discussed in paragraph 9 of note 2, which is as of February 28, 1994 PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. Part of the information concerning executive officers required by this item is set forth in Part I pursuant to General Instruction G to Form 10-K and part is incorporated herein by reference to "Security Ownership" in the Proxy Statement. The information as to directors is incorporated herein by reference to "Election of Directors" in the Proxy Statement. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. The information required by this item is incorporated herein by reference to "Executive Compensation" in the Proxy Statement. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The information required by this item is incorporated herein by reference to "Security Ownership" in the Proxy Statement. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The information required by this item is incorporated herein by reference to "Transactions Involving Directors and Executive Officers" in the Proxy Statement. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (A)(1) FINANCIAL STATEMENTS The financial statements required by this item are listed under Item 8, which list is incorporated herein by reference. (A)(2) FINANCIAL STATEMENT SCHEDULES The following financial statement schedules for Westinghouse Electric Corporation are included in Part IV of this report: Other schedules are omitted because they are not applicable or because the required information is included in the financial statements or notes thereto. (A) EXHIBITS * Identifies management contract or compensatory plan or arrangement. (B) REPORTS ON FORM 8-K: No reports on Form 8-K were filed during the fourth quarter of the year ended December 31, 1993. REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Board of Directors of Westinghouse Electric Corporation Our audits of the consolidated financial statements referred to in our report dated January 26, 1994, except as to the matter discussed in paragraph 9 of note 2, which is as of February 28, 1994, appearing on page 57 of this Form 10-K of Westinghouse Electric Corporation (which report and consolidated financial statements are included in this Annual Report on Form 10-K) also included an audit of the Financial Statement Schedules listed in Item 14(a)(2) of this Form 10-K. In our opinion, these Financial Statement Schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. Price Waterhouse 600 Grant Street Pittsburgh, Pennsylvania 15219-9954 January 26, 1994, except as to the matter discussed in paragraph 9 of note 2, which is as of February 28, 1994 SCHEDULE VIII VALUATION AND QUALIFYING ACCOUNTS - - --------- (a) at December 31, 1993, 1992 and 1991, all amounts were classified as current. SCHEDULE X SUPPLEMENTARY INCOME STATEMENT INFORMATION SIGNATURE 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, on the 4th day of March, 1994. WESTINGHOUSE ELECTRIC CORPORATION /s/ Robert E. Faust By: -------------------------------- Robert E. Faust Vice President and Controller 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. Signature and Title Frank C. Carlucci, Director Gary M. Clark, President and Director George H. Conrades, Director William H. Gray, III, Director Michael H. Jordan, Chairman and Chief Executive Officer (principal executive officer) and Director /s/ Robert E. Faust David T. McLaughlin, Director By -------------------------- Rene C. McPherson, Director Robert E. Faust Richard M. Morrow, Director Attorney-In-Fact Richard R. Pivirotto, Director Paula Stern, Director March 4, 1994 Fredric G. Reynolds, Executive Vice President, Finance (principal financial officer) Robert E. Faust, Vice President and Controller (principal accounting officer) Original powers of attorney authorizing Michael H. Jordan, Fredric G. Reynolds and Robert E. Faust, individually, to sign this report on behalf of the listed directors and officers of the Corporation and a certified copy of a resolution of the Board of Directors of the Corporation authorizing each of said persons to sign on behalf of the Corporation have been filed with the Securities and Exchange Commission and are included as Exhibit 24 to this report. EXHIBIT INDEX - - -------------------------------------------------------------------------------- * Incorporated by reference

1993 ITEM 1. BUSINESS THE COMPANY Bank of New Hampshire Corporation (the "Company") is a registered bank holding company incorporated in 1979 under the laws of the State of New Hampshire. The Company is a member of the Federal Reserve System and transacts its business through its only subsidiary, Bank of New Hampshire (the "Bank"), a state-chartered, Federal Reserve non-member, commercial bank organized under the laws of the State, headquartered, along with the executive offices of the Company, at 300 Franklin Street, Manchester, New Hampshire 03105 (telephone 603-624-6600). The Company assumed its present structure on September 30, 1991, with the merger of its five separate subsidiary banks into the Bank. The Company conducts its business through twenty-eight offices of the Bank located throughout the southern, central, seacoast, and lakes regions of New Hampshire, which areas contain approximately 80% of the State's population, and employs approximately 570 employees. BUSINESS OF THE COMPANY The Bank is a full service commercial bank engaged in providing a wide variety of financial services to New Hampshire individuals, businesses and governments, including commercial and real estate lending, retail banking, consumer finance, mortgage origination, sales and servicing, cash management, and trust and investment services. Through its Trust and Investment Services Division, the Bank administers estates, personal and corporate trusts, and provides fiduciary services to individuals, businesses, and governments. The Bank also offers electronic banking services through a network of twenty-four ATMs. The Bank maintains a centralized data processing facility at its Data Services Center located in Manchester, New Hampshire. The Company, from time to time, may investigate possible future acquisitions of deposits and banking assets which could strengthen the Company and enhance market coverage within New Hampshire. No agreements presently exist regarding possible future acquisitions. The Company, primarily, provides management resources to the Bank. Activities in which the Company and the Bank are presently engaged or which they may undertake in the future are subject to certain statutory and regula- tory restrictions. Banks and bank holding companies are extensively regulated under both federal and state law. There are various legal limitations upon the extent to which the Bank can finance or otherwise supply funds to the Company. In addition, there are certain regulatory limitations on the payment of dividends by the Company and by the Bank. See "REGULATORY MATTERS," "DIVIDENDS AND DIVIDEND POLICY," and "SUPERVISION AND REGULATION," on pages 5 and 7 of this Report. Page 5 of 249 COMPETITION The business of the Bank is extremely competitive. In addition to competing actively with other commercial banks in their market area for deposits and loans, the Bank competes with larger commercial banks located outside of New Hampshire. The Bank also competes with other financial institutions, including mutual and stock savings banks, savings and loan associations, finance companies and credit unions in addition to non-banking institutions including insurance companies and other financial services organizations. Competition among financial institutions is based upon product pricing, customer service, convenience of banking locations and a variety of other factors. At December 31, 1993, the Bank's deposits totalled $865 million which represents approximately 6% of the total time, savings and demand deposits of all banks, national banks, federal and state savings banks and state co-operatives and savings and loan's based in the State of New Hampshire. REGULATORY MATTERS During 1992, the Bank entered into a Memorandum of Understanding (the "MOU") and a Capital Directive (the "Capital Directive") with the Federal Deposit Insurance Corporation ("the FDIC") and the State of New Hampshire Banking Department. The MOU and the Capital Directive require, among other things, the attainment of increased capital ratios on an incremental basis, through and by, June 30, 1994. As of December 31, 1993, the Bank's capital ratios already exceed the minimum levels required on June 30, 1994 under the MOU and the Capital Directive. See "DIVIDENDS AND DIVIDEND POLICY." CAPITAL Information concerning the Company and the Bank with respect to capital is set forth in Management's Financial Review - "Capitalization" and "Capital Resources", contained in the Company's 1993 Annual Report to Stockholders on pages 12 and 24, respectively, filed as Exhibit 1, which is incorporated herein by reference. See "DIVIDENDS AND DIVIDEND POLICY" and "SUPERVISION AND REGULATION" discussed on pages 5 and 7, respectively, of this Report. DIVIDENDS AND DIVIDEND POLICY The Company is a legal entity separate and distinct from the Bank. The Company's revenues (on a Parent Company only basis) result, in part, from dividends paid to the Company by the Bank. The Bank did not pay dividends to the Company in either 1993 or 1992. The right of the Company, and consequently the right of creditors and stockholders of the Company, to participate in any distribution of the assets or earnings of the Bank through the payment of such dividends or otherwise is necessarily subject to the prior claims of creditors of the Bank (including depositors), except to the extent that claims of the Company in its capacity as a creditor may be recognized. Page 6 of 249 The Company's dividend policy with respect to its common stock is reviewed quarterly. Prior to 1991, the Company paid quarterly cash dividends on its common stock. However, commencing with the first quarter of 1991 and continuing through the third quarter of 1993, the Company's Board of Directors (the "Board") consistently voted, on a quarterly basis, not to declare a dividend. Such votes acknowledged (i) the need for a continued conservative approach in utilization of the Company's capital, (ii) regulatory restrictions on the Bank's capital and the resultant limited capacity of the Company to pay dividends without the benefit of upstreamed dividends from the Bank, and (iv) actions taken by the regulators at other financial institutions to restrict or otherwise direct the discontinuance of dividend payments to stockholders. On November 17, 1993, the Board declared a quarterly dividend of eight cents per share payable December 15, 1993, to stockholders of record at December 1, 1993. Such dividends totalled approximately $325,000 and did not require upstreaming of Bank earnings, in the form of a dividend, to the Company. The Board voted to declare a quarterly dividend after giving consideration to the following events - eight consecutive quarters of reported net income totalling $10.7 million; the previously mentioned sale of common stock on September 30, 1993, which generated $11.6 million in net proceeds for the Company and a $7.5 million contribution from the Company to the capital of the Bank. Consideration was also given to the fact that the federal and state regulators (the "Regulators") granted prior approval of the dividend. The Regulators have indicated that, provided the Bank maintains a leverage ratio of at least 6.00%, the Bank will have the capacity to upstream dividends to the Company out of current earnings on a quarterly basis in amounts determined in accordance with the current rules and regulations, subject to approval by the Bank's independent Board of Directors. Additionally, in accordance with the requirements of the Regulators, common stock dividend declarations and payments by the Company require prior notice to and approval of the Federal Reserve Bank of Boston and dividend declara- tions and payments by the Bank require prior approval of the State and FDIC. Any dividend declaration by the Company or the Bank must consider factors such as the amount of current period earnings, capital adequacy and other factors. However, the Regulators have the authority to prohibit the Bank and the Company from paying dividends at any time if they deem such payment to be an unsafe or unsound practice. Page 7 of 249 SUPERVISION AND REGULATION Bank holding companies and banks are subject to extensive supervision, regulation and examination by various bank regulatory authorities and other agencies of Federal and State governments. The supervision, regulation and examinations to which the Company and the Bank are subject are often intended by the regulators primarily for the protection of depositors or are aimed at carrying out broad public policy goals rather than for the protection of security holders. Several of the more significant regulatory provisions applicable to banks and bank holding companies to which the Company and the Bank are subject are noted below along with certain current regulatory matters concerning the Company and the Bank. To the extent that the following information describes statutory or regulatory provisions, it is qualified in its entirety by reference to the particular statutory provisions. Any change in applicable law or regulation may have a material effect on the business and prospects of the Company. BANK HOLDING COMPANY REGULATION The Company is a bank holding company registered under the Bank Holding Company Act of 1956 (the "BHCA") and is subject to supervision by the Board of Governors of the Federal Reserve ("FRB"). The Company is required to file an annual report and certain other information with the Federal Reserve Bank of Boston ("FRBB"). The FRBB also makes examinations of the Company. Under regulations issued under the BHCA and other provisions, a bank holding company may be required to serve as a source of financial and managerial strength to its subsidiary banks. As a result, the FRB, pursuant to such regulations, may initiate efforts to require the Company to use its resources to provide adequate capital funds to the Bank during periods of financial stress or adversity, even in situations where the Company would be adversely affected by the provision of such capital funds. The Company, currently a "one" bank holding company, may also in the future, under certain circumstances discussed below, be regulated under the provisions of the New Hampshire Bank Holding Company Act (the "NH BHCA"). Acquisitions by Bank Holding Companies The BHCA prohibits the Company from acquiring direct or indirect control of more than 5% of the outstanding shares of any class of voting stock or substantially all of the assets of any bank, or merging or consolidating with another bank holding company, without prior approval of the FRB. Similar restrictions apply to acquisition of control of shares of stock of the Company by other bank holding companies. Page 8 of 249 The BHCA also prohibits the Company from engaging in, or from acquiring ownership or control of, more than 5% of the outstanding shares of any class of voting stock of any company engaged in a nonbanking activity unless such activity has been determined by the FRB to be so closely related to banking as to be a proper incident thereto. The BHCA does not place territorial restrictions on the activities of such nonbanking-related activities. Although the Company is not presently subject to the NH BHCA as a one bank holding company, the Company may in the future again become subject to the NH BHCA if it acquires 25% or more of the voting stock of another bank. The NH BHCA prohibits bank holding companies (defined as companies owning 25% or more of the voting stock of "two or more" banks) from acquiring any voting stock of an additional bank if, after such acquisition, the bank holding company would (i) have more than twelve affiliates in New Hampshire, or (ii) if the total deposits of such bank holding company and all its affiliates in New Hampshire would exceed twenty percent of the dollar volume of total deposits, time, savings, and demand, of all banks, national banks, and federal savings and loan associations, in the State of New Hampshire. If the test in (ii) is met, the banking subsidiaries of a bank holding company may not engage in further branching activities. Under certain circumstances the State Banking Department is permitted to waive the above limits. Control of Bank Holding Company The Change in Bank Control Act (the "CBCA") requires notice to and approval of the FRB prior to the acquisition by any person or entity of "control" of a bank holding company. The CBCA defines "control" as the power, directly or indirectly, to vote 25% or more of any class of voting securities. The FRB has promulgated regulations pursuant to which it presumes that one has "control" of a bank holding company if one owns, controls, or holds with the power to vote 10% or more of any class of voting securities of a publicly-traded bank holding company. New Hampshire statutes and regulations also place certain potential restrictions on acquisitions of control of New Hampshire bank holding companies. Since September 1987, interstate banking has been permitted, with certain restrictions, in New Hampshire. These restrictions, which limited such acquisitions or affiliations to New England financial institutions, were deleted from the statute effective April 13, 1990. The statute was further amended in July 1992 to allow the Board of Directors of individual banks, or bank holding companies, to adopt resolutions which, upon filing with the State Banking Department, prohibit their acquisition by an out-of-state bank. Neither the Board of Directors of the Company nor the Board of Directors of the Bank has taken action with regard to these resolutions. Page 9 of 249 Other New Hampshire legislation exists which requires full and fair disclosure and prior registration of acquiring corporations, and in the discretion of the New Hampshire Secretary of State, may require public hearings on registration compliance. The Company is excluded from this statute, so long as any takeover bid is subject to federal regulatory approval. Capital Adequacy The FRB has adopted risk-based capital adequacy guidelines to evaluate the capital adequacy of bank holding companies. Such guidelines require bank holding companies to maintain risk-based capital ratios substantially similar to those required for state banks, as described below. In addition to the risk-based capital guidelines, the FRB and the FDIC have adopted the use of the leverage ratio as an additional tool to evaluate the capital adequacy of bank holding companies. Under current regulations, all except the most highly rated institutions are expected to exceed the 3% minimum regulatory ratio by 100 to 200 basis points or more. Dividends The FRB has issued a policy statement that bank holding companies should serve as a source of managerial and financial strength to their subsidiary banks. As part of this policy, the FRB expects that if a major subsidiary bank is unable to pay dividends to a bank holding company, the bank holding company should seriously consider reducing or eliminating its dividends in order to conserve its capacity to provide capital assistance to the subsidiary bank. The policy also discourages bank holding companies with subsidiary banks which are experiencing earnings weaknesses, other serious problems, or that have inadequate capital, from paying dividends not covered by current earnings, from borrowed funds, or from unusual or nonrecurring gains. In addition, a bank holding company is prohibited under the Federal Deposit Insurance Act from paying dividends without the prior approval of the FRB if an insured bank subsidiary is deemed to be "significantly undercapitalized" (as discussed below) or is deemed to be "undercapitalized" and has failed to submit and implement a required capital restoration plan. BANK REGULATION Deposits in the Bank are insured by the FDIC to the extent allowed by law. The Bank is not a member of the FRB system and is a state-chartered institution; therefore, the Bank is subject to supervision and regulation by both the FDIC and the State Banking Department. The Bank is required to maintain cash reserves against deposits and is subject to restrictions, among others, upon (i) the nature and amount of loans which it may make to a borrower, (ii) the nature and amount of securities in which it may invest, (iii) the portion of its assets Page 10 of 249 which may be invested in bank premises, (iv) the geographic location of its branches, and (v) the nature and extent to which it can borrow money. In December 1991, the Federal government enacted the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"). In general, FDICIA (i) requires the adoption of regulations establishing minimum capital ratio requirements for insured institutions such as the Bank, (ii) establishes a system of classifications for insured institutions based on capital ratios and other factors under which federal regulatory agencies are required to take "prompt corrective action" with regard to capital and other deficiencies, and (iii) provides for the recapitalization of the FDIC's Bank Insurance Fund (the "BIF") by setting up a risk-based scheme of premium assessments of insured institutions. Capital Adequacy Under the FDIC's minimum capital ratio regulations, state banks are required to have a ratio of "Tier 1," or core, capital-to-total risk-weighted assets of 4.0% and a ratio of total capital-to-total risk-weighted assets of 8.0%. Except in the case of the strongest institutions, the FDIC expects state banks to substantially exceed these minimum risk-based capital ratios. As of December 31, 1993, the Bank's ratio of "Tier 1" capital-to-total risk-weighted assets was 12.88% and its ratio of total capital-to-total risk-weighted assets was 14.16%. Also under FDIC regulations, state banks are required, in most cases, to maintain a leverage ratio, or "Tier 1" capital-to-average total assets ratio, of no less than 4.0%. As of December 31, 1993, the Bank's leverage ratio was 6.09%. Under certain circumstances, the FDIC may establish higher minimum capital ratio requirements than set forth above; for example, when a bank has received special regulatory attention or has high susceptibility to interest rate risk. A bank is restricted from paying dividends it if is, or as a result of the dividend would be, considered to be undercapitalized under these minimum capital ratio requirements. Banks with capital ratios below the required minimums are also subject to certain administrative actions, including termination of deposit insurance upon notice and hearing, or temporary suspension of insurance without a hearing in the event the institution has no tangible capital. Prompt Corrective Action The regulations relating to "prompt corrective action" establish five classifications based on capital levels, some of which require or permit the FRB or the FDIC to take supervisory action -- "well capitalized," "adequately capitalized," "undercapitalized," "signficantly undercapitalized," and "critically undercapitalized." The classifications are determined by the ratios of the institution's "Tier 1" capital-to-total risk-weighted assets, its total capital-to-total Page 11 of 249 risk-weighted assets, and its leverage ratio. To fall within the "well capitalized" category, ratios (as described above) must be at least 6.0%, 10.0%, and 5.0%, respectively. The regulations require a bank to notify the appropriate agency of material events that decrease the capital level of the bank, and to do so within 15 days. In addition, the federal banking regulators are authorized to effectively downgrade an institution to a lower capital category than the institution's capital ratios would otherwise indicate, based upon safety and soundness considerations (such as when the institution has received a less than satisfactory examination rating for any of the rating categories for asset quality, management, earnings, or liquidity). The scope and degree of regulatory intervention is linked to the extent of the shortfall in the capital ratios of the insured institution. In the case of an insured institution which is "critically undercapitalized" (a term defined to include institutions which have a positive net worth), the federal bank regulatory authorities are generally required to appoint a conservator or receiver. An "undercapitalized" bank must develop a capital restoration plan and its parent holding company must guarantee the bank's compliance with the plan. The liability of the parent holding company under any such guarantee is limited to the lesser of 5% of the bank's assets at the time it became "undercapitalized" or the amount needed to comply with the plan. An "undercapitalized" bank also is subject to limitations in numerous areas, including, but not limited to: capital distributions, asset growth, acquisitions, branching, new business lines and borrowings from the FRB. Under the regulations relating to brokered deposits, "well capitalized" banks may accept brokered deposits without restriction, "adequately capitalized" banks may accept such funds only if they first obtain a waiver from the FDIC, and "undercapitalized" banks are prohibited from accepting such deposits. In addition, banks which are not "well capitalized" (even if meeting minimum capital requirements) are subject to limits on the rates of interest they may pay on brokered and other deposits. Based on its capital ratios as of December 31, 1993, the Bank would be deemed to be "well capitalized" under the prompt corrective action regulations. Due to the fact that the Bank is subject to the Capital Directive, however, the Bank is deemed to be "adequately capitalized" under these regulations. As such, the Bank may not accept brokered deposits without the prior waiver from the FDIC, but it is not subject to any of the above restrictions with respect to "undercapitalized" institutions. Deposit Insurance Assessments In order to implement the recapitalization of the BIF pursuant to FDICIA, the FDIC has established a schedule to increase the reserve ratio of the BIF to 1.25% of insured deposits by January 1, 2002, and may impose higher deposit insurance premiums on BIF members, if necessary, to achieve that ratio. Each institution is placed in one of nine risk categories using a two-step process. First, a bank will be assigned to one of three groups based on whether it is "well capitalized," "adequately capitalzied," or "undercapitalized" based on the same definitions contained in Page 12 of 249 the prompt corrective action regulations discussed above. Second, a bank will be assigned to one of three subgroups based on an evaluation of the risk posed by the bank. Based on these new classifications, the FDIC has adopted an insurance premium schedule under which the healthiest banks will pay 23 cents per $100 of deposits, which is the same rate previously in effect. The rates increase incrementally to a top rate of 31 cents per $100 of deposits for the weakest banks. The Bank does not presently expect that any increased BIF insurance assessments which are reasonably foreseeable would significantly impair the Bank's overall financial condition or results of operations. FDICIA contains numerous other provisions, including new accounting, audit and reporting requirements, the termination (beginning not later than January 1, 1995) of the "too big to fail" doctrine except in special cases, new regulatory standards in areas such as asset quality, earnings and compensation, and revised regulatory standards for, among other things, powers of state chartered banks, real estate lending, branch closures, and capital adequacy. The full impact of FDICIA will not be completely known until the enactment by the various federal banking agencies of all the underlying regulations implementing the new legislation's provisions. However, it is anticipated that FDICIA will result in increased costs for the banking industry due to higher FDIC assessments, higher costs of compliance and recordkeeping, and more limitations on the activities of all but the most well capitalized banks. FIRREA The Bank may also be affected on an ongoing basis by various provisions of the Financial Institutions Reform, Recovery and Enforcement Act of 1989 ("FIRREA"). FIRREA empowers regulatory authorities to use their "cease-and-desist" authority to require institutions to take certain affirmative actions. Such cease-and-desist orders may include restricting the growth of the institution, disposing of any loan or assets, rescinding agreements or contracts, employing qualified officers or employees or taking other actions. Regulatory agencies also have the authority to order restitution where an institution or "institution-affiliated party" (a term which does not include bank holding companies) was "unjustly enriched" or recklessly disregarded the law. Page 13 of 249 OTHER MATTERS GOVERNMENTAL POLICIES AND ECONOMIC CONDITIONS The earnings and business of the Company and the Bank are and will be affected by a number of external influences, including general economic conditions in New Hampshire and New England and the policies of various regulatory authorities. Important functions of the FRB, in addition to those enumerated under "SUPERVISION AND REGULATION" on page 7 of this Report, are to regulate the supply of money and of bank credit, to deal with general economic conditions within the United States and to be responsive to international economic conditions. Among the means available to the FRB to affect the money supply are open market operations in U.S. Government securities, changes in the discount rate on member bank borrowings, and changes in reserve requirements against member bank deposits. These means are used in varying combinations to influence overall growth and distribution of bank loans, investments and deposits, and their use may affect interest rates charged on loans or paid for deposits.From time to time, the FRB has taken specific steps to control domestic inflation and to control the country's money supply. FRB monetary policies have materially affected the operating results of commercial banks in the past and are expected to continue to do so in the future. The nature of future monetary policies and the effect of such policies on the business and earnings of the Company cannot be predicted. Economic fundamentals indicated that U.S. economic activity strengthened during 1993 and, most economists believe, should continue to show improvement in 1994. Similarly, during 1993, the New Hampshire economy showed definite signs of improvement. For example, the unemployment rate declined to a four year low of 5.3% in November, 1993, sales of existing homes have increased during the last several years and building permits issued for new privately-owned housing units have risen since 1991. In addition, property values appear to have stabilized, and there was a modest increase in the average sale price of homes from $113,000 in 1992 to $115,000 in 1993. Overall, the Company remains optimistic that these favorable trends will continue, and anticipates that these economic factors will have a positive effect on its 1994 operating results. The impact upon the future business and earnings of the Company, of prospective economic and political conditions, and of the policies of the FRB as well as other regulatory authorities, cannot be precisely determined at this time. This section should be read in conjunction with "Management's Financial Review" contained in the Company's 1993 Annual Report to Stockholders on pages 10 through 28 of this Report, filed as Exhibit 1, which is incorporated herein by reference. Page 14 of 249 Table of Contents of Statistical Information Page No. I. A. Distribution of Assets, Liabilities, and Stockholders' Equity 15 B. Interest Income and Expense 16 C. Interest Rates 17 D. Volume and Rate Analysis 18 II. Investment Securities 19 III. A. Loans 20 B. Maturities and Interest Rate Sensitivity of Loans 21 C. Nonperforming Assets 22 IV. A. Analysis of Allowance for Possible Loan Losses 23 B. Allocation of Allowance for Possible Loan Losses 24 V. Deposits 25 VI. Return on Equity and Assets and Other Ratios 25 VII. Federal Funds Purchased and Securities Sold Under Agreements to Repurchase 26 VIII. Trust Data 27 Page 15 of 249 I. A. Distribution of Assets, Liabilities and Stockholders' Equity The following Table presents, for the years indicated, the average balances of each principal category of assets, liabilities and stockholders' equity of the Company. Page 16 of 249 I. B. Interest Income and Expense The following Table presents, for the years indicated, interest income on earning assets on a fully taxable equivalent ("FTE") basis, interest expense on interest-bearing liabilities and net interest income. Interest earned from loans includes fees earned on loans. Page 17 of 249 I. C. Interest Rates The following Table presents, for the years indicated, the interest rate earned on average earning assets, on an FTE basis, and the interest rate paid on average interest-bearing liabilities: ____________________ (1) For the calculation of rate earned on loans, non-accrual and restructured loans are included in the average amounts outstanding. (2) Interest rate spread is the average rate earned on total earning assets less the average rate paid for interest-bearing liabilities. (3) Interest rate margin is calculated by dividing net interest income by total earning assets. Page 18 of 249 I. D. Volume and Rate Analysis The following Table presents an analysis of the effect on net interest income, on an FTE basis, of volume and rate changes for 1993 as compared with 1992. The effect of changes due to both volume and rate have been allocated to the change in volume and change in rate categories in proportion to the relationship of the absolute dollar amounts of the change in each category. Page 19 of 249 II. Investment Securities The following Table presents, for the years indicated, the book values of investment securities of the Company: The following Table presents the relative maturities at book value and weighted average interest rates of investment securities at December 31, 1993. The Parent Company's investment in equity securities having a book value of $606,000 is not included in the Table. Weighted average rates on tax-exempt obligations have been computed on an FTE basis assuming a tax rate of 34%. The rates are calculated by dividing annual interest, net of amortization of premiums and accretion of discounts, by the book value of the securities at December 31, 1993: Page 20 of 249 III. A. Loans The balance of loans outstanding and the percent, for each cate gory, of loans to total loans at the dates indicated are shown in the following Tables. The Company does not have an automatic renewal policy for maturing loans. Rather, loans are renewed at the maturity date only at the request of those customers who are deemed to be creditworthy by the Company. Additionally, the Company reviews such requests in substantially the same manner as applications by new customers for extensions of credit. The maturity date and interest terms of renewed loans are based, in part, upon the needs of the individual customer and the Company's credit review and evaluation of current and future economic conditions. Since these factors have varied considerably and will most likely continue to do so, the Company believes it is impracticable to estimate the amount of loans in the portfolio which may be renewed in the future. Page 21 of 249 III. B. Maturities and Interest Rate Sensitivity of Loans The following Table presents the maturities and interest rate sensitivity, based on original contractual terms, of the Company's loans exclusive of residential real estate construction loans and loans secured by residential properties and installment loans as of December 31, 1993: Page 22 of 249 III. C. Nonperforming Assets The following Table summarizes the Company's nonperforming assets: Substantially all of the nonaccrual loans at December 31, 1993 are secured. At December 31, 1993, the Company had $19.8 million in commercial loans which are not 90 day past due, restructured, or on nonaccrual but which are internally rated substandard, defined as inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any, with well defined weakness(s) that jeopardize the liquidation of the debt. The following information and analysis of unrecorded interest income relates to loans on nonaccrual and/or restructured loans at December 31: Page 23 of 249 IV. A. Analysis of Allowance for Possible Loan Losses The Company's allowance for possible loan losses (the "APLL") is available for future charge-offs of loans. The provision for possible loan losses (the "Provision"), added to the APLL by charges to income, is based upon management's estimation of the amount necessary to maintain the APLL at an adequate level, considering evaluations of individual credits and concentrations of credit risk, net losses charged to the APLL, changes in the quality of the loan portfolio, levels of nonaccrual loans, current economic conditions, changes in the size and character of the loan risks and other pertinent factors warranting current recognition. The Company charges all or a portion of a loan against the APLL when a probability of loss has been established, with consideration given to such factors as the customer's financial condition, underlying collateral and guarantees. In addition, the Company's independent certified public accountants perform reviews of the loan portfolio. The loans of the Company are also subject to periodic examination by bank regulatory authorities. The following Table presents a five year analysis of the Company's allowance for possible loan losses. Page 24 of 249 IV. B. Allocation of Allowance for Possible Loan Losses The Company's allowance for possible loan losses is a general reserve available for all categories of possible loan loss. The Company has made an allocation of its reserve giving consideration to management's evaluation of risk in the portfolios. The allocations are based on estimates and subjective judgments and are not necessar ily indicative of the specific amounts or loan categories in which losses may ultimately occur. The following Table presents a four year analysis of the allocation of the reserve by loan categories. For the percentage of loans outstanding in each category to total loans, refer to the Table "Loans" on page 21. Page 25 of 249 V. Deposits The average daily amount of deposits and rates paid on such deposits is summarized for the years indicated in the following Table: The maturity schedule of time certificates of deposit of $100,000 or more at December 31, 1993, is as follows (in thousands): VI. Return on Equity and Assets and Other Ratios The ratio of net income (loss) to average stockholders' equity ("ROE") and average total assets ("ROA") and certain other ratios for the last three years are presented below: Page 26 of 249 VII. Federal Funds Purchased and Securities Sold Under Agreements to Repurchase The following Table presents the distribution of the Company's federal funds purchased and securities sold under agreements to repurchase and the weighted average interest rates thereon at the end of each of the last three years. Also provided are the maximum amount of these borrowings and the average amount of these borrowings as well as weighted average interest rates for the last three years. Page 27 of 249 VIII. Trust Data The following presents information with respect to Trust Investments and Trust Accounts for which the Bank has both sole and shared investment responsibility at December 31, 1993. (1) Assets for which the Bank has shared investment responsibility (2) Predominantly invested in certificates of deposit Page 28 of 249 ITEM 2. ITEM 2. PROPERTIES The Company's headquarters occupies a portion of the Bank's building at 300 Franklin Street, Manchester, New Hampshire, and the Company conducts its meetings of the Board of Directors at the Bank's Data Services Center at John Devine Drive, Manchester, New Hampshire. The Bank owns or leases numerous premises used in the conduct of the business of the Company. The Company does not own or lease any real property, other than a branch office in Portsmouth, which is sub-let to the Bank. Additional information on the Bank's properties is set forth in Note H on page 38 of the Company's 1993 Annual Report to Stockholders, filed as Exhibit 1, and such information is hereby incorporated by reference. ITEM 3. ITEM 3. LEGAL PROCEEDINGS Various actions and proceedings are presently pending to which the Company and the Bank are parties. All such actions are deemed to be ordinary routine litigation incidental to the business of the Company and/or the Bank. Resolution of these matters is not expected to have a material effect on the consolidated financial statements of the Company. ITEM 3A. EXECUTIVE OFFICERS OF THE COMPANY The names, positions, ages and backgrounds of the executive officers of the Company, as of March 11, 1994 are set forth below. Executive officers are generally elected annually by the Board of Directors and hold office until the following year and until their successors are chosen and qualified, unless they sooner resign, retire, die, are removed or become disqualified. There are no family relationships existing between or among any of the executive officers listed below. Names Position Age Davis P. Thurber Chairman of the Board, 68 President, and Director of Company; Chairman of the Board and Director of Bank Paul R. Shea Executive Vice President and 61 Director of Company; Director, President and Chief Executive Officer of Bank Gregory D. Landroche Senior Vice President, Chief 45 Financial Officer and Treasurer of Company and Chief Financial Officer of Bank Alice L. DeSouza Senior Vice President/ 49 Administration & Planning of Company; Executive Vice President/Administration and Retail Banking of Bank Page 29 of 249 Names Position Age Robert J. McDonald Senior Vice President/Loan 44 Administration of Company Allen G. Tarbox, Jr. Senior Vice President/Data 59 Services of Company and Director of Information Systems of Bank William D. Biser Vice President/Auditor 52 of Company Robert A. Boulay Vice President/Controller 40 of Company Robert B. Field, Jr. Director and Secretary of 51 Company Mr. Thurber became a Director of the Bank in 1949, and joined The Second National Bank of Nashua, a predecessor to the Bank, in 1956 as Assistant Cashier, and became President in 1962, and, Chairman and President in 1969. On March 27, 1981, Mr. Thurber was re-elected President and Chairman of the Board of Directors of the Company. He is additionally Chairman of the Board of Directors of the Bank. Mr. Shea has served the Company since October 16, 1980, when he was appointed Assistant to the Chairman. On December 22, 1982, he was elected Vice President, Corporate Planning. On June 26, 1985, he was elected Senior Vice President, Corporate Planning, and on December 18, 1985, he was elected Senior Vice President, Corporate Development of the Company. On July 22, 1987, he was elected Executive Vice President. On October 21, 1991, he was elected President and Chief Executive Officer of the Bank. He also serves as a Director of the Company and the Bank. Mr. Landroche was elected Controller of the Company on September 28, 1983, was elected Vice President, Controller of the Company on June 26, 1985, and was elected Vice President, Treasurer of the Company on December 17, 1986. On July 22, 1987, he was elected Senior Vice President, Chief Financial Officer and Treasurer of the Company. On July 22, 1992 he was elected Chief Financial Officer of the Bank. Mr. Landroche is a Certified Public Accountant. Ms. DeSouza was elected Vice President, Director of Marketing of the Bank in November, 1981. On December 18, 1985, she was elected Vice President, Marketing Services of the Company. On July 22, 1987, she was elected Senior Vice President, Planning and Marketing for the Company. Early in 1991, her duties were expanded to include administration, and, as of October, 1991, she became Senior Vice President, Administration & Planning of the Company. On July 22, 1992 she was elected Executive Vice President, Administration and Retail Banking of the Bank. Page 30 of 249 Mr. McDonald was elected Senior Vice President, Loan Administration of the Company on June 24, 1992. During the five years prior thereto, Mr. McDonald was employed by Bank of Boston Corporation, most recently as a Vice President in the Financial Institutions Division. Mr. Tarbox was elected Senior Vice President, Data Services of the Company on July 25, 1990. During the five years prior thereto, Mr. Tarbox was President of Fleet/Norstar Services-NH. On July 22, 1992 he was elected Director of Information Systems of the Bank. Mr. Biser was elected Vice President, Auditor of the Company in September, 1987. Mr. Biser is a Certified Public Accountant. Mr. Boulay was elected Controller of the Company on December 17, 1986. On February 24, 1988, he was elected Vice President of the Company. Mr. Boulay is a Certified Public Accountant. Mr. Field was elected as a Director and Secretary of the Company on March 27, 1981, and served as a Director of the Bank, until February 22, 1989. His principal employment during the past five years is as a practicing attor- ney-at-law, director and member of Sheehan, Phinney, Bass + Green, Professional Association. Mr. Field's law firm has served as general counsel for the Company and as general, or special counsel, for the Bank since April 13, 1981. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURTIY HOLDERS Not applicable Part II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The information required by this item is presented on page 27 of the Company's 1993 Annual Report to Stockholders, filed as Exhibit 1, and such information is hereby incorporated by reference. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The consolidated "Summary of Selected Financial Data" of the Company for the five years ended December 31, 1993 appears on page 26 of the Company's 1993 Annual Report to Stockholders, filed as Exhibit 1, and such information is hereby incorporated by reference. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION The information in response to this item is included in Manage- ment's Financial Review on pages 10 through 28 of the Company's 1993 Annual Report to Stockholders, filed as Exhibit 1, and such information is hereby incorporated by reference. Page 31 of 249 ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The financial statements and supplementary data required by this Item are included as indicated below in the Company's 1993 Annual Report to Stockholders, filed as Exhibit 1, and such statements and data are hereby incorporated by reference. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY The information which responds to this Item is contained, with respect to directors, on pages 4 and 5 of the Company's Proxy Statement for its 1994 Annual Meeting of Stockholders, filed as Exhibit 2. Information concerning the executive officers of the Company which responds to this Item is contained in the response to Item 3A contained in Part I, on pages 28 through 30, of this Report. The foregoing information is hereby incorporated by reference. Page 32 of 249 ITEM 11. ITEM 11. EXECUTIVE COMPENSATION The information required in response to this Item is contained on pages 9 through 14 of the Company's Proxy Statement for its 1994 Annual Meeting of Stockholders, filed as Exhibit 2. The foregoing information is hereby incorporated by reference. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required in response to this Item is contained on pages 2, 3, 7 and 8 of the Company's Proxy Statement for its 1994 Annual Meeting of Stockholders, filed as Exhibit 2. The foregoing information is hereby incorporated by reference. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required in response to this Item is contained on pages 2, 3 and 9 of the Company's Proxy Statement for its 1994 Annual Meeting of Stockholders, filed as Exhibit 2. The foregoing information is hereby incorporated by reference. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) 1. Financial Statements The financial statements required in response to this Item are listed in response to Item 8 on page 31 of this Report and are incorporated herein by reference. (a) 2. Financial Statement Schedules Schedules have been omitted because the information is either not required, not applicable, or is included in the financial statements or notes thereto listed in response to Item 8 on page 31 of this Report and are incorporated herein by reference. Page 33 of 249 (B) FILED BY ENCLOSURE: Form 10-K Document Consecutive Page No. (a) 4. During the fourth quarter of 1993, the Company filed no Reports on Form 8-K. * - Management contract or compensatory plan. Page 35 of 249 DOCUMENTS INCORPORATED BY REFERENCE Exhibit 1 - 1993 Annual Report to Shareholders of the Company Exhibit 2 - Notice of 1994 Annual Meeting of Shareholders and Proxy Statement Page 36 of 249 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, in the City of Manchester, New Hampshire on the 23rd day of March, 1994. Bank of New Hampshire Corporation By:/s/Davis P. Thurber Davis P. Thurber, Chairman 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 Company and in the capacities and on the dates indicated. Date: Date: 3/23/94 /s/Davis P. Thurber 3/23/94 /s/Gregory D. Landroche Davis P. Thurber Gregory D. Landroche President, Chairman SVP/CFO & Treasurer and Director (Principal Financial (Principal Executive Officer) Officer) 3/23/94 /s/Paul R. Shea 3/23/94 /s/Robert A. Boulay Paul R. Shea Robert A. Boulay Executive Vice President VP & Controller and Director (Principal Accounting Officer) 3/23/94 /s/Robert L. Bailey 3/23/94 /s/Sidney Thurber Cox Robert L. Bailey Sidney Thurber Cox Director Director 3/23/94 /s/Robert P. Bass, Jr. 3/23/94 /s/Raymond J. Creteau Robert P. Bass, Jr. Raymond J. Creteau Director Director 3/23/94 /s/Robert B. Field, Jr. Arthur E. Comolli Robert B. Field, Jr. Director Director and Secretary 3/23/94 /s/Raymond G. Cote 3/23/94 /s/Morton E.Goulder Raymond G. Cote Morton E. Goulder Director Director Page 37 of 249 3/23/94 /s/Joseph G. Sakey Philip deG. Labombarde Joseph G. Sakey Director Director 3/23/94 /s/Floyd A. Lamb 3/23/94 /s/George R. Walker Floyd A. Lamb George R. Walker Director Director 3/23/94 /s/Daniel R.W. Murdock Daniel R.W. Murdock Richard S. West Director Director 3/23/94 /s/Constance T. Prudden Constance T. Prudden Director

1993 Item 1. Business General Compaq Computer Corporation, founded in 1982, designs, develops, manufactures, and markets personal computers, PC systems, and related products for sale primarily to business, home, government, and education customers. The Company operates in one principal industry segment across geographically diverse markets. As used herein, the term "Company" means Compaq Computer Corporation and its consolidated subsidiaries, unless the context indicates otherwise. In 1993 the Company focused its business activities on increasing the Company's market share by expanding sales to new customers while augmenting sales to its existing customer base. The Company plans to capitalize on its leadership position in integrating hardware and software to furnish the building blocks of personal and corporate computing while participating in software and communications markets either directly or through business alliances. Through this strategy, the Company expects to become the leading computer platform provider in the information technology industry by offering the products and services that customers need to easily access and manage information. The Company believes its key to success is leveraging the Company's engineering talent, purchasing power, manufacturing capabilities, distribution strengths, and brand name to bring to market high-quality cost- competitive products with different features in different price ranges. Compaq Products The Company offers a wide range of personal computing products, including desktop personal computers, battery-powered notebook computers, AC-powered portable computers, and tower PC systems that store and manage data in network environments. The Company's products are available with a broad variety of functions and features designed to accommodate a wide range of user needs. Each of the Company's PC products is backed by a three-year worldwide warranty, the most comprehensive in the industry. In 1993 sales of desktop personal computers accounted for 56% of the Company's CPU sales, which exclude option sales. The Deskpro product line is the Company's vehicle for delivering high-performance and advanced features to the business user. The ProLinea value line products, the Company's leading unit sellers in 1993, include the "all-in-one" Compaq ProLinea Net 1/25s featuring an integrated monitor, a network interface card, and Energy Star compliant low power mode. The easy-to-use Presario family of personal computers for the home and small business market includes new multi-media PCs introduced in November offering a double-speed CD-ROM drive, stereo sound, external stereo speakers, a microphone, and a choice between family or small office pre-installed software and CD-ROM programs. Sales of portable personal computers accounted for 32% of the Company's CPU sales in 1993. In October the Company continued its strong leadership in portable computing by announcing the Compaq Concerto, the first fully-featured notebook personal computer to offer interactive use of keyboard and pen. The Company's most popular notebook product line in 1993 was the COMPAQ Contura family, which was expanded in March to include models featuring the battery efficiency and high performance of the 486SL microprocessor and advanced displays. In September 1993 the Company introduced the Compaq Proliant family of tower computers, a line of advanced server products coupled with new service, support, and management capabilities. The ProLiant family includes one, two, or four processor models and features SmartStart, a set of CD-ROM-based utilities for intelligent hardware configuration and operating system installation. The Company's leading unit seller in 1993 in its PC systems products was the COMPAQ Prosignia line, which received a Product of the Year award from InfoWorld in the network hardware category. Sales of PC system products accounted for 10% of the Company's CPU sales in 1993. In December 1993 the Company announced its plans to withdraw from the printer market to devote its resources to other opportunities that provide a more effective leverage of the Company's market leadership and technological strengths. The Company will continue to offer the existing PageMarq product line during the first half of 1994. Customers purchasing a PageMarq product will receive a full range of support offerings, including consumables, 7x24 hotline support, technical assistance, and service for its printer products. The Company offers a number of options products for its desktop, portable, and systems products, including add-on video display monitors and communications products. Its products for its systems customers include the Dual Port Ethernet Controller, a high performance controller that combines two bus-master Ethernet controllers on one board in a single slot, and Compaq UPS, a new integrated power supply with battery backup that along with Insight Manager can initiate a controlled shutdown if power fails. In October 1993 the Company announced TabWorks, an easy-to-use icon-based software that is designed to look and function like a three-ring binder and offers an alternative to the Windows Program Manager for organizing and accessing documents. Product Development The Company is actively engaged in the design and development of additional products and enhancements to its existing products. During 1993, 1992, and 1991, the Company expended $169 million, $173 million, and $197 million, respectively, on research and development. Since personal computer technology develops rapidly, the Company's continued success is dependent on the timely introduction of new products with the right price and features. Its engineering effort focuses on new and emerging technologies as well as design features that will increase efficiency and lower production costs. In 1993 the Company focused on technological developments for PC products related to color and monochrome active and passive matrix flat panels, power conservation, communication devices, full-motion video and stereo sound, pen-based PCs, and component densification, as well as new technologies applicable to future products such as small form-factor devices. Many of the Company's products utilize technology developed in alliances with third parties. Technological and development alliances have become increasingly important in the information management sector and the Company believes that its size and technological skills give it an advantage forming such relationships. In September 1993 the Company announced two strategic alliances. The Company and Novell, Inc. signed a formal agreement to define a broad set of coordinated activities, including the design of integrated hardware and software platforms and the development of industry-wide network testing standards and procedures. The Company also announced a joint effort with VLSI, Intel, and Microsoft to develop a hand-held mobile companion device. Manufacturing and Materials The Company's manufacturing operations consist of manufacturing finished products and various circuit boards from components and subassemblies that the Company acquires from a wide range of vendors. The Company's principal manufacturing operations are located in Houston, Texas; Erskine, Scotland; and Singapore. Products sold in Europe are manufactured primarily in the Company's facilities in Erskine, Scotland and Singapore. Products sold in the U.S. are primarily manufactured in the Company's facilities in Houston, Texas, and Singapore. Products sold in the Pacific Rim are primarily manufactured in Singapore while products sold in Latin America are primarily manufactured in Houston. The Company believes that there is a sufficient number of competent vendors for most components, parts, and subassemblies. A significant number of components, however, are purchased from single sources due to technology, availability, price, quality, or other considerations. Key components and processes currently obtained from single sources include certain of the Company's displays, microprocessors, application specific integrated circuits and other custom chips, and certain processes relating to construction of the plastic housing for the Company's computers. In addition, new products introduced by the Company often initially utilize custom components obtained from only one source until the Company has evaluated whether there is a need for an additional supplier. In the event that a supply of a key single-sourced material, process, or component were delayed or curtailed, the Company's ability to ship the related product in desired quantities and in a timely manner could be adversely affected. The Company attempts to mitigate these risks by working closely with key suppliers on product plans, strategic inventories, and coordinated product introductions. Like other participants in the personal computer industry, Compaq ordinarily acquires materials and components through purchase orders typically covering the Company's requirements for periods averaging 90 to 120 days. From time to time the Company has experienced significant price increases and limited availability of certain components that are available from multiple sources, such as dynamic random-access memory devices. In 1993 the Company was constrained by parts availability in meeting product orders. Any similar occurrences in the future could have an adverse effect on the Company's operating results. Marketing and Distribution The Company distributes its products principally through third-party computer resellers. In response to changing industry practices and customer preferences, the Company is continuing its expansion into new distribution channels, such as mass merchandise stores, consumer electronics outlets, and computer superstores. The Company's products are sold to large and medium- sized business and government customers through dealers, value-added resellers, and systems integrators and to small business and home customers through dealers, consumer channels, and beginning in March 1993 directly through the Company's DirectPlus mail order business that features a variety of personal computers, printers, and software products. Business customers account for the largest portion of the Company's revenues. Business customers are attracted to the Company's products for a variety of reasons, including the Company's reputation for reliability, price, product performance, and technological excellence, the availability of a wide variety of application software, ease of use, and connectivity solutions. In 1993 North American sales constituted 51% of the Company's total revenues and European sales constituted 38%. The Company's North America Division markets its products in the United States and Canada, while the Company's Europe Division, based in Munich, Germany, focuses on opportunities in Europe as well as in parts of Africa and the Middle East. The Company has Asia/Pacific, Japan and Latin America Divisions to focus on opportunities in these high growth areas. For further geographic information for 1993, 1992, and 1991, see the Management's Discussion and Analysis of Financial Results and Note 10 of Notes to Consolidated Financial Statements. Service and Support The Company provides support and warranty repair to its customers through full-service computer dealers and independent third-party service companies. Compaq offers its customers CompaqCare, which includes a number of customer service and support programs, most notably a three-year warranty on PC products (excluding monitors and batteries) and round-the-clock lifetime telephone technical support at no additional charge to the customer. Patents, Trademarks, and Licenses The Company held 203 patents (including 28 design patents) and had 262 patent applications (including 28 design patent applications) pending with the United States Patent and Trademark Office at the close of 1993. In addition, the Company has registered certain trademarks in the United States and in a number of foreign countries. While the Company believes that patent and trademark protection plays an important part in its business, the Company relies primarily upon the technological expertise, innovative talent, and marketing abilities of its employees. The Company has from time to time entered into cross-licensing agreements with other companies holding patents to technology used in the Company's products. The Company holds a license from IBM for all patents issued on applications filed prior to July 1, 1993. In the third quarter of 1993 the Company entered into a patent cross-license agreement with Texas Instruments, Inc. The Company agreed to pay Texas Instruments royalties for products sold from January 1, 1990 to January 31, 1993, and to make additional payments through December 31, 1997. Because of technological changes in the computer industry, extensive patent coverage, and the rapid rate of issuance of new patents, certain components of the Company's products may unknowingly infringe patents of others. The Company believes, based in part on industry practices, that if any infringements do exist, the Company will be able to modify its products to avoid infringement or obtain licenses or rights under such infringed patents on terms not having a material adverse effect on the Company. Seasonal Business Although the Company does not consider its business to be highly seasonal, the Company in general experiences seasonally higher sales and earnings in the first and fourth quarters of the year. The Company experienced an increase in the seasonality of its North American sales in the fourth quarter of 1993 as it expanded the consumer retail portion of its business and anticipates that this trend will continue. Working Capital Information regarding the Company's working capital position and practices is set forth in Item 7 of this Form 10-K under the caption "Liquidity and Capital Resources." Customers No customer of the Company accounted for 10% or more of sales for 1993. Intelligent Electronics, Inc. and Computerland, Inc. accounted for 9% and 7% of 1993 sales, respectively. Backlog The Company's resellers typically purchase products on an as-needed basis and resellers frequently change delivery schedules and order rates depending on market conditions. Unfilled orders can be, and often are, canceled at will and without penalties. In 1993 the Company was unable to produce certain products on a timely basis due to supply constraints on certain components. Should the Company continue to be unable to meet demand for its products on a timely basis, customer satisfaction and sales could be adversely affected. In the Company's experience the actual amount of unfilled orders at any particular time is not a meaningful indication of its future business prospects since orders rapidly become balanced as soon as supply begins meeting demand. Competition The computer industry is intensely competitive with many U.S., Japanese, and other international companies vying for market share. The market continues to be characterized by rapid technological advances in both hardware and software development that have substantially increased the capabilities and applications of information management products and have resulted in the frequent introduction of new products. The principal elements of competition are price, product performance, product quality and reliability, service and support, marketing and distribution capability, and corporate reputation. While the Company believes that its products compete favorably based on each of these elements, the Company could be adversely affected if its competitors introduce innovative or technologically superior products or offer their products at significantly lower prices than the Company. No assurance can be given that the Company will have the financial resources, marketing and service capability, or technological knowledge to continue to compete successfully. The Company results could also be adversely affected should it be unable to implement effectively its technological and marketing alliances with other companies, such as Microsoft, Intel, Sharp, Novell, and VLSI and manage the competitive risks associated with these relationships. Environmental Laws and Regulations The Company has eliminated chlorofluorocarbons (CFCs) from its worldwide manufacturing operations and undertakes ongoing environmental programs, including energy efficiency, recycling, design for environment, waste reduction, and environmental auditing. Compliance with laws enacted for protection of the environment to date has had no material effect upon the Company's capital expenditures, earnings, or competitive position. Although the Company does not anticipate any material adverse effects in the future based on the nature of its operations and the purpose of environmental laws and regulations, there can be no assurance that such laws or future laws will not have a material adverse effect on the Company. Employees At December 31, 1993, the Company had 10,541 full-time regular employees and 2,500 temporary and contract workers. Item 2. Item 2. Properties The Company's principal administrative facilities and a manufacturing facility are located in Houston, Texas. They include 860,000 square feet of manufacturing space on the Company's 1,000-acre Compaq Center in Houston and an additional 70,000 square feet of manufacturing space under leases. The Company owns 13 administrative buildings with a total of 2,600,000 square feet of space at Compaq Center. The Company also owns or leases certain facilities abroad. In Erskine, Scotland the Company owns a 43-acre tract where it has 540,000 square feet of manufacturing space. In Singapore the Company owns 360,000 square feet of manufacturing space and leases an additional 128,000 square feet. In 1993 the Company began operations in its 372,000 square-foot distribution facility in Gorinchem, The Netherlands. The Company moved into its 80,000 square-foot marketing facility in Madrid, Spain in February 1993. In 1993 the Company entered into an agreement to lease a 200,000 square foot administrative building to be constructed to house its European headquarters. The facility will be built on a twelve-acre tract that the Company previously planned to acquire. Item 3. Item 3. Legal Proceedings In May 1991 a number of class action lawsuits were filed in the United States District Court for the Southern District of Texas, Houston Division. These suits were consolidated into a single class action suit in June 1991. The action is brought on behalf of all persons who purchased Compaq common stock or options from December 18, 1990, through May 14, 1991, and the named defendants include the Company and certain of its current and former officers and directors. The second amended consolidated complaint alleges, among other things, that through certain public statements the defendants misled investors regarding a deterioration in the Company's markets and the demand for its products, marketing problems such as pricing pressure from competitors and reduced dealer loyalty, and other industry and Company conditions. The actions are brought under provisions of the federal securities laws, including Section 10(b) and Rule 10b-5 under the Securities Exchange Act of 1934, provisions of Texas law, and common law principles of fraud and negligence. The complaint seeks damages in an unspecified amount. On October 2, 1993, the defendants filed a motion to dismiss, which the court on October 28, 1993, converted to a motion for summary judgment. On December 28, 1993, the Court granted in part and denied in part the defendants' motion. Allegations similar to those contained in the federal action have been made in individual suits brought by certain stockholders in Texas State Court in Houston. In May 1991 Michael Ashkenazi and Herbert Kestenbaum brought a derivative action against the Company and certain of its current and former officers and directors. The complaint was brought in the District Court of Harris County, Texas, 61st Judicial District. The complaint alleges that the individual defendants breached their fiduciary duty to the Company under principles of common law by misleading investors through certain public statements. The allegations of misleading statements and/or omissions are similar to the allegations made in the class action complaints. The complaint also alleges that sales of Company stock made by eight of the defendants were made while those defendants were in possession of material adverse information and were therefore in violation of their fiduciary duties. The plaintiffs ask that the individual defendants pay to the Company any profits that they may have made as a result of such stock sales and all other damages that may be incurred by the Company as a result of the individual defendants' alleged actions. The Company has been named as a defendant in a number of repetitive stress injury lawsuits, primarily in New York state courts or federal district courts for the New York City area. In each of these lawsuits the plaintiff alleges that he or she suffers from symptoms generally known as repetitive stress injury, which allegedly were caused by the design of the keyboard supplied with the computer the plaintiff used. The suits naming the Company are similar to those filed against other major suppliers of personal computers. Ultimate resolution of the litigation against the Company may depend on progress on resolving this type of litigation overall. The Company is unable to determine at this time the outcome of these suits or the likelihood of the Company's being named in additional suits by plaintiffs' alleging similar injuries. The Company has denied the claims described in this Item 3 and intends to defend vigorously the suits. The Company believes that the claims will not have a material adverse effect on the Company's financial results of operations or its financial position. Item 4. Item 4. Submission of Matters to a Vote of Security Holders There were no matters submitted to a vote of security holders during the fourth quarter of 1993. PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters Market for Common Stock The Company's Common Stock is listed on the New York Stock Exchange and trades under the symbol CPQ. The following table presents the high and low sale prices for the Company's Common Stock for each quarter of 1993 and 1992, as reported by Dow Jones Historical Stock Quote Reporter Service. High Low 1993: 1st quarter $ 58 1/2 $ 41 3/4 2nd quarter 61 3/4 46 1/8 3rd quarter 59 5/8 43 1/8 4th quarter 75 3/4 57 1992: 1st quarter $ 35 1/2 $ 25 5/8 2nd quarter 29 1/2 22 1/4 3rd quarter 35 1/8 24 1/4 4th quarter 49 7/8 31 Holders of Record At January 31, 1994, there were 6,065 holders of record of the Company's common stock. Dividends The Company has never paid cash dividends on its common stock. It is the present policy of the Board of Directors to retain all earnings for use in the Company's business. Registration Statements on Form S-8 For the purposes of complying with the amendments to the rules governing Form S-8 under the Securities Act of 1933, the undersigned registrant hereby undertakes as follows, which undertaking shall be incorporated by reference into registrant's Registration Statements on Form S-8 Nos. 33-44115, 33-31819, 33-23504, 33-7499, 2-89925, 33-10106, 33-38044, and 33-16987. That, insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers and controlling persons of the Registrant pursuant to any provision or arrangement whereby the Registrant may indemnify a director, officer, or controlling person of the Registrant against liabilities arising under the Securities Act, or otherwise, the Registrant has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Act and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the Registrant of expenses incurred or paid by a director, officer, or controlling person of the Registrant in the successful defense of any action, suit, or proceeding) is asserted by such director, officer, or controlling person in connection with the securities being registered, the Registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Act and will be governed by the final adjudication of such issue. Item 6. Item 6. Selected Consolidated Financial Data The following data have been derived from consolidated financial statements that have been audited by Price Waterhouse, independent accountants. The information set forth below is not necessarily indicative of the results of future operations and should be read in conjunction with the consolidated financial statements and notes thereto appearing elsewhere in this Annual Report on Form 10-K. Year ended December 31, In millions, except per share amounts 1993 1992 1991 1990 1989 - -------------------------------------------------------------------------- Consolidated Statement of Income Data: Sales $ 7,191 $ 4,100 $ 3,271 $ 3,599 $ 2,876 Cost of sales 5,493 2,905 2,053 2,058 1,715 ------------------------------------------------- 1,698 1,195 1,218 1,541 1,161 ------------------------------------------------- Research and development costs 169 173 197 186 132 Selling, general, and administrative expense 837 699 722 706 539 Unrealized gain on investment in affiliated company (34) (13) Other income and expenses, net 76 28 145 42 19 ------------------------------------------------- 1,082 900 1,064 900 677 ------------------------------------------------- Income from consolidated companies before provision for income taxes 616 295 154 641 484 Provision for income taxes 154 97 43 216 165 ------------------------------------------------- Income from consolidated companies 462 198 111 425 319 Equity in net income of affiliated company 15 20 30 14 ------------------------------------------------- Net income $ 462 $ 213 $ 131 $ 455 $ 333 ================================================= Earnings per common and common equivalent share: Primary $ 5.45 $ 2.58 $ 1.49 $ 5.14 $ 3.89 ================================================= Assuming full dilution $ 5.35 $ 2.52 $ 1.49 $ 5.12 $ 3.88 ================================================= December 31, In millions 1993 1992 1991 1990 1989 - -------------------------------------------------------------------------- Consolidated Balance Sheet Data: Total assets $ 4,084 $ 3,142 $ 2,826 $ 2,718 $ 2,090 Long-term debt 73 74 274 Stockholders' equity 2,654 2,006 1,931 1,859 1,172 Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations The following discussion should be read in conjunction with the consolidated financial statements. Results of Operations The following table presents, as a percentage of sales, certain selected consolidated financial data for each of the three years in the period ended December 31, 1993. Year ended December 31, 1993 1992 1991 - -------------------------------------------------------------------------- Sales 100.0 % 100.0 % 100.0 % Cost of sales 76.4 70.9 62.8 ----------------------------- Gross margin 23.6 29.1 37.2 ----------------------------- Research and development costs 2.3 4.2 6.0 Selling, general, and administrative expense 11.6 17.0 22.1 Other income and expense, net 1.1 0.7 4.4 ----------------------------- 15.0 21.9 32.5 ----------------------------- Income from consolidated companies before provision for income taxes 8.6 % 7.2 % 4.7 % ============================= Sales Sales for 1993 increased approximately 75% over the prior year as compared with an increase of 25% in 1992 from 1991. In 1993 the geographic mix of sales shifted as sales in the United States and Canada and Asia Pacific increased at a faster pace than in Europe. North American sales, which include Canada, increased 100% during 1993, compared with an increase of 32% in 1992 from 1991. International sales, excluding Canada, represented 49% of total sales in 1993 as compared with 55% in 1992 and 58% in 1991. European sales increased 44% during 1993 compared to an increase of 9% in 1992 from 1991. Other international sales, excluding Canada, increased 111% during 1993, compared with an increase of 139% in 1992 from 1991. The Company believes that the lower comparable rate of growth in Europe in 1993 was related to the weak European economy, the rapid expansion of the personal computer market in Asia and Latin America, and the increase in the consumer computer market in North America. The personal computer industry is highly competitive and marked by frequent product introductions, continual improvement in product price/performance characteristics, and a large number of competitors. The Company significantly altered its product line in 1993 by introducing 35 new notebook, desktop, and server computer models. Approximately 36% of the Company's CPU sales and 30% of the Company's sales in 1993 were derived from products introduced in 1993. These new products have been designed to allow the Company to achieve low product costs while maintaining the quality and reliability for which the Company's products have been known, thereby increasing the Company's ability to compete on price and value. The Company's significant increase in consolidated sales in 1993 stemmed primarily from an increase in the number of units sold. In 1993 the Company's worldwide unit shipments increased 98%, while they increased 78% in 1992. The 1993 increase included a 196% expansion in unit shipments of the Company's tower server CPU products. Unit growth primarily resulted from the Company's aggressively priced Compaq ProLinea line in its desktop products, the Compaq Contura portable lines, and the Compaq Prosignia products in its tower systems. The Company believes that the personal computer industry as a whole experienced significant increases in unit shipments in 1993, especially in North America, with industry unit growth worldwide according to third party estimates increasing approximately 20% in contrast to a 19% increase in 1992. Industry unit growth did not translate directly into sales growth because of significantly lower unit prices. Third-party estimates indicate that industry sales increased by approximately 16% worldwide in 1993, compared to an 11% increase in 1992. The Company's average sales price per unit decreased slightly in 1993 from 1992, primarily as a result of the lower prices of the Company's products aimed at the small business and consumer markets, pricing actions undertaken by the Company on existing products, and currency fluctuations. The relative stability in the Company's average sales price per unit resulted from a more stabilized pricing environment and a higher sales mix of units using 486 microprocessors. Price competition continues to have a significant impact on prices of the Company's products, especially those aimed at the consumer market, and additional pricing actions may occur as the Company attempts to maintain its competitive mix of price and performance characteristics. The Company attempts to mitigate the effect of any pricing actions through implementation of effective design-to-cost goals, the aggressive pursuit of reduced component costs, manufacturing efficiencies, and control of operating expenses. Gross Margin Gross margin as a percentage of sales declined to 23.6% in 1993, from 29.1% in 1992 and 37.2% in 1991, primarily as a result of industrywide competitive pressures and associated pricing and promotional actions. Although it appears that gross margin has stabilized in recent quarters, and the gross margin percentage during the fourth quarter of 1993 was 23.7% compared to 23.6% in the first nine months of 1993, there can be no assurance that currency fluctuations, competitive actions affecting pricing, or increases in product costs will not place additional pressure on gross margins. Although the Company continues to aggressively pursue the reduction of product costs both at the supplier and manufacturing levels, the Company anticipates that gross margins for its personal computers will remain under pressure and pricing actions in 1994 could result in further reductions of gross margin. The Company's operating strategy and pricing take into account changes in foreign currency exchange rates over time; however, the Company's results of operations may be significantly affected in the short-term by fluctuations in foreign currency exchange rates. When the value of the dollar strengthens against other currencies, sales made in those currencies translate into fewer dollars. The opposite effect occurs when the dollar weakens. The Company attempts to reduce the impact of currency movements on net income primarily through the use of forward exchange contracts that are used to hedge a portion of the net monetary assets of its international subsidiaries. The Company also utilizes forward exchange contracts and foreign currency options to hedge certain capital expenditures and inventory purchases. In 1992 the Company began to hedge a portion of the probable anticipated sales of its international marketing subsidiaries through the use of purchased currency options. The gains associated with the hedging of anticipated sales of the Company's international marketing subsidiaries, net of premium costs associated with the related purchased currency options, are included in sales and were $13 million in 1993 compared to $3 million in 1992. See "Other Items" below for the impact of translation gains and losses. Operating Expenses Research and development costs decreased in absolute dollars (to $169 million from $173 million) and as a percentage of sales in 1993 as compared to 1992. Because the personal computer industry is characterized by rapid product cycles and price cuts on older products, the Company believes that its long- term success is directly related to its ability to bring new products to market on a timely basis and to reduce the costs of new and existing products. Accordingly, it is committed to continuing a significant research and development program and research and development costs are likely to increase in absolute dollars in 1994. Selling, general, and administrative expense increased in amount in 1993 while declining as a percentage of sales. The decrease as a percentage of sales reflects the Company's ongoing efforts to manage operating expense growth relative to gross margin levels. The increase in absolute dollars was the result of higher domestic and international selling expense related to the entry into new markets (both domestically and internationally), the expansion of distribution channels, and a greater emphasis on advertising, sales and marketing programs, customer service, technical support, and general infrastructure. Advertising expense increased to $114 million in 1993 from $82 million in 1992. The Company continues to expand geographically, especially in Asia and Eastern Europe, and the ongoing costs necessary to penetrate successfully new international markets will cause additional selling, general, and administrative expense. The Company continues to face the challenge of managing growth in selling, general, and administrative expense relative to gross margin levels. The Company believes its ability to control operating expenses is an important factor in its ability to be price competitive and accordingly continues to pursue cost reduction alternatives throughout the Company. In an environment of increased efforts to penetrate new markets, greater diversity of distribution channels, and increased customer support, the Company may not be successful in identifying areas to cut additional costs. Other Items Interest expense, net of interest and dividend income from investment of excess funds, was $43 million, $12 million, and $6 million in 1993, 1992, and 1991, respectively. Net interest expense was higher in 1993 when compared to 1992 primarily due to increased interest expense associated with financing resellers' inventories, increased interest expense in connection with the Company's hedging program, and lower interest income due to lower levels of invested cash at lower rates of interest. Net interest expense was higher for 1992 than 1991 for similar reasons. The translation gains and losses relating to the financial statements of the Company's international subsidiaries, net of offsetting gains and losses associated with hedging activities related to the net monetary assets of these subsidiaries, are included in other income and expense and resulted in a net loss of $15 million in 1993, a net loss of $11 million in 1992, and a net gain of $4 million in 1991. In 1993 the Company recorded charges associated with its plans to withdraw from the printer business, including costs related to certain contractual liabilities and the write-downs of the carrying value of certain assets. The charge, net of the reversal of previously recorded restructuring reserves, totaled $10 million. In 1992 and 1991 the Company recorded restructuring charges associated principally with reducing the number of employees and consolidating and streamlining operations. The charges totaled $73 million in 1992 and $135 million in 1991. In addition, in 1992 and 1991 the Company had charges related to the disposition or write-downs of the carrying value of certain fixed assets. In the third quarter of 1992 the Company sold its equity interest in Conner Peripherals, Inc. ("Conner") realizing a gain of $86 million. The Company's ownership in Conner created an after-tax contribution to the Company's net income of $10 million in 1992 and $13 million in 1991. The Company's effective tax rate was 25% in 1993, 33% in 1992, and 28% in 1991. The decline in 1993 from 1992 is attributable to the Company's decision to invest indefinitely a portion of the undistributed earnings of the Company's Singaporean subsidiaries in operations outside the United States. The Company anticipates that it will continue this international investment strategy for several years. The Company has adopted the provisions of the Financial Accounting Standards Board's Statement No. 109 (FAS 109), Accounting for Income Taxes, changing the method of determining reported income tax expense. Adoption of the provisions of FAS 109 had an immaterial impact on the Company's financial statements. Liquidity and Capital Resources During 1993 the Company's working capital increased to $2.0 billion compared to $1.4 billion at December 31, 1992. The Company's cash and cash equivalents increased to $627 million at December 31, 1993, from $357 million at December 31, 1992, primarily because of positive cash flow from operating activities and cash received in connection with the exercise of employee stock options, partially offset by capital expenditures. Accounts receivable increased to $1.4 billion at December 31, 1993, from $1.0 billion at December 31, 1992. Accounts receivable days stood at 59 days at the end of 1993 compared to 62 days at the end of 1992. Inventory increased to $1.1 billion at December 31, 1993, from $834 million at December 31, 1992. The Company's higher levels of inventory, associated with higher sales levels, could adversely affect the Company in the event of a drop in worldwide demand for PC products. During 1993 the Company funded its capital expenditures and other investing activities with cash generated from operations and previously accumulated cash balances. The Company estimates that capital expenditures for land, buildings, and equipment during 1994 will be approximately $250 million. Such expenditures are currently expected to be funded from a combination of available cash balances, internally generated funds, and, if necessary, external financing. Although the Company fully expects that such expenditures will be made, it has commitments for only a small portion of such amounts. The Company's ability to fund its activities from operations is directly dependent on its rate of growth, inventory management, the terms and financing arrangements under which it extends credit to its customers, and the manner in which it finances any capital expansion. The Company currently expects to fund expenditures for capital requirements as well as liquidity needs created by changes in working capital from a combination of available cash balances, internally generated funds, and borrowings as appropriate. The Company from time to time may borrow funds for actual or anticipated funding needs or because it is economically beneficial to borrow funds for the Company's needs instead of repatriating funds in the form of dividends from its foreign subsidiaries. The Company has in place committed lines of credit totaling $300 million and a shelf registration of $300 million of debt securities, all of which were unused and available at December 31, 1993. The Company believes that these lines of credit and shelf registration provide financial flexibility to meet future funding requirements and to take advantage of attractive market conditions. Factors That May Affect Future Results The Company participates in a highly volatile industry that is characterized by dynamic customer demand patterns, rapid technological advances, and industry-wide competition resulting in aggressive pricing practices. The Company's operating results could be adversely affected should the Company be unable to accurately anticipate customer demand, to introduce new products on a timely basis, to manage lead times required to obtain components in order to be responsive to short-term shifts in customer demand patterns, to offer customers the latest competitive technologies while effectively managing the impact on inventory levels and the potential for customer confusion created by product proliferation, or to effectively manage the impact on the Company of industry-wide pricing pressures. The Company's results of operations also could be adversely affected, and inventory valuation reserves could result, if anticipated unit growth projections for new and current product offerings are not realized. In order to maintain or increase its market share, the Company must continue to price its products competitively, which lowers the average sales price per unit and may cause declines in gross margin. To compensate for the impact on its sales and profitability, the Company must increase unit shipments, aggressively reduce costs, and maintain tight control over operating expenses. The Company believes its pricing and product strategies are competitive and have created demand for its products and the Company is actively engaged in cost reduction programs. If the Company takes pricing actions and does not achieve significant unit shipment increases and cost reductions, however, there could be an adverse impact on sales and profitability. Because of the pace of technological advances in the personal computer industry, the Company must design and develop new and more sophisticated products in its core business while expanding its product offering into other markets. The Company's product strategy focuses in part on marketing products with distinctive features and at prices that appeal to a variety of purchasers. The Company designs many of its own components for its products. Across the Company's product range, however, certain elements of product strategy are dependent on technological developments by other manufacturers. There can be no assurance that the Company will obtain the delivery of the technology needed to introduce new products in a timely manner, will be able to obtain a sufficient supply of components utilizing such technology, or will be able to obtain any competitive advantage in access to such technology. If the Company were unable to develop and launch new products in a timely fashion, this failure could have a material adverse effect on the Company's business. During 1993 the Company continued to broaden its product distribution into new geographic locations and new sales channels. Certain of the Company's sales were to newly appointed resellers and new locations for sale of the Company's products as well as direct sales through the Company's mail order program. Offering its products in an increasing number of geographic locations and through a variety of distribution channels, including distributors, electronics superstores, and mail order, requires the Company to increase its geographic presence and to provide direct sales and support interface with customers. There can be no assurance, however, that this direction will be effective, or that the requisite service and support to ensure the success of the Company's operations in new locations or through new channels can be achieved without significantly increasing overall expenses. While the Company anticipates that its geographic expansion will continue and the number of outlets for its products will increase in 1994, a reduction in this growth could affect sales. The Company's primary means of distribution remains third-party resellers. While the Company continuously monitors and manages the credit it extends to resellers to limit its credit risk, the Company's business could be adversely affected in the event that the generally weak financial condition of third- party computer resellers worsens. In the event of the financial failure of a major reseller, the Company could experience disruptions in its distribution as well as the loss of the unsecured portion of any outstanding accounts receivable. The Company believes that the continued expansion of its distribution outlets and geographic growth will help mitigate any potential impact on its sales. The value of the U.S. dollar continues to affect the Company's financial results. The functional currency for the Company's international marketing subsidiaries is the U.S. dollar. When the U.S. dollar strengthens against other currencies, sales made in those currencies translate into fewer sales in U.S. dollars; and when the U.S. dollar weakens, sales made in local currencies translate into higher sales in U.S. dollars. Correspondingly, costs and expenses incurred in non-U.S. dollar currencies increase when the U.S. dollar weakens and decline when the U.S. dollar strengthens. Accordingly, changes in exchange rates may negatively affect the Company's consolidated sales (as expressed in U.S. dollars) and gross margins and the Company's results of operations can be significantly affected in the short term by fluctuations in foreign currency exchange rates. The Company engages in a program to hedge a portion of anticipated sales of its international marketing subsidiaries using purchased foreign currency options. In addition, the Company hedges its Japanese yen denominated purchase commitments through the use of forward exchange contracts and option contracts. Although these programs may reduce the impact of changes in currency exchange rates, when the U.S. dollar sustains a strengthening position against currencies in which the Company sells its products or a weakening exchange rate against currencies in which the Company incurs costs, particularly the Japanese yen, the Company's sales or its costs are adversely affected. The majority of the Company's research and development activities, its corporate headquarters, its U.S. manufacturing operations, and other critical business operations are approximately 75 miles from the Texas Gulf Coast. The Company's business and operating results could be adversely affected in the event of a major hurricane. General economic conditions have an impact on the Company's business and financial results. Many of the markets in which the Company sells its products are currently experiencing economic recession and the Company cannot predict when these conditions will improve or if conditions in these and other markets will decline. Although the Company does not consider its business to be highly seasonal, it generally experiences seasonally higher sales and earnings in the first and fourth quarters of the year. In the fourth quarter of 1993 the Company experienced a higher degree of seasonality as its sales increased, especially in North America, in connection with the expansion of the consumer retail portion of its business. The continued expansion of its retail business is likely to result in the increased seasonality of the Company's business and its results being more dependent on retail business fluctuations. Because of the foregoing factors, as well as other variables affecting the Company's operating results, past financial performance should not be considered a reliable indicator of future performance, and investors should not use historical trends to anticipate results or trends in future periods. In addition, the Company's participation in a highly dynamic industry often results in significant volatility of the Company's common stock price. Item 8. Item 8. Financial Statements and Supplementary Data Index to Consolidated Financial Statements Page Financial Statements: Report of Independent Accountants 13 Consolidated Balance Sheet at December 31, 1993 and 1992 14 Consolidated Statement of Income for the three years ended December 31, 1993 15 Consolidated Statement of Cash Flows for the three years ended December 31, 1993 16 Consolidated Statement of Stockholders' Equity for the three years ended December 31, 1993 17 Notes to Consolidated Financial Statements 18 Financial Statement Schedules:- For the three years ended December 31, 1993: Schedule V - Property, Plant, and Equipment S-1 Schedule VI - Accumulated Depreciation and Amortization of Property, Plant, and Equipment S-2 Schedule VIII - Valuation and Qualifying Accounts S-3 Schedule X - Supplementary Income Statement Information S-4 All other schedules and financial statements are omitted because they are not applicable or the required information is shown in the financial statements or notes thereto. Item 9. Item 9. Disagreements on Accounting and Financial Disclosure None. REPORT OF INDEPENDENT ACCOUNTANTS To the Stockholders and Board of Directors of Compaq Computer Corporation In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Compaq Computer Corporation and its subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. 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 of these statements in accordance with generally accepted auditing standards which 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, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. PRICE WATERHOUSE Houston, Texas January 25, 1994 COMPAQ COMPUTER CORPORATION CONSOLIDATED BALANCE SHEET December 31, In millions, except par value and number of shares 1993 1992 - ------------------------------------------------------------------------------ ASSETS Current assets: Cash and cash equivalents $ 627 $ 357 Accounts receivable, less allowance of $49 and $25 1,377 987 Inventories 1,123 834 Prepaid expenses and other current assets 164 140 ---------------------- Total current assets 3,291 2,318 ---------------------- Property, plant, and equipment, less accumulated depreciation 779 808 Other assets 14 16 ---------------------- $ 4,084 $ 3,142 ====================== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable $ 637 $ 516 Income taxes payable 69 36 Other current liabilities 538 408 ---------------------- Total current liabilities 1,244 960 ---------------------- Deferred income taxes 186 176 ---------------------- Commitments and contingencies Stockholders' equity:- Preferred stock: $.01 par value; 10,000,000 shares authorized; none outstanding Common stock and capital in excess of $.01 par value: 400,000,000 shares authorized; 84,348,000 shares and 79,830,000 shares issued and outstanding 586 400 Retained earnings 2,068 1,606 ---------------------- Total stockholders' equity 2,654 2,006 ---------------------- $ 4,084 $ 3,142 ====================== The accompanying notes are an integral part of these financial statements. COMPAQ COMPUER CORPORATION CONSOLIDATED STATEMENT OF INCOME Year ended December 31, In millions, except per share amounts 1993 1992 1991 - --------------------------------------------------------------------------- Sales $ 7,191 $ 4,100 $ 3,271 Cost of sales 5,493 2,905 2,053 ----------------------------------- 1,698 1,195 1,218 ----------------------------------- Research and development costs 169 173 197 Selling, general, and administrative expense 837 699 722 Other income and expense, net 76 28 145 ----------------------------------- 1,082 900 1,064 ----------------------------------- Income from consolidated companies before provision for income taxes 616 295 154 Provision for income taxes 154 97 43 ----------------------------------- Income from consolidated companies 462 198 111 Equity in net income of affiliated company 15 20 ----------------------------------- Net income $ 462 $ 213 $ 131 =================================== Earnings per common and common equivalent share: Primary $ 5.45 $ 2.58 $ 1.49 =================================== Assuming full dilution $ 5.35 $ 2.52 $ 1.49 =================================== Shares used in computing earnings per common and common equivalent share: Primary 84.7 82.6 88.1 =================================== Assuming full dilution 86.3 84.7 88.1 =================================== The accompanying notes are an integral part of these financial statements. COMPAQ COMPUTER CORPORATION CONSOLIDATED STATEMENT OF CASH FLOWS Year ended December 31, In millions 1993 1992 1991 - ------------------------------------------------------------------------------ Cash flows from operating activities: Cash received from customers $ 6,731 $ 3,595 $ 3,325 Cash paid to suppliers and employees (6,331) (3,642) (2,823) Interest and dividends received 20 32 32 Interest paid (64) (41) (36) Income taxes paid (116) (3) (104) -------------------------------- Net cash provided by (used in) operating activities 240 (59) 394 -------------------------------- Cash flows from investing activities: Purchases of property, plant, and equipment, net (145) (159) (189) Proceeds from sale of investment in Conner Peripherals, Inc. 241 Investment in Silicon Graphics, Inc. 135 (135) Other, net 13 (17) -------------------------------- Net cash provided by (used in) investing activities (145) 230 (341) -------------------------------- Cash flows from financing activities: Purchases of treasury shares (216) (82) Proceeds from sale of equity securities 142 57 23 Repayment of borrowings (73) (1) -------------------------------- Net cash provided by (used in) financing activities 142 (232) (60) -------------------------------- Effect of exchange rate changes on cash 33 (34) 24 -------------------------------- Net increase (decrease) in cash and cash equivalents 270 (95) 17 Cash and cash equivalents at beginning of year 357 452 435 -------------------------------- Cash and cash equivalents at end of year $ 627 $ 357 $ 452 ================================ Reconciliation of net income to net cash provided by (used in) operating activities: Net income $ 462 $ 213 $ 131 Depreciation and amortization 156 160 166 Provision for bad debts 33 14 9 Equity in net income of affiliated company (15) (20) Gain on sale of investment in affiliated company (86) Deferred income taxes (38) 34 (9) Loss on disposal of assets 2 14 4 Exchange rate effect 15 11 (4) Income tax refund 51 Decrease (increase) in accounts receivable (484) (412) 138 Decrease (increase) in inventories (289) (396) 108 Decrease (increase) in prepaid expenses and other current assets 24 (53) (132) Increase (decrease) in accounts payable 125 325 (96) Increase (decrease) in income taxes payable 78 38 (3) Increase in other current liabilities 156 43 102 -------------------------------- Net cash provided by (used in) operating activities $ 240 $ (59) $ 394 ================================ The accompanying notes are an integral part of these financial statements. COMPAQ COMPUTER CORPORATION CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY Common stock Par value Number and capital In millions, of in excess Retained except number of shares in thousands shares of par earnings Total - ----------------------------------------------------------------------------- Balance, December 31, 1990 86,090 $ 597 $ 1,262 $ 1,859 Issuance pursuant to stock option plans 1,112 23 23 Purchases of treasury shares (3,000) (96) (96) Tax benefit associated with stock options 14 14 Net income 131 131 ---------------------------------------- Balance, December 31, 1991 84,202 538 1,393 1,931 Issuance pursuant to stock option plans 2,628 57 57 Purchases of treasury shares (7,000) (202) (202) Tax benefit associated with stock options 7 7 Net income 213 213 ---------------------------------------- Balance, December 31, 1992 79,830 400 1,606 2,006 Issuance pursuant to stock option plans 4,518 142 142 Tax benefit associated with stock options 44 44 Net income 462 462 ---------------------------------------- Balance, December 31, 1993 84,348 $ 586 $ 2,068 $ 2,654 ======================================== The accompanying notes are an integral part of these financial statements. COMPAQ COMPUTER CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1 - Description of Business and Significant Accounting Policies: Description of business - Compaq Computer Corporation designs, develops, manufactures, and markets personal computers, PC systems, and related products for sale primarily to business, home, government, and education customers. The Company operates in one principal industry segment across geographically diverse markets. Principles of consolidation - The consolidated financial statements include the accounts of Compaq Computer Corporation and its wholly owned subsidiaries. The investment in Conner Peripherals, Inc., which represented a less than majority interest, was accounted for under the equity method. All significant intercompany transactions have been eliminated. Cash and cash equivalents - Cash and cash equivalents include cash on hand, amounts due from banks, money market instruments, commercial paper, and other investments having maturities of three months or less at date of acquisition and are reflected as such for purposes of reporting cash flows and are stated at cost which approximates fair value. Inventories - Inventories are stated at the lower of cost or market, cost being determined on a first-in, first-out basis. Property, plant, and equipment - Property, plant, and equipment are stated at cost. Major renewals and improvements are capitalized; minor replacements, maintenance, and repairs are charged to current operations. Depreciation is computed by applying the straight-line method over the estimated useful lives of the related assets, which are 30 years for buildings and range from three to ten years for equipment. Leasehold improvements are amortized over the shorter of the useful life of the improvement or the life of the related lease. Intangible assets - Licenses and trademarks are carried at cost less accumulated amortization, which is being provided on a straight-line basis over the economic lives of the respective assets. Warranty expense - The Company provides currently for the estimated cost which may be incurred under product warranties. Sales recognition - The Company recognizes sales at the time products are shipped to its customers. Provision is made currently for estimated product returns which may occur under programs the Company has with its third-party resellers and floor planning arrangements with third-party finance companies. Foreign currency - The Company uses the U.S. dollar as its functional currency. Financial statements of the Company's foreign subsidiaries are translated to U.S. dollars for consolidation purposes using current rates of exchange for monetary assets and liabilities and historical rates of exchange for nonmonetary assets and related elements of expense. Sales and other expense elements are translated at rates which approximate the rates in effect on the transaction dates. Gains and losses from this process are included in results of operations. The Company hedges certain portions of its foreign currency exposure through the use of forward exchange contracts and option contracts. Generally, gains and losses associated with currency rate changes on forward exchange contracts are recorded currently, while the interest element is recognized over the life of each contract. However, to the extent such contracts hedge a commitment for capital expenditures or inventory purchases, no gains or losses are recognized, and the rate at the time the forward exchange contract is made is, effectively, the rate used to determine the U.S. dollar value of the asset when it is recorded. In addition, during 1992 the Company began to hedge a portion of its probable anticipated sales of its international marketing subsidiaries using purchased foreign currency options. Realized and unrealized gains and the net premiums on these options are deferred and recognized as a component of sales in the same period that the related sales occur. Income taxes - The provision for income taxes is computed based on the pretax income included in the consolidated statement of income. Research and development tax credits are recorded to the extent allowable as a reduction of the provision for federal income taxes in the year the qualified research and development expenditures are incurred. In January 1993 the Company adopted Statement of Financial Accounting Standards No. 109 (FAS 109), Accounting for Income Taxes. The adoption of FAS 109 changed the Company's method of accounting for income taxes from the deferred method (APB 11) to an asset and liability approach. Previously the Company deferred the past tax effects of timing differences between financial reporting and taxable income. The asset and liability approach requires the recognition of deferred tax liabilities and assets for the expected future tax consequences of temporary differences between the carrying amounts and the tax bases of assets and liabilities. The adoption of FAS 109 had an immaterial effect on the consolidated financial statements. Earnings per share - Primary earnings per common and common equivalent share and earnings per common and common equivalent share assuming full dilution are computed using the weighted average number of shares outstanding adjusted for the incremental shares attributed to outstanding options to purchase common stock. Note 2 - Inventories: Inventories consisted of the following components: December 31, In millions 1993 1992 - ------------------------------------------------------------------------------ Raw material $ 535 $ 351 Work-in-process 90 124 Finished goods 498 359 ---------------------- $ 1,123 $ 834 ====================== Note 3 - Property, Plant, and Equipement: Property, plant, and equipment are summarized below: December 31, In millions 1993 1992 - ------------------------------------------------------------------------------ Land $ 72 $ 75 Buildings 542 532 Machinery and equipment 660 548 Furniture and fixtures 53 53 Leasehold improvements 23 20 Construction-in-progress 32 56 ---------------------- 1,382 1,284 Less-accumulated depreciation 603 476 ---------------------- $ 779 $ 808 ====================== Interest aggregating $4 million and $6 million was capitalized and added to the cost of the Company's property, plant, and equipment in 1992 and 1991, respectively. Depreciation expense totaled $155 million, $159 million, and $164 million in 1993, 1992, and 1991, respectively. Note 4 - Investment in Conner Peripherals, Inc.: In 1992 the Company sold its equity interest in Conner Peripherals, Inc. (Conner) realizing a gain of $86 million. The Company made disk drive purchases from Conner during 1992 through the date it sold its equity interest and during 1991 of $149 million and $197 million, respectively. While the Company controlled approximately 20% of the equity securities of Conner, the Company believes that purchases from Conner were made at market prices. Note 5 - Other Current Liabilities: The estimated costs which may be incurred under product warranties of $166 million and $73 million were included in other current liabilities at December 31, 1993 and 1992, respectively. Note 6 - Credit Agreement and Financing Arrangements: At December 31, 1993, the Company had an unsecured line of credit from a consortium of banks for $300 million, all of which was available and unused. Borrowings under this credit agreement bear interest, at the Company's election, at either the base rate (6.0% at December 31, 1993), an interbank offered rate plus a margin, or a market auction rate. The agreement provides for payment of commitment fees and contains the usual and customary covenants. In May 1993 the Company filed a shelf registration with the Securities and Exchange Commission which permits the Company to issue $300 million in debt securities. As of December 31, 1993, no amounts had been borrowed under this shelf registration. During 1992 the Company repaid its outstanding mortgage note which had a 9.77% interest rate. Note 7 - Other Income and Expense: Other income and expense consisted of the following components: Year ended December 31, In millions 1993 1992 1991 - ----------------------------------------------------------------------------- Interest and dividend income $ (20) $ (32) $ (32) Interest expense associated with hedging 22 15 11 Other interest expense 41 29 27 Currency exchange (gains) losses, net 15 11 (4) Restructuring charges and other asset write downs 12 87 139 Realized gain on investment in affiliated company (86) Other, net 6 4 4 --------------------------- $ 76 $ 28 $ 145 =========================== In 1991 the Company announced a major restructuring of its operations and a reorganization into distinct product divisions. The restructuring plan included, among other things, a reduction of the Company's worldwide workforce and provided for the consolidation and streamlining of certain operations. The estimated cost of the restructuring plan, $135 million, was recorded by the Company in the third quarter of 1991. In the third quarter of 1992 the Company recorded $73 million in additional restructuring charges in conjunction with additional plans for consolidating and streamlining operations. In the fourth quarter of 1993 the Company recorded charges associated with its plans to withdraw from the printer business, including costs related to certain contractual liabilities and the write-downs of the carrying value of certain assets. The charge, net of the reversal of previously recorded restructuring reserves, totaled $10 million. Reserves related to these restructurings of $26 million and $54 million were included in other current liabilities at December 31, 1993 and 1992, respectively. In 1992 the Company sold its $135 million equity interest in Silicon Graphics, Inc. (SGI) and discontinued the joint technical development agreement with SGI. The transaction resulted in no material gain or loss to the Company. Note 8 - Provision for Income Taxes: The components of income before provision for income taxes were as follows: Year ended December 31, In millions 1993 1992 1991 - ----------------------------------------------------------------------------- Domestic $ 284 $ 99 $ (33) Foreign 332 196 187 --------------------------- $ 616 $ 295 $ 154 =========================== The provision for income taxes charged to operations was as follows: Year ended December 31, In millions 1993 1992 1991 - ----------------------------------------------------------------------------- Current tax expense U.S. federal $ 130 $ 36 $ 17 State and local 4 2 Foreign 58 27 33 --------------------------- Total current 192 63 52 --------------------------- Deferred tax expense U.S. federal (18) 30 (4) Foreign (20) 4 (5) --------------------------- Total deferred (38) 34 (9) --------------------------- Total provision $ 154 $ 97 $ 43 =========================== Total income tax expense for 1993, 1992, and 1991 resulted in effective tax rates of 25%, 33%, and 28%, respectively. The reasons for the differences between these effective tax rates and the U.S. statutory rate of 35% in 1993 and 34% in 1992 and 1991 are as follows: Year ended December 31, In millions 1993 1992 1991 - ----------------------------------------------------------------------------- Tax expense at U.S. statutory rate $ 216 $ 100 $ 52 Research and development tax credits (6) (3) (9) Foreign tax effect, net (64) 6 Tax exempt Foreign Sales Corporation income (7) (1) (7) Provision for tax on equity in net income of affiliated company 5 7 Other, net 15 (4) (6) --------------------------- $ 154 $ 97 $ 43 =========================== The Company increased its U.S. deferred tax liability in 1993 as a result of legislation enacted during 1993 which increased the corporate tax rate to 35% from 34% retroactive to January 1, 1993. The increase had an immaterial effect on the consolidated financial statements. The Company benefits from a tax holiday in Singapore which expires in 1997, subject to certain extensions. During the first quarter of 1993 the Company determined that a portion of the undistributed earnings of its Singaporean subsidiaries will be reinvested indefinitely. As a result of this determination, no provision for U.S. income tax was made on $158 million of earnings of such subsidiaries during 1993. These earnings would become subject to U.S. tax if they were actually or deemed to be remitted to the Company as dividends or if the Company should sell its stock in these subsidiaries. The Company estimates an additional tax provision of $55 million would be required at such time. Deferred tax liabilities (assets) at December 31, 1993 and January 1, 1993 (the date of adoption of FAS 109) are comprised of the following: December 31, Date of In millions 1993 adoption - ----------------------------------------------------------------------------- Unremitted earnings of foreign subsidiaries $ 178 $ 153 Difference arising from different tax and financial reporting year ends 12 18 Depreciation and property, plant, and equipment basis differences 6 13 Unrealized currency gains 2 5 Other 9 15 ---------------------- Gross deferred tax liabilities 207 204 ---------------------- Warranty reserves (47) (14) Inventory valuation allowances (26) (24) Receivable valuation allowances (22) (11) Intercompany transfer pricing (18) (21) Loss carryforwards (10) (7) Restructuring charges (10) (24) Compensatory absences accruals (4) (4) Depreciation and property, plant, and equipment basis differences (2) (3) Other (8) (9) ---------------------- Gross deferred tax assets (147) (117) ---------------------- Deferred tax assets valuation allowance 11 ---------------------- $ 60 $ 98 ====================== The decrease in the deferred tax assets valuation allowance in 1993 of $11 million is primarily attributable to the utilization (or expected future utilization) of loss carryforwards associated with certain of the Company's foreign subsidiaries. Deferred tax assets of $126 million and $78 million were included in prepaid expenses and other current assets at December 31, 1993 and 1992, respectively. Note 9 - Stockholder's Equity and Employee Benefit Plans: Equity incentive plans - At December 31, 1993, there were 18,432,000 shares of common stock reserved by the Board of Directors for issuance under the Company's employee stock option plans. Options are generally granted at the fair market value of the common stock at the date of grant and generally vest over four to five years. In limited circumstances, options may be granted at prices less than fair market value and may vest immediately. Options granted under the plans must be exercised not later than ten years from the date of grant. Options on 4,292,000 shares were exercisable at December 31, 1993. The following table summarizes activity under the plans for each of the three years in the period ended December 31, 1993: Shares Price per share (In thousands) Options outstanding, December 31, 1990 12,893 Options granted 4,416 23.88-69.75 Options lapsed or cancelled (1,663) Options exercised (1,112) 22.25-73.50 -------- Options outstanding, December 31, 1991 14,534 Options granted 2,746 23.63-42.38 Options lapsed or cancelled (703) Options exercised (2,607) .25-47.19 -------- Options outstanding, December 31, 1992 13,970 Options granted 2,152 44.63-73.88 Options lapsed or cancelled (718) Options exercised (4,490) .26-69.75 -------- Options outstanding, December 31, 1993 10,914 ======== There were 7,518,000; 9,041,000; and 11,083,000 shares available for grants under the plans at December 31, 1993, 1992, and 1991, respectively. In 1987 the stockholders approved the Stock Option Plan for Non-Employee Directors (the Director Plan). At December 31, 1993, there were 430,000 shares of common stock reserved for issuance under the Director Plan. Pursuant to the terms of the plan, each non-employee director is entitled to receive options to purchase common stock of the Company upon initial appointment to the Board (initial grants) and upon subsequent reelection to the Board (annual grants). Initial grants are exercisable during the period beginning one year after initial appointment to the Board and ending ten years after the date of grant. Annual grants vest over two years and are exercisable thereafter until the tenth anniversary of the date of grant. Both initial grants and annual grants have an exercise price equal to the fair market value of the Company's stock on the date of grant. Additionally, pursuant to the terms of the Director Plan, non-employee directors may elect to receive stock options in lieu of all or a portion of the annual retainer to be earned. Such options are granted at 50% of the price of the Company's common stock at the date of grant and are exercisable during the period beginning one year after the grant date and ending ten years after the date of grant. Options totaling 117,877 were exercisable under the Director Plan at December 31, 1993. Activity under the plan for each of the three years in the period ended December 31, 1993 was as follows: Shares Price per share (In thousands) Options outstanding, December 31, 1990 116 Options granted 37 17.88-35.76 ----- Options outstanding, December 31, 1991 153 Options granted 27 12.69-25.38 Options exercised (21) 40.25-43.00 ----- Options outstanding, December 31, 1992 159 Options granted 35 24.38-48.75 Options lapsed or cancelled (5) Options exercised (28) 12.69-40.06 ----- Options outstanding, December 31, 1993 161 ===== There were 269,000; 299,000; and 327,000 shares available for grants under the plan at December 31, 1993, 1992, and 1991, respectively. Pursuant to a plan adopted by the Board of Directors in 1986, the Company granted to selected officers and key employees options on shares of Conner stock owned by the Company. Such options, which were granted at $.09 per share, vested ratably over four years and expire ten years from the date of grant. During 1993 options on 22,000 shares were exercised and no options lapsed or were cancelled. At December 31, 1993, options on 83,000 shares of Conner common stock were exercisable and outstanding. Compaq Computer Corporation Investment Plan - The Company has an Investment Plan available to all domestic employees and intended to qualify as a deferred compensation plan under Section 401(k) of the Internal Revenue Code of 1986. Employees may contribute to the plan up to 14% of their salary with a maximum of $8,994 in 1993 ($9,240 in 1994). The Company will match employee contributions for an amount up to 6% of each employee's base salary. Contributions are invested at the direction of the employee in one or more funds or can be directed to purchase common stock of the Company at fair market value. Company contributions generally vest over three years although Company contributions for those employees having five years of service vest immediately. Company contributions are charged to expense in accordance with their vesting. Amounts charged to expense were $16 million, $13 million, and $12 million in 1993, 1992, and 1991, respectively. Incentive compensation plan - The Company adopted an incentive compensation plan for the majority of its employees beginning in the second half of 1992. Provision for payments to be made under the plan is based on 6% of net income from operations, as defined, and is payable semiannually. The amount expensed under the plan was $27 million and $8 million in 1993 and 1992, respectively. Stock repurchases - On May 16, 1991, the Company's Board of Directors authorized the Company to repurchase up to ten million shares of its common stock on the open market. During 1992 and 1991 the Company repurchased seven million and three million shares of its common stock, respectively, at an aggregate cost of $202 million and $96 million, respectively. The repurchases of these shares have been accounted for using the par value method. Post retirement and post employment benefits - The Financial Accounting Standards Board has issued Statements requiring accrual basis accounting for post retirement and post employment benefits offered to employees. The Company currently offers very limited post retirement and post employment benefits and accordingly the provisions of the Statements had minimal impact on the Company's financial statements when they were adopted in 1993. Stockholder rights plan - The Board of Directors adopted a Stockholder Rights Plan in May 1989 which in certain limited circumstances would permit stockholders to purchase securities at prices which would be substantially below market value. Note 10 - Certain Market and Geographic Data: The Company has subsidiaries in various foreign countries which manufacture and sell the Company's products in their respective geographic areas. Summary information with respect to the Company's geographic operations in 1993, 1992, and 1991 follows: United States & Other Elimin- Consol- In millions Canada Europe countries nations idated - ---------------------------------------------------------------------------- - ---- Sales to customers $ 3,670 $ 2,718 $ 803 $ 7,191 Intercompany transfers 1,514 109 990 $ (2,613) --------------------------------------------------- $ 5,184 $ 2,827 $ 1,793 $ (2,613) $ 7,191 =================================================== Income from operations $ 310 $ 183 $ 245 $ 5 $ 743 ========================================= Corporate expenses, net (127) --------- Pretax income $ 616 ========= Identifiable assets $ 2,457 $ 1,032 $ 620 $ (652) $ 3,457 ========================================= General corporate assets 627 --------- Total assets $ 4,084 ========= - ---- Sales to customers $ 1,833 $ 1,886 $ 381 $ 4,100 Intercompany transfers 899 50 537 $ (1,486) --------------------------------------------------- $ 2,732 $ 1,936 $ 918 $ (1,486) $ 4,100 =================================================== Income (loss) from operations $ 37 $ 74 $ 143 $ (2) $ 252 ========================================= Corporate income, net 43 --------- Pretax income $ 295 ========= Identifiable assets $ 2,006 $ 961 $ 323 $ (505) $ 2,785 ========================================= General corporate assets 357 --------- Total assets $ 3,142 ========= - ---- Sales to customers $ 1,388 $ 1,724 $ 159 $ 3,271 Intercompany transfers 838 16 361 $ (1,215) --------------------------------------------------- $ 2,226 $ 1,740 $ 520 $ (1,215) $ 3,271 =================================================== Income (loss) from operations $ (29) $ 101 $ 133 $ 12 $ 217 ========================================= Corporate expenses, net (63) --------- Pretax income $ 154 ========= Identifiable assets $ 1,825 $ 696 $ 125 $ (272) $ 2,374 ========================================= General corporate assets 452 --------- Total assets $ 2,826 ========= Note 11 - Commitments, Contingencies, and Financial Instruments: Litigation - The Company and certain of its current and former officers and directors are named in a consolidated, alleged class action, lawsuit brought in federal court in Houston on behalf of persons who purchased Compaq stock or held certain types of options during the period December 18, 1990 through May 14, 1991. The second amended complaint alleges, among other things, that the defendants, through certain public statements, misled investors respecting (i) deterioration in the Company's markets and the demand for its products, (ii) marketing problems such as pricing pressure from competitors and reduced dealer loyalty, and (iii) other industry, competitive, and Company conditions. The complaint seeks damages in an unspecified amount. On October 2, 1993, the defendants filed a motion to dismiss, which the court on October 28, 1993 converted to a motion for summary judgment. On December 28, 1993, the Court granted in part and denied in part the defendants' motion. Allegations similar to those contained in the federal action have been made in individual suits brought by certain stockholders in Texas State Court in Houston. Management believes that the outcome of this litigation will not have a material adverse effect on the financial condition of the Company. The Company is also subject to legal proceedings and claims which arise in the ordinary course of its business. Management does not believe that the outcome of any of those matters will have a material adverse effect on the Company's financial condition. Financial instruments, off-balance sheet risk, and concentration of credit risk - - At December 31, 1993 and 1992, respectively, the Company had entered into forward exchange contracts with financial institutions to sell $581 million and $488 million of foreign currencies and also had entered into foreign currency option contracts relating to the hedges of certain portions of its foreign currency exposure of the net monetary assets of its international subsidiaries. In addition, at December 31, 1993 and 1992, respectively, the Company had entered into forward exchange contracts with financial institutions to buy $325 million and $107 million of foreign currencies and also had entered into foreign currency option contracts to hedge purchase commitments. Forward exchange contracts had maturity dates ranging from one day to six months. In the event of a failure to honor one of these contracts by one of the banks with which the Company had contracted, management believes any loss would be limited to the exchange rate differential from the time the contract was made until the time it was compensated. At December 31, 1993, the Company had entered into option contracts to sell currency to hedge a portion of its probable anticipated sales over the next three months of its international marketing subsidiaries. The net unrealized gain deferred on these contracts at December 31, 1993 totaled $12 million and if realized will be recognized in the periods that the related sales occur. At December 31, 1992, the net unrealized gain on these types of contracts totaled $26 million. The gains associated with the hedging of anticipated sales of the Company's international marketing subsidiaries, net of premium cost associated with the related purchased currency options, are included in sales and were $13 million and $3 million in 1993 and 1992, respectively. To the extent the Company has such options outstanding, the amount of any loss resulting from a breach of contract would be limited to the amount of premiums paid for the options and the unrealized gain, if any, related to such contracts. The Company enters into various types of financial instruments in the normal course of business. Fair values for certain financial instruments are based on quoted market prices. For other financial instruments, fair values are based on the appropriate pricing models using current market information. The amounts ultimately realized upon settlement of these financial instruments will depend on actual market conditions during the remaining life of the instruments. Fair values of cash and cash equivalents, accounts receivable, accounts payable, and other current liabilities reflected in the December 31, 1993 balance sheet approximate carrying value at that date. The fair value of prepaid expenses and other current assets at December 31, 1993 would have been increased by approximately $12 million to reflect the unrealized deferred gain on the option contracts to sell currency to hedge a portion of the Company's probable anticipated sales of its international marketing subsidiaries. The Company's cash and cash equivalents and accounts receivable are subject to potential credit risk. The Company's cash management and investment policies restrict investments to low risk, highly-liquid securities and the Company performs periodic evaluations of the relative credit standing of the financial institutions with which it deals. The Company distributes products primarily through third-party resellers and as a result maintains individually significant accounts receivable balances from various major resellers. The Company evaluates the credit worthiness of its resellers on an ongoing basis and may, from time to time, tighten credit terms to particular resellers. Such tightening may take the form of shorter payment terms, requiring security, reduction of credit availability, or the deauthorization of a reseller. In addition, the Company uses various risk transfer instruments such as credit insurance, factoring, and floor planning with third-party finance companies and financial institutions; however, there can be no assurance that these arrangements will be sufficient to avoid significant accounts receivable losses or will continue to be available. While the Company believes that its distribution strategies will serve to minimize the risk associated with the loss of a reseller or the decline in sales to a reseller due to tightened credit terms, there can be no assurance that disruption to the Company's sales and profitability will not occur. If the financial condition and operations of these resellers deteriorate, the Company's operating results could be adversely affected. At December 31, 1993, the receivable balances from the Company's five largest resellers represented approximately 22% of accounts receivable. The Company's resellers typically purchase products on an as-needed basis through purchase orders. Certain of the Company's resellers finance a portion of their inventories through third-party finance companies. Under the terms of the financing arrangements, the Company may be required, in limited circumstances, to repurchase certain products from the finance companies. Additionally, the Company has on occasion guaranteed a portion of certain resellers' outstanding balances with third-party finance companies and financial institutions. Guarantees under these and other arrangements aggregating $29 million and $14 million were outstanding at December 31, 1993 and 1992, respectively. During the years that the Company has supported these financing programs, claims under these arrangements have been negligible. The Company makes provisions for estimated product returns and bad debts which may occur under these programs. Lease commitments - The Company leases certain manufacturing and office facilities and equipment under noncancelable operating leases with terms from one to 30 years. Rent expense for 1993, 1992, and 1991 was $32 million, $35 million, and $39 million, respectively. The Company's minimum rental commitments under noncancelable operating leases at December 31, 1993 were as follows: Year Amount (In millions) ------- --------- 1994 $ 29 1995 22 1996 16 1997 14 1998 13 Thereafter 50 --------- $ 144 ========= Note 12 - Selected Quarterly Financial Data (not covered by report of independent accountants): The table below sets forth selected financial information for each quarter of the last two years. In millions, 1st 2nd 3rd 4th except per share amounts quarter quarter quarter quarter - ------------------------------------------------------------------------------ Sales $ 1,611 $ 1,632 $ 1,746 $ 2,202 Gross margin 370 393 413 522 Net income 102 102 107 151 Earnings per common and common equivalent share Primary 1.23 1.21 1.26 1.74 Assuming full dilution 1.23 1.21 1.25 1.73 Sales $ 783 $ 827 $ 1,067 $ 1,423 Gross margin 262 250 300 383 Net income 45 29 50 89 Earnings per common and common equivalent share Primary 0.53 0.35 0.61 1.11 Assuming full dilution 0.53 0.35 0.61 1.10 PART III Items 10 to 13 inclusive. These items have been omitted in accordance with instructions to Form 10-K Annual Report. The Registrant will file with the Commission in March 1994, pursuant to Regulation 14A, a definitive proxy statement which will involve the election of directors. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. (a) The following documents are filed as a part of this report: Financial Statements and Financial Statement Schedules - See Index to Consolidated Financial Statements at Item 8 of this report. Exhibit No. Description of Exhibits 3.1 Restated Certificate of Incorporation of Registrant (incorporated herein by reference to the corresponding exhibit in the Registrant's Registration Statement No. 2-96069 on Form S-1). 3.2 Amendment to Registrant's Certificate of Incorporation, filed May 19, 1987 (incorporated herein by reference to the corresponding exhibit in the Registrant's Form 10-K for the year ended December 31, 1987 (the "1987 Form 10-K")). 3.3 Registrant's Certificate of Amendment to its Restated Certificate of Incorporation dated July 26, 1991, along with a complete copy of the Registrant's Restated Certificate of Incorporation, as amended (incorporated herein by reference to Exhibit 10.1 to the Registrant's Form 10-Q for the quarter ended June 30, 1991). 3.4 Registrant's Certificate of Stock Designation filed June 28, 1989 (incorporated herein by reference to Exhibit No. 3.1 to the Registrant's Form 10-Q for the quarter ended June 30, 1989 (the "1989 Second Quarter Form 10-Q")). 3.5 By-laws of Registrant, as amended (incorporated herein by reference to Exhibit No. 3.5 to the Registrant's Form 10-Q for the quarter ended June 30, 1992). 4.1 Form of Rights Agreement dated as of May 18, 1989 between Registrant and Bank of America NT & SA, as Rights Agent, including form of Right Certificate (incorporated herein by reference to Exhibits 1 and 2 to the Registrant's Form 8-A Registration Statement dated May 30, 1989). 4.2 Successor Rights Agent Agreement dated as of September 17, 1991 between Registrant and First National Bank of Boston (incorporated herein by reference to Exhibit 4.2 to the Registrant's Form 10-K for the year ended December 31, 1991 (the "1991 Form 10-K")). 10.1 Registrant's 1982 Stock Option Plan, as amended (incorporated herein by reference to the corresponding exhibit in the 1989 Second Quarter Form 10-Q). * 10.2 Registrant's 1983 Nonqualified Stock Option Plan, as amended (incorporated herein by reference to the corresponding exhibit in the Registrant's Form 10-K for the year ended December 31, 1988). * 10.3 Registrant's 1985 Stock Option Plan (incorporated herein by reference to Exhibit 10.3 to the 1991 Form 10-K). * 10.4 Registrant's 1985 Executive and Key Employees Stock Option Plan, as amended (incorporated herein by reference to Exhibit 10.3 to the 1989 Second Quarter Form 10-Q). * 10.5 Registrant's 1985 Nonqualified Stock Option Plan, as amended (incorporated herein by reference to Exhibit 10.4 to the 1989 Second Quarter Form 10-Q). * 10.6 Forms of Stock Option Agreements relating to Exhibits 10.1 through 10.5 (incorporated herein by reference to Exhibit 10.6 to the 1987 Form 10-K). * 10.7 Registrant's 1989 Equity Incentive Plan, as amended (incorporated herein by reference to Exhibit 10.7 to the 1991 Form 10-K). * 10.8 Form of Stock Option Notice relating to Exhibit 10.7 (incorporated herein by reference to Exhibit 10.8 to the 1991 Form 10-K). * 10.9 Registrant's Stock Option Plan for Non-Employee Directors, as amended, and Form of Stock Option Agreement (incorporated herein by reference to Exhibit 10.9 to the 1991 Form 10-K). * 10.10 Registrant's Deferred Compensation and Supplemental Savings Plan as amended. * 10.11 Form of Agreement for Underleases dated October 1988 between Compaq Computer Limited, the Company, Hambros Bank Executor and Trustee Company Limited, Haslemere Estates Public Limited Company, and Haslemere Estates (Developments) Limited, and related License, Deed, and Underleases (incorporated by reference to Exhibit No. 10.3 to the Registrant's Form 10-Q for the quarter ended September 30, 1988). 10.12 Employment Agreement dated as of January 1, 1992 between the Registrant and Eckhard Pfeiffer (incorporated by reference to Exhibit 10.15 to the 1991 Form 10-K). * 10.13 Form of letter agreement between Registrant and its executive officers (incorporated by reference to Exhibit 10.16 to the 1991 Form 10-K). * 10.14 Credit Agreement dated as of May 10, 1993, among Compaq Computer Corporation, the banks signatory thereto and NationsBank of Texas, N.A. as Agent, and Bank of America National Trust and Savings Association as Co-agent (incorporated by reference to Exhibit 10.1 to the Registrant's Form 8-K dated May 10, 1993). 11. Statement regarding the computation of per share earnings. 21. Subsidiaries of Registrant. 23. Consent of Price Waterhouse, independent accountants. * Indicates management contract or compensatory plan or arrangement. Exhibit numbers may not correspond in all cases to those numbers in Item 601 of Regulation S-K because of special requirements applicable to EDGAR filers. (b) Reports on Form 8-K: Report on Form 8-K dated January 26, 1994, containing the Company's news release dated January 26, 1994, with respect to its financial results for the period ended December 31, 1993, including an unaudited consolidated balance sheet as of December 31, 1993, and an unaudited consolidated statement of income for the periods ended December 31, 1993. The following trademarks and service marks owned by the Company appear in this Report: Compaq, CompaqCare, Compaq Concerto, Compaq Contura, Compaq Insight Manager, Compaq ProLinea, Compaq ProLinea Net 1/25s, Compaq ProLiant, Compaq ProSignia, PageMarq, Deskpro, DirectPlus, Presario, and SmartStart. 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. Compaq Computer Corporation By: /s/ ECKHARD PFEIFFER ------------------------------- Eckhard Pfeiffer, President and Chief Executive Officer Date: 2/24/94 ------- 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 in the capacities and on the dates indicated. Signature Title Date /s/ ECKHARD PFEIFFER 2/24/94 - ----------------------------- President and Director ------- (Eckhard Pfeiffer) (principal executive officer) /s/ DARYL J. WHITE 2/24/94 - ----------------------------- Senior Vice President-Finance ------- (Daryl J. White) and Chief Financial Officer (principal financial officer) /s/ BENJAMIN M. ROSEN 2/24/94 - ----------------------------- Chairman of the ------- (Benjamin M. Rosen) Board of Directors /s/ ROBERT TED ENLOE III 2/24/94 - ----------------------------- Director ------- (Robert Ted Enloe III) /s/ GEORGE E.R. KINNEAR, II 2/24/94 - ----------------------------- Director ------- (George E.R. Kinnear, II) /s/ PETER N. LARSON 2/24/94 - ----------------------------- Director ------- (Peter N. Larson) /s/ KENNETH L. LAY 2/24/94 - ----------------------------- Director ------- (Kenneth L. Lay) /s/ KENNETH ROMAN 2/24/94 - ----------------------------- Director ------- (Kenneth Roman) PAGE S-1 SCHEDULE V COMPAQ COMPUTER CORPORATION PROPERTY, PLANT, AND EQUIPMENT Balance, Balance, beginning Additions, Retirements end Description of year at cost or sales of year - ------------------------------------------------------------------------------- (in millions) Year ended December 31, 1991: Land $ 65 $ 8 $ (3) $ 70 Buildings 416 95 (1) 510 Machinery and equipment 529 105 (19) 615 Furniture and fixtures 47 8 (1) 54 Leasehold improvements 24 4 (1) 27 Construction-in-progress, net 106 (60) 46 ------------------------------------------------ $ 1,187 $ 160 $ (25) $ 1,322 ================================================ Year ended December 31, 1992: Land $ 70 $ 6 $ (1) $ 75 Buildings 510 37 (15) 532 Machinery and equipment 615 97 (164) 548 Furniture and fixtures 54 5 (6) 53 Leasehold improvements 27 4 (11) 20 Construction-in-progress, net 46 10 56 ------------------------------------------------ $ 1,322 $ 159 $ (197) $ 1,284 ================================================ Year ended December 31, 1993: Land $ 75 $ (3) $ 72 Buildings 532 $ 12 (2) 542 Machinery and equipment 548 150 (38) 660 Furniture and fixtures 53 2 (2) 53 Leasehold improvements 20 5 (2) 23 Construction-in-progress, net 56 (24) 32 ------------------------------------------------ $ 1,284 $ 145 $ (47) $ 1,382 ================================================ During 1991 additions to Construction-in-progress, net include $20 million of assets which were written off as part of the restructuring. PAGE S-2 SCHEDULE VI COMPAQ COMPUTER CORPORATION ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT, AND EQUIPMENT Balance, Balance, beginning Additions, Retirements end Description of year at cost or sales of year - --------------------------------------------------------------------------- (in millions) Year ended December 31, 1991: Buildings $ (34) $ (22) $ (56) Machinery and equipment (230) (132) $ 18 (344) Furniture and fixtures (16) (9) 2 (23) Leasehold improvements (15) (1) (16) -------------------------------------------- $ (295) $ (164) $ 20 $ (439) ============================================ Year ended December 31, 1992: Buildings $ (56) $ (23) $ 2 $ (77) Machinery and equipment (344) (126) 109 (361) Furniture and fixtures (23) (7) 2 (28) Leasehold improvements (16) (3) 9 (10) -------------------------------------------- $ (439) $ (159) $ 122 $ (476) ============================================ Year ended December 31, 1993: Buildings $ (77) $ (23) $ 1 $ (99) Machinery and equipment (361) (122) 22 (461) Furniture and fixtures (28) (7) 3 (32) Leasehold improvements (10) (3) 2 (11) -------------------------------------------- $ (476) $ (155) $ 28 $ (603) ============================================ PAGE S-3 SCHEDULE VIII COMPAQ COMPUTER CORPORATION VALUATION AND QUALIFYING ACCOUNTS Allowance for Doubtful Accounts Year ended December 31, In millions 1993 1992 1991 - -------------------------------------------------------------------- Balance, beginning of period $ 25 $ 18 $ 14 Additions charged to expense 33 14 9 Reductions (9) (7) (5) ------------------------------ Balance, end of period $ 49 $ 25 $ 18 ============================== PAGE S-4 SCHEDULE X COMPAQ COMPUTER CORPORATION SUPPLEMENTARY INCOME STATEMENT INFORMATION Year ended December 31, In millions 1993 1992 1991 - ----------------------------------------------------------------------------- Advertising expense $ 114 $ 82 $ 55 Royalties $ 119 All other expenses required by this Schedule are disclosed in the consolidated financial statements or notes thereto included elsewhere in this Annual Report on Form 10-K. COMPAQ COMPUTER CORPORATION EXHIBIT INDEX Exhibit No. Description of Exhibits 3.1 Restated Certificate of Incorporation of Registrant (incorporated herein by reference to the corresponding exhibit in the Registrant's Registration Statement No. 2-96069 on Form S-1). 3.2 Amendment to Registrant's Certificate of Incorporation, filed May 19, 1987 (incorporated herein by reference to the corresponding exhibit in the Registrant's Form 10-K for the year ended December 31, 1987 (the "1987 Form 10-K")). 3.3 Registrant's Certificate of Amendment to its Restated Certificate of Incorporation dated July 26, 1991, along with a complete copy of the Registrant's Restated Certificate of Incorporation, as amended (incorporated herein by reference to Exhibit 10.1 to the Registrant's Form 10-Q for the quarter ended June 30, 1991). 3.4 Registrant's Certificate of Stock Designation filed June 28, 1989 (incorporated herein by reference to Exhibit No. 3.1 to the Registrant's Form 10-Q for the quarter ended June 30, 1989 (the "1989 Second Quarter Form 10-Q")). 3.5 By-laws of Registrant, as amended (incorporated herein by reference to Exhibit No. 3.5 to the Registrant's Form 10-Q for the quarter ended June 30, 1992). 4.1 Form of Rights Agreement dated as of May 18, 1989 between Registrant and Bank of America NT & SA, as Rights Agent, including form of Right Certificate (incorporated herein by reference to Exhibits 1 and 2 to the Registrant's Form 8-A Registration Statement dated May 30, 1989). 4.2 Successor Rights Agent Agreement dated as of September 17, 1991 between Registrant and First National Bank of Boston (incorporated herein by reference to Exhibit 4.2 to the Registrant's Form 10-K for the year ended December 31, 1991 (the "1991 Form 10-K")). 10.1 Registrant's 1982 Stock Option Plan, as amended (incorporated herein by reference to the corresponding exhibit in the 1989 Second Quarter Form 10-Q). * 10.2 Registrant's 1983 Nonqualified Stock Option Plan, as amended (incorporated herein by reference to the corresponding exhibit in the Registrant's Form 10-K for the year ended December 31, 1988). * 10.3 Registrant's 1985 Stock Option Plan (incorporated herein by reference to Exhibit 10.3 to the 1991 Form 10-K). * 10.4 Registrant's 1985 Executive and Key Employees Stock Option Plan, as amended (incorporated herein by reference to Exhibit 10.3 to the 1989 Second Quarter Form 10-Q). * 10.5 Registrant's 1985 Nonqualified Stock Option Plan, as amended (incorporated herein by reference to Exhibit 10.4 to the 1989 Second Quarter Form 10-Q). * 10.6 Forms of Stock Option Agreements relating to Exhibits 10.1 through 10.5 (incorporated herein by reference to Exhibit 10.6 to the 1987 Form 10-K). * 10.7 Registrant's 1989 Equity Incentive Plan, as amended (incorporated herein by reference to Exhibit 10.7 to the 1991 Form 10-K). * 10.8 Form of Stock Option Notice relating to Exhibit 10.7 (incorporated herein by reference to Exhibit 10.8 to the 1991 Form 10-K). * 10.9 Registrant's Stock Option Plan for Non-Employee Directors, as amended, and Form of Stock Option Agreement (incorporated herein by reference to Exhibit 10.9 to the 1991 Form 10-K). * 10.10 Registrant's Deferred Compensation and Supplemental Savings Plan as amended. * 10.11 Form of Agreement for Underleases dated October 1988 between Compaq Computer Limited, the Company, Hambros Bank Executor and Trustee Company Limited, Haslemere Estates Public Limited Company, and Haslemere Estates (Developments) Limited, and related License, Deed, and Underleases (incorporated by reference to Exhibit No. 10.3 to the Registrant's Form 10-Q for the quarter ended September 30, 1988). 10.12 Employment Agreement dated as of January 1, 1992 between the Registrant and Eckhard Pfeiffer (incorporated by reference to Exhibit 10.15 to the 1991 Form 10-K). * 10.13 Form of letter agreement between Registrant and its executive officers (incorporated by reference to Exhibit 10.16 to the 1991 Form 10-K). * 10.14 Credit Agreement dated as of May 10, 1993, among Compaq Computer Corporation, the banks signatory thereto and NationsBank of Texas, N.A. as Agent, and Bank of America National Trust and Savings Association as Co-agent (incorporated by reference to Exhibit 10.1 to the Registrant's Form 8-K dated May 10, 1993). 11. Statement regarding the computation of per share earnings. 21. Subsidiaries of Registrant. 23. Consent of Price Waterhouse, independent accountants. * Indicates management contract or compensatory plan or arrangement. Exhibit numbers may not correspond in all cases to those numbers in Item 601 of Regulation S-K because of special requirements applicable to EDGAR filers.

1993 Item 1. Description of Business BACKGROUND Weirton Steel Corporation, together with its wholly owned subsidiary Weirton Receivables, Inc., (the "Company") and its predecessor companies have been in the business of making and finishing steel products for more than eighty years at the Company's facility located in Weirton, West Virginia. From November 1929 to January 1984, the Company's business had been operated as a division of National Steel Corporation ("National"). Incorporated in Delaware in November 1982, the Company acquired the principal assets of National's former Weirton Steel Division ("the Division") in January 1984. PRINCIPAL PRODUCTS The Company is a major integrated producer of flat rolled carbon steels with principal product lines consisting of sheet products and tin mill products ("TMP"). The Company offers a full range of sheet products that include hot and cold rolled sheet steel up to 48" wide and both hot-dipped and electrolytic galvanized products. TMP includes tin plate, chrome coated, and black plate. Historically, the Company's products have emphasized the narrow to medium widths reflective of its rolling and finishing equipment and covered a broad range of gauges, finishes and performance specifications. The Company has developed significant expertise in filling orders with demanding specifications. The Company does not produce bars, wire or structural products. The Company's sales as a percentage of its total revenues for each year in the period 1989 through 1993 are shown in the following table. [TEXT] PRINCIPAL MARKETS The following table shows the percentage of total net tons of steel products shipped for each year in the period 1989 through 1993 by the Company to each of its principal markets. [TEXT] A substantial portion of the Company's revenues are derived from long-time, steady customers, although the Company actively seeks new customers and constantly seeks new markets for its products. A substantial share of the Company's TMP and sheet products are shipped to customers located in the eastern portion of the United States. The Company's products are sold through salaried Company representatives who operate from 12 district sales offices. Sales orders taken in the field are subject to home office approval. Trade orders on hand for the Company's products at December 31, 1993, 1992, and 1991 amounted to approximately 449 thousand tons, 308 thousand tons, and 307 thousand tons, respectively. Substantially all orders on hand at any time are expected to be filled within a twelve month period. Since the Company produces steel in response to orders primarily of established grades and specifications, resulting in short order processing time and relatively rapid inventory turnover, it does not believe that order backlog is a material aspect of its business. SHEET PRODUCTS. Hot rolled products are sold directly from the hot strip mill as "hot bands," or are further processed using hydrochloric acid to remove surface scale and are sold as "hot rolled pickled." Hot rolled sheet is used for unexposed parts in machinery, construction products and other durable goods. Most of the Company's sales in hot rolled have been to pipe and tube manufacturers and converters and, to a lesser extent, steel service centers. In 1993, the Company sold 658 thousand tons of hot rolled sheet, which accounted for 17.8% of its total revenues. Cold rolled sheet, which requires further processing consisting of additional rolling, annealing and tempering to enhance ductility and surface characteristics, is used in the construction, steel service center, commercial equipment and container markets, primarily for exposed parts where appearance and surface quality are important considerations. In 1993, the Company sold 169 thousand tons of cold rolled sheet, which accounted for 6.6% of its total revenues. Galvanized hot-dipped and electrolytic sheet, which is coated primarily with zinc compounds to provide extended anti- corrosive properties, is sold to the electrical, construction, automotive, container, appliance and steel service center markets. In 1993, the Company sold 642 thousand tons of galvanized products, which accounted for 28.7% of total revenues. Generally, the Company's more highly processed sheet products provide higher profit margins. The following table, based on AISI information, shows the Company's historical share of the domestic Sheet Products market. [TEXT] While the Company's presence in the overall sheet market is limited, the Company has concentrated on developing its offerings of more highly processed products and production capacity to provide the larger coils favored by most of its customers. The Company's goals for development of its sheet business are focused on increasing its percentage of coated products, such as galvanized, while capitalizing on developing specialty markets such as construction where the Company believes that its GALFAN product has potential in roofing and framing applications. As part of its sheet marketing strategy, the Company is also making efforts to enhance high quality end use of its products marketed through steel service centers, as well as developing the hot rolled market for heavier gauge and higher carbon applications for all markets. Tin Mill Products. The Company has enjoyed substantial market share and a widely held reputation as a high quality producer of TMP. TMP comprise a wide variety of light gauge coated steels. Tin plate and black plate products are sold under the Company name and under such trademarks as WEIRITE and WEIRLITE. In addition to tin plate and black plate, the Company produces electrolytic chromium coated steel under the trademark WEIRCHROME. Based upon the Company's share of the domestic market for TMP, which has remained relatively constant in recent years, the Company believes it is one of the largest domestic producers of TMP. In 1993, the Company accounted for approximately 22% of the TMP market, a slight decrease from the 23% market share it held in 1992. TMP shipments on an industry-wide basis have remained relatively steady over the same period even as plastic, aluminum, composites and other materials competed for potential growth in some applications. The TMP market is now primarily directed at food, beverage, and general line cans. The majority of the Company's TMP sales have been to can manufacturing and packaging companies, a substantial amount of whose annual requirements are established in advance. This market is characterized by a relatively low number of manufacturers. During 1993, shipments to ten major can manufacturers accounted for approximately 90% of the Company's TMP sales and its five largest TMP customers accounted for approximately 29.6% of total revenues. One customer, Crown Cork & Seal Company, a major can manufacturer, accounted for approximately 11% of total revenues. The balance of the TMP output is sold to other can manufacturers, manufacturers of caps and closures and specialty products ranging from film cartridges, lighting fixtures and battery jackets to cookie sheets and curtain rods. As a result of predictable sales patterns for TMP, the Company is able to gauge in advance a significant portion of its production requirements which allows the Company to operate its production facilities more efficiently and adjust its marketing and production efforts for other products. The following table, based on AISI information, shows the Company's historical share of the domestic TMP market. [TEXT] Steelmaking and hot rolling improvements derived from the Company's recent capital improvement program have allowed for the production of sufficient quantities of "clean" steel to fill anticipated TMP orders for the near term. Expansion of downstream annealing and tempering capacity, however, would be necessary before large TMP production increases could be effected. The Company's facilities and expertise also allow it to produce the lightest gauges of tin plate, enhancing the manufacturing efficiencies of the Company's customers and promoting the use of its steel in leading edge technology products such as thin-walled containers. The Company has been a leading innovator in the development of can making technology through its WEIRTEC research and development center. Although accounting for less than 5% of the domestic beverage container market in recent years, largely due to highly competitive prices for aluminum, the Company believes that two piece thin-walled steel beverage containers have significant potential for growth. This is primarily because of improved production efficiencies for cans and increased industry success in promoting the recycling of steel. The Company engages in other end product research and development and provides support services to its customers. The Company believes these services have been of significant assistance, particularly to its TMP customers, and promotes the consumption of the Company's products. See "Research and Development." A 1.1 million square foot Finished Products Warehouse with storage and staging areas for TMP has been located near the Company's mill to facilitate "just in time" production and delivery to several of the Company's major customers who are located in attached, or nearby, manufacturing facilities. As steel coils are needed by customers' operations, they are moved from the adjoining central storage areas and loaded directly on to their production lines. This arrangement provides significant savings for the Company and its customers. PRODUCTION AND SHIPMENTS In 1991, after three years of close to 100 million tons of raw steel production per year, the domestic steel industry's raw steel production fell to 87.3 million tons and shipments declined to 78.9 million tons. However, starting with December 1991 and continuing through 1993, the steel industry experienced a rebound in both production and shipments. Steel production for 1993 was up approximately 4.9% to 96.1 million tons compared to 1992, while shipments increased by approximately 7.4% to 88.4 million tons. Similarly, capacity utilization which had dropped to 74% in 1991 rebounded to 87.4% in 1993. During 1991 and 1992 in particular, the Company's production, and consequently its ability to sell steel products, was constrained by facilities' outages stemming from the Company's capital improvement program. See "Investment in Facilities" in Item 7 hereof for a more complete discussion of the Company's capital improvement program. Although these factors for the most part concerned the Company's primary steelmaking and first stage finishing facilities, downstream operations were also affected. In many instances, with the cooperation of its customers, the Company limited orders it would accept for finished products, rather than take orders it could not fill. The Company seeks to maximize the utilization of its production capacity. Until the Company began implementing its capital program in 1989, historically it had exceeded the industry average in that regard. However, during 1990 and 1991, outages and complications from several installations adversely affected the Company's relative position in the industry at a time when the industry itself was operating at near recessionary levels. Facilities outages, both planned and unplanned, which plagued operations during installation phases became less frequent throughout the break-in period for new equipment and, in 1993, were reduced to only one 2-day unscheduled outage due to flood water damage. In 1993, the Company produced 2.7 million tons of raw steel and shipped 2.4 million tons of finished and semi-finished steel products. The following table sets forth annual production capability, utilization rates and shipment information for the Company and the domestic steel industry (as reported by the American Iron and Steel Institute ("AISI")) for the period 1989 through 1993. [TEXT] STEELMAKING PROCESS In primary steelmaking, iron ore pellets, iron ore, coke, limestone and other raw materials are consumed in blast furnaces to produce molten iron or "hot metal." The Company then converts the hot metal into raw or liquid steel through its basic oxygen furnaces where impurities are removed, recyclable scrap is added and metallurgy for end use is determined on a batch by batch basis. The Company's basic oxygen process shop ("BOP") is one of the largest in North America, employing two vessels, each with a steelmaking capacity of 360 tons per heat. Liquid steel from the BOP is then formed into slabs through the process of continuous casting. The Company operates a multi-strand continuous caster, rebuilt in 1990, which allows the Company to cast 100% of its steel requirements. The slabs are then reheated, reduced and finished by extensive rolling, shaping, tempering and, in many cases, by the application of plating or coating at the Company's downstream operations. Finished products are normally shipped to customers in the form of coils. The Company believes that its hot rolling mill, with two walking beam reheat furnaces, reversing rougher and millstand drive and control improvements, greatly enhances its competitive capabilities. In addition, the Company has linked its steelmaking and rolling equipment with computer-control systems and is in the process of installing an integrated manufacturing control system to coordinate production and sales activities. RAW MATERIALS The Company purchases iron ore pellets, iron ore, coal, coke, limestone, scrap and other necessary raw materials in the open market. Substantially all the Company's raw materials needs are available through multiple sources where the primary concern is price rather than availability of supply; however, the Company continues to explore potential new sources of raw materials. In October 1991, the Company entered into a contract with a subsidiary of Cleveland-Cliffs Inc ("Cliffs") to purchase a substantial part of the Company's standard and/or flux grade iron ore pellet requirements for a twelve year period which began in 1992. The contract provides for a minimum tonnage of pellets to be supplied based on the production capacity of the mining source during the contract periods, and for additional tonnages of pellets in specified circumstances. Purchase prices established under the contract formulas may vary depending on whether the Company's Redeemable Preferred Stock, Series B, acquired by Cliffs at the time the supply agreement was entered into, has been redeemed. See Note 10 to the Company's Financial Statements included as Item 8 hereof for a more complete discussion of the Series B Preferred. The Company also has other contracts for iron ore pellets and iron ore through 1994. The Company and other steelmakers are installing technology calculated to achieve some reduction in the consumption of coke in blast furnace operations. However, if coke making capacity available to the industry continues to decline, future coke prices may be subject to significant escalation. Unlike many of the other major integrated producers, the Company does not have its own coke making facilities. From time to time, the Company has considered rebuilding the former coke making facilities of the Division; however, in view of the availability of metallurgical coke, its price and the emergence of alternative non-coking technologies for ironmaking, the Company does not believe an investment to rebuild those facilities is justified at this time. In July 1993, the Company entered into an agreement with USX Corporation to purchase blast furnace coke. The agreement provides for tonnages of 750,000 per calendar year in 1994 through 1996, or the actual annual requirements of the Company if less than the stated amount. The price is to be the prevailing market price for blast furnace coke determined each October prior to the delivery year. In 1990, the Company's continuous caster was rebuilt and placed back in service with enhanced capacity. Since that time, the rebuilt caster has achieved production levels which enable it to provide substantially all the Company's requirements for slabs. The increased capacity of the caster allowed the Company to close its ingot teeming and reduction operations in 1991. The Company's requirements for slabs have from time to time exceeded its caster's production ability and it has purchased and may continue to purchase slabs from other sources in order to meet the demand for its products and to maximize the overall production efficiency of its entire operations. In general, the Company does not expect to have undue difficulty in purchasing slabs as and when needed. However, in times of high capability utilization, slabs of certain required specifications may not be available from other producers. The primary sources of energy used by the Company in its steel manufacturing process are natural gas, oil, coal and electricity. The Company generates a significant amount of electricity and steam for processing operations from a mixture of excess blast furnace gas and natural fuels. The Company continually attempts to conserve and reduce the consumption of energy in its steelmaking operations. A number of the Company's facilities have alternate fuel burning capability. In recent years, due to the increased availability and sources of natural gas, the Company has entered into natural gas purchase contracts with gas suppliers and transportation contracts with transmission companies in an effort to reduce prices paid for gas. A substantial increase in the Company's energy costs or a shortage in the availability of its sources could have an adverse effect on the Company. Management believes that the Company's long term raw materials contracts are at competitive terms over the course of a business cycle. COMPETITION AND OTHER INDUSTRY FACTORS The domestic steel industry is a cyclical business with intense competition among producers. Manufacturers of products other than steel, including plastics, aluminum, cardboard, ceramics and glass, have made substantial competitive inroads into traditional steel markets. During recessionary periods, the industry's high level of production capacity relative to demand levels has resulted in a lack of ability to achieve satisfactory selling prices across a broad range of products. Integrated steelmakers also face increased competition from mini-mills. Mini-mills are relatively efficient, low-cost producers that generally produce steel from scrap in electric furnaces, utilize new technologies, have lower employment costs and target regional markets. Mini-mills historically have produced lower profit margin bars, rods, wire and other commodity-type steel products not produced by the Company. Recently developed thin cast technology has allowed mini-mills to enter certain of the sheet markets supplied by integrated producers, and certain mini-mills have built, or are building, facilities to do so. One such facility has been placed in operation and is competing in the hot rolled, cold rolled and galvanized marketplace. During the past decade, a number of domestic steelmakers have gone through reorganization under Chapter 11 of the United States Bankruptcy Code, including several of the Company's major competitors. Reorganization under Chapter 11 generally has enabled bankrupt companies to reduce costs, making them more efficient competitors. In response to increased competition, domestic steel producers have invested heavily in new plant and equipment, which has improved efficiency and increased productivity. Many of these improvements are in active service and, together with the achievement of other production efficiencies such as manning and other work rule changes, have tended to lower competitors' costs. The Company has responded to technological competitive pressures through its capital improvement program and strategies for future operating efficiencies. Foreign competition also remains a major concern. The VRAs covering 17 steel exporting nations and the European Community, which limited steel imports into the United States market, expired on March 31, 1992, and negotiations among governments in 36 countries to achieve a global multilateral steel agreement to reduce subsidies and other unfair trade practices by foreign producers have not yet resulted in any agreement being reached. The prospects of such an agreement being reached in the near future are not good. During 1993, steel imports were approximately 18% of total domestic steel consumption. Imports represent a slightly smaller percentage of consumption of sheet products and TMP, amounting to 13% and 11% of such consumption, respectively, in 1993. As a result of anti-dumping cases brought by domestic steelmakers, the Commerce Department, earlier in 1993, imposed tariffs averaging approximately 36.5% on imported, flat- rolled carbon steel from a number of countries. On July 27, 1993, however, the U.S. International Trade Commission (the "ITC") found that the domestic industry had sustained no injury from imports of hot rolled sheet, and no injury from 9 of 12 importing countries on cold rolled sheet. Several domestic producers have filed appeals of the ITC rulings. The ITC did affirm that the domestic industry had sustained injury from imports of coated sheet products, which has since reduced imports of the same and consequently improved domestic coated sheet pricing and volume. The Company's primary competitors in sheet products consist of substantially the entire steel industry. The Company's primary TMP competitors in recent years have been USX Corporation, LTV Corporation, Bethlehem Steel Corporation, National Steel Corporation, Wheeling-Pittsburgh Steel Corporation and USS-POSCO Industries. The Company experiences strong competition in all its principal markets with respect to price, service and quality. The Company believes that it competes effectively in all these categories by focusing its marketing efforts on high quality products and strong customer relationships. RESEARCH AND DEVELOPMENT The Company engages in research and devlopment for the improvement of existing products, the development of new products, and the development of product applications. It also seeks more efficient operating techniques. During 1993, 1992 and 1991, respectively, the Company spent approximately $5.4 million, $4.7 million, and $5.3 million for Company sponsored research and development activities. Expenditures for customer sponsored research have not been material to the Company. The Company operates WEIRTEC, its research and development center specializing in the advancement of steel food and beverage packaging and steel manufacturing processes. WEIRTEC maintains research and prototype steel packaging manufacturing facilities and analytical laboratory facilities located in Weirton. The facilities are engaged in improving the Company's production and finishing processes for TMP and sheet products. In recent years, WEIRTEC has played a central role in the development of thin-wall, two piece beverage can technology and other products seeking to capitalize on the Company's production expertise, particularly in coated products. See "Principal Products." The Company believes that the facilities and the scientists, engineers and technicians at WEIRTEC enhance the Company's technical excellence, product quality and customer service. The Company owns a number of patents that relate to a wide variety of products and applications and steel manufacturing processes, has pending a number of patent applications, and has access to other technology through agreements with other companies. The Company believes that none of its patents or licenses, which expire from time to time, or any group of patents or licenses relating to a particular product or process, is of material importance in its overall business. The Company also owns a number of registered trademarks for its products which, unlike patents and licenses, do not expire when they are continued in use and are properly protected. ENVIRONMENTAL CONTROL COMPLIANCE. The Company's business operations are affected by extensive federal, state and local laws and regulations governing discharges into the air and water, as well as the handling and disposal of solid and hazardous wastes. The Company is also subject to federal and state requirements governing the remediation of environmental contamination associated with past releases of hazardous substances. In recent years, environmental control regulations have been marked by increasingly strict compliance standards. Governmental authorities have the power to enforce compliance with these requirements, and violators may be subject to civil or criminal penalties, injunctions or both. Third parties also may have the right to sue to enforce compliance. Expenditures for environmental control facilities were approximately $1 million in 1993, $1 million in 1992, and $2 million in 1991. For 1994, the Company has budgeted approximately $3.3 million in capital expenditures toward environmental control facilities. Given the nature of the steelmaking industry, it can be expected that substantial additional capital expenditures will be required from time to time to permit the Company to remain in compliance with environmental regulations. In the past, the Company has entered into consent decrees with certain environmental authorities pursuant to which it has paid various fines and penalties relating to violations, or alleged violations, of laws and regulations in the environmental control area. Those payments have not been material to the Company's financial position or its cash flows. The Company believes that, at the present time, it is in substantial compliance with the various environmental control consent orders and agreements applicable to it and does not anticipate any material problems in taking required actions to remain in compliance with such orders and agreements. The Company does not operate coke making facilities and, accordingly, has not been affected by the stringent Clean Air Act limitations imposed on those installations. The Company's near-term focus for environmental compliance centers on procedures to achieve ambient air quality and water pollution control standards. In addition to improving its monitoring and study programs, the Company anticipates taking affirmative action to reduce sulfur dioxide and particulate emissions primarily by changing operating policies and by improving the quality of maintenance procedures. In an effort to improve its water pollution discharge compliance performance, the Company initiated in 1993 a full-time, round-the-clock environmental control supervisory function and is seeking to create a mobile maintenance group dedicated to high quality, environmentally safe operation. WASTE SITES AND PROCEEDINGS. Under the Comprehensive Environmental Response Compensation and Liability Act of 1980, as amended ("CERCLA"), and similar state statutes, the Environmental Protection Agency (the "EPA") and state regulators generally have authority to impose joint and several liability on waste generators, owners, operators and others with respect to superfund sites as potentially responsible parties ("PRPs"), regardless of fault or the legality of the original disposal activity. The Company is entitled to indemnification from National for certain environmental liabilities, including those relating to CERCLA and similar statutes, as more fully described below. The Company believes that National has registered a number of sites as required by CERCLA, some of which had been used by the Division prior to its sale to the Company, and two of which subsequently became the property of the Company. The Company understands that National has been involved, at the request of the EPA or state agencies, in voluntary remedial activities with respect to some sites; National has declined to participate with respect to some sites; National has declined to participate with respect to others (because its records do not indicate any involvement with those sites); and National has not been notified with respect to other sites. Insofar as any of those sites involve liabilities under CERCLA or other environmental laws or regulations for prior Division activities, the Company believes it is fully indemnified by National. In March 1988 and September 1989, respectively, the Pennsylvania Department of Environmental Resources and/or the EPA notified the Company that it was considered to be among a number of PRPs for the dumping of wastes at the Municipal and Industrial Disposal Company site near Elizabeth, Pennsylvania and at the Tex Tin site near Texas City, Texas, and requested the Company's voluntary participation in certain remedial actions. The Company's records do not indicate any involvement with either site by the Company. The Company believes that National would be responsible for any remedial actions, if there had been prior involvement by the Division. The Company has given all required notices to National for the purpose of facilitating its response to this matter. During February 1991, the Company received notification under CERCLA that it may incur or may have incurred a liability as a PRP with respect to a drum site located near Avenue H in Weirton, West Virginia. According to Company records, the drum site is on property owned, but never used, by the Company. Following consultation with appropriate agencies, the Company initiated a voluntary remediation program at the site, which program has been substantially completed. The Company has entered into negotiations with the EPA to resolve all remaining issues raised by the notification. The Company believes that National, under its agreements with the Company, is responsible for any environmental liabilities involving the site, including reimbursement for the total cost of the remediation program. National has reimbursed the Company for the $761,000 spent by the Company to date on the remediation program at this site. The Company believes that any future expenditures related to the remediation program will not exceed $100,000. In May 1992, the Company received notice from the Pennsylvania Department of Environmental Resources that it was considering a closure plan and post-closure plan for a solid waste landfill facility in Hanover Township, Pennsylvania (the "Hanover Site") operated by Starvaggi Industries Inc. From at least the 1960's through mid-1983, National and, after mid-1983, the Division and the Company disposed of solid wastes at the facility. The Company believes that certain of the solid wastes disposed of at the facility by National were classified as hazardous wastes under applicable law. The Company believes that while it disposed of various materials which were residual to the steelmaking industry, such materials were not classified as hazardous wastes under applicable law. At this time, definitive closure plans and post- closure care plans have not been adopted. National's liability to the Company under the indemnification agreements for liabilities which may result from the closure of this facility is limited to $1.0 million. However, the Company does not believe that any costs associated with these plans for which it would be responsible would exceed that amount. In October 1992, the Company entered into a consent order with the West Virginia Division of Environmental Protection (the "DEP") that provided for administrative fines and penalties to be assessed against the Company for asserted spills of various substances under provisions of the Federal Clean Water Act administered by such agency. The consent order required the payment of an administrative settlement in the amount of $99,000, as well as the application of $40,000 to a "Best Management Practices" ("BMP") plan to reduce or eliminate the frequency of hazardous waste spills, which plan is being implemented. The consent order also provides for stipulated penalties upon the occurrence of future spills. The Company is seeking to improve its operating practices to minimize the occurrence of spills. In January 1993, the Company received a notification from the DEP that four ground water monitoring wells situated at the Division's former coke making facilities on Brown's Island in Hancock County, West Virginia tested in excess of maximum contaminant levels established by the EPA and DEP for certain elements specified in the notice. The DEP requested the Company to supply it with additional data regarding the site and stated that it felt additional investigation, and possible remediation, would be required. The Company and the DEP are discussing the implementation of an enhanced ground water monitoring program for the area. As required by the relevant indemnification agreements, the Company has given notice to National of the DEP communication. As described more fully below, the Company believes that National will be responsible for any required remediation. In December 1993, the Company was informed by the DEP that the EPA was considering initiating a "multimedia" enforcement action against the Company during 1994. Such a proceeding could involve coordinated enforcement proceedings relating to water, air and waste-related issues stemming from a number of federal statutes and rules. The DEP has indicated that it prefers first to issue new NPDES water discharge permits to the Company and then monitor compliance by the Company before making any recommendation to the EPA. The Company expects that such permits could be issued by April 1994. However, no assurance can be given that a permit will be issued or that improved compliance by the Company or any recommendation by West Virginia environmental authorities to the EPA not to initiate such a proceeding will result in avoiding commencement of a multimedia enforcement action by the EPA. In recent years, such actions have resulted in penalties and other commitments being obtained from many of the Company's competitors. INDEMNIFICATION. According to the agreements by which the Company acquired the assets of the Division from National, the parties determined to apportion their respective responsibilities for environmental liability claims based on two dates, May 1, 1983 (the "Purchase Date"), and January 11, 1984 (the "Closing Date"). In general, the Company is entitled to indemnification from National for liabilities, including governmental and third-party claims, arising from violations prior to the Purchase Date, and National is entitled to indemnification from the Company for such items after the Purchase Date. In addition, the Company, subject to the $1.0 million limitation applicable to the Hanover Site described above, is entitled to reimbursement for clean-up costs related to facilities, equipment or areas involved in the management of solid or hazardous wastes of the Division ("Waste Sites"), as long as the Waste Sites were not used by the Company after the Closing Date. Third-party liability claims relating to Waste Sites are likewise covered by the parties' respective indemnification undertakings, in each case based on whether the particular site was used by the Company after the Closing Date. Until 1993, National had performed in accordance with its responsibilities under the applicable agreements with the Company. However, in July 1993, National indicated that it would not reimburse the Company for approximately $210,000 expended by the Company in cleaning out tar and other bottom sludge sediments from a lagoon at National's former Brown's Island Coke Plant (acquired by the Company on the Closing Date, but never operated). The Company performed this remediation in 1990 to avoid the facility becoming an unpermitted hazardous waste disposal site, but did not submit a final invoice until February 1993. National has indicated its belief that the Company was not entitled to reimbursement for remediation at this site. The Company believes that National's interpretation of the relevant agreements as applied to this site is erroneous. As a result of these developments, the Company's ability to obtain future reimbursement or indemnification relating to environmental claims from National has become more dependent on factors beyond the Company's control. These factors include, in addition to National's continued financial viability, the nature of future claims made by the Company, whether the parties can settle their differences relating to indemnification rights and the outcome of any necessary litigation. Although it is possible that the Company's future results of operations in particular quarterly or annual periods could be materially affected by the future costs of environmental compliance, the Company does not believe the future costs of environmental compliance will have a material adverse effect on its financial position or on its competitive position with respect to other integrated domestic steelmakers that are subject to the same environmental requirements. EMPLOYEES At December 31, 1993, the Company had 6,026 employees, of whom 4,542 were engaged in the manufacture of steel products, 779 in support services, 71 in sales and marketing activities and 634 in management and administration. The number of employees at December 31, 1993 represented an 8% reduction compared to the prior year end. The Company continues to implement a program as part of its business strategy designed to reduce its workforce primarily through retirement programs and attrition. The Company's goal by 1997 is to reduce its workforce by another 15% from the 1993 year end level. The Company has new collective bargaining agreements with the Independent Steelworkers Union, which represents 4,966 employees in bargaining units covering production and maintenance workers, clerical workers, nurses, and the Independent Guard Union, which represents 39 employees. The agreements run through September 25, 1996. The Company believes that its compensation structure places a heavier emphasis on profit sharing compared to other major integrated steel producers. This tends to cause the wage portion of the Company's employment costs to be relatively higher during periods of profitability and relatively lower during periods of low earnings or losses. The agreements provide for the payment of bonuses in the gross amount of $3,500 per employee, paid in installments, but do not provide for wage increases. Through the end of the new agreements, the Company's profit sharing plan, which covers substantially all employees, provides for participants to share in the Company's profits each year at a rate equal to 1/3 of the Company's "adjusted net earnings" for that year as defined under the plan, provided its net worth exceeds $100 million. If, however, payment of the full profit sharing amount would reduce the Company's net worth below $100 million, payments are reduced to an amount necessary to maintain the $100 million threshold. If the Company's net worth is in excess of $250 million, the profit sharing rate increases to 35%. However, if payment of the full profit sharing amount would reduce the Company's net worth below $250 million, payments at this rate would be limited as necessary to maintain the $250 million threshold and the remainder of the payment would be made at the 1/3 rate. The agreements limit the Company's exposure to increased costs of healthcare while providing increased medical coverages through a mandatory managed healthcare "point of service" program and a ceiling on the Company's cash basis cost of healthcare for future retirees. Although no assurances can be given, the Company anticipates a savings of approximately $24 million over three years as a result of these healthcare programs. The agreements also contain limitations on the Company's ability to reduce its workforce by layoffs, with exceptions for adverse financial, operational, and business circumstances. In addition, the parties have agreed to certain improvements in the Company's pension plan, which the Company anticipates will increase costs on an annual basis by approximately $7.5 million. From January 1984 until June 1989, the Company was owned in its entirety by its employees through an Employee Stock Ownership Plan (the "1984 ESOP"). In June 1989, the 1984 ESOP completed a public offering of 4.5 million shares of common stock of the Company, which security is now listed and traded on the New York Stock Exchange. In connection with the public offering of common stock, the Company also sold 1.8 million shares of Convertible Voting Preferred Stock, Series A (the "Series A Preferred") to a new Employee Stock Ownership Plan which shares are entitled to ten times the number of votes of the common stock into which it is convertible. Substantially all of the Company's employees participate in the two ESOPs which, after giving effect to the above-mentioned and certain other transactions, owned approximately 52% of the combined issued and outstanding common and preferred shares of the Company at December 31, 1993. This, in turn, accounts for approximately 75% of the voting power of the Company's voting stock. Item 2. Item 2. Properties and Facilities The Company owns approximately 2,500 acres in the Weirton, West Virginia, area which are devoted to the production and finishing of steel products, research and development, storage, support services and administration. The Company owns trackage and railroad rolling stock for materials movement, water craft for barge docking, power generation facilities and numerous items of heavy industrial equipment. The Company has no material leases for property. The Company's mill and related facilities are accessible by water, rail and road transportation. The Company believes that its facilities are suitable to its needs and are adequately maintained. The Company's operating facilities include four blast furnaces; however, its current operating strategy employs a two blast furnace configuration with an annual hot metal capacity of approximately 2.5 million tons. One currently idled furnace is being refurbished and will replace one operating furnace that is nearing the end of its campaign which is estimated to be in 1995, at which time the Company will undertake a major reline of that furnace. Although the Company does not anticipate operating a three blast furnace configuration in the near term, under this operating scenario, its annual hot metal capacity could be increased to 3.2 million tons. The Company's primary steelmaking facilities also include a sinter plant, and a two vessel BOP with an annual capacity of 3.0 million tons of raw steel based on a two blast furnace operation. During December 1993, the Company began the installation of a new vessel in its BOP furnace, replacing one that had been in service for nearly 20 years. The new vessel was placed in service in early February 1994. The Company's primary steelmaking facilities also include a CAS-OB facility, two RH degassers, a four strand continuous caster with an annual slab production capacity of up to 3.0 million tons. The Company's downstream operations include a hot strip mill with a design capacity of 3.8 million tons, two continuous picklers, three tandem cold reduction mills, three hot dip galvanize lines, one electro- galvanize line, two tin platers, one chrome plater, one bi-metallic chrome/tin plating line and various annealing, temper rolling, shearing, cleaning and edge slitting lines, together with packaging, storage and shipping and receiving facilities. See the "Production and Shipments" section of Item 1 for additional information regarding production capacity and utilization rates. Item 3. Item 3. Legal Proceedings On August 7, 1992, an action entitled "Larry G. Godich, et. al. v Herbert Elish, et. al." was commenced in the West Virginia Circuit Court for Hancock County against ten current members of the Company's Board of Directors, certain officers of the Company, former Board members, the Company's outside counsel, and the Company. The suit purports to be brought derivatively by stockholders on behalf of the Company and seeks a recovery on its behalf. The plaintiffs' complaint alleges that the defendants were negligent or grossly negligent in the selection and supervision of contractors engaged by the Company to design and construct reheat furnaces for the hot mill project under the capital improvement program, thereby breaching their respective fiduciary and other duties to the Company and, as a result, that the Company incurred substantial cost overruns in connection with the specific project. The complaint seeks compensatory damages, jointly and severally, against all defendants in the amount of $30 million. In November 1992, plaintiffs dismissed the claims against outside counsel. A trial date for this suit has been scheduled for the second quarter of 1994. Following dismissal of claims against outside counsel, plaintiffs made demands on the Board of Directors to initiate legal proceedings for malpractice against outside counsel and a director who is a member of that firm, a former director and the law firm of which he is a member, and the Company's independent public accountants. In July 1993, plaintiffs reinstituted suit against outside counsel and also filed suit against an additional officer of the Company. This suit is in the early stages of discovery. Since both suits are on behalf of the Company, if the plaintiffs prevail, the Company would receive the net benefit of any recovery. The Company is involved in other litigation relating to claims arising out of its operations in the normal course of business. Such claims are generally covered by insurance. It is management's opinion that any liability resulting from existing litigation would not have a material adverse effect on the Company's business or financial position. Item 4. Item 4. Submission of Matters to a Vote of Security Holders The Company scheduled a Special Meeting of Stockholders for November 11, 1993 to approve a proposal to amend the Company's Restated Certificate of Incorporation to increase its authorized capital. On November 9, 1993, the Company's Board of Directors canceled the meeting. Reference is made to Item 5 Item 5. Market for the Registrant's Common Stock and Related Security Holder Matters As of March 15, 1994, there were 26,639,894 shares of common stock, $.01 par value ("Common Stock"), outstanding held by 2,907 stockholders of record. The principal market for the Common Stock is the New York Stock Exchange, on which that security has been listed since June 1989. Prior to that date, all Common Stock was held by the Company's 1984 ESOP and did not trade on any exchange. Dividends on the Company's Common Stock are paid when and as declared by the Company's Board of Directors. Quarterly cash dividends of $0.16 per share on Common Stock were last paid on December 15, 1990. The payment of future dividends is subject to the applicable provisions of Delaware corporate law governing the Company and the discretion of the Company's Board of Directors, which normally will take into consideration applicable provisions of the Company's Certificate of Incorporation, as well as its financial performance, and its capital requirements. Under covenants of the indenture covering the Company's 11-1/2% Senior Notes, the Company's ability to pay dividends on its Common Stock is limited as to the payment of aggregate dividends after March 31, 1993, to the greater of (i) $5.0 million or (ii) $5.0 million plus one-half of the Company's cumulative consolidated net income since March 31, 1993, plus the net proceeds from future issuances of certain capital stock less certain allowable payments. As of December 31, 1993, pursuant to this covenant, the Company's ability to pay dividends on its Common Stock was limited to $5.0 million. As of March 15, 1994, 12,826,723 shares of Common Stock, or 47.7% of the outstanding shares of Common Stock, were held by one stockholder of record, United National Bank - North, as Trustee of the 1984 ESOP. As of that date, the 1984 ESOP had approximately 7,735 participants who were active or former employees of the Company. In addition, as of March 15, 1994 there were 1,779,681 shares of Series A Preferred Stock outstanding held by 240 stockholders of record. As of that date, United National Bank - North, as Trustee of the Company's 1989 ESOP, was the record owner of 1,774,164 shares of the Series A Preferred Stock, or over 99% of the outstanding shares of Series A Preferred Stock, subject to the terms and conditions of said Plan. As of that date, the 1989 ESOP had approximately 7,829 participants who were active or former employees of the Company. The Series A Preferred Stock is not listed for trading on any exchange. The Series A Preferred Stock has a preference of $5 per share over the Common Stock on liquidation and is convertible into one share of Common Stock, subject to adjustment. Each share of Series A Preferred Stock is entitled to 10 times the number of votes as the Common Stock into which it is convertible. Participants in the Company's two ESOPs have full voting rights over all shares allocated to their accounts. See "Employees" included in Item 1. As of March 15, 1994, there were 500,000 shares of the Company's Redeemable Preferred Stock, Series B outstanding, held by one stockholder of record. The Series B Preferred Stock, which is ordinarily non-voting, was issued in October 1991 to evidence a $25 million investment in the Company by Cliffs. See Note 10 to the Financial Statements. The following table sets forth, for the periods indicated, the high and low sales prices of the Common Stock as reported in the consolidated transaction reporting system. [TEXT] Item 6. Item 6. Selected Financial Data The information required by this Item is incorporated herein by reference to "Selected Financial and Statistical Data" on page 48 of the Company's 1993 Annual Report to Stockholders. With the exception of the information specifically incorporated by reference, the 1993 Annual Report to Stockholders is not to be deemed filed as part of this Report for purposes of this Item. Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations The information required by this Item is incorporated herein by reference to pages 19 to 24, inclusive, of the Company's 1993 Annual Report to Stockholders. With the exception of the information specifically incorporated by reference, the 1993 Annual Report to Stockholders is not to be deemed filed as part of this Report for purposes of this Item. Item 8. Item 8. Financial Statements and Supplementary Data The financial statements and supplementary data required by this Item are incorporated herein by reference to pages 25 to 46, inclusive, of the Company's 1993 Annual Report to Stockholders and are listed in "Item 14.--Exhibits, Financial Statement Schedules and Reports on Form 10-K" hereof. Item 9. Item 9. Changes in or Disagreements with Accountants on Accounting and Financial Disclosure None PART III Item 10. Item 10. Directors and Executive Officers of the Registrant Directors of the Company The information required by this item with respect to Directors of the Company is incorporated herein by reference to the caption "Election of Directors" in the Company's definitive Proxy Statement relating to its 1994 Annual Meeting of Stockholders. With the exception of the information specifically incorporated by reference, said definitive Proxy Statement is not to be deemed filed as part of this report for purposes of this item. Executive Officers of the Company The executive officers of the Company as of March 15, 1994, were as follows: Age at March 15, NAME 1994 OFFICE Herbert Elish 60 President, Chairman and Chief Executive Officer Craig T. Costello 46 Vice President - Operations William C. Brenneisen 52 Vice President - Human Resources James B. Bruhn 53 Vice President - Tin Mill Products Business Thomas W. Evans 57 Vice President - Materials Management David M. Gould 55 Vice President - Sales and Marketing Sheet Products William R. Kiefer 44 Vice President - Law and Secretary Dennis R. Mangino 50 Vice President - Product Quality & WEIRTEC Narendra M. Pathipati 36 Treasurer Richard K. Riederer 50 Vice President and Chief Financial Officer Mac S. White, Jr. 61 Vice President - Engineering Unless otherwise indicated below, the executive officers of the Company have held the positions described for at least the last five years. Herbert Elish has been Chairman of the Board of Directors, President and Chief Executive Officer of the Company since July 1987. He has been a director of the Company since 1983. From April 1986 until July 1987, Mr. Elish was Senior Vice President of Dreyfus Corp., a company engaged in financial services. Previously, he served as a Senior Vice President of International Paper Company, a producer of paper, paper packaging and forest products. William C. Brenneisen has served as the Company's Vice President - Human Resources since February 1988. From September 1985 through February 1988, he was the Director of Industrial Relations for the Company. James B. Bruhn joined the Company as Vice President - Sales and Marketing - Tin Mill Products in July 1987. He has been a director of the Company since May 1990. He was appointed Vice- President Tin Mill Products Business, with added responsibility for tin finishing operations in November 1992. From May 1985 until July 1987, he served as Vice President - Sales and Marketing for Titanium Metals Corporation of America. Craig T. Costello has been Vice President - Operations since October 1993. Mr. Costello served as General Manager - Operations since 1988 and prior to that was responsible for the design, building, and operation of the Hot Mill Rebuild. Thomas W. Evans has been Vice President - Materials Management since February 1988. From April 1986 to February 1988, he was Vice President - Purchasing and Traffic. From 1979 to April 1986, he was Vice President - Material Control for Sharon Steel Corporation. David M. Gould has served as the Company's Vice President - - Sales and Marketing - Sheet Products since 1983. He was a director of the Company from February 1989 to May 1990. Mr. Gould has been employed by the Company and its predecessor for over 30 years. William R. Kiefer has been the Company's Vice President - Law and Secretary since May 1990. From March 1988 to May 1990 he was Director - Legal Affairs and Secretary. From February 1985 to March 1988, he was Corporate Attorney and Assistant Secretary for the Company. Dennis R. Mangino has served as a Vice President of the Company at WEIRTEC since November 1989. From February 1986 to October 1989, Mr. Mangino was employed by Enichem America where he served as Director - Corporate Division and General Manager - Electrical Materials Division. Narendra M. Pathipati has served as Treasurer of the Company since August 1991. From February 1990 to July 1991, he served as Director of Financial Planning and Analysis for the Company. Mr. Pathipati served as Treasurer for Century II, Inc., a multi-national capital goods manufacturer, from April 1988 to January 1990. Previous to that, he was responsible for financial planning at Harnischfeger Industries, Inc. Richard K. Riederer has been Vice President and Chief Financial Officer of the Company since January 1989. He has been a director of the Company since October 1993. From March 1986 to December 1988, he served as Vice President and Treasurer of Harnischfeger Industries, Inc., a producer of manufacturing equipment. Mr. Riederer is also a director of Portico Funds Inc. Mac S. White, Jr. has been Vice President - Engineering of the Company since May 1992. From April 1989 to April 1992, Mr. White was Director of Engineering for the Company. Prior to that, he was Director of Project Management for Italimpianti, Spa., a steel mill equipment builder. Item 11. Item 11. Executive Compensation The information required by this Item is incorporated herein by reference to the caption "Executive Compensation" in the Company's definitive Proxy Statement relating to its 1994 Annual Meeting of Stockholders. With the exception of the information specifically incorporated by reference, said definitive Proxy Statement is not to be deemed to be filed as part of this report. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management The information required by this Item is incorporated herein by reference to the caption "Security Ownership of Certain Beneficial Owners and Management" in the Company's definitive Proxy Statement relating to its 1994 Annual Meeting of Stockholders. With the exception of the information specifically incorporated by reference, said definitive Proxy Statement is not to be deemed to be filed as part of this report. Item 13. Item 13. Certain Relationships and Related Transactions The information required by this Item is incorporated herein by reference to the caption "Certain Relationships and Related Transactions" in the Company's definitive Proxy Statement relating to its 1994 Annual Meeting of Stockholders. With the exception of the information specifically incorporated by reference, said definitive Proxy Statement is not to be deemed to be filed as part of this report. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K 1. The list of financial statements required to be filed by "Item 8 - -Financial Statements and Supplementary Data" of this Annual Report on Form 10-K is as follows: Page Financial Statements a. Independent Public Accountants' Report * b. Statements of Income for the years ended December 31, 1993, 1992, and 1991. . . * c. Balance Sheets as of December 31, 1993 and 1992 . . . . . . . . . * d. Statements of Cash Flows for the years ended December 31, 1993, 1992, and 1991 * e. Notes to Financial Statements. . . . . * Supplementary Financial Information * * Incorporated in this Report by reference from pages 25 to 46, inclusive, of the Company's 1993 Annual Report to Stockholders referred to below. 2. The list of financial statement schedules required to be filed by "Item 8 - -Financial Statements and Supplementary Data" of this Annual Report on Form 10-K is as follows: a. Independent Accountants' Report on Financial Statement Schedules . . . . . . . . . . . . . S-1 b. Schedules: III - Condensed Financial Information of Registrant S-2 V - Property, Plant and Equipment S-3 VI - Accumulated Depreciation of Property, Plant and Equipment S-4 VIII - Valuation and Qualifying Accounts S-5 IX - Short-term Borrowings S-6 X - Supplementary Income Statement Information S-7 3. Exhibits The following listing of exhibits are included in this Report or incorporated herein by reference. Exhibit 3.1 Restated Certificate of Incorporation of the Company (incorporated by reference to Exhibit 3.1 to the Company's Registration Statement on Form S-1 filed May 3, 1989, Commission File No. 33-28515). Exhibit 3.2 By-laws of the Company (incorporated by reference to Exhibit 3.3 to the Company's Registration Statement on Form S-1 filed May 3, 1989, Commission File No. 33-28515). Exhibit 3.3 Certificate of the Designation, Powers, Preferences and Rights of the Convertible Voting Preferred Stock, Series A (incorporated by reference to Exhibit 3.2 to the Company's Annual Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 on Form 10-K filed March 28, 1990, Commission File No. 1-10244). Exhibit 3.4 Certificate of Designation, Powers, Preferences and Rights of the Redeemable Preferred Stock, Series B (incorporated by reference to Exhibit 4.1 to the Company's Current Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 on Form 8-K filed October 9, 1991, Commission File No. 1-10244). Exhibit 4.1 Indenture dated October 17, 1989 between the Company and First Bank (N.A.) as Trustee, pursuant to which the 10-7/8% Senior Notes due October 15, 1999 Notes were issued (incorporated by reference to Exhibit 4.1 to the Company's Annual Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 on Form 10-K filed March 28, 1990, Commission File No. 1-10244). Exhibit 4.2 Form of Notes (included as Exhibit A to Exhibit 4.1). Exhibit 10.1 Pellet Sale Agreement dated June 25, 1991, between USX Corporation and the Company (incorporated by reference to Exhibit 10.2 to the Company's Annual Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 on Form 10-K filed March 27, 1992, Commission File No. 1-10244). Exhibit 10.2 1984 Employee Stock Ownership Plan, as amended and restated (incorporated by reference to Exhibit 10.3 to the Company's Annual Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 on Form 10-K filed March 28, 1990, Commission File No. 1- 10244). Exhibit 10.3 1989 Employee Stock Ownership Plan (incorporated by reference to Exhibit 10.4 to the Company's Annual Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 on Form 10-K filed March 28, 1990, Commission File No. 1-10244). Exhibit 10.4 1987 Stock Option Plan (incorporated by reference to Exhibit 10.5 to the Company's Registration Statement on Form S-1 filed May 3, 1989, Commission File No. 33-28515). Exhibit 10.5 Employment Agreement between Herbert Elish and the Company dated as of July 1, 1990 (incorporated by reference to Exhibit 10.6 to the Company's Annual Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 on Form 10-K, filed April 1, 1991, Commission File No. 1-10244). Exhibit 10.6 Employment Agreement between Warren E. Bartel and the Company (incorporated by reference to Exhibit 10.8 to the Company's Registration Statement on Form S-1 filed May 3, 1989, Commission File No. 33-28515). Exhibit 10.7 Employment Agreement between James B. Bruhn and the Company (incorporated by reference to Exhibit 10.11 to the Company's Registration Statement on Form S-1 filed May 3, 1989, Commission File No. 33-28515). Exhibit 10.8 Employment Agreement between Thomas W. Evans and the Company dated April 21, 1987 (filed herewith). Exhibit 10.9 Employment Agreement between Richard K. Riederer and the Company (incorporated by reference to Exhibit 10.12 to the Company's Registration Statement on Form S-1 filed May 3, 1989, Commission File No. 33-28515). Exhibit 10.10 Stock Purchase and Contribution Agreement dated September 27, 1991 among the registrant and U.S. Trust Company of California, N.A., as investment manager (incorporated by reference to Exhibit 10.1 to the Company's Current Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 on Form 8-K filed October 9, 1991, Commission File No. 1- 10244). Exhibit 10.11 Preferred Stock Purchase Agreement dated as of September 30, 1991 between the registrant and Cleveland-Cliffs Inc (incorporated by reference to Exhibit 10.2 to the Company's Current Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 on Form 8-K filed October 9, 1991, Commission File No. 1- 10244). Exhibit 10.12 Registration Rights Agreement dated October 2, 1991 between the registrant and Cleveland- Cliffs Inc (incorporated by reference to Exhibit 10.3 to the Company's Current Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 on Form 8-K filed October 9, 1991, Commission File No. 1- 10244). Exhibit 10.13 Redacted Pellet Sale and Purchase Agreement dated as of September 30, 1991 between the Cleveland-Cliffs Iron Company and the Company (incorporated by reference to Exhibit 10.18 to the Company's Quarterly Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 on Form 10-Q filed August 14, 1992, Commission File No. 1-10244). Exhibit 10.14 Deferred Compensation Plan for Directors effective as of January 1, 1991, for all directors who are not officers or other employees of the Company (incorporated by reference to Exhibit 10.19 of the Company's Annual Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 on form 10-K filed April 1, 1991, Commission File No. 1-10244). Exhibit 10.15 Registration Rights Agreement dated September 30, 1991, between the Company and U.S.Trust Company of California, N.A. (incorporated by reference to Exhibit 1 to the Company's Quarterly Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 on Form 10-Q filed November 14, 1991, Commission File No. 1-10244). Exhibit 10.16 Amendment No. 1 dated September 30, 1992, to the Registration Rights Agreement dated September 30, 1991, among the Company and U.S. Trust Company of California, N.A. (incorporated by reference to Exhibit 10.34 of Amendment 2 to the Company's Registration Statement on Form S- 2 filed February 9, 1993, Commission File No. 33-53476). Exhibit 10.17 Stock Contribution Agreement dated September 30, 1992, between the Company and U.S. Trust Company of California, N.A., as investment manager (incorporated by reference to Exhibit 10.36 of Amendment 2 to the Company's Registration Statement on Form S-2 filed February 9, 1993, Commission File No. 33- 53476). Exhibit 10.18 Coke Sale Agreement dated January 1, 1993 and signed July 13, 1993 between the Registrant and USX Corporation (incorporated by reference to Exhibit 10.30 to the Company's quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 filed August 13, 1993, Commission File No. 1-10244). Exhibit 10.19 Employment Agreement between Craig T. Costello and the Company dated July 20, 1993 (filed herewith). Exhibit 10.20 Employment Agreement between William R. Kiefer and the Company dated July 21, 1993 (filed herewith). Exhibit 10.21 Employment Agreement between Dennis R. Mangino and the Company dated July 26, 1993 (filed herewith). Exhibit 10.22 Employment Agreement between John H. Walker and the Company dated July 21, 1993 (filed herewith). Exhibit 10.23 Employment Agreement between Narendra M. Pathipati and the Company dated December 16, 1993 (filed herewith). Exhibit 10.24 Employment Agreement between Mac S. White and the Company dated July 28, 1993 (filed herewith). Exhibit 10.25 Amendment dated August 5, 1993 to the Employment Agreement dated July 1, 1990 between Herbert Elish and the Company (filed herewith). Exhibit 10.26 Amendment dated July 19, 1993 to the Employment Agreement dated June 8, 1987 between David M. Gould and the Company (filed herewith). Exhibit 10.27 Amendment dated July 21, 1993 to the Employment Agreement dated June 8, 1987 between William C. Brenneisen and the Company (filed herewith). Exhibit 10.28 Amendment dated July 19, 1993 to the Employment Agreement dated April 21, 1987 between Thomas W. Evans and the Company (filed herewith). Exhibit 13.1 1993 Annual Report to Stockholders of Weirton Steel Corporation (filed herewith). Except for those portions of the Annual Report specifically incorporated by reference, such report is furnished for the information of the Securities and Exchange Commission and is not to be deemed filed as part of this Annual Report on Form 10-K. Exhibit 22.1 Subsidiaries of the Registrant (filed herewith). Exhibit 24.1 Consent of Arthur Andersen & Co., independent public accountants (filed herewith). (b) The Registrant filed a report on Form 8-K in reference to Item 5 thereof on November 23, 1993. (c) The exhibits as listed under Item 14.(a)(3), are filed herewith or incorporated herein by reference. (d) The financial statement schedules listed under Item 14.(a)(2), are filed herewith. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, Weirton Steel Corporation has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized, on the 28th day of March, 1994. WEIRTON STEEL CORPORATION By /s/ Herbert Elish Herbert Elish Chairman, President and Chief Executive Officer /s/ Richard K. Riederer Richard K. Riederer Vice President and Chief Financial Officer (Principal Financial and Accounting Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this Report has been signed below by the following persons on behalf of Weirton Steel Corporation and in the capacities indicated on the 28th day of March, 1994. /s/ Herbert Elish /s/ F. James Rechin Herbert Elish F. James Rechin Chairman of the Board Director /s/ Richard K. Riederer /s/Richard F. Schubert Richard K. Riederer Richard F. Schubert Director Director /s/ James B. Bruhn James B. Bruhn Phillip H. Smith Director Director /s/ Harvey L. Sperry Robert J. D'Anniballe, Jr. Harvey L. Sperry Director Director Mark G. Glyptis Thomas R. Sturges Director Director /s/ Gordon C. Hurlbert /s/ David I.J. Wang Gordon C. Hurlbert David I.J. Wang Director Director Phillip A. Karber Director Arthur Andersen & Co. 2100 One PPG Place Pittsburgh, PA 15222 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Board of Directors of Weirton Steel Corporation: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements included in Weirton Steel Corporation's Annual Report to shareholders incorporated by reference in this Form 10-K, and have issued our report thereon dated January 24, 1994. Our audit was made for the purpose of forming an opinion on those basic financial statements taken as a whole. The schedules listed in the index in Item 14 - 2(b) of the Form 10-K are the responsibility of the Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not a part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly state 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 & Co. ARTHUR ANDERSEN & CO. Pittsburgh, Pennsylvania January 24, 1994 S-1

1993 ITEM 1. BUSINESS GENERAL PACCAR Financial Corp. PACCAR Financial Corp. (the "Company"), a wholly owned subsidiary of PACCAR Inc ("PACCAR"), is a Washington corporation organized in 1961 to finance the sale of PACCAR products. The Company provides retail financing and leasing of trucks and related equipment manufactured primarily by PACCAR and sold through PACCAR's independent dealers in the United States. The Company also finances dealer inventories of transportation equipment. PACCAR Inc PACCAR is a multi-national company which designs and manufactures various types of industrial equipment that are marketed primarily through its dealers. Class 8 heavy-duty diesel trucks (gross vehicle weight in excess of 33,000 pounds) and related service parts are the principal products of PACCAR and accounted for 88% of PACCAR's total revenues in 1993. PACCAR markets these trucks under the "Kenworth," "Peterbilt" and "Foden" nameplates. They are manufactured in five plants in the United States. Outside of the U.S., the Company manufactures and sells through wholly owned subsidiary companies in Canada and Australia, through a United Kingdom branch of a wholly owned U.S. subsidiary and through an affiliate in Mexico. PACCAR also manufactures medium-duty trucks in Canada which are distributed in the United States and Canada. Other PACCAR products include industrial winches and oilfield equipment. PACCAR competes in the truck parts aftermarket primarily through its dealer network and also sells general automotive parts and accessories through retail outlets. In the United States, Kenworth and Peterbilt trucks are sold to an independent dealer network, consisting of 310 outlets, for resale to retail purchasers. Trucks manufactured in the United States for export are marketed by a division of PACCAR through an international dealer network. In addition to the Company, which provides financing and leasing in the United States, four other subsidiaries of PACCAR offer similar financing programs for PACCAR products in Canada, Australia and the United Kingdom. As of December 31, 1993, PACCAR and its subsidiaries had total assets of $3.3 billion and stockholders' equity of $1.1 billion. For the year ended December 31, 1993, PACCAR's consolidated revenues and net income were $3.6 billion and $142.2 million respectively. There were six principal competitors, including PACCAR, in the United States Class 8 truck market in 1993. Based on 1993 industry registration statistics, PACCAR's Kenworth and Peterbilt combined truck sales accounted for approximately 22% of domestic Class 8 new truck registrations. The domestic heavy-duty truck market is highly competitive in price, quality and service. PACCAR is not dependent on any single customer for its sales. PACCAR's common stock, $12 par value, is traded in the over-the- counter market under the NASDAQ symbol "PCAR." PACCAR is subject to the informational requirements of the Securities Exchange Act of 1934 and in accordance therewith files reports and other information with the Securities and Exchange Commission (the "Commission"). All reports, proxy statements and other information filed by PACCAR with the Commission may be inspected and copied at the Public Reference Section of the Commission at 450 Fifth Street NW, Washington, D.C. 20549. BUSINESS OF THE COMPANY The Company operates primarily in one industry segment, truck and related equipment financing. The Company provides retail, inventory and lease financing for dealers selling Kenworth and Peterbilt trucks in the United States. In addition, the Company provides financing for dealers for new Class 6, 7 and 8 trucks and used trucks, regardless of make or model. Financing is also provided for truck trailers and allied equipment such as mixer and dump bodies attached to the truck. The Company currently conducts business with most PACCAR dealers. The volume of the Company's business is significantly affected by PACCAR's sales and competition from other financing sources. As of December 31, 1993, the Company employed 224 full-time employees, none of whom are represented by a collective bargaining agent. The Company considers relations with its employees to be good. The Company's Products The receivables acquired in the Company's retail financing activities include retail installment obligations of purchasers of new and used trucks and related equipment (the "Retail Contracts") and loan obligations of dealers secured by retail installment contracts originated and owned by those dealers (the "Pledge Line Contracts"). The Company provides financing of dealer inventories for new and used trucks and related equipment (the "Wholesale Contracts"). The Company's leases to customers are classified as direct financing or operating leases (the "Leases"). Retail Receivables Retail Contracts. The Company purchases contracts from dealers and receives assignments of the contracts and a first lien security interest in the vehicles financed. Collateral for vehicles sold to leasing companies may also include an assignment of leases and rentals due thereunder. Retail Contracts purchased by the Company have fixed or floating interest rates. At December 31, 1993, approximately 80% in principal amount of the Retail Contracts outstanding had fixed interest rates. At December 31, 1993, approximately 82% of the Company's Retail Contracts outstanding were for sales of new equipment. Pledge Line Contracts These contracts are an alternative form of retail financing offered to selected dealers for new and used trucks. Retail installment contracts originated by the dealer for new or used trucks and meeting the Company's requirements as to form, terms and creditworthiness for Retail Contracts, are pledged to the Company as collateral for direct, fixed or floating interest rate, full recourse loans by the Company to the dealer. Wholesale Contracts The Company currently provides wholesale financing for new and used truck and trailer inventories for dealers. Wholesale Contracts are secured by the inventories financed. The amount of credit extended by the Company for each truck is generally limited to the invoice price of new equipment and to the wholesale value of used equipment. At December 31, 1993, approximately 81% of the Company's Wholesale Contracts were for the financing of new equipment. Interest under Wholesale Contracts is based upon floating rates. Leases The Company offers lease contracts where it is treated as the owner of the equipment for tax purposes and generally retains the tax depreciation. The lessee is responsible for the payment of property and sales taxes, licenses, maintenance and other operating items. The lessee is obligated to maintain the equipment, to return it to the Company in good repair and to insure the equipment against casualty losses. Most of the Company's lease contracts contain a Terminal Rental Adjustment Clause (TRAC) which requires the lessee to guarantee to the Company a stated residual value upon disposition of the equipment at the end of the lease term. Insurance In 1993, the Company initiated a property damage insurance program offered through PACCAR dealers who are licensed insurance agents. The Company retains the premium revenue and loss exposure for the policies which are issued by an unrelated insurance carrier. In 1993, these activities were immaterial to the Company's results. CUSTOMER CONCENTRATION, PAST DUE ACCOUNTS AND LOSS EXPERIENCE Customer Concentration At December 31, 1993, the largest single retail or lease customer represented 1.7% of the Company's net receivables, and the five largest such accounts amounted to 6.4% of net receivables. With respect to wholesale financing, at December 31, 1993, the largest single dealer accounted for .8% of the Company's net receivables and the five largest dealers collectively accounted for 2.2% of net receivables. At December 31, 1993, the largest Pledge Line dealer borrowing amounted to 6.5% of the Company's net receivables and the five largest dealer notes under Pledge Line Contracts amounted to 11.1% of net receivables. Pledge Line Contracts are secured by numerous retail installment contracts which offset the amount of dealer concentration. Past Due Retail Contract Receivables and Allowance for Losses An account is considered past due by the Company if any portion of an installment is due and unpaid for more than 30 days. In periods of adverse economic conditions, past due levels, repossessions and losses generally increase. The Company maintains an allowance for losses on receivables at a level which it considers to be adequate based on management's estimates of future losses. The following table summarizes the activity in the Company's allowance for losses on receivables and presents related ratios: Allowance for Losses (Thousands of Dollars) For discussion of the allowance for losses and past due receivables, see "Management's Discussion and Analysis of Financial Condition and Results of Operations, 1991-1993." COMPETITION AND ECONOMIC FACTORS The truck financing business is highly competitive among banks, commercial finance companies, captive finance companies and leasing companies. Many of these institutions have substantially greater financial resources than the Company and may occasionally borrow funds at lower rates. The dealers are the primary source of contracts acquired by the Company. However, dealers are not required to obtain financing from the Company, and they have a variety of other sources which may be used for wholesale and customer retail financing of trucks. Retail purchasers also have a variety of sources available to finance truck purchases. The ability of the Company to compete in its market is principally based on the rates and terms which the Company offers dealers and retail purchasers, as well as the specialized services it provides. Rates and terms are based on the Company's desire to provide flexible financing which meets dealer and customer financing needs, the ability of the Company to borrow funds at competitive rates and the Company's need to earn an adequate return on its invested capital. The Company's business is also affected by changes in market interest rates, which in turn are related to general economic conditions, demand for credit, inflation and governmental policies. Seasonality is not a significant factor in the Company's business. The volume of receivables available to be acquired by the Company from dealers is largely dependent upon the number of Kenworth and Peterbilt trucks sold. Domestic sales of heavy-duty trucks depend on the capital equipment requirements of the transportation industry, which in turn is influenced by economic growth and cyclical variations in the economy. Heavy-duty truck sales are also sensitive to economic factors such as fuel costs, interest rates, federal excise and highway use taxes and taxation of the acquisition and use of capital goods. REGULATIONS AND SIMILAR MATTERS In certain states, the Company is subject to retail installment sales or installment loan statutes and related regulations, the terms of which vary from state to state. These laws may require the Company to be licensed as a sales finance company and may regulate disclosure of finance charges and other terms of retail installment contracts. The Company is also subject to some of the provisions of federal law relating to discrimination in the granting of credit. SOURCES OF FUNDS The operations of the Company have been financed by short-term indebtedness (including commercial paper and bank loans), term indebtedness (primarily publicly offered medium-term notes), retained earnings plus equity investments from PACCAR. The Company's profitable acquisition of additional receivables is dependent upon its ability to raise funds at competitive rates in the private and public debt markets. In order to minimize its exposure to fluctuations in interest rates, the Company generally seeks to borrow funds with interest rate characteristics similar to the characteristics of its receivables and leases. The Company also reduces its interest rate risk and cost by entering into interest rate contracts. See "Note E--Term Debt" in the Notes to Financial Statements for information regarding interest rate contracts. Other considerations which affect the Company's funding operations include the amount of fixed and variable rate receivables, the maturity schedule of existing debt, the availability of desired debt maturities and the level of interest rates. As of December 31, 1993, PACCAR and the Company together had $265.0 million of unused, confirmed bank lines of credit that are reviewed annually for renewal. These lines are maintained primarily to support the Company's short-term borrowings. Neither PACCAR nor the Company is liable for the borrowings of the other. As of December 31, 1993, the Company had $624.1 million of term debt outstanding, $220.8 million of which was due within 12 months. See "Note E--Term Debt" in the Notes to Financial Statements for term debt maturities. An indenture of the Company dated as of December 1, 1983 as amended by a first supplemental indenture dated June 19, 1989 (Exhibit 4.1), with respect to the Company's term debt which is publicly issued from time to time, contains restrictions limiting secured debt which may be incurred by the Company and any subsidiary. RELATIONSHIP WITH PACCAR General The operations of the Company are fundamentally affected by its relationship with PACCAR. Sales of PACCAR products are the Company's principal source of financing business. The Company also receives administrative support and may occasionally borrow funds from PACCAR. Since the majority of the directors of the Company are executives of PACCAR and PACCAR is the sole owner of the Company's outstanding voting common stock, PACCAR can determine the course of the Company's business. See "Note D--Transactions with PACCAR" in the Notes to Financial Statements. Support Agreement The Company and PACCAR are parties to a Support Agreement which obligates PACCAR to provide, when required, financial assistance to the Company to assure that the Company maintains a ratio of net earnings available for fixed charges to fixed charges (as defined) of at least 1.25 to 1 for any fiscal year. The Support Agreement also requires PACCAR to own, directly or indirectly, all outstanding voting stock of the Company. The required ratio for the years ended December 31, 1993, 1992, 1991 and 1989 was met without assistance. In order to maintain the ratio of 1.25 to 1 in 1990, PACCAR provided earnings support of $7.3 million by assuming $4.5 million of the Company's interest expense and forgiving $2.8 million in administrative service charges. The Company and PACCAR may amend or terminate any or all of the provisions of the Support Agreement upon 30 days notice, with copies of the notice being sent to all nationally recognized statistical rating organizations ("NRSROs") which have issued ratings with respect to debt of the Company ("Rated Debt"). Such amendment or termination will be effective only if (i) two NRSROs confirm in writing that their ratings with respect to any Rated Debt would remain the same after such amendment or termination, or (ii) the notice of amendment or termination provides that the Support Agreement will continue in effect with respect to Rated Debt outstanding on the effective date of such amendment or termination unless such debt has been paid or defeased pursuant to the indenture or other agreement applicable to such debt, or (iii) the holders of at least two-thirds of the aggregate principal amount of all outstanding Rated Debt with an original maturity in excess of 270 days consent in writing to such amendment or termination, provided that the holders of Rated Debt having an original maturity of 270 days or less shall continue to have the benefit of the Support Agreement until the maturity of such debt. The Support Agreement expressly states that PACCAR's commitments to the Company thereunder do not constitute a PACCAR guarantee of payment of any indebtedness or liability of the Company to others and do not create rights against PACCAR in favor of persons other than the Company. There are no guarantees, direct or indirect, by PACCAR of payment of any indebtedness of the Company. ITEM 2. ITEM 2. PROPERTIES The Company's principal office is located in the corporate headquarters building of PACCAR (owned by PACCAR) at 777 - 106th Avenue N.E., Bellevue, Washington 98004. Other offices of the Company are located in leased premises. Annual lease rentals for offices in the aggregate are not material in relation to expenses as a whole. ITEM 3. ITEM 3. LEGAL PROCEEDINGS The Company is a party to various routine legal proceedings incidental to its business involving the collection of accounts and other matters. The Company does not consider such matters to be material with respect to the business or financial condition of the Company as a whole. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS All outstanding common stock is owned by PACCAR; therefore, there is no trading market in the common stock. To date, the Company has never declared or paid cash dividends on its common or preferred stock. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The following table summarizes selected financial data for the Company and should be read in conjunction with the more detailed financial statements included under "Financial Statements and Supplementary Data." The information with respect to each of the five years in the period ended December 31, 1993 has been derived from the Company's audited financial statements. Balance Sheet Data and Income Statement Data (Thousands of Dollars) (1) In 1990, PACCAR provided earnings support of $7.3 million through the assumption of $4.5 million of the Company's interest expense and the forgiveness of $2.8 million in administrative service charges. (See "Relationship with PACCAR.") (2) Effective January 1, 1991, the Company adopted Financial Accounting Standards Board Statement (FASB) No. 96, "Accounting for Income Taxes." The most significant impact of this Statement was to change the tax rate at which deferred taxes were recognized on the balance sheet to the lower rate then specified by federal tax laws. The change resulted in a one-time increase in net income of $11,323 in the first quarter of 1991. (3) For purposes of this ratio, earnings consist of income from operations plus fixed charges. Fixed charges consist of interest expense plus one-third of rent expense (which is deemed representative of an interest factor). The method of computing the ratio of earnings to fixed charges shown above complies with SEC reporting requirements but differs from the method called for in the Support Agreement between the Company and PACCAR. The ratios computed pursuant to the Support Agreement were 1.89x, 1.59x, 1.26x, 1.25x and 1.40x for the years 1993-1989, respectively. See Exhibits 12.1 and 12.2. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, 1991-1993 Results of Operations 1993 Compared to 1992: Pre-tax earnings increased to $30.4 million from $18.6 million in 1992 primarily as a result of higher income attributable to the growth in receivables as well as a lower provision for losses. Average receivables increased $185 million (16%) to $1.3 billion from $1.1 billion in 1992. The growth resulted from record high new business volume of $850 million in 1993 related to increased heavy-duty truck sales by PACCAR. While total debt increased to fund the growth in assets, interest expense decreased due to the general decline in interest rates during 1993. Operating and other expenses remained relatively stable. The 1993 loss provision of $6.1 million, compared to $8.6 million in 1992, reflected significantly lower net credit losses and an improvement in past due balances. The lower credit losses resulted from an improving economy, the Company's implementation of procedural and organizational changes to achieve stronger credit controls, and a greater emphasis on portfolio quality. The number and magnitude of problem accounts continued to decline from the levels in earlier years. At year end 1993, contracts over 60 days past due declined to 0.40% of period end gross retail and lease receivables compared to 1.49% and 2.39% at year ends 1992 and 1991, respectively. The reserve for credit losses was increased to $24.0 million to reflect the growth in the portfolio and risks inherent in the financing of heavy-duty trucks. The August 1993 tax law, which increased corporate income tax rates from 34% to 35% effective January 1, 1993, had a $2.6 million adverse impact on net income. The Company recorded a one-time increase to the income tax provision of $2.3 million to adjust deferred tax liabilities to the higher rate; in addition, income taxes on current year earnings increased by $.3 million. As the result of these foregoing factors, net income for 1993 improved to $17.0 million from $11.7 million in 1992. 1992 Compared to 1991: Income before taxes for 1992 improved to $18.6 millon from $5.7 million in 1991 due primarily to a lower provision for credit losses. Net income for 1992 was $11.7 million compared to $14.9 million in 1991. Included in the 1991 net income was a one-time adjustment of $11.3 million for the Company's adoption of FASB 96, "Accounting for Income Taxes." Net income for 1991 would have been $3.6 million without the adjustment. Gross income and interest expense in 1992 declined from 1991 as a result of lower market interest rates. Funding and Liquidity The Company manages its capital structure consistent with industry standards. Since 1983, the Company has made available registered senior debt securities for offering to the public. In 1993, the Company registered $1 billion of senior debt securities for offering to the public under the Securities Act of 1933. At the end of 1993, $980 million of such securities had not been issued. The Company believes that it has sufficient financial capabilities, including internally generated funds, access to public and private debt markets, lines of credit and other financial resources, to fund current business needs and service debt maturities. Impact of New Accounting Rules FASB No. 114, "Accounting by Creditors for Impairment of a Loan," was issued in May 1993 and is effective for fiscal years beginning December 15, 1994. The Company does not expect the adoption of FASB No. 114 to have a material impact on the Company. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The financial statements of the Company and related schedules described under Item 14, "Exhibits, Financial Statement Schedules, and Reports on Form 8-K," are included following this page. Report of Independent Auditors Board of Directors PACCAR Inc and PACCAR Financial Corp. We have audited the accompanying balance sheets of PACCAR Financial Corp. as of December 31, 1993 and 1992, and the related statements of income and retained earnings and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedule listed in the Index at Item 14a. These financial statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule 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 financial statements referred to above present fairly, in all material respects, the financial position of PACCAR Financial Corp. at December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein. As discussed in Note A to the Financial Statements, in 1991 the Company changed its method of accounting for income taxes. /S/ Ernst & Young Seattle, Washington February 4, 1994 BALANCE SHEETS PACCAR Financial Corp. See notes to financial statements. STATEMENTS OF INCOME AND RETAINED EARNINGS PACCAR Financial Corp. See notes to financial statements. STATEMENTS OF CASH FLOWS PACCAR Financial Corp. See notes to financial statements. NOTES TO FINANCIAL STATEMENTS PACCAR Financial Corp. December 31, 1993 (Thousands of Dollars) NOTE A--SUMMARY OF ACCOUNTING POLICIES Industry: PACCAR Financial Corp. (the "Company"), a wholly owned subsidiary of PACCAR Inc ("PACCAR"), provides retail financing and leasing of trucks and related equipment manufactured primarily by PACCAR and sold by authorized dealers. The Company also finances dealer inventories of transportation equipment. Due to the nature of the Company's business, customers are concentrated in the transportation industry throughout the United States. The Company's receivables and direct financing lease portfolio are not concentrated in any geographic region. Generally, all receivables are collateralized by the equipment being financed. The risk of bad debt losses related to this concentration has been considered in establishing the allowance for losses. Revenue Recognition: Revenue from net receivables and direct financing leases is recognized using the interest method. Certain loan origination costs are deferred and amortized to interest income. Equipment: Equipment on operating leases is recorded at cost and depreciated on a straight-line basis over the term of each operating lease based upon its estimated useful life of five years to an estimated residual value. Income Taxes: The Company is included in the consolidated federal income tax return of PACCAR. Any related tax liability is paid by the Company to PACCAR and any current related tax benefit is paid by PACCAR to the Company exclusive of the effect of Alternative Minimum Tax. Effective January 1, 1991, the Company adopted Financial Accounting Standards Board Statement No. 96, "Accounting for Income Taxes." The most significant impact of FASB Statement No. 96 was to change the tax rate at which deferred taxes were recognized on the balance sheet to the lower rate then specified by federal tax laws. The change resulted in a one-time increase in net income of $11,323 in the first quarter of 1991. There was no material effect on the Company from the 1993 adoption of FASB No. 109 (an amendment to FASB No. 96), "Accounting for Taxes." During 1993, the federal income tax rate was increased effective January 1, 1993. The effect on operations was a one-time increase in income tax expense of $2,302 recorded in the third quarter of 1993. Credit Losses: The provision for losses on receivables is charged to income in an amount sufficient to maintain the allowance for losses at a level considered adequate to cover anticipated losses. Receivables are charged to this allowance when, in the judgement of management, they are deemed uncollectible. Interest Rate Contracts: The Company enters into interest rate contracts which generally involve the exchange of fixed or floating rate interest payment obligations without the exchange of the underlying principal amounts. These contracts are used to effectively change the terms of debt to better match the interest rate characteristics of the Company's receivables and thereby reduce the effect of interest rate fluctuation on the Company's income. NOTES TO FINANCIAL STATEMENTS (Continued) PACCAR Financial Corp. (Thousands of Dollars) NOTE B--RECEIVABLES Terms for retail notes, contracts and direct financing leases range up to 84 months. Wholesale financing terms are generally for less than one year. Experience of the Company has shown that some receivables will be paid prior to contractual maturity and others will be extended or renewed. Accordingly, the maturities of receivables presented here should not be regarded as a forecast of future collections. The Company's receivables are as follows: The Company's net investment in direct financing leases is as follows: NOTES TO FINANCIAL STATEMENTS (Continued) PACCAR Financial Corp. (Thousands of Dollars) Future minimum lease payments on direct financing leases at December 31, 1993 are due as follows: The allowance for losses on receivables is summarized as follows: NOTE C--OPERATING LEASES Terms of operating leases range up to 44 months. Future minimum rental payments for transportation equipment on operating leases at December 31, 1993 are due as follows: NOTE D--TRANSACTIONS WITH PACCAR INC The Company has a Support Agreement with PACCAR that requires, among other provisions, that PACCAR maintain a ratio of earnings to fixed charges, as defined, for the Company of at least 1.25 to 1 for any fiscal year, and that PACCAR own all outstanding voting stock of the Company. The required ratio of 1.25 to 1 for the years ended December 31, 1993 - 1991 was met without assistance. NOTES TO FINANCIAL STATEMENTS (Continued) PACCAR Financial Corp. (Thousands of Dollars) PACCAR charges the Company for certain administrative services it provides. These costs are charged to the Company based upon the Company's specific use of the services and PACCAR's cost. Management considers these charges reasonable and not significantly different from the costs that would be incurred if the Company were on a stand-alone basis. Fees for services of $3,628, $3,093 and $3,824 for 1993, 1992 and 1991, respectively, were charged to the Company. Beginning July 1993, in lieu of payment, PACCAR Inc began recognizing certain of these administrative services as an additional investment in the Company. The Company records the investment as paid-in capital. The Company's employees are covered by a defined benefit pension plan, an unfunded postretirement medical and life insurance plan and a defined contribution plan sponsored by PACCAR. Separate allocations of plan assets, defined benefit accumulated plan benefits and defined contribution plan benefits relating to the Company have not been made. Expenses charged to the Company by PACCAR for these plans were $482, $326 and $255 for years 1993, 1992 and 1991, respectively. The Company's Articles of Incorporation provide that the 6% noncumulative, nonvoting preferred stock (100% owned by PACCAR) is redeemable only at the option of the Company's Board of Directors. NOTE E--TERM DEBT Term debt is summarized as follows: Interest rates on the floating interest rate medium-term notes are based on various indices such as LIBOR and the prime rate. Principal amounts due over the next five years at December 31, 1993 are $220,800 in 1994, $203,800 in 1995, $130,500 in 1996, $59,000 in 1997 and $10,000 in 1998. At December 31, 1993, the Company had outstanding 40 interest rate contracts with various financial institutions, having a total notional principal amount of $599.5 million. These agreements expire as follows: $300.0 million in 1994, $195.5 million in 1995, $104.0 million in 1996. The notional amount is used to measure the volume of these contracts and does not represent exposure to credit loss. The Company's risk in these transactions is the cost of replacing, at current market rates, these contracts in the event of default by the counterparty. Management believes the risk of incurring such losses is remote, and any losses would be immaterial. NOTES TO FINANCIAL STATEMENTS (Continued) PACCAR Financial Corp. (Thousands of Dollars) NOTE F-- CREDIT ARRANGEMENTS The Company and PACCAR together have lines of credit arrangements with various commercial banks that are reviewed annually for renewal. These lines are maintained primarily to support the Company's short-term borrowings. At December 31, 1993, the unused portion of these credit lines was $265 million. The Company compensates banks with fees which are immaterial in amount. The Company has entered into loan participation programs with various lending institutions under which notes, between the Company and the lending institutions, are sold by the lending institutions to investors on the open market. These notes generally mature within 30 days. At December 31, 1993, there was $49 million borrowed under these terms. NOTE G--INTEREST EXPENSE The following is a summary of interest expense: Cash paid for interest was $45,734 in 1993, $49,667 in 1992 and $65,835 in 1991. NOTE H--INCOME TAXES The provision for income taxes consists of the following: NOTES TO FINANCIAL STATEMENTS (Continued) PACCAR Financial Corp. (Thousands of Dollars) Deferred income tax assets and liabilities consisted of the following: A reconciliation between the statutory federal income tax rate and the actual provision for income taxes is shown below: The change in the federal income tax rate from 34% to 35%, effective January 1, 1993, increased the 1993 provision for income tax by $2,302. Cash paid for income taxes was $20,960 in 1993, $11,173 in 1992 and $2,715 in 1991. NOTE I--FAIR VALUES OF FINANCIAL INSTRUMENTS The following methods and assumptions were used by the Company in estimating its fair value disclosures for financial instruments: Cash and equivalents: The carrying amount reported in the balance sheets approximates fair value. Net Receivables: For floating rate loans including wholesale financings that reprice frequently with no significant change in credit risk, fair values are based on carrying values. For fixed rate loans, fair values are estimated using discounted cash flow analyses using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. The carrying amount of accrued interest and other receivables approximates their fair value. Direct financing leases and the related loss provision are not included in net receivables. NOTES TO FINANCIAL STATEMENTS (Continued) PACCAR Financial Corp. (Thousands of Dollars) Off-Balance-Sheet Instruments: Fair values for the Company's interest rate contracts are based on costs which would be incurred to terminate existing agreements and enter into new agreements with similar notional amounts, maturity dates and counterparties' credit standing, but at current market interest rates. Bank Loans and Term Debt: The carrying amount of the Company's commercial paper and bank loans and floating rate term debt approximates their fair value. The fair value of the Company's fixed rate term debt is estimated using discounted cash flow analyses, based on the Company's current incremental borrowing rates for similar types of borrowing arrangements. The carrying amount of trade payables and receivables approximate their fair value and have been excluded from the accompanying table. The carrying amounts and fair values of the Company's financial instruments at December 31, 1993 are as follows: The Company's off-balance-sheet financial instruments (interest rate contracts) represented an additional liability of $2,000 if recorded at fair value as of December 31, 1993. NOTE J--QUARTERLY RESULTS (Unaudited) NOTES TO FINANCIAL STATEMENTS (Continued) PACCAR Financial Corp. (Thousands of Dollars) PACCAR Financial Corp. SCHEDULE IX--SHORT-TERM BORROWINGS ---------------------------------- (Thousands of Dollars) (1) Commercial paper maturities can range from 1-270 days, and bank loans can range from 1-364 days. There are no provisions for the extension of maturities. (2) Average amount outstanding for commercial paper and bank loans is the average daily balance for the year. (3) The weighted average interest rate during the period was computed by dividing the actual interest expense by average short-term debt outstanding. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The directors and executive officers of the Company at February 1, 1994, their ages, current positions with the Company and principal occupations during the past five years are set forth in the following table. The table also shows directorships held by a director in public corporations. Directors and Executive Officers The directors of the Company are elected annually by PACCAR. All officers are elected annually by the Board of Directors or appointed by the Board of Directors or Chairman to serve at the pleasure of the Board or until their successors are elected or appointed. There is no family relationship between any of the directors or officers. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION This item is omitted pursuant to Form 10-K General Instruction J(1) and (2)(c). ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Securities of the Company PACCAR owns beneficially and of record 100% of the outstanding preferred stock (310,000 shares, $100 par value) and common stock (145,000 shares, $100 par value) of the Company. Securities of PACCAR This item is omitted pursuant to Form 10-K General Instruction J(1) and (2)(c). ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS See generally "Relationship with PACCAR," "Selected Financial Data" and "NOTE D--Transactions with PACCAR Inc" in the Notes to Financial Statements. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K a. LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES The following financial statements of the Company are included in Item 8: At December 31, 1993 and 1992 and for the Years Ended December 31, 1993, 1992, and 1991 Balance Sheets -- December 31, 1993 and 1992 Statements of Income and Retained Earnings -- Years Ended December 31, 1993, 1992 and 1991 Statements of Cash Flows -- Years Ended December 31, 1993, 1992 and 1991 Notes to Financial Statements -- December 31, 1993 The following financial statement schedule of the Company is also included in Item 8. Schedule IX -- Short-Term Borrowings All other schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions, are inapplicable or have been otherwise disclosed and, therefore, have been omitted. Listing of Exhibits The exhibits required by Item 601 of Regulation S-K are listed in the accompanying Exhibit Index. b. REPORTS ON FORM 8-K FILED IN THE FOURTH QUARTER OF 1993 There were no reports on Form 8-K for the quarter ended December 31, 1993. 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. PACCAR Financial Corp. By /S/ T. Ronald Morton ---------------------------------- T. Ronald Morton President Date: March 28, 1994 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 as of the above date and in the capacities indicated. (1) Principal Executive Officer /S/ T. Ronald Morton President ------------------------------------- T. Ronald Morton (2) Principal Financial Officer /S/ Ron E. Ranheim Treasurer ------------------------------------- Ron E. Ranheim (3) Principal Accounting Officer /S/ Brian J. Kimble Controller ------------------------------------- Brian J. Kimble (4) A Majority of the Board of Directors: /S/ T. Ronald Morton ------------------------------------- T. Ronald Morton William E. Boisvert* G. Don Hatchel* David J. Hovind* Charles M. Pigott* Michael A. Tembreull* James L. Shiplet* John J. Waggoner* *By /S/ T. Ronald Morton ------------------------------------- T. Ronald Morton Attorney-in-Fact EXHIBIT INDEX EXHIBIT INDEX (Cont.) __________________ Other exhibits listed in Item 601 of Regulation S-K are not applicable.

1993 ITEM 1. BUSINESS (A) GENERAL DEVELOPMENT OF BUSINESS ALC Communications Corporation was incorporated in Delaware on August 26, 1985 ("ALC" or the "Registrant"). ALC commenced business on December 19, 1985, the date of the affiliation of two long distance telephone companies, Allnet Communication Services, Inc. ("Allnet") and Lexitel Corporation ("Lexitel"). Allnet, a wholly owned subsidiary of ALC, now has the former businesses and operations of both Allnet and Lexitel. ALC conducts no business other than its position as a holding company for its subsidiary, Allnet. Unless the context otherwise requires, the term "Company" includes ALC, its wholly owned subsidiary, Allnet, and all of the wholly owned subsidiaries of Allnet. The principal executive offices of ALC are located at 30300 Telegraph Road, Bingham Farms, Michigan 48025 (810/647-4060). In the summer of 1990 the Company had begun an overall refinancing (the "Refinancing") of substantially all of its funded debt and in 1992 concluded the second phase of the Refinancing by substantially deferring or reducing the debt service obligations of the Company. In August 1992, the Company's then majority shareholder, Communications Transmission, Inc. ("CTI") conveyed the ALC Common Stock (the "Common Stock" or "ALC Stock"), Class B Preferred Stock (the "Class B Preferred") and Class C Preferred Stock (the "Class C Preferred") it owned to NationsBank of Texas, N.A., The First National Bank of Chicago, National Westminster Bank USA, CoreStates Bank, N.A. and First Union National Bank of North Carolina (the "Banks") pro-rata in exchange for the release of certain portions of CTI's obligations to each of the Banks. The Banks, in the aggregate, acquired all of the outstanding Class B Preferred and Class C Preferred, as well as 14,324,000 shares of Common Stock. In October 1992, the Company completed a stock offering (the "1992 Equity Offering") for 9,863,600 shares of Common Stock, a portion of which resulted from the exchange of the Class A Preferred Stock (the "Class A Preferred") held by individual stockholders and the remainder of which was due to Common Stock held by other entities, including the Banks. The Banks sold, in the aggregate, 3,000,000 shares of Common Stock in the 1992 Equity Offering. In January 1993, the Company filed a registration statement (the "shelf registration") under the Securities Act of 1933, as amended (the "Securities Act") to permit the sale, from time to time, of up to 19,500,909 shares of Common Stock held by certain stockholders, including the Banks, or issuable upon exercise of certain outstanding warrants or conversion of outstanding Class B Preferred and Class C Preferred. Pursuant to the shelf registration, in March 1993, the Company completed a stock offering (the "March 1993 Equity Offering") whereby the Banks and the Prudential Insurance Company of America ("Prudential") sold an aggregate of 10,350,000 shares of Common Stock to the public. As part of the March 1993 Equity Offering, the Banks converted all outstanding shares of Class B Preferred and Class C Preferred to Common Stock. The Class B Preferred and Class C Preferred were retired effective March 25, 1993. The Banks subsequently reduced their ownership interest in the Company to a minimal position through subsequent sales and the transfer of other shares to Prudential by four of the five Banks. In February 1994 the one remaining Bank, First Union National Bank of North Carolina, sold shares in a series of brokerage transactions, then transferred the remaining balance of shares to or as directed by Prudential. In May 1993, the Company completed an offering of $85.0 million principal amount 9% Senior Subordinated Notes ("1993 Notes") and in June 1993 redeemed all of the 11-7/8% Subordinated Notes then outstanding, which were issued as part of the note exchange offer which occurred during the 1992 phase of the Refinancing. As of June 30, 1993, the Company executed an agreement for a $40.0 million line of credit (the "Revolving Credit Facility"), replacing the Company's prior revolving credit facility. Effective December 31, 1993, the Company redeemed the issued and outstanding Class A Preferred Stock (the "Class A Preferred"). Following such redemption, the Class A Preferred was retired effective January 4, 1994. For more detailed information regarding stock ownership in the Company, reference is hereby made to "Item 13. Certain Relationships and Related Transactions." In July 1993, the Company acquired the specialized 800 customer base of Call Home America, Inc. Call Home America, Inc. had approximately 50,000 customers, including parents of college students and frequent travelers, who continue to receive services under the Call Home America(R) name. These customers, who were then generating annualized revenue of approximately $20 million, are also able to utilize a wide range of other telecommunications services from the Company. (B) FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS The Company operates in one industry segment. All significant revenues relate to sales of telecommunication services to the general public. (C) NARRATIVE DESCRIPTION OF BUSINESS ALC is the holding company for Allnet and conducts no other business. Allnet provides long distance telecommunications services primarily to commercial and, to a lesser extent, residential subscribers in the majority of the United States and completes subscriber calls to all directly dialable locations worldwide. Allnet is one of the few nationwide carriers of long distance services and in 1993 carried in excess of 800 million calls over its network. The Company operates its own switches, develops and implements its own products, monitors and deploys its transmission facilities and prepares and designs its own billing and reporting systems. The Company focuses on a highly profitable segment of the long distance industry with high operating margins, specifically, commercial accounts, whose calling volume consists primarily of calls made during regular business hours which command peak-hour pricing. Commercial subscribers tend to make most of their calls on weekdays during normal business hours, while the Company's residential subscribers tend to make most of their calls in the evening and on weekends, when business usage is lowest. Neither commercial nor residential subscribers' access to the Company's service is limited as to the time of day or day of week. SEASONALITY The Company experiences certain limited seasonality in the use of its services due to periods where commercial subscribers experience higher levels of time-off by their employees, such as during national holidays and vacation periods. Fewer business days during a calendar month will also impact usage. The Company will experience decreased commercial usage resulting from these factors. Seasonality in usage from residential subscribers tends to vary with the return of students to college and national holidays. The Company will experience increased residential usage resulting from these factors. PRODUCTS AND SERVICES The Company provides a variety of long distance telephone products and services to commercial and residential subscribers nationwide. The bulk of the Company's revenue is derived from outbound and inbound long distance services which are all under the "Allnet(R)" trademark. Many of the Company's products, however, differ from those of certain of its competitors due to the level of value-added services the Company offers, the flexibility of product pricing to maintain competitiveness and its broader geographic reach. The variety of products offered are categorized by the Company based upon certain primary characteristics: pricing, value-added services, reporting and 800 Services. Pricing. All of the Company's customers are identified by their telephone number, dedicated trunk or validated access code, and have a rating which is used to determine the price per minute that they pay on their outbound or inbound long distance calls. Rates typically vary by the volume of usage, the distance of the calls, the time of day that calls are made, the region that originates the call, and whether or not the product is being provided on a promotional basis. The outbound commercial product line is broken into three major types of services. Regional: Rates vary by area code or region and subscribers pay a flat rate for all long distance calls within these area codes or regions. Rates are determined by competitive positioning and vary according to the regions which the Company currently services. These products are priced at the area code level, and rates offered on these products are the primary method used to compete with small and more regionalized carriers. Nationwide: Rates are by mileage bands set at a distance around the call initiating point. Long Haul: Rates are designed for users who tend to make substantial bicoastal and international calls. These products offer distance-insensitive domestic pricing and two time-of-day period rates, along with aggressive international pricing options. The Company's outbound residential product line is made up of Allnet "Dial 1" Service which also has two special discount options to service employees of commercial accounts ("EBP") and members of associations ("ABP"). Different rates are applied to inbound telephone services than to outbound telephone services. The inbound product line is provided for commercial accounts which use 800 telephone numbers to receive and pay for calls from customers and potential prospects and for residential accounts wishing similar type services. Value-added Services. When customers subscribe to value-added services on the Company's network, their calls are charged a fee based on the services provided. Customers access value-added services through Allnet Access(R), which is an interactive voice response system that allows subscribers to interact with the phone system by pressing numbers on the telephone. Allnet Access(R) is a customized platform or menu from which customers select the desired services to which they have subscribed. For example, a customer who would like to deliver a prerecorded message would dial an Allnet Access(R) 800 number or through a new streamlined dialing method known as "00 Platform" from an Allnet presubscribed Touch Tone(R) telephone and select "call delivery" from the voice menu. If the customer had subscribed to other services, these services would be offered on the menu as well. Once the customer makes a selection, the call is routed and charged accordingly. The Company's value-added services are aimed primarily at the business subscriber, although the Company also offers products for residential customers. Value-added services include: Allnet Call Delivery(R), a message delivery service which enables a customer to send a prerecorded message to a number; VoiceQuote, an interactive stock quotation service; Allnet InfoReach(R), numerous audio/text programs such as news and weather; a voice mail service; Option USA(R), a service to provide calls to the U.S. from selected international locations on Allnet Access(R); and three different teleconferencing services. During 1992 the Company launched a full spectrum of facsimile services including Allnet Broadcast FAX(R), which allows the customer to send or fax documents to multiple locations at the same time; fax on demand, which allows the customer to make a fax document available to people who call an 800 number; fax mail, which allows a customer to receive facsimile messages in a fax mailbox and pick them up at a later date; PC software, which allows the customer to manage his facsimile lists and documents from a PC; and special international pricing to accommodate short duration facsimile traffic. During 1993 the Company began to focus on mobile products and services, offering MobileLine, the resale of cellular service provided by the regional Bell Operating Companies ("BOCs"), along with consolidated billing. In addition, the Company currently plans to introduce PageLine, a nationwide paging resale and consolidated billing product, in the second quarter of 1994. Reporting. The Company offers its customers a variety of billing options and media (two sizes of paper invoices [8-1/2X11 or 4X7 inches], diskette, and magnetic tape) aimed primarily at business customers. When a new commercial account is opened, the customer is offered the opportunity to custom design the format of its reports. For example, the Company can include company accounting codes or internal auditing codes for each call made with each billing statement. If a customer would like to change a particular reference code for a telephone line, the code can be changed automatically. The Company's primary product in this area is Allnet ESP(R) or Executive Summary Profile. A typical Allnet ESP(R) statement breaks out calls in a number of ways: by initiating caller number, by terminating number, by ranking, by department, by frequently dialed number/area/country or by time of day. Allnet customers pay a fixed monthly fee for these custom-tailored billing services. In late 1992, Allnet ESP(R) II was launched which gives customers graphic reports of traffic patterns on a nationwide basis by state, within state by area of dominant influence ("ADI") and within ADI by zip code. The Company believes this will be useful to certain customers for direct response and customer service applications. In mid-1992, the Company also launched its proprietary personal computer reporting service Allnet Invoice Manager(sm) ("AIM") which allows customers to design their own reports, prepare separate itemized bills, do mark-up reporting and generate numerous other customized reports. 800 Services. The Company greatly expanded its 800 product offerings, capitalizing on opportunities resulting from FCC mandated portability in May 1993 (which allows customers to select a different long distance carrier without changing their 800 number). These new offerings include area code blocking and routing; time of day routing; Home Connection 800(sm) , fractional 800 service which allows residential customers to acquire 800 service utilizing a 4 digit security Personal Identification Number ("PIN"); Multi-Point(sm) 800 services, which allow the customer to use accounting codes on an 800 number or route a single 800 number to numerous locations simultaneously; Follow-Me 800, which allows a customer to change his routing from a Touch Tone(R) telephone; and TargetLine(sm) 800, which routes calls to the closest location and provides custom prompts based upon a customer specific database. To supplement the Company's internal growth in this market, the Company also will evaluate strategic external growth opportunities. For example, in July 1993, the Company acquired the specialized 800 customer base of Call Home America, Inc. These customers, who were then generating annualized revenue of approximately $20 million, are also able to utilize a wide range of other telecommunications services from the Company. TRANSMISSION The Company endeavors to have sufficient switching capacity, local access circuits and long distance circuits at and between its network switching centers to permit subscribers to obtain access to the switching centers and its long distance circuits on a basis which exceeds industry standards regarding clarity, busy signals or delays. The network utilizes fiber optic and digital microwave transmission circuits to complete long distance calls. With the exception of a digital microwave system located in California for which Allnet holds the Federal Communications Commission ("FCC") licenses, such facilities are leased on a fixed price basis under both short and long term contracts. The California microwave facilities are on leased real estate and are subject to zoning and other land use restrictions. In recent years abundant availability and declining prices have dictated a strategy of generally obtaining new capacity for terms between six months and one year. While the Company has several long term contracts, these contracts have either annual "mark-to-market" clauses or, in one case, a "most favored nation" clause. These provisions function to keep the price the Company pays at or near current market rates. An important aspect of the Company's operation is planning the mix of the types of circuits and transmission capacity to be leased or used for each network switching center so that calls are completed on a basis which is cost effective for the Company without compromising prompt service and high quality to subscribers. Over 99% of the Company's domestic traffic is carried on owned or leased facilities ("on-net"). In establishing a network switching center, the Company can select equipment with varying capacities in order to meet the anticipated needs of the service origination region(s) served by the center. The equipment used by the Company is, for the most part, designed to permit expansion to its capacity by the addition of standard components. If the maximum capacity of the equipment in any center is reached, the Company replaces it with higher capacity switching equipment and attempts to move the replaced unit to a network switching center in a different service origination region. The Company is dependent upon the local telephone company for installing local access circuits and providing related service when establishing a network switching center. As of December 31, 1993, the Company had 16 network switching centers which originate traffic in all Local Access Transport Areas ("LATAs") in the United States. International service is provided through participation in the International Carrier Group ("ICG") with three other major long distance companies. The ICG in turn contracts with other long distance companies and foreign entities to provide high quality international service at competitive rates. MARKETING Approximately 60% of the Company's employees are engaged in sales, marketing or customer services. The Company markets its services and products through personal contacts with an emphasis on customer service, network quality, value-added services, reporting, rating and promotional discounts. Allnet currently operates a sales network with 48 offices in the United States. The Company employs 866 sales, marketing and customer service individuals. Field sales representatives focus on making initial sales to commercial users. They solicit business through face-to-face meetings with small- to medium-sized businesses. Each field sales representative earns a commission dependent on the customer's usage and value-added services. The Company's sales strategy is to make frequent personal contact with existing and potential customers. The prices and promotions offered for the Company's services are designed to be competitive with other long distance carriers. Prices will vary as to interstate or intrastate calls as well as with the distance, duration and time-of-day of a call. In addition, the Company may offer promotional discounts based upon duration of commitment to purchase services, incremental increases in service or "free" trial use of the many value-added and reporting services. Volume discounts are also offered based upon amount of monthly usage in the day, evening and night periods or based solely on total volume of usage. The Company has three groups which provide ongoing customer service designed to maximize customer satisfaction and increase usage. First, customer service personnel located in Southfield, Michigan are available telephonically free of charge 24 hours a day, seven days a week. Second, a customer service center in Columbus, Ohio processes calls from customers with significant usage levels who have been enrolled in the Company's "Select Service" programs. Third, communications specialists located at the sales offices provide personal service to large commercial accounts. The Company services more than 295,000 customers. Of these customers, approximately 137,000 are commercial accounts, with the remainder being residential accounts. During the past two years, the Company has become more geographically diversified, adding new markets as necessary. The Company is currently focusing on an agent program to increase customer acquisition in specific target markets. COMPETITION AND GOVERNMENT REGULATION Competition is based upon pricing, customer service, network quality and value-added services. The Company views the long distance industry as a three tiered industry which is dominated on a volume basis by the nation's three largest long distance providers: American Telephone and Telegraph Company ("AT&T"), MCI Telecommunications Corporation ("MCI") and Sprint Communications, Inc. ("Sprint"). AT&T, MCI and Sprint, which generate an aggregate of approximately 88% of the nation's long distance revenue of $65 billion, comprise the first tier. Allnet is positioned in the second tier with four other companies with annual revenues of $250 million to $1.5 billion each. The third tier consists of more than 300 companies with annual revenues of less than $250 million each, the majority below $50 million each. Allnet targets small- and medium-sized commercial customers ($100 to $50,000 in monthly long distance volume) with the same focus and attention to customer service that AT&T, MCI and Sprint offer to large commercial customers. Allnet is one of the few long distance companies with the ability to offer high quality value-added services to small- and medium-sized commercial customers on a nationwide basis. A number of the Company's competitors are primarily regional in nature, limited by the size of their transmission systems or dependent on third parties for their billing services and product offerings. Generally, the current trend is toward lessened regulation for both the Company and its competitors. Regulatory trends have had, and may have in the future, both positive and negative effects upon Allnet. For example, more markets are opening up to Allnet, as state regulators allow Allnet to compete in markets from which it was previously barred. On the other hand, the largest competitor, AT&T, has gained increased pricing flexibility over the years, allowing it to price its services more aggressively. As a nondominant Interexchange Carrier ("IXC"), the Company is not required to maintain a certificate of public convenience and necessity with the FCC other than with respect to international calls, although the FCC retains general regulatory jurisdiction over the sale of interstate long distance services by IXCs, including the requirement that calls be charged on a nondiscriminatory, just and reasonable basis. Although the FCC had previously ruled that nondominant carriers, such as Allnet, do not need to file tariffs for their interstate service offerings, a recent Court of Appeals decision has vacated that FCC ruling. The impact of the Court of Appeals decision on Allnet was minimal and primarily administrative in nature. Allnet has already taken any necessary steps to comply with that decision, including filing an interstate tariff with the FCC. The FCC has since adopted reduced requirements regarding the filing of tariffs for non-dominant carriers, including Allnet. The Company believes that it has operated and continues to operate in compliance with all applicable tariffing and related requirements of the Communications Act of 1934, as amended. In the FCC decision implementing certain provisions of the Telephone Operator Consumer Services Improvement Act ("TOCSIA"), Allnet was designated subject to the payment of charges by "private payphone owners." Allnet presently is challenging that designation with the FCC and in the courts, as it does not believe that it is engaged in the sort of activity intended to be regulated under TOCSIA. In addition, by virtue of its ownership of interstate microwave facilities located in California (as described in "Transmission"), Allnet is subject to the FCC's common carrier radio service regulations. In 1984, pursuant to the AT&T Divestiture Decree, AT&T divested its 22 Bell Operating Companies ("BOCs"). In 1987, as part of the triennial review of the AT&T Divestiture Decree, the U.S. District Court for the District of Columbia denied the BOCs' petition to enter, among other things, the long distance ("inter-LATA") telecommunications market. The District Court's ruling was appealed to the United States Court of Appeals for the District of Columbia which, in 1990, affirmed the District Court's decision to retain the inter-LATA prohibition for the BOCs. Currently pending before Congress is legislation that would allow the BOCs into the inter-LATA business in competition with long distance carriers, such as Allnet. The recently introduced "Brooks-Dingell Bill" (in the House of Representatives, H.R. 3626) and the "Hollings Bill" (in the Senate, S. 1822) set forth various time frames and certain entry requirements for the BOCs to enter certain markets, including the long distance market, from which the BOCs are currently barred under the AT&T Divestiture Decree. As initially proposed, the Brooks-Dingell Bill would allow entry into various segments of the long distance business when various combinations of conditions and timing requirements have been satisfied. Some entry requirements may be successfully applied almost immediately upon the passage of the bill, while others may not be applied until 18 months or 60 months have passed. In contrast, as initially proposed, the Hollings Bill would require that long distance only be offered by a BOC through a separate subsidiary, but only after the FCC, after consultation with the Attorney General, finds that the BOCs have met certain entry requirements. Under the Hollings Bill, there is one set of entry tests for "out-of-market" services, and another for "in-market" services. To allow a BOC to provide long distance service outside of its market area through a separate subsidiary, the FCC must find there is no substantial possibility that the BOC could use its market power to impede competition in the long distance market that the BOC seeks to enter. To allow a BOC to provide long distance service in its local market (i.e., where it provides telephone exchange or exchange access services), the FCC must make additional findings that the BOC has opened up its local network to competitors, and that it faces actual and demonstrable competition based on objective standards of competitive penetration set forth in the Hollings Bill. It cannot be determined at this time whether these or other bills will be adopted or the timing of such adoption or, if adopted, whether the final legislation will be similar to either of these proposed bills. To the extent final legislation, if any, results in the BOCs being permitted to provide inter-LATA long distance telecommunications services and to compete in the long distance market, existing IXCs, including the Company, would likely face substantial additional competition from local BOC monopolies. As part of the AT&T Divestiture Decree, the divested BOCs were required to charge AT&T and all other carriers (including Allnet) equal per minute rates for "local transport" service (the transmission of switched long distance traffic between the BOCs' central offices and the IXCs' points of presence). BOC and other local exchange company ("LEC") tariffs for local transport service have been based upon these "equal per unit" rules since 1984, pursuant to the AT&T Divestiture Decree and the FCC's waiver of certain local transport pricing rules. Although the portion of the AT&T Divestiture Decree containing this rule ceased to be effective by its terms on September 1, 1991, the FCC had extended its effect until it concluded the rulemaking proceeding in which it considered whether to retain or modify the "equal per unit" local transport pricing structure. On September 17, 1992, the FCC voted to maintain the existing "equal per unit" pricing rules until late 1993. A two year interim would then begin. Based on the interim plan rates that have now taken effect as of January 1, 1994, Allnet does not anticipate a material impact during 1994 and 1995. To moderate IXC costs, the FCC has ordered that non-recurring charges for reconfiguring a carrier's access lines should be waived until May 1994, to accommodate the change in access pricing structure. The FCC has left open the access rate structure issue for the post 1995 period. The FCC issued a Further Notice of Proposed Rulemaking for consideration of a permanent rate structure to take effect beginning no earlier than late 1995. The FCC has also recently voted to allow expanding competition for monopoly local access through expanded local switched access interconnection. This could ultimately provide Allnet with alternatives to purchasing its local access from the monopoly local exchange carriers. The FCC has issued orders stating that carriers, such as Allnet, were entitled to refunds for overcharges paid to a number of local exchange carriers during the 1985-1986 and 1987-1988 periods. These awards have, in most cases, been paid to Allnet. Although these awards are in the aggregate significant, they are not a material portion of the Company's total access costs. Some local exchange carriers have appealed the orders and some of the awards which were paid are conditioned on the outcome of the appeals. In addition Allnet has pending claims for overcharges during the 1989-1990 period. Two of the four claims have been settled. At this time, Allnet is not aware of any pending rulings on the remaining claims. The intrastate long distance telecommunications operations of the Company are also subject to various state laws and regulations, including certification requirements. Generally, the Company must obtain and maintain certificates of public convenience and necessity as well as tariffs from regulatory authorities in most states in which it offers intrastate long distance services, and in most of these jurisdictions, must also file and obtain prior regulatory approval of tariffs for its intrastate offerings. At the present time, the Company can provide originating services to customers in all 50 states and the District of Columbia. Those services may terminate in any state in the United States, and may also terminate to countries abroad. Only 31 states have public utility commissions that actively assert regulatory oversight over the services currently offered by the Company. Like the FCC, many of these regulating jurisdictions are relaxing the regulatory restrictions currently imposed on telecommunication carriers for intrastate service. While some of these states restrict the offering of intra-LATA services by the Company and other IXCs, the general trend is toward opening up these markets to the Company and other IXCs. Those states that do permit the offering of intra-LATA services by IXCs generally require that end users desiring to access these services dial special access codes which place the Company and other IXCs at a disadvantage as compared to LEC intra-LATA toll service which generally requires no access code. PATENTS In December 1992, MCI filed a lawsuit in the United States District Court for the District of Columbia against AT&T. The complaint seeks, among other things, a declaration that certain AT&T patents relating to basic long distance services, toll free "800" service, and other telephone services are invalid or unenforceable against MCI (and other similarly situated telecommunications providers). AT&T counterclaimed against MCI for patent infringement. Contemporaneously with the filing of its declaratory judgment action, MCI requested the court in the AT&T Divestiture Decree case to rule that AT&T should be barred from asserting its pre-divestiture patents to impede competition in the interexchange telecommunications market. Both of the foregoing actions are currently pending. AT&T has generally indicated that it believes that long distance telecommunications companies may be infringing on certain AT&T patents and has offered to license such patents. AT&T has numerous patents, some of which may pertain to the provision of services similar to those currently provided or to be provided by the Company or to equipment similar to that used or to be used by the Company. If it were ultimately determined that the Company has infringed on any AT&T patents and the Company is required to license such patents and pay damages for infringement, such costs could have an adverse effect on the Company. EMPLOYEES As of December 31, 1993, the Company employed 1,488 employees in the United States, none of whom were subject to any collective bargaining agreements. ITEM 2. ITEM 2. PROPERTIES On December 31, 1993, the Company had under lease approximately 113,000 square feet of office space in Bingham Farms, Michigan for executive and administrative functions and approximately 43,000 square feet in Southfield, Michigan for customer service, collections, and data processing. The Company also leases approximately 290,000 square feet in the aggregate for sales and administrative offices, network switching centers and unmanned microwave sites in 90 other locations in the continental United States. Most of the leased premises are for an initial term of five-to-ten years with, in many cases, options to renew. All properties presently being used for operations of the Company are suitable, well maintained and equipped for the purposes for which they are used. ITEM 3. ITEM 3. LEGAL PROCEEDINGS None. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. Executive Officers Of The Registrant The following table sets forth as of February 14, 1994 the executive officers of ALC as designated by the Company or otherwise required by law to be so designated. Executives are elected annually and serve at the pleasure of the Board. John M. Zrno has held his positions since August 1988. From December 1981 until joining the Company, Mr. Zrno held a number of executive positions with Cable & Wireless North America, Inc., the most recent of which was President and Chief Executive Officer. Between 1972 and 1981, Mr. Zrno first served as an officer of MCI Telecommunications Corporation, a long distance provider, then as an officer of American Satellite Corporation, a satellite common carrier, and finally as an officer of F/S Communications Corporation, an independent telephone interconnect company. Marvin C. Moses has held his officer positions since October 1988, and director since September 1989. From February 1982 through September 1988, Mr. Moses held a number of executive positions with Cable & Wireless North America, Inc., the most recent of which was Chief Financial Officer and Senior Vice President. From 1980 through February 1982, Mr. Moses worked with Atlantic Research Corporation, where he was involved in obtaining project financing for an alternative energy product. From 1975 to 1980, Mr. Moses was Vice President - Finance and Chief Financial Officer of GTE Telenet, a data communications company now part of Sprint. William H. Oberlin has held the position of Chief Operating Officer since July 1990, the position of Executive Vice President since October 1988 and director since July 1993. From November 1983 through September 1988, Mr. Oberlin held a number of executive positions with Cable & Wireless North America, Inc., the most recent of which was Senior Vice President - Sales and Marketing. During 1983, Mr. Oberlin was founder and principal shareholder of Electronic Express, Inc., a facsimile-based priority mail and delivery system. From April 1982 through March 1983, Mr. Oberlin was Chief Executive Officer of DHL Business Systems, Inc., a worldwide manufacturer and distributor of word processing terminals. From 1974 through April 1982, Mr. Oberlin was employed by Sprint. From September 1979 through April 1982, Mr. Oberlin was President of Southern Pacific/Distributed Message Systems, Inc., distributors of facsimile machines and electronic mail services. Gregory M. Jones has held the position of Senior Vice President since December 1990 and had formerly served as Vice President - Marketing since January 1989. Mr. Jones was previously director of Sure Check and Retail Services, Inc., a wholly owned subsidiary of Comp-U-Check, Inc. From July 1979 to June 1987 Mr. Jones held various positions with MCI Telecommunications Corporation including director of marketing for MCI Midwest in Chicago, senior manager of telemarketing, and senior manager of customer service. Connie R. Gale has held the position of Vice President since January 1991 and has held the positions of General Counsel and Secretary since October 1988, commencing her employment with the Company December 1986 as Associate General Counsel and Assistant Secretary. Ms. Gale previously served as corporate counsel for Chrysler Corporation from July 1973 to February 1980 and for American Natural Resources, Inc. from February 1980 to March 1981. Ms. Gale was Associate General Counsel at Federal-Mogul Corporation from April 1981 to November 1986. _____________________________ References to "Sprint" include its former designations: Southern Pacific Communications Co., GTE Sprint and U.S. Sprint. PART II ITEM 5. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Common Stock, $.01 par value, has been traded on the AMEX since September 4, 1991 and is listed under the symbol ALC. The table below sets forth the ranges of high and low closing sales prices of the Common Stock as reported on the AMEX composite tape for calendar years 1992 and 1993. As of February 21, 1994, there were 2,079 holders of record of the Common Stock. The high and low sales price per share of the Common Stock for the period from January 1, 1994 to February 21, 1994, as reported by AMEX, were $33.63 and $28.13, respectively. Since its inception, ALC has not declared or paid any dividends on its Common Stock. While any Preferred Stock was outstanding, dividends could not be paid on Common Stock if any dividends were due on, or ALC had any past-due obligation to redeem, Preferred Stock. The Company is allowed to pay dividends by the terms of its Revolving Credit Facility as long as (a) the sum of such dividend distribution does not exceed at any one time an amount equal to 30 percent of cumulative Net Adjusted Income (calculated after January 1, 1993) and (b) no default in payment of any Obligations or Event of Default exists at the time such distribution is made, or would be created by any such distribution (capitalized terms not otherwise defined herein are defined in the Revolving Credit Facility). ALC paid $1.5 million in cash dividends to the Class A Preferred holders in 1988. On July 22, 1993 and on October 21, 1993, the Board of Directors of ALC declared current quarterly dividends of $0.32 per share on each of the 355,956 issued and outstanding shares of Class A Preferred. On December 10, 1993, the ALC Board of Directors announced the redemption of the 355,956 issued and outstanding shares of Class A Preferred on December 31, 1993 to stockholders of record at the close of business December 13, 1993. The redemption price was $20.00 per share plus all accrued dividends (including the dividend which was declared on October 21, 1993) in the total amount of $10,361,879. Following the redemption, the Class A Preferred was retired as of January 4, 1994. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA The following table sets forth for the indicated fiscal years and periods ended, selected historical financial information for the Company. Such information is derived from financial statements presented in Part IV, Item 14. of this Annual Report on Form 10-K and should be read in conjunction with such financial statements and related notes thereto. ALC COMMUNICATIONS CORPORATION AND SUBSIDIARY Selected Financial Data - ------------- (1) 1989 and 1990 have been restated to reflect the 1:5 reverse stock split. (2) 1989 through 1992 include Class A Preferred Stock. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW By 1993, ALC had completed a multi-year series of refinancing transactions which provided for the simplification and improvement of the debt and capital structure of the Company. ALC was successfully transformed from a Company that in 1990 was owned by a controlling interest stockholder, Communications Transmission, Inc. ("CTI"), and had an equity structure that included three issues of preferred stock. In addition, at December 31, 1990 the Company had a debt structure which required principal and interest payments of as much as $79 million in 1992, a level which could not be met from operating cash flow and therefore required significant refinancing actions. Accordingly, during 1992, the Company completed the Refinancing which included the rescheduling of substantially all debt, resulting in significantly reduced or deferred debt service obligations. In 1992, the Company's major debt instrument represented by the Company's Original Debentures, Replacement Debentures, PIK Debentures and accrued interest was replaced by 11 7/8% Subordinated Notes of Allnet ("1992 Notes"). As part of the restructuring of the Debentures, 3,400,000 ALC Common Stock warrants were issued representing 10.2% of the fully-diluted equity of ALC. These debentures were replaced in May 1993 with 9% Senior Subordinated Notes ("1993 Notes") which do not mature until May 2003. Additional debt including the $20.0 million Restructured Promissory Note and the approximately $8.0 million balance on the 1990 Note Agreements was paid in full. As a result, at December 31, 1993 ALC has a single debt instrument outstanding, $85.0 million of 9% Senior Subordinated Notes. During 1992, the Refinancing also included the restructuring and simplification of the equity of ALC. In August 1992, the equity interest of CTI represented by 14,324,000 shares of ALC Common Stock, and the ALC Class B and Class C Convertible Preferred Stock ("Preferred Stock") was transferred to a group of five banks ("Banks"). Subsequently such Preferred Stock was converted into 3,796,000 shares of ALC Common Stock. A series of stock offerings in 1992 and 1993 was used to facilitate the sale of substantially all of the shares held by the Banks. As part of the stock offering in October 1992, the Company also completed an Exchange Agreement which provided for the exchange of 2,144,044 Class A Preferred Shares for 6,399,227 shares of ALC Common Stock at an effective 40% discount. During 1992 and continuing throughout 1993, the Company achieved both the successful completion of the Refinancing and a significant financial turnaround which included twelve consecutive quarters of income through the quarter ended December 31, 1993. Net income grew from a level of $3.3 million for the first quarter of 1992 to $12.4 million for the fourth quarter of 1993. Net income for the year ended 1993 increased approximately 90% over the previous year (excluding the effect of the extraordinary item and cumulative effect of the accounting change in 1993). The results of operations for 1992 and 1993 reflect increases in both billable minutes and revenue and a significant reduction in operating expenses as a percent of revenue. RESULTS OF OPERATIONS The Company reported net income of $45.7 million for the year ended December 31, 1993. This includes the impact of both the $13.5 million cumulative effect of a change in method of accounting for income taxes and the $7.5 million net loss related to early retirement of debt. Excluding these items, income for the year ended December 31, 1993 totalled $39.7 million on revenue of $436.4 million. This compares to net income of $20.8 million on revenue of $376.1 million and $5.3 million on revenue of $346.9 million for the years ended December 31, 1992 and 1991, respectively. Operating income increased from $23.9 million for the year ended December 31, 1991 to $40.7 million in 1992 to $68.9 million in 1993. This improvement is primarily the result of increased revenue from increased billable minutes and improved gross margin. REVENUE Revenue increased 16.1% to $436.4 million from 1992 to 1993 resulting from an 18.9% increase in billable minutes offset somewhat by a decrease in the revenue per minute. Revenue per minute decreased from 1992 to 1993 resulting from certain changes in the sales mix which were more than offset by additional efficiencies in network costs. Billable minutes have continued to increase since the third quarter of 1990 when compared to the same quarter in the prior year. Most importantly, billable minutes reached their highest level in 1993. The increase in billable minutes results from traffic generated by new customers and increased minutes per customer. Beginning in May 1993, the Company benefited from new traffic growth generated from the availability of 800 portability. Beginning in July 1993, the Company had additional revenue from the acquisition of the customer base of Call Home America, Inc. ("CHA") which represented 2.5% of the increase in revenue for the year ended December 31, 1993 compared to 1992. In addition, resellers contributed an additional $20.0 million to revenue during 1993. Revenue increased from $346.9 million in 1991 to $376.1 million in 1992. The 8.4% increase in revenue represents a 9.6% increase in billable minutes offset by a modest decrease in the revenue per minute. Revenue per minute decreased slightly from 1991 to 1992 resulting from lower unit prices which were more than offset by the impact of reduced cost of communication services as a percent of revenue. The revenue generated from customers' first full month of service in 1993 was 30.7% higher than in 1992 and 7.5% higher in 1992 than in 1991. The increased revenue from new sales along with revenue from existing customers is outpacing revenue lost from customer attrition. Attrition improved from 2.0% in 1991 to 1.8% in 1992. Attrition increased in 1993 to 2.4%, reflecting the change to the portability of 800 numbers from carrier to carrier. The provision for uncollectible revenue, which is deducted from gross revenue to arrive at reported revenue, was 1.9% for the year ended December 31, 1993, 3.0% for the year ended December 31, 1992, and 3.4% for the year ended December 31, 1991. During the last three years, procedures were implemented to improve the collection process and provide earlier detection of credit risks. Procedures include an expanded system for initial credit review and screening, monitoring of early usage levels on new accounts, modification of dunning and collection methods and timing, and improved collection processes on past due accounts. COST OF COMMUNICATION SERVICES The cost of communication services increased from $212.7 million and $216.9 million to $234.8 million for the years 1991, 1992, and 1993, respectively. The increase in cost of communication services is due to the 18.9% and 9.6% increase in billable minutes in 1993 and 1992. These increases were offset by unit cost reductions for transmission capacity experienced in 1992 and further efficiencies gained during 1993. The cost of communication services decreased, however, as a percent of revenue from 61.3% for 1991 to 53.8% in 1993, the lowest rate in the Company's history. Switched access costs per hour as a percent of revenue declined 3.5% reflecting lower tariffed rates. A combination of the use of high volume, fixed price leased facilities to transmit traffic and reduced international costs through contractual agreements have contributed to this percentage decline. In addition, the Company has continued to reconfigure its network to optimize utilization. The Company's use of high volume, fixed price transmission capacity is significantly more cost effective than the use of measured services. By utilizing fixed price leased facilities to transmit traffic, the Company has successfully decreased its network costs without the capital expenditures associated with construction of its own fiber optic or digital microwave network. Over 99% of traffic traverses low cost "on-net" digital facilities. OTHER EXPENSES Sales, general and administrative expense was $98.0 million, $107.3 million and $119.8 million for the years 1991, 1992 and 1993, respectively. Sales, general and administrative expense for 1993 increased $12.5 million or 11.7% compared to 1992. The increase reflects increased commissions, taxes other than income, and other expenses related to sales. Sales, general and administrative expense, however, declined as a percent of revenue which reflects management's continuing focus on cost containment. Procedures implemented to improve efficiencies and contain expenses included improved budgeting techniques, continued review of actual expenses against budgeted levels, incentive programs tied directly to achievement of budget objectives, and detailed review of general expense programs. Sales, general and administrative expense for 1992 increased $9.3 million or 9.5% compared to 1991. Sales expense increased 19.6% from 1991 which resulted from increased advertising and marketing expenses as well as increased commissions reflecting higher first full month revenue as well as enhancements to the commission plan to encourage customer retention. General and administrative expenses continued to decrease as a percent of net revenue. The increase in depreciation and amortization from $11.2 million in 1992 to $12.8 million in 1993 is primarily the result of depreciation on newly capitalized fixed assets and intangible assets reflecting the increase in capital expenditures in 1992 and 1993 and the purchase of CHA. The decrease from 1991 to 1992 reflected the termination of depreciation on analog multiplex and switch equipment, for which the Company provided a reserve, and the termination of depreciation as assets reach the end of their useful lives. These reductions in depreciation were partially offset by depreciation on assets capitalized during the period. INTEREST EXPENSE Interest expense has dramatically decreased from $18.1 million in 1991 and $17.2 million in 1992 to $10.5 million in 1993. This resulted from reduced interest related to the replacement of the 11 7/8% Subordinated Notes, which had an effective interest rate of 13.6%, with the 9% Senior Subordinated Notes. In connection with the Refinancing, the Restructured Promissory Note and the 1990 Note Agreement were paid in full in 1993 and 1992, respectively. Interest expense also declined due to lower average balances on the Revolving Credit Facility, as well as lower interest rate charged under the new Revolving Credit Facility. INCOME TAXES Effective January 1, 1993, the required implementation date, the Company adopted the Financial Accounting Standards Board Statement 109 "Accounting for Income Taxes" ("Statement 109"). Application of the new rules resulted in the recording of a net deferred tax asset and additional income of $13.5 million as of January 1, 1993, related primarily to the future tax benefits which are expected to be realized upon utilization of a portion of the Company's tax net operating loss carryforwards ("NOLs"). Statement 109 requires that the tax benefit of NOLs be recorded as an asset to the extent that management assesses that the realization of such NOLs is "more likely than not". Management believes that realization of the benefit of the NOLs beyond a three-year period is difficult to predict and therefore has recorded a valuation allowance which has the effect of limiting the recognition of future NOL benefits to those expected to be realized within the three year period. The Company has not applied Statement 109 retroactively and thus did not restate prior year financial statements to reflect adoption of the new rules. Prior to January 1, 1993, the Company accounted for income taxes in accordance with Accounting Principles Board Opinion No. 11. The tax provisions for the years ended December 31, 1992 and 1991 included an amount that would have been payable except for the availability of NOLs. The tax benefits of the loss carryforwards utilized were reported as an extraordinary item for the years ended 1992 and 1991. With the adoption of Statement 109, the income tax expense for 1993 includes the benefit of utilizing net operating losses. In 1992 and 1993 the Company was subject to regular tax and due to a Code Section 382 "ownership change", the utilization of net operating losses was limited. In 1991, the Company was subject to alternative minimum tax and the operating losses were utilized to offset 90% of the taxable income. SECTION 382 LIMITATION Section 382 (in conjunction with Sections 383 and 384) of the Code provides rules governing the utilization of certain tax attributes, including a corporation's NOLs, "built-in-losses," capital loss carryforwards, unused investment tax credits ("ITCs") and other unused credits, following significant changes in ownership of a corporation's stock. Generally, Section 382 provides that if an ownership change occurs, the taxable income of a corporation available for offset by these tax attributes will be subject to an annual limitation ("382 Limitation"). The transfer of ALC Common Stock, Class B Preferred and Class C Preferred by CTI to the Banks in August 1992 resulted in an ownership change with a 382 Limitation of approximately $10 million per annum. As a result of this annual limitation, along with the 15 year carryforward limitation, the maximum cumulative NOLs and ITCs which can be utilized for federal income tax purposes in 1994 and future years are limited to approximately $120 million, assuming no future ownership change or built-in gain recognition. The Company is also subject to numerous state and local income tax laws which limit the utilization of NOLs after an ownership change. Future events beyond the control of the Company could reduce or eliminate the Company's ability to utilize the tax benefit of its NOLs and ITCs. Any future ownership change under Section 382 would require a new computation of the 382 Limitation based on the value of the Company and the long term tax-exempt rate in effect at that time. Furthermore, the tax benefit of NOLs would be reduced to zero if the Company fails to satisfy the continuity of business enterprise requirement for the two-year period following an ownership change. Under the continuity of business requirement, the Company must either continue its historic business or use a significant portion of its pre-ownership change assets in a business. SEASONALITY The Company's long distance revenue is subject to certain limited seasonal variations. Because most of the Company's revenue is generated by commercial customers, the Company traditionally experiences decreases in long distance usage and revenue in those periods with holidays. In past years the Company's long distance traffic has declined slightly during fourth quarters from previous quarters due to the holiday periods. However, in 1993 and 1992 the impact of this trend was more than offset by strong year over year traffic growth, which was up 26.0% and 12.3% from the fourth quarter of 1992 and 1991, respectively. LIQUIDITY AND CAPITAL RESOURCES For the years ended December 31, 1993, 1992 and 1991, the Company generated positive cash flow from operations of $59.4 million, $30.4 million and $27.3 million, respectively, reflecting the strong trend of profitability. The positive cash flow reflects fourteen consecutive quarters of increased revenue and operating profits as of December 31, 1993 versus prior year comparable quarters. The positive cash flow from operations resulted in working capital of $1.4 million at December 31, 1993 compared to negative $31.7 million at December 31, 1992. The increase in working capital is largely attributable to: (a) the pay down of the Revolving Credit Facility which was classified at December 31, 1992 as a short term liability, (b) the increase in accounts receivable due to the increase in revenue, and (c) the reduced balance in the current portion of notes payable due to the payoff of the Restructured Promissory Notes and payments made on capital leases. In addition to the positive cash flow from operations, the Company's short term liquidity position is further strengthened by the unused availability under the Revolving Credit Facility. As of June 30, 1993 the Company executed an agreement for a $40.0 million line of credit, replacing the previous Facility. The new Revolving Credit Facility expires June 30, 1995. Under this Revolving Credit Facility, the Company is able to minimize interest expense by structuring the borrowings under three alternatives. Each alternative has a varying interest rate calculation associated with it. The effective rate under the Facility during 1993 approximated 5.8%. The agreement includes financial covenants which allow the Company to further reduce interest expense on outstanding borrowings beginning in July 1994. A .375% per annum charge is made on the unused portion of the line. Advances under the Revolving Credit Facility are made based on the level of receivables. As of December 31, 1993, the Company had availability of $39.8 million under the line and no balance outstanding. Further evidence of the Company's stronger liquidity position was the Company's ability to finance the cash needs of $19.6 million for the CHA customer base acquisition and $10.4 million for the redemption including accrued dividends of Class A Preferred Stock from cash flow from operations. Because the Company has chosen to lease rather than own its transmission facilities, the Company's requirements for capital expenditures are modest. Capital expenditures totalled $16.2 million in 1993. Capital expenditures during the year ended December 31, 1993 included projects for enhanced efficiency and technical advancement in the network, information systems and customer service. The future investment requirements for capital expenditures relate directly to traffic growth which necessitates the purchase of switching and related equipment. In addition, a major component of the capital budget relates to technological advancements as the Company continually updates its network capabilities to offer enhanced products and services. The level of capital expenditures for 1994 is expected to be $20 - $25 million. In March 1993, an equity offering was completed in which an aggregate of 10,350,000 shares of ALC Common Stock were sold by certain stockholders of ALC at $14.25 per share. ALC did not receive any of the proceeds from the sale of these shares, although it did receive $1.9 million upon exercise of 963,684 warrants. In May 1993, the Company completed an offering of $85.0 million of 9% Senior Subordinated Notes. Interest on the 1993 Notes is payable semiannually commencing November 15, 1993. The 1993 Notes will mature on May 15, 2003 but are redeemable at the option of the Company on or after May 15, 1998. Management used the $84.3 million of proceeds of this offering to repay the outstanding 1992 Notes aggregating $72.4 million, and to reduce the amount outstanding under the Revolving Credit Facility. The 1993 Notes provide additional benefits on both short and long term liquidity by reducing interest expense as well as deferring redemption requirements. In September 1993, an equity offering was completed in which an aggregate of 7,763,391 shares of ALC Common Stock were sold by certain shareholders at $25.50 per share. This offering included the exercise of 3,240,025 warrants. In October 1993, an additional 177,100 warrants were exercised, and the shares subsequently sold to the public. ALC did not receive any proceeds from the sale of any of these shares but did receive $6.9 million from the exercise of warrants. In December 1993, the Company redeemed the remaining 355,956 shares of Class A Preferred for $10.4 million including $3.2 million of accrued dividends. Management believes that the Company's cash flow from operations will provide adequate sources of liquidity to meet the Company's anticipated short and long-term liquidity needs. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The financial statements and supplementary data required by this Item 8. are set forth in Part IV, Item 14. of this Annual Report on Form 10-K. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES None. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT As of the date of this Annual Report on Form 10-K, the Board of Directors of ALC consists of seven positions, all elected by the holders of Common Stock. Six of the seven positions are presently filled. The following list identifies (i) the persons who are Directors of the Company; and (ii) each Director's principal occupation for the past five years. RICHARD D. IRWIN has held the position of Chairman of the Board of Directors since August 1988. He is the President of Grumman Hill Associates, Inc. ("Grumman Hill"), a merchant banking firm, having held that position since its formation in 1985. Prior to the formation of Grumman Hill, Mr. Irwin was a Managing Director of Dillon, Read & Co. Inc. from 1983 through 1985. Mr. Irwin is also a member of the Board of Directors of Caire, Inc. and Pharm Chem Laboratories, Inc. JOHN M. ZRNO has held the positions of President, Chief Executive Officer and Director since August 1988. From December 1981 until joining Allnet, Mr. Zrno held a number of executive positions with Cable & Wireless North America, Inc., the most recent of which was President and Chief Executive Officer. Between 1972 and 1981, Mr. Zrno first served as an officer of MCI, then as an officer of American Satellite Corporation, a satellite common carrier, and finally as an officer of F/S Communications Corporation, an independent telephone interconnect company. MARVIN C. MOSES has held the positions of Executive Vice President, Chief Financial Officer and Assistant Secretary since October 1988. Mr. Moses was elected as a Director in September 1989. From February 1982 through September 1988, Mr. Moses held a number of executive positions with Cable & Wireless North America, Inc., the most recent of which was Chief Financial Officer and Senior Vice President. From 1980 through February 1982, Mr. Moses worked with Atlantic Research Corporation, where he was involved in obtaining project financing for an alternative energy product. From 1975 to 1980, Mr. Moses was Vice President - Finance and Chief Financial Officer of GTE Telenet, a data communications company now part of Sprint. WILLIAM H. OBERLIN has held the position of Director since July 22, 1993, and has held the position of Chief Operating Officer since July 1990 and the position of Executive Vice President since October 1988. From November 1983 through September 1988, Mr. Oberlin held a number of executive positions with Cable & Wireless North America, Inc., the most recent of which was Senior Vice President - Sales and Marketing. During 1983, Mr. Oberlin was founder and principal stockholder of Electronic Express, Inc., a facsimile-based priority mail and delivery system. From April 1982 through March 1983, Mr. Oberlin was Chief Executive Officer of DHL Business Systems, Inc., a worldwide manufacturer and distributor of word processing terminals. From 1974 through April 1982, Mr. Oberlin was employed by Sprint. From September 1979 through April 1982, Mr. Oberlin was President of Southern Pacific/Distributed Message Systems, Inc., distributors of facsimile machines and electronic mail services. RICHARD J. UHL has held the position of Director since September 3, 1991. Mr. Uhl is the President and a member of the Board of Directors of Chicago Holdings, Inc. ("CHI"), having held those positions since 1985. CHI is a privately owned company which manages several lease portfolios owned by it and its subsidiaries. Since November 1990 he has also been the Chief Executive Officer and a member of the Board of Directors of Hurrah Stores, Inc. ("Hurrah"), a subsidiary of CHI. Mr. Uhl has also been President of Steiner Financial Corporation, another subsidiary of CHI, since December 1987. Mr. Uhl currently serves on the Boards of Directors of Dealers Alliance Credit Corp. (as Chairman of the Board, since October 1993) and of First Merchants Acceptance Corporation, since March 1991, which are both privately-owned companies in which CHI has a significant equity investment. Prior to 1991, Mr. Uhl served in a number of executive capacities as well as on the Boards of Directors of certain finance organizations as well as a distributor of personal computer equipment, and a manufacturer of automotive products. MICHAEL E. FAHERTY has held the position of Director since June 23, 1992. Mr. Faherty primarily works (since 1977) as a business consultant and in the contract executive business, in connection with which Mr. Faherty formerly served in a number of executive positions, including Chairman of the Board and President, with Shared Financial Systems, Inc. from January 1992 through January 1994. As part of his duties as a contract executive, he has worked for Digital Sound Corporation, Systeme Corporation, Advanced Business Communications, Inc., BancTec, Inc. and Intec Corporation. Mr. Faherty is also a member of the Board of Directors of BancTec, Inc., Biomagnetic Technologies, Inc. and Davox Corporation. The Board of Directors held eight regularly scheduled and special meetings in the aggregate during the fiscal year from January 1, 1993 through December 31, 1993. Several important functions of the Board of Directors of ALC have been performed by committees comprised of members of the Board of Directors. The Amended and Restated Bylaws of ALC (the "Bylaws") prescribe the functions and the standards for membership on the Audit Committee. Subject to those standards, the Board of Directors acting as a body appoints the members of the Audit Committee at the meeting of the Board of Directors coincident with the annual meeting of stockholders. However, the Board of Directors has the power at any time to change the authority or responsibility delegated to the committee or the members serving on the committee. Under the Bylaws, the Audit Committee performs the following functions: (i) recommends to the Board of Directors annually a firm of independent public accountants to act as auditors of the Company; (ii) reviews with the auditors the scope of the annual audit; (iii) reviews accounting and reporting principles, policies and practices; (iv) reviews with the auditors the results of their audit and the adequacy of accounting, financial and operating controls; and (v) performs such other duties as are delegated to it by the Board of Directors. The members of the Audit Committee during the 1993 fiscal year were Richard D. Irwin, Richard J. Uhl and Michael E. Faherty. During 1993, the Audit Committee met four times. The Board, pursuant to the Bylaws, also established a Compensation Committee. The Compensation Committee has the authority to: (i) establish the compensation (including salaries and bonuses) of the officers; (ii) establish incentive compensation plans for the officers; (iii) administer the stock option plans and grants of options under those plans; and (iv) perform such other duties as are from time to time delegated to the Compensation Committee by the Board of Directors. The members of the Compensation Committee during fiscal 1993 were Richard D. Irwin, Richard J. Uhl and Michael E. Faherty. During 1993, the Compensation Committee met five times. The Board of Directors does not have a standing committee responsible for nominating individuals to become directors. Section 16(a) of the Securities Exchange Act requires the Company's officers and directors, and persons who own more than ten percent of a registered class of the Company's equity securities, to file reports of ownership and changes in ownership on Forms 3, 4 and 5 with the Securities and Exchange Commission and the American Stock Exchange. In addition, officers, directors and greater than ten percent shareholders are required to furnish the Company with copies of all Forms 3, 4 and 5 they file. Based solely on the Company's review of the copies of such forms it has received and written representations from certain reporting persons that they were not required to file Forms 5 for specified fiscal years, the Company believes that all of its officers, directors, and greater than ten percent shareholders complied with all filing requirements applicable to them with respect to transactions during fiscal 1993 except that the Company has been informed as follows: Saulene M. Richer, a former director elected by holders of the Company's Class A Preferred Stock (redeemed in 1993) and also a ten percent shareholder of Class A Preferred, failed to timely file one required report relating to one transaction in ALC Stock. A series of five related transactions, although reported on a timely basis by NationsBank of Texas, N.A., was not reported on a timely basis by NationsBank Corporation (the parent corporation of NationsBank of Texas, N.A.) due to its late filing of a required report (which transactions were otherwise properly disclosed in the Company's reports filed under the Exchange Act). The Trustees of General Electric Pension Trust ("General Electric") failed to timely file three required reports relating to seventeen transactions in ALC Stock. General Electric subsequently filed three late Forms 4 regarding such transactions. Reference is made to the Item captioned "Executive Officers of the Registrant" in Part I of this Report. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION DIRECTOR COMPENSATION For 1992 and 1993, and to be continued for 1994, Richard J. Uhl and Michael E. Faherty received or will receive remuneration of up to $20,000 per year for their services as Board members. Of that fee, $8,000 is dependent upon per meeting attendance at the four regularly scheduled Board meetings. Richard D. Irwin waived his right to fees throughout his term of service on the Board. On September 3, 1991, ALC granted Richard J. Uhl an option to purchase 40,000 shares of Common Stock at $4.25 per share, the market price at date of grant. Mr. Uhl is entitled to exercise the option in full; it expires on the earlier of 60 days subsequent to Mr. Uhl's death, resignation or removal as a director and September 3, 1998. On June 23, 1992, ALC granted Michael E. Faherty an option to purchase 40,000 shares of Common Stock at $4.63 per share, the market price at date of grant. Mr. Faherty is entitled to exercise the option in full; it expires on the earlier of 60 days subsequent to Mr. Faherty's death, resignation or removal as a director and June 23, 1998. It is anticipated that the Common Stock issuable upon the exercise of the options held by Messrs. Uhl and Faherty will be registered under the Securities Act. In addition, Grumman Hill, of which Richard D. Irwin is President, entered into an Advisory Agreement with Stock Option dated September 7, 1988 (the "Advisory Agreement") with the Company. Pursuant to the terms of the Advisory Agreement, Grumman Hill performs certain advisory services with respect to the management, operation and business development activities of the Company. In exchange for such services, Grumman Hill was initially granted a stock option to purchase at a price of $11.25 per share 153,163 shares of Common Stock and receives an annual fee of $100,000. In conjunction with the 1990 phase of the Refinancing, the option was regranted at an exercise price of $3.50 per share. The option was subsequently assigned to Grumman Hill Investments, L.P. ("Grumman Hill, L.P.") (of which Mr. Irwin is the General Partner). Grumman Hill, L.P. is entitled to exercise the option in full. It is anticipated that the Common Stock issuable upon the exercise of the option will be registered under the Securities Act. The option will expire on September 7, 1998. EXECUTIVE COMPENSATION Summary Compensation Table The following table summarizes the total compensation paid to the Chief Executive Officer and the four most highly compensated executive officers at the end of calendar year 1993 for each of the past three fiscal years during which the named executive acted as an executive officer. - ------------------------- (1) Total perquisites for each officer were less than either $50,000 or 10% of total salary and bonus. (2) Options granted in 1992 include options granted in 1990 and amended in 1992 (the exercise price was not changed). (3) Consists of Company contributions to defined contribution plan during 1993 and 1992 in the amounts of $600 and $500, respectively, for each officer. (4) Represents gross up for income taxes relating to a perquisite. STOCK OPTION GRANTS DURING LAST FISCAL YEAR The following table sets forth information about stock option awards granted to the Chief Executive Officer and the four most highly compensated executive officers during 1993. - ------------------------- * These amounts represent assumed rates of appreciation which may not necessarily be achieved. The actual gains, if any, are dependent on the market value of the Company's Common Stock at a future date as well as the option holder's continued employment throughout the vesting period. Appreciation reported is net of exercise price. (1) All options were granted at market value on date of grant. The 1990 Stock Option Plan allows the exercise price and tax withholding obligations to be paid by delivery of already owned shares or with shares purchased pursuant to the exercise, subject to certain conditions. Vesting may be accelerated in the event of certain situations resulting in a change of ownership of the Company. The Compensation Committee, as administrator of the Company's stock option plans, has discretion to modify the terms of outstanding options, subject to certain limitations set forth in the plans. (2) One third of each grant will vest one third November 22, 1994, November 22, 1995 and November 22, 1996. The second third shall vest one third November 22, 1995, November 22, 1996 and November 22, 1997. The final third shall vest one third November 22, 1996, November 22, 1997 and November 22, 1998. (3) Unless earlier terminated due to such events as termination of employment or death. Note: No matter what theoretical value is placed on a stock option on the date of grant, its ultimate value will be dependent on the market value of the Company's Common Stock at a future date. AGGREGATED OPTION/SAR EXERCISES IN LAST FISCAL YEAR AND FY-END OPTION/SAR VALUES - ------------------------- (1) Values are calculated by determining the difference between the fair market value of the Common Stock at December 31, 1993 and the exercise price of the options. EMPLOYMENT CONTRACTS AND TERMINATION OR CHANGE IN CONTROL ARRANGEMENTS In late 1988, ALC entered into employment agreements with John M. Zrno, Marvin C. Moses and William H. Oberlin. These arrangements had initial four year terms and were amended in 1991 to extend for an additional two years. In January 1994, ALC and Allnet jointly entered into amended and restated employment agreements with John M. Zrno, Marvin C. Moses and William H. Oberlin. These agreements provide for a base salary of $319,041, $245,417 and $245,417, respectively, for Messrs. Zrno, Moses and Oberlin for service provided in 1993 through 1994, beginning and ending with the month of each officer's respective anniversary of hire. Each of these agreements has an initial three year term and contains a provision that, in the event the officer's employment is terminated for any reason except death, disability, voluntary resignation or cause, such officer will continue to receive his current salary from twelve to twenty-four months. Should the officer be terminated without cause, the stock options granted in the agreement would fully vest and remain exercisable for the succeeding twelve months. According to the employment agreements with Messrs. Zrno, Moses and Oberlin, each officer may receive incentive compensation as determined by the Board of Directors, based on the Board's determination of the officer's individual achievements. Officers below the level of Executive Vice President entered into severance agreements wherein the Company agreed to provide salary continuation and certain employee benefits for a period of twelve months (formerly, from six-to-twelve months) should an officer be terminated from employment prior to December 31, 1995. These agreements, originally effective February 1990, were renewed in February 1991, August 1992, July 1993 and January 1994. COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION The members of the Compensation Committee during fiscal 1993 were Richard D. Irwin, Richard J. Uhl and Michael E. Faherty. Richard D. Irwin, Chairman of the Board of Directors since August 1988 and a member of the Compensation Committee, is a former officer of the Company because, prior to March 1991, the position of Chairman of the Board was an officer position under the Company's Bylaws. Grumman Hill, of which Richard D. Irwin is President, entered into the Advisory Agreement with the Company in 1988. Pursuant to the terms of the Advisory Agreement, Grumman Hill performs certain advisory services with respect to the management, operation and business development activities of the Company. In exchange for such services, Grumman Hill was initially granted a stock option to purchase 153,163 shares of Common Stock at a price of $11.25 per share and receives an annual fee of $100,000. In conjunction with the 1990 phase of the Refinancing, the option was regranted at an exercise price of $3.50 per share. The option was subsequently assigned to Grumman Hill, L.P. (of which Mr. Irwin is the General Partner). Grumman Hill, L.P. is entitled to exercise the option in full. It is anticipated that the Common Stock issuable upon the exercise of the option will be registered under the Securities Act. The option will expire on September 7, 1998. Prior to the Note Exchange Offer (as defined in "Certain Relationships and Related Transactions - Banks Stock Ownership in the Company"), Grumman Hill, L.P., the Grumman Hill Associates Pension Plan, Mr. Irwin and Mr. Irwin's Individual Retirement Account held approximately $2.5 million, $75,000, $339,000 and $188,000, respectively, in principal amount of 11 7/8% Senior Subordinated Debentures of ALC due December 31, 1995 (the "Replacement Debentures") (exclusive of PIK Debentures issued or issuable in respect of certain interest payments on the Replacement Debentures). As a consequence of the Note Exchange Offer, prior to January 28, 1993 Mr. Irwin and Grumman Hill, L.P. and affiliates owned $4.1 million in principal amount of 1992 Notes and owned 194,393 1992 Warrants (capitalized terms as defined in "Certain Relationships and Related Transactions - Banks Stock Ownership in the Company"). Mr. Irwin subsequently purchased 40,000 shares of Common Stock in the 1992 Equity Offering, which, together with other options and warrants, give these entities the right to purchase in the aggregate up to 815,646 shares of Common Stock. Grumman Hill, L.P. subsequently sold $3.3 million in principal amount of 1992 Notes. In June 1993, the 1992 Notes, including the remaining $800,000 in principal amount held by Mr. Irwin and affiliates, were paid in full. As of January 1994, Mr. Irwin, Mr. Faherty (as general partner of a family-owned partnership), Mr. Uhl, Mr. Zrno and Mr. Moses own $533,000, $600,000, $200,000, $100,000 and $100,000, respectively, in principal amount of 1993 Notes which they acquired either in the 1993 Note Offering or in open-market transactions. PRINCIPAL STOCKHOLDERS The following table sets forth information regarding beneficial ownership of the stock of ALC as of February 21, 1994 by each person known by ALC to be the beneficial owner of more than 5.0% of any class of stock, each director of ALC and all executive officers and directors of ALC as a group. The figures presented are based upon information available to ALC. - ------------------------- * Percentage calculation based on 33,101,601 shares of Common Stock, issued and outstanding on February 21, 1994, plus shares of Common Stock which may be acquired pursuant to warrants and options exercisable within sixty days by such individual or group listed. ** Less than one percent. (1) Based on information set forth in a Schedule 13G, dated February 14, 1994, filed with the Securities and Exchange Commission. (2) Includes all shares held by Fidelity Management & Research Company (acting as investment adviser) and by Fidelity Management Trust Company (acting as investment manager), which are wholly-owned subsidiaries of FMR Corp. These shares are deemed to be beneficially owned by Edward Johnson 3d; Mr. Johnson is the Chairman of the Board and a member of a controlling group with respect to FMR Corp. (3) Based on information set forth in a Schedule 13G, dated February 2, 1994, filed with the Securities and Exchange Commission. (4) Includes 1,494,845 shares of ALC Stock which may be acquired pursuant to the exercise of outstanding warrants. (5) Includes 153,163 shares of ALC Stock which may be acquired pursuant to the exercise of outstanding stock options held by Grumman Hill, L.P. and 622,483 shares of ALC Stock which may be acquired pursuant to the exercise of outstanding warrants held individually and by Grumman Hill and Grumman Hill, L.P. These Grumman Hill and Grumman Hill, L.P. shares are deemed to be beneficially owned by Mr. Irwin, as President and Director of Grumman Hill and as General Partner of Grumman Hill, L.P. (6) Includes 485,992 shares of ALC Stock which may be acquired pursuant to the exercise of outstanding warrants and 153,163 shares of ALC Stock which may be acquired pursuant to the exercise of outstanding stock options. (7) These shares of ALC Stock may be acquired pursuant to the exercise of outstanding warrants. (8) Includes 395,108 shares of ALC Stock which Mr. Zrno has the right to acquire pursuant to the exercise of outstanding stock options, and 800 shares of ALC Stock which Mr. Zrno's wife and mother-in-law own jointly (Mr. Zrno disclaims beneficial interest as to these shares). (9) Includes 386,060 shares of ALC Stock which Mr. Moses has the right to acquire pursuant to the exercise of outstanding stock options, 3,000 shares of ALC Stock which Mr. Moses owns as custodian for his children under UGMA and 1,000 shares of ALC Stock which Mr. Moses' daughter owns (Mr. Moses disclaims beneficial interest as to the latter 1,000 shares). (10) Includes 40,000 shares of ALC Stock which Mr. Uhl has the right to acquire pursuant to the exercise of outstanding stock options. (11) Shares of ALC Stock which Mr. Faherty has the right to acquire pursuant to the exercise of outstanding stock options. (12) Includes 420,666 shares of ALC Stock which Mr. Oberlin has the right to acquire pursuant to the exercise of outstanding stock options. (13) Includes 61,542 shares of ALC Stock which Ms. Gale has the right to acquire pursuant to the exercise of outstanding stock options. (14) Includes 1,663,483 shares of ALC Stock which executive officers and directors of ALC have the right to acquire pursuant to the exercise of outstanding stock options and 622,483 shares of ALC Stock which Mr. Irwin has the right to acquire or is deemed to have the right to acquire pursuant to the exercise of outstanding stock warrants held individually and by Grumman Hill and Grumman Hill, L.P. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS BANKS STOCK OWNERSHIP IN THE COMPANY In August 1992, the Company's then majority stockholder, CTI conveyed the Common Stock, Class B Preferred and Class C Preferred it owned to the Banks pro-rata in exchange for the release of certain portions of CTI's obligations to each of the Banks. The Banks, in the aggregate, acquired all of the Class B Preferred and Class C Preferred, as well as 14,324,000 shares of Common Stock. Pursuant to a Registration Rights Agreement dated June 4, 1990, the Banks, Prudential, General Electric and Grumman Hill and Grumman Hill, L.P. (and their transferees of securities covered by such agreement) (the "Registration Rights Agreement") each had the right to require ALC to register the 1990 Warrants issued in connection with the 1990 phase of the Refinancing (the "1990 Warrants"), shares of Common Stock issuable upon exercise of such 1990 Warrants, shares of Common Stock issuable upon conversion of the Class B Preferred and Class C Preferred, and the shares of Common Stock previously held by the Banks, in each case held by such party, to permit a public sale of such shares under the Securities Act and applicable state securities laws. The parties could demand, in the aggregate, six such registrations, and may join in an unlimited number of ALC initiated registrations. Pursuant to the Registration Rights Agreement and an Assignment of Rights Agreement dated August 6, 1992 among the Banks and ALC (the "Assignment of Rights"), ALC registered and otherwise accommodated the 1992 Equity Offering and the 1993 Equity Offering through a "shelf registration." Also in the Assignment of Rights, ALC gave the Banks the right to participate on a preemptive basis in certain future private issuances of Common Stock by ALC. In October 1992, the Company completed the 1992 Equity Offering for 9,863,600 shares of Common Stock, a portion of which resulted from the exchange of the Class A Preferred held by individual stockholders and the remainder of which was due to Common Stock held by other entities, including the Banks. The Banks sold, in the aggregate, 3,000,000 shares of Common Stock in the 1992 Equity Offering. In the 1993 Equity Offering (which term includes all secondary public offerings pursuant to the shelf registration in 1993), the Banks sold 8,386,216 shares of Common Stock, of which 3,796,000 were received upon conversion of all outstanding shares of Class B Preferred and Class C Preferred. After the 1993 Equity Offering, the Banks held an aggregate of 4,321,784 shares of Common Stock, representing 15.0% of the then total voting power of ALC capital stock (10.9% assuming the exercise of certain warrants and options). Also pursuant to the shelf registration, in September 1993, the Company completed a stock offering whereby General Electric, Prudential and a major lessor sold an aggregate of 7,763,391 shares of Common Stock to the public. As a result of the 1993 Equity Offering and subsequent transfers pursuant to an escrow agreement, Prudential no longer holds a significant number of shares of Common Stock. Prudential agreed with a group of equipment lessors of Communications Transmission Group, Inc. ("CTGI") to allow them to share in up to half of the shares of ALC capital stock acquired by Prudential pursuant to a Residual Option or received from the Banks, in each case under certain circumstances. Further, in August 1992 the Banks agreed under certain circumstances to transfer to Prudential 10% of the shares subject to the Residual Option upon disposition of any shares of ALC capital stock owned by them. In addition, each Bank agreed that after each Bank had received its pro rata portion of an amount calculated by the formula used to determine the aggregate exercise price for the Residual Option, plus interest thereon at 10% per annum from August 6, 1992 to the date of determination, each Bank would pay Prudential any additional proceeds received by it from the disposition of any shares of the ALC capital stock owned by it as a result of the August 1992 transactions and to deliver to Prudential any remaining shares of such ALC capital stock. In accordance with an agreement entered into in August 1992, the Banks paid Prudential 10% of their net proceeds from the 1992 Equity Offering, and transferred 1,412,000 shares of Common Stock to Prudential as a consequence of the 1993 Equity Offering. Subsequently, by March 1994, all of the Banks disposed of a sufficient number of shares to result in such Banks receiving their respective pro rata portions of the amount of debt of CTI released by the Banks on August 18, 1992 (plus interest), and such Banks tranferred all of their remaining shares of Common Stock to or as directed by Prudential. In October 1993, Electra Communications Holding Corporation ("ECHC") acquired rights from certain of CTGI's equipment lessors, including the right to share in 30.77% of the shares of ALC Stock subsequently acquired by Prudential from the Banks. ECHC further agreed to pledge any such shares it might receive to Sanwa as pledge agent for Nissho Iwai American Corporation ("NIAC"), one of CTGI's other equipment lessors. Prudential retained 282,035 shares of the 407,388 shares of ALC Stock it received from the Banks in March 1994 and transferred the remaining 125,353 shares to ECHC, subject to ECHC's pledge to NIAC. Pursuant to a certain escrow agreement (the "Escrow Agreement") among Prudential, Nissho Iwai American Corporation, as administrative lessor for certain of CTGI's equipment lessors, and Sanwa Bank & Trust Company of New York ("Sanwa"), as Escrow Agent, on August 27, 1993, Prudential deposited 1,555,683 shares of Common Stock (the "Escrow Shares") with the Escrow Agent. Under the terms of the Escrow Agreement, subject to contractual restrictions to which Prudential was subject contained in one or more underwriting agreements relating to ALC Stock, the Escrow Agent had the power to sell the Escrow Shares under certain circumstances. These Escrow Shares were subsequently sold in the 1993 Equity Offering and the Escrow Agreement terminated in October 1993. In August 1992, ALC had agreed with the Banks that it would not issue in excess of 8,000,000 shares of Common Stock prior to the earlier of (a) August 6, 1994 or (b) the date on which the Banks collectively held less than 8,000,000 shares of Common Stock or Common Stock equivalents. As a result of the 1993 Equity Offering, this restriction on ALC terminated. In addition, ALC agreed with Prudential that it would not issue in excess of 8,000,000 shares of Common Stock prior to the earlier of (a) March 31, 1994, or (b) the expiration of the Residual Option. As a result of the 1993 Equity Offering, this restriction on ALC also terminated. Also in August 1992, the Banks entered into a Stock Option Agreement (the "Stock Option") and a Residual Stock Option Agreement (the "Residual Option" and, together with the Stock Option, the "Options") with Prudential. By exercise of the Options, Prudential had the ability to acquire all of the shares of Class B Preferred, Class C Preferred and Common Stock owned by the Banks. The Stock Option covered 1,000,000 shares of Common Stock owned by the Banks. As part of the 1993 Equity Offering, Prudential exercised the Stock Option and sold the 1,000,000 shares of Common Stock acquired thereby. The Residual Option covered all of the shares of Class B Preferred and Class C Preferred, and all shares of Common Stock (other than the shares covered by the Stock Option), owned by the Banks. The exercise price for the Residual Option was an amount calculated by a formula that equaled the amount of the debt of CTI released by the Banks on August 18, 1992 as adjusted according to a formula. Upon the sale by the Banks of shares of Common Stock in the 1993 Equity Offering, the Residual Option terminated. TRANSACTIONS WITH GENERAL ELECTRIC AND PRUDENTIAL General Electric and Prudential participated in the cash financing as part of the 1990 phase of the Refinancing. As a result, General Electric held a note issued in 1990 (the "1990 Note") in the original principal amount of $3.5 million and was issued 1990 Warrants to purchase up to 2,305,105 shares of the Common Stock. In addition, prior to a note exchange offer (the "Note Exchange Offer") pursuant to which ALC and Allnet exchanged 11 7/8% debentures previously issued by ALC (the "Debentures") for note-warrant units (the "Units") consisting of 11 7/8% Subordinated Notes of Allnet due June 30, 1999 (the "1992 Notes") and warrants to purchase shares of Common Stock (the "1992 Warrants"), General Electric held $23.8 million in principal amount of the outstanding Original Debentures and Replacement Debentures (exclusive of PIK Debentures issued or issuable in respect of certain interest payments due on certain Debentures), which constituted 43% of the total outstanding amount of those Debentures. As a consequence of the Note Exchange Offer, General Electric owns 1,494,845 1992 Warrants. Also as a consequence of the Note Exchange Offer, General Electric owned $31.8 million in principal amount of 1992 Notes (which the Company has been informed were subsequently sold by General Electric). General Electric purchased 500,000 shares of Common Stock in the 1992 Equity Offering; the Company has been informed 400,000 shares were subsequently sold in the open market. General Electric is also deemed to be the beneficial owner of 120,000 shares of Common Stock which are held of record by its investment manager. General Electric sold the 2,305,105 shares of Common Stock issued pursuant to its 1990 Warrants in the 1993 Equity Offering and in subsequent brokerage transactions. Pursuant to the 1990 Note Agreement between ALC and General Electric, as amended in August 1992, General Electric also had the right to nominate one person for election to the Board of Directors of ALC. There was no such nominee proposed by General Electric for election at the most recent Annual Meeting of Shareholders and, following its participation in the 1993 Equity Offering, General Electric no longer has equity ownership sufficient to maintain this right. The General Electric 1990 Note was amended and replaced in August 1992. Such amended and restated 1990 Note in the principal amount of $3,908,700 was paid in full as of December 1992. Prudential was the holder of a 1990 Note in the original principal amount of $3.0 million which was paid in full as of August 1992. Prudential retained the right to purchase up to 1,975,804 shares of Common Stock pursuant to warrants for same. These warrants were exercised and the related shares were sold in the 1993 Equity Offering. FINANCIAL SERVICES Richard D. Irwin has been a director of CTGI since June 1986 and is President of Grumman Hill. See also "Compensation Committee Interlocks and Insider Participation." TRANSACTIONS WITH MANAGEMENT AND OTHERS As of January 1994, Mr. Irwin, Mr. Faherty (as general partner of a family-owned partnership), Mr. Uhl, Mr. Zrno and Mr. Moses own $533,000, $600,000, $200,000, $100,000 and $100,000, respectively, in principal amount of 1993 Notes which they acquired either in the 1993 Note Offering or in open-market transactions. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) Documents filed as a part of this report 1. Financial Statements. The following consolidated financial statements of ALC and its subsidiary required by Part II, Item 8. are included in Part IV of this Report: 3. Exhibits required by Item 601 of Regulation S-K EXHIBIT INDEX [refer to definitions at end of Index] * Except as otherwise indicated, all references to "Forms" are to those of ALC. _______________ ** Management contract or compensation plan or arrangement required to be identified by Item 14(a)(3) of this report _______________ ** Management contract or compensation plan or arrangement required to be identified by Item 14(a)(3) of this report The Registrant hereby agrees to furnish the Commission a copy of each of the Indentures or other instruments defining the rights of security holders of the long-term debt securities of the Registrant and any of its subsidiaries for which consolidated or unconsolidated financial statements are required to be filed. (b) Reports on Form 8-K A report on Form 8-K was filed by the Company on December 29, 1993 to describe the redemption of the Class A Preferred Stock on December 31, 1993 and to summarize the contents of the letter of resignation dated December 28, 1993 of Saulene M. Richer, the former Director elected by holders of the Class A Preferred. (c) Refer to Item 14(a)(3) above for Exhibits required by Item 601 of Regulation S-K. (d) Schedules other than those set forth in response to Item 14(a)(2) above for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and therefore have been omitted. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has caused this report to be signed on its behalf by the duly authorized, undersigned individual on the 29th day of March, 1994. ALC Communications Corporation Registrant By: /s/ John M. Zrno John M. Zrno, Director, President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this Annual Report on Form 10-K has been signed below by the following persons in their respective capacities on behalf of the registrant as of the 29th day of March, 1994. Signature Title --------- ----- /s/ John M. Zrno President, Chief Executive - ---------------------------- Officer, Director John M. Zrno /s/ Richard D. Irwin Chairman of the Board, - ---------------------------- Director Richard D. Irwin /s/ Marvin C. Moses Executive Vice President and - ---------------------------- Chief Financial Officer, Marvin C. Moses Director (Principal Financial Officer) /s/ Marilyn M. Lesnau Vice President, Controller - --------------------------- Marilyn M. Lesnau (Principal Accounting Officer) /s/ William H. Oberlin Executive Vice President and - --------------------------- Chief Operating Officer, William H. Oberlin Director /s/ Richard J. Uhl Director - --------------------------- Richard J. Uhl /s/ Michael E. Faherty Director - --------------------------- Michael E. Faherty REPORT OF INDEPENDENT AUDITORS BOARD OF DIRECTORS AND STOCKHOLDERS ALC COMMUNICATIONS CORPORATION We have audited the accompanying consolidated balance sheets of ALC Communications Corporation and subsidiary as of December 31,1993 and 1992, and the related consolidated statements of operations, cash flows, and preferred stock and stockholders' equity for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules 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 consolidated financial position of ALC Communications Corporation and subsidiary at December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects the information set forth therein. /s/ ERNST & YOUNG Ernst & Young Detroit, Michigan January 25, 1994 ALC COMMUNICATIONS CORPORATION AND SUBSIDIARY CONSOLIDATED BALANCE SHEETS ALC COMMUNICATIONS CORPORATION AND SUBSIDIARY CONSOLIDATED BALANCE SHEETS LIABILITIES, CLASS A PREFERRED STOCK AND STOCKHOLDERS' EQUITY See notes to consolidated financial statements ALC COMMUNICATIONS CORPORATION AND SUBSIDIARY CONSOLIDATED STATEMENTS OF OPERATIONS See notes to consolidated financial statements ALC COMMUNICATIONS CORPORATION AND SUBSIDIARY CONSOLIDATED STATEMENTS OF CASH FLOWS See notes to consolidated financial statements ALC COMMUNICATIONS CORPORATION AND SUBSIDIARY CONSOLIDATED STATEMENT OF CLASS A PREFERRED STOCK AND STOCKHOLDERS' EQUITY ALC COMMUNICATIONS CORPORATION AND SUBSIDIARY CONSOLIDATED STATEMENT OF CLASS A PREFERRED STOCK AND STOCKHOLDERS' EQUITY Years Ended December 31, 1993, 1992 and 1991 (In Thousands) See notes to consolidated financial statements ALC COMMUNICATIONS CORPORATION AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 AND 1992 Note A -- Summary of Significant Accounting Policies Description of Business Allnet Communication Services, Inc. ("Allnet"), the operating subsidiary of ALC Communications Corporation ("ALC" or the "Company"), provides long distance telecommunications services primarily to commercial and, to a lesser extent, residential subscribers in a majority of the United States and completes subscriber calls to all directly dialable locations worldwide. The Company transmits long distance telephone calls through its network facilities over transmission lines which are leased from other long haul transmission providers. All of the transmission facilities utilized by the Company are digital. Basis of Consolidation The consolidated financial statements include the accounts of ALC and its wholly-owned subsidiary, Allnet Communication Services, Inc. Intercompany transactions have been eliminated. Fixed Assets Fixed assets are stated at cost. Depreciation is provided on the straight-line method over the estimated useful lives or lease terms of the assets. Maintenance and repairs are charged to operations as incurred. Intangible Assets The cost in excess of net assets acquired of $61.0 million, resulting from the acquisition of Lexitel is being amortized on a straight line basis over 40 years. In July 1993, the Company acquired the customer base of Call Home America, Inc. ("CHA") (Note C). The purchase price has been allocated between the value of the customer base acquired and the covenant not to compete which are being amortized over seven years and 42 months, respectively. Additionally, the Company is amortizing over five years the costs incurred under a marketing agreement with CHA. Amortization expense related to the acquisition and marketing agreement totaled $1.2 million in 1993. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Amortization expense, including amortization of cost in excess of net assets acquired and cost associated with the issuance of debentures and the Revolving Credit Facility as well as amortization associated with CHA, totaled $3.1 million, $1.8 million and $1.8 million for the years ended December 31, 1993, 1992 and 1991, respectively. Revenue Recognition Customers are billed as of monthly cycle dates. Revenue is recognized as service is provided and unbilled usage is accrued. Accrued Facility Costs In the normal course of business, the Company estimates its accrual for facility costs. Subsequently, the accrual is adjusted based on invoices received from local exchange carriers. Income Taxes The Company adopted Statement of Financial Standards No. 109 "Accounting for Income Taxes" as of January 1, 1993, the required implementation date (Note F). Prior to January 1, 1993, income taxes were accounted for in accordance with Accounting Principles Board Opinion No. 11 ("APB 11"). Reclassifications Certain prior year amounts have been reclassified to conform to the current year presentation. NOTE B -- Refinancing Events During 1992, the Company completed a comprehensive refinancing plan ("Refinancing") which included the rescheduling of substantially all debt and resulted in significantly reduced or deferred debt service obligations. The Refinancing resulted in a simplified equity structure and a revised redemption and maturity schedule. The Company anticipates it will be able to meet these obligations from expected cash flow from operations. Highlights of the Refinancing include the following: * A Note Exchange Offer was completed in August 1992 whereby the Company's Original Debentures, Replacement Debentures, PIK Debentures, and accrued interest on the NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) nonconsenting Debentures totalling $73.3 million were replaced by 11 7/8% Subordinated Notes of Allnet ("1992 Notes"). As part of the Note Exchange Offer, 3,400,000 Common Stock warrants ("1992 Warrants") were issued representing 10.2% of the fully diluted equity of ALC at an exercise price of $5.00 per share of Common Stock. * In August 1992, the Restructured Promissory Note was restated and extended to June 30, 1995 and a $5.0 million principal prepayment was made. The note was subsequently paid in full in May 1993. * In August 1992, 14,324,000 shares of ALC Common Stock and the ALC Class B and Class C Preferred Stock ("Preferred Stock") held by Communications Transmission Inc. ("CTI") were transferred to a group of five banks ("Banks"). Subsequently, the Preferred Stock was converted into 3,796,000 shares of Common Stock. * In October 1992 an equity offering for 9,863,600 shares of ALC Common Stock at $5.50 per share was completed. A portion of the 1992 equity offering relating to 3,464,373 shares was to facilitate the sale of shares for existing major holders. * The remaining 6,399,227 shares of the equity offering were issued in conjunction with an Exchange Agreement with the major holders of the Class A Preferred Stock ("Class A Preferred"). The major holders of the Class A Preferred agreed to exchange the 2,144,044 shares of Class A Preferred with an aggregate redemption value of $58.7 million, including all accrued and unpaid dividends, for shares of ALC Common Stock at an effective 40% discount. * The 1990 Note Agreements with a principal balance of approximately $8.0 million were paid in full by December 1992. Financing activities in 1993 included: * In March 1993, an equity offering was completed in which an aggregate of 10,350,000 shares of ALC Common Stock were sold at $14.25 per share. ALC did not receive the proceeds from the sale of these shares by existing major holders, although it did receive $1.9 million upon exercise of 963,784 warrants. * In May 1993, the Company completed an offering of $85.0 million 9% Senior Subordinated Notes ("1993 Notes"). NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) The net proceeds of $84.3 million were used to repay the outstanding 11 7/8% Senior Subordinated Notes of Allnet aggregating $72.4 million and to reduce the amount outstanding under the short term Revolving Credit Facility. The early retirement of the 1992 Notes resulted in an extraordinary loss of $7.5 million, net of the related tax effect of $4.0 million. * As of June 30, 1993, the Company executed an agreement for a $40.0 million long term line of credit, replacing the previous Revolving Credit Facility. * In September 1993, an equity offering was completed in which an aggregate of 7,763,391 shares of ALC Common Stock were sold at $25.50 per share. This offering included the exercise of 3,240,025 warrants. ALC did not receive any proceeds from the sale of these shares by existing major holders, but did receive $6.9 million from the exercise of warrants. * As of December 31, 1993, the Company redeemed the remaining 355,956 shares of Class A Preferred for a total of $10.4 million including $3.2 million of accrued dividends. Note C - Purchase of Customer Base During July 1993, the Company acquired the specialized 800 customer base of Call Home America, Inc. for $15.5 million plus a future payment to be made based on certain average monthly revenue generated by the customers in April, May and June 1994. The Company is also acquiring additional customers from CHA under a marketing agreement from August 1993 through 1994. Under this agreement, an additional $4.1 million has been allocated to the purchase price for customers acquired during 1993. The following unaudited proforma summary presents the Company's revenue and income as if the transaction occurred at the beginning of the periods presented. The proforma financial data is not necessarily indicative of the results that actually would have occurred had the transactions taken place on the dates presented and do not project the Company's results of operations. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE D - Long Term Debt and Other Financing Long-term debt, including amounts due within one year, consists of: Revolving Credit Facility The Company has a $40.0 million Revolving Credit Facility which expires on June 30, 1995. Under this Facility, the Company is able to minimize interest expense by structuring borrowings under three alternatives. Each alternative has a varying interest rate calculation associated with it. The effective rate under the Facility during 1993 approximated 5.8%. The agreement includes financial covenants which allow the Company to further reduce interest expense on outstanding borrowings beginning in July 1994. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) A .375% per annum charge is made on the unused portion of the line. Availability under the Facility is based on the level of eligible accounts receivable. As of December 31, 1993, the Company had $39.8 million of availability under the line. Borrowings under the facility (none at December 31, 1993) are collateralized by accounts receivable. 9% Senior Subordinated Notes In May 1993, the Company issued the 1993 Notes with a face value of $85.0 million. Interest on the 1993 Notes is payable semi-annually commencing November 15, 1993. The Notes will mature on May 15, 2003, but are redeemable at the option of the Company, in whole or in part, on or after May 15, 1998. In the event of an ownership change, the holders have the right to require the Company to purchase all or part of the 1993 Notes. The 1993 Notes contain restrictive covenants which could limit additional indebtedness and restrict the payment of dividends. Other Long-Term Debt Other long-term debt represents deferred liabilities relating to certain operating leases. Future Maturities The future maturities of long-term debt at December 31, 1993 are as follows: NOTE E - Redeemable Preferred Stock As of December 31, 1991, the Company had 2,500,000 shares of Class A Preferred outstanding with a redemption value of $48.9 million plus accrued dividends. In October 1992, pursuant to the NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Exchange Agreement with the major holders of the Class A Preferred the Company exchanged 2,144,044 shares of Class A Preferred for 6,399,227 shares of ALC Common Stock at an effective 40% discount. In September 1992, ALC paid approximately $1.3 million to certain major holders of the Class A Preferred in connection with a concession agreement entered into in June 1990. In July 1993, a dividend of $0.32 per share was declared which was subsequently paid September 30, 1993. In December 1993, the Company redeemed the remaining 355,956 shares of Class A Preferred for $10.4 million including $3.2 million of accrued dividends. NOTE F - Taxes on Income Effective as of January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("Statement 109"). Under Statement 109, the liability method is used in accounting for income taxes. Under this method, deferred tax assets and liabilities are determined based on differences between the financial reporting and tax basis of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when those differences are expected to reverse. As permitted by Statement 109, the Company has elected not to restate the financial statements of any prior years. The cumulative effect of the change resulted in recording net deferred tax assets and increasing net income in 1993 by $13.5 million. Income tax expense and the extraordinary item as shown in the Consolidated Statement of Operations are composed of the following: Due to the change of ownership which occurred in August 1992 and the resulting limitation on the utilization of net operating loss carryforwards ("NOLs"), the Company is subject to the regular tax, resulting in federal taxes currently payable of $6.7 million NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) for 1993 and $1.6 million for 1992. In 1991, the Company was subject to alternative minimum tax which was imposed at a 20% rate on the Company's alternative minimum taxable income. NOLs were used to offset 90% of the taxable income resulting in federal taxes currently payable of $100,000 for 1991. The provisions for state and local income taxes reflect the effect of filing separate company state and local income tax returns for members of the consolidated group. This amount is reduced, where appropriate, by the availability to utilize state and local portions of operating loss carryforwards. State and local income taxes currently payable were $1.2 million, $1.1 million, and $200,000 in 1993, 1992, and 1991, respectively. The $5.5 million tax benefit realized from the exercise of stock options in 1993 was added to capital in excess of par value and is not reflected in operations. A reconciliation between the statutory federal and the effective income tax rates follows: Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting and income tax purposes. Significant components of the Company's deferred taxes as of December 31, 1993 are as follows (in thousands): NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) The Company has tax net operating loss, alternative tax net operating loss and investment tax credit ("ITC") carryforwards which can be utilized annually to offset future taxable income. Because of the "ownership changes" which occurred in 1989 and 1992 under provisions of Internal Revenue Code Section 382, the utilization of carryforwards is presently limited to approximately $10 million per year through 2005. This annual limitation, coupled with the 15 year carryforward limitation, results in a maximum cumulative NOL and ITC carryforward which may be utilized of approximately $120 million as of December 31, 1993. Because it is difficult to predict the realization of the NOL benefit beyond a period of three years, the Company has established a valuation allowance of $34.9 million as of December 31, 1993. NOTE G - Earnings Per Share and Stockholders' Equity Earnings per share Earnings per share are computed using weighted average shares outstanding, adjusted for the one for five reverse stock split in 1991, and common stock equivalents. To arrive at income available for common stockholders, the Company's net income is adjusted by amounts relating to the accretion of discount and dividends accrued on Class A Preferred, and in 1992 and 1991, the accretion of a contract payment to certain major holders of the Class A Preferred. Anti-dilutive securities for 1992 were warrants and options and for 1991 also included Class B and Class C Preferred Stock. Earnings per share for the third and fourth quarters of 1992 and for all of 1993 include the impact of the exercise of outstanding stock options and warrants utilizing the Treasury Stock Method. Common Stock Warrants As of December 31, 1993, warrants for the purchase of 428,090 shares of Common Stock at $2.00 per share, 3,177,856 shares at $5.00 per share and 660,000 shares at $63.75 per share were outstanding. The warrants expire in June 2005, June 1997 and December 1995, respectively. The $2.00 and $5.00 warrants were issued in connection with the Company's refinancings and the difference between the exercise price and the fair value of the warrants at NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) the time of issuance was recorded as a discount on the related notes and an increase to Paid-in-capital - warrants. Employee Stock Options The Company has two Employee Stock Option Plans. The maximum number of shares for which options may be granted under both plans is 6,000,000 (adjusted for certain events such as a recapitalization). The plans provide for the granting of stock options and stock appreciation rights to key employees. Shares under option are summarized below: NOTE H - Leases NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Future minimum rental payments under non-cancelable operating leases with initial or remaining terms of one or more years are $36.4 million, $24.8 million, $20.2 million, $14.7 million, $11.6 million and $15.0 million for 1994, 1995, 1996, 1997, 1998 and 1999 and thereafter, respectively. The Company's lease arrangements frequently include renewal options and/or bargain purchase or fair market value purchase options, and for leases relating to office space, rent increases based on the Consumer Price Index or similar indices. Non-cancelable operating leases relate primarily to intercity transmission facilities, building and office space, and office equipment. Rental expense was $49.9 million, $52.3 million, and $56.9 million for the years ended December 31, 1993, 1992 and 1991, respectively. Fixed assets include amounts financed by capital leases of $600,000 net of $400,000 of accumulated depreciation, and $11.4 million, net of $9.4 million of accumulated depreciation as of December 31, 1993 and 1992, respectively. NOTE I - Transactions with Related Parties The Company leases transmission capacity, multiplexing and various other technical equipment on both capital and operating leases from an affiliate of CTI, a major shareholder through August 1992. Amounts paid under the leases were $17.7 million and $19.7 million for the years ended December 31, 1992 and 1991, respectively. In June 1992, the Company paid $2.0 million to CTI for the purchase of certain assets including an $800,000 note from a major holder of Class A Preferred which was paid in full upon closing of the 1992 equity offering. Consideration for the transaction also included $1.2 million of prepaid transmission capacity to be utilized over a 37 month period. During August 1992, CTI conveyed 14,324,000 shares of ALC Common Stock, 1,000,000 shares of Class B Preferred Stock and 1,000,000 shares of Class C Preferred Stock to the Banks in exchange for the release of certain obligations of CTI. This exchange effected a transfer of controlling interest in the Company from CTI to the Banks. Pursuant to this transfer, The Prudential Insurance Company of America ("Prudential") became a related party through beneficial ownership of options on the stock held by the Banks. During 1992, Prudential held $3.4 million of 1990 Notes which were paid in full in August 1992. As of December 31, 1992, Prudential owned 1990 Warrants to purchase NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 1,975,804 shares of ALC Common Stock. During the March 1993 equity offering Prudential sold 1,963,784 shares of which 963,784 represented the exercise of a portion of their warrants. Prudential exercised their remaining 1,012,020 warrants during the September 1993 equity offering and as a result of these sales, no longer has a substantial equity position in ALC. The transfer of stock during August 1992 from CTI to the Banks gave NationsBank of Texas, N.A. and The First National Bank of Chicago related party status through their ownership of Common, Class B Preferred Stock and Class C Preferred Stock. The March 1993 equity offering facilitated the sale by the Banks of 8,386,216 shares of which 3,796,000 were received upon the conversion of all the Class B and Class C Preferred Stock. The Banks further reduced their ownership interest in the Company to a minimal position through subsequent sales and the transfer of other shares to Prudential. The Banks held the Restructured Promissory Note which was paid in full in May 1993. As of December 31, 1993, Grumman Hill Associates, Inc. and Grumman Hill Investments L.P., of which Richard D. Irwin (the Chairman of the Board of Directors of the Company) is the General Partner, held an aggregate of 622,486 warrants to purchase shares of Common Stock. Additionally, Grumman Hill Investments, L.P. holds options to purchase 153,163 shares of Common Stock. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) NOTE J - Selected Quarterly Financial Data (Unaudited) ALC COMMUNICATIONS CORPORATION AND SUBSIDIARY SCHEDULE V Property and Equipment ALC COMMUNICATIONS CORPORATION AND SUBSIDIARY SCHEDULE VI Accumulated Depreciation on Property and Equipment ALC COMMUNICATIONS CORPORATION AND SUBSIDIARY SCHEDULE VIII Valuation and Qualifying Accounts and Reserves - ----------------------- (1) Amounts accounted for as a reduction of revenue. (2) In connection with the Company's adoption of Statement of Financial Standards No. 109, "Accounting for Income Taxes", a valuation allowance for deferred tax assets of $37,000,000 was recorded January 1, 1993. (See Note F to the Consolidated Financial Statements). (3) Uncollectible accounts written off, net of recoveries. ALC COMMUNICATIONS CORPORATION AND SUBSIDIARY SCHEDULE IX Short-term Borrowings (1) Based on month end amounts outstanding during the period (2) Based on total interest expense for the period and average amount outstanding during the period (3) Line of Credit was classified as short-term through May 1993, upon refinancing the line in June 1993, the balance was transfered to long-term.

1993 ITEM 1. BUSINESS THE COMPANY Green Mountain Power Corporation (the "Company") is a public utility operating company engaged in supplying electrical energy in the State of Vermont in a territory with an estimated population of 195,000. It serves approximately 79,500 customers. For the year ended December 31, 1993, the Company's sources of revenue were derived as follows: 33.2% from residential and lease customers, 31.6% from small commercial and industrial customers, 21.1% from large commercial and industrial customers, 9.6% from sales to other utilities, and 4.5% from other sources. For the same period, the Company's energy resources for retail and requirements wholesale sales were obtained as follows: 42.5% from hydroelectric sources (6.6% Company-owned, 1.6% New York Power Authority ("NYPA"), 28.6% Hydro- Quebec and 5.7% small power producers), 28.5% from nuclear generating sources (the Vermont Yankee plant described below), 14.8% from coal sources, 1.1% from natural gas, 0.7% from oil and 0.4% from wood. The remaining 12.0% was purchased on a short-term basis from other utilities and through the New England Power Pool ("NEPOOL"). In 1993, the Company purchased 91.8% of the energy required to satisfy its retail and requirements wholesale sales (including energy purchased from Vermont Yankee and under other long-term purchase arrangements). See Note K of Notes to Consolidated Financial Statements. A major source of the Company's power supply is its entitlement to a share of the power generated by the 520-MW Vermont Yankee nuclear generating plant owned and operated by Vermont Yankee Nuclear Power Corporation ("Vermont Yankee"), in which the Company has a 17.9% equity interest. For information concerning Vermont Yankee, see "Power Resources - - Vermont Yankee." The Company participates in NEPOOL, a regional bulk power transmission organization established to assure the reliability and economic efficiency of power supply in the Northeast. The Company's representative to NEPOOL is the Vermont Electric Power Company, Inc. ("VELCO"), a transmission consortium owned by the Company and other Vermont utilities, in which the Company has a 30% equity interest. As a member of NEPOOL, the Company benefits from increased efficiencies of centralized economic dispatch, availability of replacement power for scheduled and unscheduled outages of its own power sources, sharing of bulk transmission facilities and reduced generation reserve requirements. The principal territory served by the Company comprises an area roughly 25 miles in width extending 90 miles across north central Vermont between Lake Champlain on the west and the Connecticut River on the east. Included in this territory are the cities of Montpelier, Barre, South Burlington, Vergennes and Winooski, as well as the Village of Essex Junction and a number of smaller towns and communities. The Company also distributes electricity in four noncontiguous areas located in southern and southeastern Vermont that are interconnected with the Company's principal service area Note: Included in the energy sales and operating statistics described in this Annual Report on Form 10-K are NYPA lease transmissions. For information concerning NYPA lease transmissions, see "Power Resources - New York Power Authority." through the transmission lines of VELCO and others. Included in these areas are the communities of Vernon (where the Vermont Yankee plant is located), Bellows Falls, White River Junction, Wilder, Wilmington and Dover. During 1993, the Company also supplied six firm wholesale customers, including four municipal and two cooperative utilities in Vermont and two utilities in other states. The Company is obligated to meet the changing electrical requirements of these wholesale customers, in contrast to the Company's obligation to other wholesale customers, which is limited to specified amounts of capacity and energy established by contract. Major business activities in the Company's service areas include computer assembly and components manufacturing (and other electronics manufacturing), granite fabrication, service enterprises such as government, insurance and tourism (particularly winter recreation), and dairy and general farming. During the years ended December 31, 1993, 1992 and 1991, electric energy sales to International Business Machines Corporation ("IBM"), the Company's largest customer, accounted for 13.6%, 13.8% and 13.0%, respectively, of the Company's operating revenues in those years. No other retail customer accounted for more than one percent of the Company's revenue. RECENT RATE DEVELOPMENTS On October 1, 1993, the Company filed a request with the Vermont Public Service Board ("VPSB") to increase retail rates by 8.6%. The increase is needed primarily to cover the cost of buying power from independent power producers, the cost of energy conservation programs, the cost of plant additions made in the past two years, and costs incurred in 1992 and 1993 associated with the Company's response to the Environmental Protection Agency's ("EPA") Remedial Investigation/Feasibility Study ("RI/FS") and proposed remedy at the Pine Street Marsh site and with the Company's litigation against its previous insurers seeking recovery of past costs incurred and indemnity against future liabilities in connection with the site. On January 28, 1994, the Company and the other parties in the proceeding reached a settlement agreement providing for a 2.9% retail rate increase effective June 15, 1994, and a target return on equity for utility operations of 10.5%. The settlement agreement also provided for the Company's recovery in rates of $4,200,000 in costs associated with the Pine Street Marsh site. The agreement must be reviewed and approved by the VPSB before it can take effect. CONSTRUCTION The Company's capital requirements result from the need to construct facilities or to invest in programs to meet anticipated customer demand for electric service. The policy of the Company is to increase diversification of its power supply and other resources through various means, including power purchase and sales arrangements, and relying on sources that represent relatively small additions to the Company's mix to satisfy customer requirements. This permits the Company to meet its financing needs in a flexible, orderly manner. Planned expenditures for the next five years will be primarily for transmission, distribution and conservation projects. Capital expenditures over the past three years and forecasted for the next five years are as follows: Construction projections are subject to continuing review and may be revised from time-to-time in accordance with changes in the Company's financial condition, load forecasts, the availability and cost of labor and materials, licensing and other regulatory requirements, changing environmental standards and other relevant factors. For the period 1991-1993, internally generated funds, after payment of dividends, provided approximately 47% of total capital requirements for construction, sinking fund obligations and other requirements, including working capital. Internally generated funds provided 46% of such requirements for 1993. It is expected that funds so generated will provide approximately 67% of such requirements for the period 1994 through 1998, with the remainder to be derived through short-term borrowings and the issuance of senior securities and common stock. In November 1993, the Company sold $20 million of its first mortgage bonds in two components: $15 million that will mature in 2018 and $5 million that will mature in 2000. The 2018 and 2000 bonds will bear interest at the rates of 6.7% and 5.71%, respectively. The proceeds from the sale of such bonds were used to refinance existing debt, to finance construction and conservation expenditures, and for other corporate purposes. The Company anticipates issuing additional shares of its common stock in 1994. The amount and timing of such issuance will depend upon the financial condition of the Company, prevailing market conditions and other relevant factors. In connection with the foregoing, see Management's Financial Analysis in Item 7 herein and the material appearing under the caption "Power Resources." OPERATING STATISTICS For the Years Ended December 31 (1) See Note K of Notes to Consolidated Financial Statements. (2) Load factor is based on net system peak and firm MWH production less off-system losses. DEMAND-SIDE MANAGEMENT The Company has committed itself to the development and implementation of demand-side management programs as part of its long-term resource strategy. These programs are aimed at improving the match between customer needs and the Company's ability to supply those needs at a reasonable cost. Energy conservation, load management and efficient electric use are central to these program efforts and provide the means for controlling operating expenses and requirements for additional capital investment. With more efficient electric consumption, the use of existing resources can be optimized. Demand-side management program components, energy conservation, load-management and efficient electric use also provide customers with options and choices with respect to their use and cost of electric service. Due to the economics of New England's current excess power supply market, the Company is expected to reevaluate demand-side management program design in 1994 to take into account lower marginal avoided costs. This program redesign may entail program modifications, curtailment or deferment, the addition of strategies for strategic efficient load growth, and modification of existing energy conservation measures. Integrated Resource Plan. In 1990, the Company entered into a collaborative design agreement with the Vermont Department of Public Service, the Conservation Law Foundation and other interested parties to assist with the development of its demand-side management plans. This collaborative design process culminated with an agreement on the design of eleven specific demand-side management programs and on issues related to regulatory approval and cost recovery for program implementation. These demand-side management programs were filed with the VPSB in May 1991. The VPSB approved these programs in September 1991. In October 1991, the Company completed development of its second formal Integrated Resource Plan. The Plan identified the most cost- effective composite of supply- and demand-side resource alternatives to meet the anticipated future energy needs of the Company's customers; integrated the planning functions of the energy supply, demand-side management, finance and engineering areas of the Company; and incorporated the implementation of those specific demand-side management programs approved by the VPSB in 1991. The Plan forecasted an increasing role for demand-side management in future Company operations. Planned demand-side management programs are projected to meet approximately one-third of the Company's expected load growth into the next century. Current engineering and economic assumptions vary from those used in the Company's October 1991 Integrated Resource Plan. Avoided power supply costs have declined considerably. As a consequence, it is likely that the pace of demand-side management expenditures could change. Rate Design. The Company seeks to design rates to encourage the shifting of electrical use from peak hours. Since 1976, the Company has offered optional time-of-use rates for residential and commercial customers. Currently, approximately 3,000 of the Company's residential customers continue to be billed on the original 1976 time-of-use rate basis. In 1987, the Company received regulatory approval for a new rate design that permits it to charge prices for electric service that reflect as accurately as possible the cost burden imposed by each customer class. The Company depends on fair pricing to keep customers satisfied and to make predictable the customer use of its power supply so that it can keep control of its costs. This rate structure helps to achieve these goals. Since inefficient use of electricity increases its cost, customers who are charged prices that reflect the cost of providing electrical service have real incentives to follow the most efficient usage patterns. Included in the VPSB's order approving this rate design was a requirement that the Company's 4,000 largest customers be charged time-of-use rates on a phased- in basis by 1994. As of April 1, 1991, approximately 1,300 of the Company's largest customers, comprising 48% of retail revenues, were successfully converted to time-of-use rates. During 1991 additional implementation of time-of-use rates was discontinued until further research on the cost effectiveness of time-of-use rates for small customers is performed. This work is continuing and will be reflected in the Company's next rate design proceeding, expected to be filed during the second quarter of 1994. Dispatchable and Interruptible Service Contracts. In 1993, the Company had dispatchable and interruptible power contracts with four major ski areas, interruptible only contracts with three other customers and dispatchable-only contracts with four customers. The dispatchable portions of the contracts allow customers to purchase additional energy when the Company has low-cost electricity available ("dispatchable hours"), while the interruptible portions of the contracts allow the Company to avoid power supply capacity charges by reducing the Company's capacity requirements. Due to the surplus capacity in the region, the Company suspended the interruptible portions of the contracts but continued to offer the dispatchable portions to its customers. In 1993, the Company revised its tariffs to permit other commercial customers to participate in the dispatchable and interruptable service contract program if their load requirements made it practical for them to do so. As of the end of 1993, three additional customers had signed contracts to participate in the program. By participating in the program these customers can now buy electricity from the Company during dispatchable hours without incurring a demand charge. The Company, in turn, is able to retain customer load requirements that otherwise might have been met through self-generation. Ripple Load-Management System. The Company has operated a remote- control load-management facility since 1976. This facility, referred to as a "Ripple" system, allows the Company, from a central signaling point, to switch off temporarily certain electrical appliances in customers' homes that have a storage capacity, such as water heaters and thermal storage heaters, thereby eliminating electric loads at discreet times. The Company's present Ripple system consists of 7,100 installed signal receivers, a central processing station and four signal injection stations. Approximately 25% of the Company's eligible customers are participating in this load-control program, which allows the Company to reduce system load by four to five MW. Commercial/Industrial Energy Management Services. In 1993, the Company offered five commercial and industrial energy efficiency programs to qualifying customers. These programs offer comprehensive technical assistance to identify cost-effective electric energy efficiency opportunities which may qualify for financial incentives. In addition, fuel-switching opportunities are identified for customers, although no direct financial incentives are provided. Approximately 1,000 customers participated in these programs in 1993, resulting in an approximate savings of 16,000 MWh. In 1993, the Company achieved approximately 160% of its energy savings targets developed in the collaborative design agreement discussed above, with the overall program performance (residential, commercial and industrial) of approximately 145% of the energy savings targets. Residential Energy Management Services. In 1993, the Company offered six demand-side management programs to serve residential customers. The VPSB had approved these programs in 1991. These programs offer a variety of services to assist customers to identify and implement appropriate electric energy strategies or fuel-switching opportunities for their residences. In the case of electric efficiency improvements, the Company will also offer various financial incentives for the installation of such measures. Approximately 6,000 residential customers participated in these programs in 1993 resulting in an annual savings of approximately 3,419 MWh. POWER RESOURCES The Company generated, purchased and (in the case of NYPA power) transmitted 1,848,608 MWh of energy for retail and requirements wholesale customers for the twelve months ended December 31, 1993. The corresponding maximum one-hour integrated demand during that period was 307.3 MW on February 1, 1993. This compares to the previous all-time peak of 322.6 MW on December 27, 1989. The following tabulation shows the annual average capacity, the source of such energy for the twelve-month period and the capacity in the month of the period system peak. See also "Power Resources - - Long-Term Power Sales." NOTE: (a) Excludes losses on off-system purchases, totaling 37,357 MWh. (b) Average annual capability associated with the Vermont Yankee source is adjusted to reflect system sale obligations. See "Power Resources -- Long-Term Power Sales." Vermont Yankee. The Company and Central Vermont Public Service Corporation acted as lead sponsors in the construction of the Vermont Yankee nuclear plant, a boiling-water reactor designed by General Electric Company. The plant, which became operational in 1972, has a generating capacity of 520 MW. Vermont Yankee has entered into power contracts with its sponsor utilities, including the Company, that expire at the end of the life of the unit. Pursuant to its Power Contract, the Company is required to pay 20% of Vermont Yankee's operating expenses (including depreciation and taxes), fuel costs (including charges in respect of estimated costs of disposal of spent nuclear fuel), decommissioning expenses, interest expense and return on common equity, whether or not the Vermont Yankee plant is operating. In 1969, the Company sold to other Vermont utilities 2.735% of its entitlement to the output of Vermont Yankee. Accordingly, those utilities have an obligation to the Company to pay 2.735% of Vermont Yankee's operating expenses, fuel costs, decommissioning expenses, interest expense and return on common equity. Vermont Yankee has also entered into capital funds agreements with its sponsor utilities that expire on December 31, 2002. Under its Capital Funds Agreement, the Company is required, subject to obtaining necessary regulatory approvals, to provide 20% of the capital requirements of Vermont Yankee not obtained from outside sources. See Notes 1 and 2 of Notes to Financial Statements of Vermont Yankee. On April 27, 1989, Vermont Yankee applied to the Nuclear Regulatory Commission ("NRC") for an amendment to its operating license to extend the expiration date from December 2007 to March 2012, in order to take advantage of current NRC policy to issue operating licenses for a 40-year term measured from the grant of the operating license. (Prior NRC policy, under which the operating license was issued, called for a term of 40 years from the date of the construction permit.) On August 22, 1989, the State of Vermont, opposing the license extension, filed a request for a hearing and petition for leave to intervene, which petition was subsequently granted. On December 17, 1990, the NRC issued an amendment to the operating license extending the expiration date until March 21, 2012, based upon a "no significant hazards" finding by the NRC Staff and subject to the outcome of the evidentiary hearing on the State of Vermont's assertions. On July 31, 1991, Vermont Yankee reached a settlement with the State of Vermont, and the State filed a withdrawal of its intervention. The proceeding was dismissed on September 3, 1991. During periods when Vermont Yankee is unavailable, the Company incurs replacement-power costs in excess of those costs that the Company would have incurred for power purchased from Vermont Yankee. Replacement power is available to the Company from NEPOOL and through special contractual arrangements with other utilities. Replacement-power costs adversely affect cash flow and, absent deferral, amortization and recovery through rates, would adversely affect reported earnings. Routinely, in the case of scheduled outages for refueling, the VPSB has permitted the Company to defer, amortize and recover these excess replacement power costs for financial reporting and ratemaking purposes over the period until the next scheduled outage. Vermont Yankee has adopted an 18-month refueling schedule. In late August 1993, Vermont Yankee began a scheduled refueling outage which was completed on October 26, 1993. Vermont Yankee's next scheduled refueling is March 1995. In the case of unscheduled outages of significant duration resulting in substantial unanticipated costs for replacement power, the VPSB generally has authorized deferral, amortization and recovery of such costs. Vermont Yankee incurred capital expenditures of approximately $7,229,000 in 1993, $10,750,000 in 1992 and $6,596,000 in 1991. Vermont Yankee estimates capital expenditures amounting to approximately $15,650,000 for 1994. During the year ended December 31, 1993, the Company utilized 531,997 MWh of Vermont Yankee energy to meet 28.6% of its retail and requirements wholesale sales. The average cost of electricity produced by the plant in 1993 was 5.3 cents per KWh. In 1993, Vermont Yankee had an annual capacity factor of 76.9%, compared to 83.3% in 1992 and 91.2% in 1991. The Price-Anderson Act currently limits public liability from a single incident at a nuclear power plant to $9,400,000,000. Any liability beyond $9,400,000,000 is indemnified under an agreement with the NRC. The first $200,000,000 of liability coverage is the maximum provided by private insurance. The Secondary Financial Protection program is a retrospective insurance plan providing additional coverage up to $9,200,000,000 per incident by assessing retrospective premiums of $79,300,000 against each of the 116 reactor units in the United States that are currently subject to the Program, limited to a maximum assessment of $10,000,000 per incident per nuclear unit in any one year. The maximum assessment is to be adjusted at least every five years to reflect inflationary changes. The above insurance covers all workers employed at nuclear facilities prior to January 1, 1988, for bodily injury claims. Vermont Yankee has purchased a master worker insurance policy with limits of $200,000,000 with one automatic reinstatement of policy limits to cover workers employed on or after January 1, 1988. Vermont Yankee's estimated contingent liability for a retrospective premium on the master worker policy as of December 1993 is $3,100,000. The secondary financial protection program referenced above provides coverage in excess of the Master Worker policy. Insurance has been purchased from Nuclear Electric Insurance Limited (NEIL II) to cover the costs of property damage, decontamination or premature decommissioning resulting from a nuclear incident. All companies insured with NEIL II are subject to retroactive assessments if losses exceed the accumulated funds available to NEIL II. The maximum potential assessment against Vermont Yankee with respect to losses arising during the current policy year is $5,800,000 at the time of the first loss and $12,300,000 at the time of a subsequent loss. Vermont Yankee's liability for the retrospective premium adjustment for any policy year ceases six years after the end of that policy year unless prior demand has been made. HYDRO-QUEBEC: Highgate Interconnection. On September 23, 1985, the Highgate transmission facilities, which were constructed to import energy from Hydro-Quebec in Canada, began commercial operation. The transmission facilities at Highgate include a 200-MW AC-to-DC-to-AC converter terminal and seven miles of 345-kV transmission line. VELCO built and operates the converter facilities, which are jointly owned by a number of Vermont utilities, including the Company. NEPOOL/Hydro-Quebec Interconnection. VELCO and certain other NEPOOL members have entered into agreements with Hydro-Quebec providing for the construction in two phases of a direct interconnection between the electric systems in New England and the electric system of Hydro-Quebec in Canada. The Vermont participants in this project, which has a capacity of 2,000 MW, will derive about 9% of the total power-supply benefits associated with the NEPOOL/Hydro-Quebec interconnection. The Company, in turn, receives about one-third of the Vermont share of those benefits. The benefits of the interconnection include access to surplus hydroelectric energy from Hydro-Quebec at a cost below that of the replacement cost of power and energy otherwise available to the New England participants; energy banking, under which participating New England utilities will transmit relatively inexpensive energy to Hydro-Quebec during off-peak periods and will receive equal amounts of energy, after adjustment for transmission losses, from Hydro-Quebec during peak periods when replacement costs are higher; and provision for emergency transfers and mutual backup to improve reliability for both the Hydro-Quebec system and the New England systems. Phase I. The first phase ("Phase I") of the NEPOOL/Hydro-Quebec Interconnection consists of transmission facilities having a capacity of 690 MW that traverse a portion of eastern Vermont and extend to a converter terminal located in Comerford, New Hampshire. These facilities entered commercial operation on October 1, 1986. Vermont Electric Transmission Company, Inc. ("VETCO"), a wholly owned subsidiary of VELCO, was organized to construct, own and operate those portions of the transmission facilities located in Vermont. Total construction costs incurred by VETCO for Phase I were $47,850,000. Of that amount, VELCO provided $10,000,000 of equity capital to VETCO through sales of VELCO preferred stock to the Vermont participants in the Project. The Company purchased $3,100,000 of VELCO preferred stock to finance the equity portion of Phase I. The remaining $37,850,000 of construction cost was financed by VETCO's issuance of $37,000,000 of long-term debt in the fourth quarter of 1986 and the balance of $850,000 was financed by short-term debt. Under the Phase I contracts, each New England participant, including the Company, is required to pay monthly its proportionate share of VETCO's total cost of service, including its capital costs, as well as a proportionate share of the total costs of service associated with those portions of the transmission facilities to be constructed in New Hampshire by a subsidiary of New England Electric System. Phase II. Agreements executed in 1985 among the Company, VELCO and other NEPOOL members and Hydro-Quebec, provided for the construction of the second phase ("Phase II") of the interconnection between the New England electric system and that of Hydro-Quebec. Phase II expands the Phase I facilities from 690 MW to 2,000 MW, and provides for transmission of Hydro- Quebec power from the Phase I terminal in northern New Hampshire to Sandy Pond, Massachusetts. Construction of Phase II commenced in 1988 and was completed in late 1990. The Phase II facilities commenced commercial operation November 1, 1990, initially at a rating of 1,200 MW, and increased to a transfer capability of 2,000 MW in July 1991. The Hydro- Quebec-NEPOOL Firm Energy Contract provides for the import of economical Hydro-Quebec energy into New England. The Company is entitled to 3.2% of the Phase II power-supply benefits. Total construction costs for Phase II were approximately $487,000,000. The New England participants, including the Company, have contracted to pay monthly their proportionate share of the total cost of constructing, owning and operating the Phase II facilities, including capital costs, for 30 years. The agreements providing for the operation and support of the Phase II facilities meet the capital lease accounting requirements under SFAS 13. At December 31, 1993, the present value of the Company's obligation was $11,000,000. The Company's projected future minimum payments under the Phase II support agreements are $501,311 for each of the years 1994-1998 and an aggregate of $8,522,270 for the years 1999-2020. The Phase II portion of the project is owned by New England Hydro- Transmission Electric Company, Inc. and New England Hydro-Transmission Corporation, subsidiaries of New England Electric System, in which certain of the Phase II participating utilities, including the Company, own equity interests. The Company owns approximately 3.2% of the equity of the corporations owning the Phase II facilities. During construction of the Phase II project, the Company, as an equity sponsor, was required to provide equity capital. At December 31, 1993, the capital structure of such corporations was 40% common equity and 60% long-term debt. Hydro-Quebec Power Supply Contracts. Under various contracts approved by the VPSB, the details of which are described in the table below, the Company purchases capacity and associated energy produced by the Hydro- Quebec system. Such contracts obligate the Company to pay certain fixed capacity costs whether or not energy purchases above a minimum level set forth in the contracts are made. Such minimum energy purchases must be made whether or not other, less expensive energy sources might be available. These contracts are intended to complement the other components in the Company's power supply to achieve the most economic power-supply mix reasonably available. * Estimated average ** Estimated average in nominal dollars, levelized over the period indicated. On October 12, 1990, the VPSB granted conditional approval of the Company's purchases pursuant to the contract with Hydro-Quebec entered into December 4, 1987: (1) Schedule A -- 17 MW of firm capacity and associated energy to be delivered at the Highgate interconnection for five years beginning 1990; (2) Schedule B -- 68 MW of firm capacity and associated energy to be delivered at the Highgate interconnection for twenty years beginning in September 1995; and (3) Schedule C3 -- 46 MW of firm capacity and associated energy to be delivered at interconnections to be determined at a later time for 20 years beginning in November 1995. The opponents to the December 1987 contract (principally the Crees, native peoples living in northern Quebec) appealed the VPSB's October 1990 order to the Vermont Supreme Court. On October 2, 1992, the Vermont Supreme Court affirmed the VPSB's October 1990 order. On February 12, 1992, the VPSB issued an order finding that the Company had complied with substantial conditions imposed by the VPSB in its October 1990 order and approved the Company's purchase under the December 1987 contract. In March 1992, the opponents to the December 1987 contract appealed the VPSB'S February 1992 compliance order to the Vermont Supreme Court. On May 7, 1993, the Vermont Supreme Court affirmed the VPSB's compliance order approving the Company's purchases under the December 1987 contract. The Company anticipates that the Schedule C3 purchases will be delivered over its entitlement to the NEPOOL/Hydro-Quebec interconnection (Phase I and Phase II). If such interconnection is utilized, the Company must forego certain savings associated with other energy deliveries and capacity arrangements that would benefit the Company if the interconnection were not utilized for delivery of the Schedule C3 purchases. The Company believes that the benefits of the Schedule C3 purchases, if power is delivered over such interconnection, will offset the value of the foregone savings. In September 1993, the Company negotiated a renewal of a short-term "tertiary energy" contract with Hydro-Quebec under which Hydro-Quebec delivers 61 MW of capacity and energy to the Company over the NEPOOL/Hydro- Quebec interconnection. The electricity purchased under this tertiary contract is priced at less than 2.5 cents per KWh. The benefits realized by the Company from this favorably priced electricity will be greater than those associated with deliveries foregone by the Company otherwise available over the NEPOOL/Hydro-Quebec interconnection. This tertiary energy contract will expire in August 1994. The Company anticipates that purchases of tertiary energy will extend beyond August 1994, but will end when the Schedule C3 deliveries begin in November 1995. On September 27, 1990, the Canadian National Energy Board ("NEB") issued its decision approving the export by Hydro-Quebec pursuant to the December 1987 contract. The NEB, however, imposed a condition on its approval: Hydro-Quebec's export license was to be deemed valid so long as Hydro-Quebec obtained all federal and environmental approvals required for any of its new hydroelectric generating units advanced in order to satisfy Hydro-Quebec's contractual obligations. Hydro-Quebec and the Province of Quebec appealed the imposition of this condition to the Federal Court of Appeal. In a decision handed down on July 9, 1991, the Federal Court of Appeal agreed with Hydro-Quebec's assertion that the NEB has no authority to regulate the construction of hydroelectric generating units -- a matter that lies exclusively within provincial jurisdiction under the Canadian Constitution. The Federal Court of Appeal struck down the challenged NEB license condition and otherwise affirmed the license. The opponents to the December 1987 contract appealed the decision of the Federal Court of Appeal to the Supreme Court of Canada. On February 24, 1994, the Supreme Court of Canada rendered a decision reversing the judgment of the Federal Court of Appeal, and reinstated the NEB decision, including the condition that Hydro-Quebec had objected to. The December 1987 contract, like the July 1984 contract, calls for the delivery of system power and is not related to any particular facilities in the Hydro-Quebec system. Consequently, there are no identifiable debt- service charges associated with any particular Hydro-Quebec facility that can be distinguished from the overall charges paid under the contract. The December 1987 contract also contains a provision that prohibits Hydro-Quebec, for a period ending in 1995, from selling power under similar terms and conditions to any other United States utility at a price lower than the Company would pay unless the lower price is made available to the Company. The price of the energy acquired under the December 1987 contract will reflect adjustments in the United States Gross National Product Implicit Price Deflator over the term of the contract. The price of the capacity acquired will reflect adjustments in a pertinent construction cost index (the Handy Whitman Index of Public Utility Construction Costs) until the time deliveries begin. From the commencement of deliveries to the expiration of the contract, the capacity price is essentially frozen. (Some adjustments are made to reflect changes in financing costs over time.) Based on current integrated resource analyses, the Company believes that these contracts for Hydro-Quebec system power compare favorably with alternative long-term resources available to the Company. In 1993, the Company utilized 353,729 MWh of Hydro-Quebec energy under the July 1984 contract, 67,833 MWh under the December 1987 contract Schedule A and 110,890 MWh under the tertiary energy contract to meet 28.6% of its retail and requirements wholesale sales. The average cost of Hydro- Quebec electricity in 1993 was 3.4 cents per KWh. See Notes J and K-2 of Notes to Consolidated Financial Statements. New York Power Authority ("NYPA"). NYPA power provided 15,425 MWh to the Vermont Department of Public Service (the "Department") customers, delivered over the Company's facilities at an average retail rate of 0.9 cents per KWh. As of August 1993, the Department chose not to continue retailing NYPA power to the Company's customers. The Department now wholesales the allocation of NYPA power to the Company who, in turn, delivers the power to residential and farm customers. In addition, the Company purchased at wholesale 13,622 MWh of NYPA power at an average cost of 1.3 cents per KWh in 1993. Under the allocation currently made by NYPA of NYPA power to states neighboring New York, the amount of such power delivered to residential and farm customers in the Company's service territory will be as follows: Entitlements to Customers in the Company's Period Service Territory (MW) ------ ------------------------- July 1993 - June 1994 2.0 July 1994 - June 1995 0.3 July 1995 - June 1996 0.3 July 1996 - June 1997 0.3 Merrimack Unit #2. Merrimack Unit #2 is a coal-fired steam plant of 356-MW capacity located in Bow, New Hampshire, and owned by Northeast Utilities. The Company is entitled to 30.457 MW of capacity and related energy from the unit under a 30-year contract terminating May 1, 1998. During the year ended December 31, 1993, the Company utilized 230,812 MWh from the unit to meet 12.4% of its total retail and requirements wholesale sales. Merrimack Unit #2 operated at a 73.1% annual capacity factor in 1993 and 66.8% in 1992. The average cost of electricity from this unit was 3.0 cents per KWh in 1993. See Note K-1 of Notes to Consolidated Financial Statements. Stony Brook I. The Massachusetts Municipal Wholesale Electric Company ("MMWEC") is principal owner and operator of a 343.0-MW combined-cycle intermediate generating station -- Stony Brook I -- located in Ludlow, Massachusetts, which commenced commercial operation in November 1981. The Company entered into a Joint Ownership Agreement with MMWEC dated as of October 1, 1977, whereby the Company acquired an 8.8% ownership share of the plant, entitling the Company to 30.2 MW of capacity. In addition to this entitlement, the Company has contracted for 13.8 MW of capacity for the life of the Stony Brook I plant, for which it will pay a proportionate share of MMWEC's share of the plant's fixed costs and variable operating expenses. The three units that comprise Stony Brook I are primarily oil- fired. Two of the units are also capable of burning natural gas. The natural gas system at the plant was modified in 1985 to allow two units to operate simultaneously on natural gas. During 1993, the Company utilized 20,591 MWh from this plant to meet 1.1% of its retail and requirements wholesale sales at an average cost of 9.8 cents per KWh. See Note I-3 and K-1 of Notes to Consolidated Financial Statements. Ontario Hydro. The State of Vermont executed a five-year contract with Ontario Hydro, commencing November 1, 1987, and expiring October 31, 1992, which provides for the purchase by the State of 73 MW of high- availability power. The contract has options for increasing the power purchased starting November 1 of 1988, 1989, 1990 and 1991, to a maximum of 88 MW, 98 MW, 108 MW and 112 MW, respectively. This contract can be extended for three additional five-year periods. The maximum option increases have been exercised. The Company receives a share of the Ontario Hydro power imported by the State. The Company's obligation under this contract terminated as of December 1993. The Company's average share of such power for 1993 was 20.3 MW, and 44,165 MWh of Ontario Hydro energy were utilized to meet 2.4% of its retail and requirements wholesale sales. The average cost of this power was 5.3 cents per KWh in 1993. Wyman Unit #4. The W. F. Wyman Unit #4, which is located in Yarmouth, Maine, is an oil-fired steam plant with a capacity of 619 MW. The construction of this plant was sponsored by the Central Maine Power Company. The Company has a joint-ownership share of 1.1% (7.1 MW) in the Wyman #4 unit, which began commercial operation in December 1978. During 1993, the Company utilized 6,474 MWh from this unit to meet 0.3% of its retail and requirements wholesale sales at an average cost of 5.3 cents per KWh. See Note I-3 of Notes to Consolidated Financial Statements. McNeil Station. The J. C. McNeil station, which is located in Burlington, Vermont, is a wood chip and gas-fired steam plant with a capacity of 53.6 MW. The Company has an 11% or 5.9 MW interest in the J. C. McNeil plant, which began operation in June 1984. During 1993, the Company utilized 11,561 MWh from this unit to meet 0.5% of its retail and requirements wholesale sales at an average cost of 7.0 cents per KWh. In 1989, the plant added the capability to burn natural gas on an as- available/interruptible service basis. See Note I-3 of Notes to Consolidated Financial Statements. New York Power Purchases: Rochester Gas and Electric Corporation. In 1988, the Company entered into a ten-year contract with Rochester Gas and Electric Corporation ("RG&E") for the purchase of up to 50 MW of firm power and associated energy. This flexible contract allows the Company the discretion of purchasing from 0 MW to 50 MW on a weekly basis. The Company has no obligation to purchase power in any week. When the Company elects to schedule a purchase, however, it must take and pay for energy at a 75% load factor, or pay a penalty, in the week of the purchase. Although the Company has no fixed capacity payments, it must pay to reserve transmission from the Niagara Mohawk Power Corporation ("Niagara Mohawk") for the 50-MW maximum purchase. Both RG&E and the Company have the option to terminate the contract effective 1995. Pursuant to an agreement with Connecticut Light and Power Corporation ("CL&P") and Bozrah Light and Power Company ("Bozrah") that was finalized in December 1992, the Company exercised the option to terminate the RG&E contract and the transmission contract with Niagara Mohawk that supports it effective October 31, 1995. The Company also agreed to offer RG&E power to CL&P for purchase on a weekly basis through the remaining term of the RG&E contract, and to terminate a contract under which the Company supplied all of the electrical requirements of Bozrah, a small electric utility operating in Gilman, Connecticut. In return, CL&P, which will replace the Company as the supplier of electricity to Bozrah, will assume responsibility for approximately 75% of the fixed costs of the transmission contract with Niagara Mohawk, and will provide the Company with up to 50 MW of system power, to be scheduled on a weekly basis, at a total price expected to be lower than that provided under the existing RG&E contract. In addition, CL&P has offered the Company an option, which may be exercised in yearly increments starting in July 1994, to purchase up to 50 additional MW of system power for the period July 1995 through December 2004. The Company expects that the reductions in its purchased power and fixed transmission costs derived from this three-party agreement will more than offset the loss of revenues associated with the termination of its electricity sales contract with Bozrah. The arrangement was approved by FERC effective May 1, 1993. Estimated Charges Annual Transmission Reservations $300,000 Average Cost per kWh (1993)(1) 4.1 cents (1994-1995) (1) No power purchases were made under the RG&E or CL&P contracts described above during 1993. Small Power Production. The VPSB has adopted rules that implement for Vermont the purchase requirements established by federal law in the Public Utility Regulatory Policies Act ("PURPA") of 1978. Under the rules, small power producers have the option to sell their output to a central state purchasing agent under a variety of long- and short-term, firm and non-firm pricing schedules, each of which is based upon the projected Vermont composite system's power costs which would be required but for the purchases from small producers. The state purchasing agent assigns the energy so purchased, and the costs of purchase, to each Vermont retail electric utility based upon its pro rata share of total Vermont retail energy sales. Utilities may also contract directly with producers. The rules provide that all reasonable costs incurred by a utility under the rules will be included in the utilities' revenue requirements for ratemaking purposes. Currently, the state purchasing agent, Vermont Power Exchange, Inc., is authorized to seek 150 MW of power from qualifying facilities under PURPA, of which the Company's current pro rata share would be 32.6% or 48.8 MW. In 1993, the Company, through both its direct contracts and the Vermont Power Exchange, purchased 106,647 MWh of small power production to meet 5.7% of its retail and requirements wholesale sales at an average cost of 10.0 cents per KWh. Short-Term Opportunity Purchases and Sales. The Company has made arrangements with several utilities in New England and New York whereby the Company may make purchases or sales of utility system power on short notice and generally for brief periods of time when it appears economic to do so. Opportunity purchases are arranged when it is possible to purchase power from another utility for less than it would cost the Company to generate the power with its own sources. Purchases also help the Company save on replacement-power costs during an outage of one of its base load sources. Opportunity sales are arranged when the Company has surplus energy available at a price that is economic to other regional utilities at any given time. The sales are arranged based on forecasted costs of supplying the incremental power necessary to serve the sale. The price is set so as to recover the forecasted fuel and capacity costs. During 1993, the Company purchased 222,565 MWh, 11.9% of the Company's retail and requirements wholesale sales, at an average cost of 2.4 cents per KWh under such arrangements. NEPOOL. As a participant of NEPOOL, through VELCO, the Company takes advantage of pool operations with central economic dispatch of participants' generating plants, pooling of transmission facilities and economy and emergency exchange of energy and capacity. The NEPOOL agreement also imposes obligations on the Company to maintain a generating capacity reserve as set by the Pool, but which is lower than the reserve which would be required if the Company were not a Pool participant. Company Hydroelectric Power. The Company wholly owns and operates eight hydroelectric generating facilities, the largest of which has a generating output of 8.8 MW, located on river systems within its service area. In 1993, these plants provided 123,946 MWh of low-cost energy, meeting 6.6% of the Company's retail and requirements wholesale sales at an average cost of 0.9 cents per KWh. See "State and Federal Regulation." VELCO. The Company, together with six other Vermont electric distribution utilities, owns VELCO. Since commencing operation in 1958, VELCO has transmitted power for its owners in Vermont, including power from NYPA and other power contracted for by Vermont utilities. VELCO also purchases bulk power for resale at cost to its owners, and as a member of NEPOOL, represents all Vermont electric utilities in pool arrangements and transactions. See Note B of Notes to Consolidated Financial Statements. Long-Term Power Sales. The Company has entered into agreements for a unit sale of power to Fitchburg Gas and Electric Light Company of 10 MW of Vermont Yankee capacity and associated energy from September 1, 1990 through October 31, 1996. In 1986, the Company entered into an agreement for the sale to UNITIL of 23 MW of capacity produced by the Stony Brook I combined-cycle plant for a 12-year period commencing October 1, 1986. The agreement provides for the recovery by the Company of all costs associated with the capacity and energy sold. Fuel. During 1993, the Company's retail and requirements wholesale sales were provided by the following fuel sources: 42.5% from hydro (6.6% Company-owned, 1.6% NYPA, 28.6% Hydro-Quebec and 5.7% small power producers), 28.5% from nuclear, 14.8% from coal, 1.1% from natural gas, 0.7% from oil and 0.4% from wood. The remaining 12.0% was purchased on a short-term basis from other utilities and through NEPOOL. Vermont Yankee has approximately $165 million of "requirements based" purchase contracts for nuclear fuel needs to meet substantially all of its power production requirements through 2002. Under these contracts, any disruption of operating activity would allow Vermont Yankee to cancel or postpone deliveries until actually needed. Vermont Yankee has a contract with the United States Department of Energy ("DOE") for the permanent disposal of spent nuclear fuel. Under this contract, DOE will provide disposal services when a facility for spent nuclear fuel and other high level radioactive waste is available, which is required under current statutes to be prior to January 31, 1998. A facility is not yet available. Vermont Yankee also bills its sponsors, including the Company, a disposal fee, which is subject to annual DOE adjustment of $.001 per KWh of net generation. See Management's Financial Analysis in Item 7 herein, Note B of Notes to Consolidated Financial Statements and Note 8 to Vermont Yankee Notes to Financial Statements. The Company does not maintain long-term contracts for the supply of oil for the oil-fired peaking unit generating stations wholly owned by it (80 MW). The Company did not experience difficulty in obtaining oil for its own units during 1993, and, while no assurance can be given, does not anticipate any such difficulty during 1994. None of the utilities from which the Company expects to purchase oil- or gas-fired capacity in 1994 has advised the Company of grounds for doubt about maintenance of secure sources of oil and gas during the year. Coal for Merrimack #2 is presently being purchased by contract and on the spot market from northern West Virginia and southern Pennsylvania sources. The sponsor of Merrimack advises that, as of February 28, 1994, there was a 90-day supply of coal at the plant. Wood for the McNeil plant is furnished to the Burlington Electric Department from a variety of sources under short-term contracts ranging from several weeks' to six months' duration. The McNeil plant used 103,814 tons of wood chips and mill residue and 257,393,000 cubic feet of gas in 1993. The McNeil plant is forecasting consumption of wood chips for 1994 to be 120,000 tons and gas consumption of 600,000,000 cubic feet. Burlington Electric Department advises that, as of February 26, 1994, there were 9,200 tons of wood chips in inventory for the McNeil plant. The Stony Brook combined-cycle generating station is capable of burning either natural gas or oil in two of its turbines. Natural gas is supplied to the plant subject to its availability. During periods of extremely cold weather, the supplier reserves the right to discontinue deliveries to the plant in order to satisfy the demand of its residential customers. The Company assumes for planning and budgeting purposes that the plant will be supplied with gas during the months of April through November, and that it will run solely on oil during the months of December through March. The plant maintains an oil supply sufficient to meet approximately one-half of its annual needs. STATE AND FEDERAL REGULATION General. The Company is subject to the regulatory authority of the VPSB, which extends to retail rates, services, facilities, securities issues and various other matters. The separate Vermont Department of Public Service, created by statute in 1981, is responsible for development of energy supply plans for the State, purchases of power as an agent for the State and other general regulatory matters. The VPSB is principally responsible for quasi-judicial proceedings, such as rate proceedings. The Department, through a Director for Public Advocacy, is entitled to participate as a litigant in such proceedings and regularly does so. Vermont law pertaining to rate proceedings of the Company provides that the rates as filed become final and effective seven months after suspension of the filed rates (which can occur within 45 days of filing) if the VPSB fails to act on the permanent rate request by that time. Once filed, a request for permanent rate relief may not be amended or supplemented except upon approval of the VPSB after hearing. The VPSB must consider an application for and, in appropriate circumstances, order temporary rate relief pending a decision. If the VPSB fails to act on an application for temporary rate relief within 30 days, or within 45 days after suspension of the permanent rate request, the temporary rates take effect. If temporary relief is ordered, revenues recovered are subject to refund. The Company's rate tariffs are uniform throughout its service area. The Company's wholesale rate on sales to eight wholesale customers is regulated by the FERC. Revenues from sales to these customers were approximately 2.4% of operating revenues for 1993. Included within these customers is the Bozrah Light and Power Company, a private electric utility in Connecticut, with whom the Company had a contract to provide wholesale electric service on a full-requirements basis. Service to Bozrah began in March 1987 and terminated May 1, 1993. See "Power Resources - New York Purchases: Rochester Gas and Electric Corporation" for a discussion of the three-party agreement negotiated by the Company relating to the termination of full-requirements service to Bozrah. Late in 1989, the Company began serving two new municipal utilities, Northfield and Hardwick, under its wholesale tariff. These customers increased electricity sales by approximately 46,000 MWh and peak requirements by approximately 9 MW. Revenues in 1993 from Northfield and Hardwick were $1,727,058. Service to Hardwick under the Company's wholesale tariff terminated on April 30, 1993. The Company provides transmission service to ten customers within the State under rates regulated by the FERC; revenues for such services amounted to less than 1% of the Company's operating revenues for 1993. By reason of its relationship with Vermont Yankee, VELCO and VETCO, the Company has filed an exemption statement under Section 3(a)(2) of the Public Utility Holding Company Act, thereby securing exemption from the provisions of such Act, except for Section 9(a)(2) thereof (which prohibits the acquisition of securities of certain other utility companies without approval of the Securities and Exchange Commission). The Securities and Exchange Commission has the power to institute proceedings to terminate such exemption for cause. Licensing. Pursuant to the Federal Power Act, the FERC has granted licenses for the following hydro projects: Project Issue Date Period - ------- ----------- ------ Bolton February 5, 1982 February 5, 1982 - February 4, 2022 Essex * January 21, 1969 May 1, 1965 - December 31, 1993 Vergennes June 29, 1979 June 1, 1949 - May 31, 1999 Waterbury July 20, 1954 September 1, 1951 - August 31, 2001 * The Company is in the process of relicensing this facility and anticipates the final FERC license to be issued by mid-1994. The facility is currently operating on an annual license. Major project licenses provide that after an initial twenty-year period, a portion of the earnings of such project in excess of a specified rate of return is to be set aside in appropriated retained earnings in compliance with FERC Order #5, issued in 1978. Although the twenty-year periods expired in 1985, 1969 and 1971 in the cases of the Essex, the Vergennes and the Waterbury projects, the amounts appropriated are not material. Department of Public Service Twenty-Year Power Plan. On October 15, 1988, the Department adopted an update of its twenty-year electrical power- supply plan (the "Plan") for the State of Vermont. The Plan includes an overview of statewide growth and development as they relate to future requirements for electrical energy; an assessment of available energy resources; and estimates of electrical energy demand. The Plan calls for exploring the potential reduction of electrical demand through conservation and load management. The Company continues to implement its Integrated Resource Plan in a manner consistent with the Department's Plan. The 1991 Integrated Resource Plan calls for the continued design and delivery of conservation and load management programs, customer programs and education programs as well as measures concerning the efficient distribution of power to the end user. ENVIRONMENTAL MATTERS In recent years, public concern for the physical environment has brought about increased government regulation of the licensing and operation of electric generation, transmission and distribution facilities. The Company must meet various land, water, air and aesthetic requirements as administered by local, state and federal regulatory agencies. Subject to the results of developments discussed below concerning the Pine Street Marsh site in Burlington, Vermont, the Company believes that it is in substantial compliance with such requirements, and no material complaints concerning compliance by the Company with present environmental protection regulations are outstanding. Because the regulations and requirements under existing legislation have not been fully promulgated (and, when promulgated, are subject to revision), because permits and licenses when issued may be conditional or may be subject to renewal and because additional legislation may be adopted in the future, the Company cannot presently forecast the costs or other effects which environmental regulation may ultimately have upon its existing and proposed facilities and operations. In 1982, the United States Environmental Protection Agency ("EPA") notified the Company that the EPA, pursuant to the Comprehensive Environmental Response, Compensation, and Liability Act of 1980 ("CERCLA"), was considering spending public funds to investigate and take corrective action involving claimed releases of allegedly hazardous substances at a site identified as the Pine Street Marsh in Burlington, Vermont. On part of this site was located a manufactured-gas facility owned and operated by a number of separate enterprises, including the Company, from the late 19th century to 1967. In its notice, the EPA stated that the Company may be a "potentially responsible party" ("PRP") under CERCLA from which reimbursement of costs of investigation and of corrective action may be sought. On February 23, 1988, the Company received a Special Notice letter from the EPA stating that the letter constituted a formal demand for reimbursement of costs, including interest thereon, that were incurred and were expected to be incurred in response to the environmental problems at the site. On December 5, 1988, the EPA brought suit against the Company, New England Electric System, and Vermont Gas Systems, Inc. in the United States District Court for the District of Vermont seeking reimbursement for costs it incurred in conducting activities in 1985 to remove allegedly hazardous substances from the site, and requested a declaratory judgment that the Company and the other defendants are liable for all costs that have been incurred since the removal and that continue to be incurred in responding to claims of releases or threatened releases from the Maltex Pond Area -- the portion of the site where the removal action occurred. The complaint specifically alleged that the EPA expended at least $741,000 during the 1985 removal action and sought interest on this amount from the date the funds were expended and costs of litigation, including attorneys' fees. The Company entered a cross-claim against New England Electric System and third-party claims against UGI Corporation, Southern Union Corporation, the State of Vermont, and an individual property owner at the site for recovery of its response costs and for contribution. Fourth-party defendants subsequently were joined. In July 1990, the Company and other parties signed a proposed Consent Decree settling the removal action litigation. All 14 settling defendants contributed to the aggregate settlement amount of $945,000. Individual contributions were treated as confidential under the proposed Consent Decree. On December 26, 1990, upon the unopposed motion of the United States, the Consent Decree was entered by the Court. During the summer and fall of 1989, the EPA conducted the initial phase of the Remedial Investigation ("RI") and commenced the Feasibility Study ("FS") relating to the site. In the fall of 1990 and in 1991, the EPA conducted a second phase of RI work and studied the treatability of soils and groundwater at the site. In the fall of 1991, the EPA responded favorably to a request from the Company and other PRPs to participate in informal discussions on the EPA's ongoing investigation and evaluation of the site, and invited the Company and other interested parties to share technical information and resources with the EPA that might assist it in evaluating remedial options. Thereafter, the Company and other PRPs held several meetings with the EPA to discuss technical issues and received copies of the EPA's Supplemental Remedial Investigation Final Report, and its Baseline Risk Assessment Final Report. On November 6, 1992, the EPA released its final RI/FS and announced a proposed remedy with an estimated total cost of approximately $49,500,000, including 30 years' operation and maintenance costs with a net present value of approximately $26,400,000. The EPA's preferred remedy called for construction of a Containment/Disposal Facility ("CDF") over a portion of the site. The CDF would have consisted of subsurface vertical barriers and a low permeability cap, with collection trenches and a hydraulic control system to capture groundwater and prevent its migration outside of the CDF. Collected groundwater would have been treated and discharged or stored and disposed of off-site. The proposed remedy also would have required construction of new wetlands to replace those that would be destroyed by construction of the CDF, and a long-term monitoring program. On May 15, 1993, the PRP group in which the Company participated submitted extensive comments to the EPA opposing the proposed remedy. In response to an earlier request from the EPA, the PRP group also submitted a detailed analysis of an alternative remedy anticipated to cost approximately $20,000,000. In early June, in response to overwhelming negative comment, the EPA withdrew its proposed remedy and announced that it would work with all interested parties in developing a new proposal. Since then, the EPA has established a coordinating council, with representatives of PRPs, environmental groups, and government agencies, and presided over by a neutral mediator. The council is charged with determining what additional studies may be appropriate for the site and may also eventually address additional response activities. The Company is represented on the council. In early 1994, the Company and other PRPs met with the EPA to commence negotiations on an Administration Order of Consent pursuant to which the PRPs would conduct additional studies agreed to by the coordinating council. Although negotiations are not yet complete, it is likely that the EPA will consent to allowing the PRPs to conduct additional studies at the site and that the EPA will not require reimbursement for its past RI/FS study costs as a condition to allowing the PRPs to conduct these additional studies. The EPA has previously advised the Company that ultimately it will seek to hold the Company and the PRPs liable for such costs. In September 1991, the Company, New England Electric System and Vermont Gas Systems, Inc. entered into confidential negotiations with most other PRPs concerning allocation of unresolved liabilities concerning the site. Those negotiations are continuing. In December 1991, the Company brought suit against several previous insurers seeking recovery of unrecovered past costs and indemnity against future liabilities associated with environmental problems at the site. The parties to this action are engaged in discovery and motions practice. The Company has reached a confidential settlement with one of the defendants that provided the Company with second layer excess liability coverage for a seven month period in 1976. The Company has also reached a confidential agreement in principle with another insurance company defendant that provided the Company with comprehensive general liability insurance between 1976 and 1982, and with environmental impairment liability insurance from 1981 to 1984. These policies were in place in 1982 when the EPA first notified the Company that it might be a potentially responsible party at the Pine Street Marsh site. The Company is unable to predict at this time the magnitude of any liability resulting from potential claims for the costs of the RI/FS or the performance of any remedial action, or the likely disposition or magnitude of claims the Company may have against others, including its insurers, except to the extent described above. In its 1991 rate case, the Company, for the first time, sought recovery for expenses associated with the Pine Street Marsh site. Specifically, the Company proposed rate recognition of its estimated, unrecovered 1991 expenditures (approximately $400,000) for technical consultants and legal assistance in connection with the EPA's enforcement actions at the site and insurance litigation. While reserving the right to argue in the future about the appropriateness of rate recovery for Pine Street Marsh related costs, the Company and the Department reached agreement that the full amount of Pine Street Marsh costs reflected in the Company's 1991 rate case should be recovered in rates. The Company's rates approved by the VPSB on April 2, 1992, reflected the 1991 Pine Street Marsh related expenditures referred to above. In its rate increase request filed on October 1, 1993, the Company proposed rate recognition for its expenditures between January 1, 1992 and July 31, 1993 (approximately $4,200,000) for technical consultants and legal assistance in connection with the EPA's enforcement actions at the site and insurance litigation. The Department and the Company have reached the same agreement regarding recovery of these costs in rates that they reached with respect to the Company's 1991 Pine Street Marsh related expenditures. A comprehensive settlement of the Company's 1993 rate case, including the agreement regarding Pine Street Marsh costs, is currently pending before the VPSB. As of December 31, 1993, the Company had reserved approximately $680,000 for costs attributable to the site, other than those costs that are the subject of the agreements between the Department and the Company mentioned above. Management expects to seek and receive ratemaking treatment for other costs incurred beyond the amounts that have been reserved. As of December 31, 1993, such other costs are approximately $4,918,000, which includes the $4,200,000 in costs that are the subject of the most recent rate case settlement agreement referred to above. COMPETITION The Company serves a fixed area of Vermont under VPSB franchise. Except as noted below, the Company's electric business is substantially free from competition from other electric utilities, municipalities and other public agencies in its franchise area, as mandated by the VPSB. The Company, however, competes with other providers of energy for the home- heating market. Wood stoves, oil-burning furnaces and natural gas represent the principal alternatives to electric heat for customers in the Company's service territory. Fluctuations in the price of fossil fuels, especially oil and natural gas, affect the Company's position in the home- heating market. Legislative authority has existed since 1941 that would permit Vermont cities, towns and villages to own and operate public utilities. Since that time, no municipality served by the Company has established or, as far as is known to the Company, is presently taking steps to establish, a municipal public utility. In 1987, the Vermont General Assembly enacted legislation that authorized the Department to sell electricity on a significantly expanded basis. Before the new law was passed, the Department's authority to make retail sales had been limited: It could sell at retail only to residential and farm customers and could sell only power that it had purchased from the Niagara and St. Lawrence projects operated by the New York Power Authority. Under the new law, the Department can sell electricity purchased from any source at retail to all customer classes throughout the state, but only if it convinces the VPSB and other state officials that the public good will be served by such sales. The Department has made limited additional retail sales of electricity. The Department retains its traditional responsibilities of public advocacy before the VPSB and electricity planning on a statewide basis. BUSINESS DEVELOPMENT The Company has a plan of diversification into energy-related businesses intended to complement the Company's basic utility enterprise. These businesses are conducted through two subsidiaries, Green Mountain Propane Gas Company and Mountain Energy, Inc., and the Company's unregulated rental water heater activities. The Company plans to limit such diversification to 20% of the Company's consolidated revenue. Beginning in the first quarter of 1992, the Company consolidated four of its wholly owned subsidiaries, including Green Mountain Propane and Mountain Energy, in its financial statements. The Company's prior years' financial statements have been restated to reflect this consolidation. Prior to consolidation, the operations of these subsidiaries were reported on the equity basis as they were not material in relation to the consolidated group. Also included in the financial statements, in equity in earnings of affiliates and non-utility operations, are the results of the Company's rental water heater business. None of these activities is regulated by the VPSB. Included in equity in earnings of affiliates and non-utility operations in the Other Income section of the Statements of Consolidated Income are the results of operations of the Company's rental water heater program which is not regulated by the VPSB, and four of the Company's wholly owned subsidiaries, Green Mountain Propane Gas Company, Mountain Energy, Inc., GMP Real Estate Corporation, and Lease-Elec, Inc. (also unregulated). Summarized financial information of the Company's unregulated activities over the last two years is as follows: For the years ended December 31 1993 1992 ---- ---- (In thousands) Revenue . . . . . . . . . . . . . . . $11,487 $11,146 Expense . . . . . . . . . . . . . . . 11,527 11,409 --------- --------- Net Income (Loss) . . . . . . . . . . ($ 40) ($ 263) ========= ========= EMPLOYEES The Company had 387 employees, exclusive of temporary employees, as of December 31, 1993. In addition, subsidiaries of the Company had 58 employees at year end. SEASONAL NATURE OF BUSINESS The Company experiences its heaviest loads in the colder months of the year. Winter recreational activities, longer hours of darkness and heating loads from cold weather usually cause the Company's peak electric sales to occur in December, January or February. The 1993 peak of 307.3 MW occurred on February 1, 1993. The Company's retail electric rates are seasonally differentiated. Under this structure, retail electric rates produce average revenues per kilowatt hour during four peak season months (December through March) that are approximately 60% higher than during the eight off- season months (April through November). EXECUTIVE OFFICERS Executive Officers of the Company as of March 31, 1994: Name Age Douglas G. Hyde 51 President, Chief Executive Officer and Chairman of the Executive Committee of the Corporation since 1993. Executive Vice President, Chief Operating Officer and Director from 1989 to 1993. Executive Vice President and Director of the Corporation from 1986 to 1989. A. Norman Terreri 60 Senior Vice President and Chief Operating Officer since 1993. Senior Vice President from 1984 to 1993. President - Mountain Energy, Inc. since December 1989. Edwin M. Norse 48 Vice President, Chief Financial Officer and Treasurer since 1986. President-Green Mountain Propane Gas Company since October 1993. Christopher L. Dutton 45 Vice President and General Counsel since 1993. Vice President, General Counsel and Corporate Secretary from 1989 to 1993. General Counsel and Corporate Secretary from 1984 to 1989. Glenn J. Purcell 60 Controller since September 1986. Thomas C. Boucher 39 Vice President-Corporate Planning since December 1992. Assistant Vice President- Energy Planning from 1986 to 1992. Stephen C. Terry 51 Vice President-External Affairs since December 1991. Assistant Vice President- Corporate Relations from 1986 to 1991. Walter S. Oakes 47 Assistant Vice President-Corporate Services since December 1988. Director-Customer Services from 1987 to 1988. Robert C. Young 56 Assistant Vice President-Operations and Engineering since December 1992. Director of Engineering from August 1991 to December 1992. Director of Special Projects from August 1991 to March 1992. Prior to joining the Company, he was employed by the Burlington Electric Department for thirty- two years, including sixteen years as General Manager. Karen K. O'Neill 42 Assistant General Counsel since December 1989. Senior Attorney from 1988 to December 1989. Corporate Attorney from 1985 to 1988. Craig T. Myotte 39 Assistant Vice President-Operations and Maintenance since May 1991. Director- System Operations from 1986 to 1991. John J. Lampron 49 Assistant Treasurer since July 1991. Prior to joining the Company, he was employed by Public Service Company of New Hampshire as an Assistant Vice President from 1982 to 1990. Donna S. Laffan 44 Corporate Secretary since December 1993. Assistant Secretary from 1986 to 1993. Officers are elected by the Board of Directors for one-year terms and serve at the pleasure of the Board of Directors. ITEM 2. ITEM 2. PROPERTY GENERATING FACILITIES The Company's Vermont properties are located in five areas and are interconnected by transmission lines of VELCO and New England Power Company. The Company wholly owns and operates eight hydroelectric generating stations with an aggregate effective capability of 35.7 MW. It also owns two gas-turbine generating stations with effective capabilities of 15.2 MW and 56.3 MW, respectively. The Company has two diesel generating stations with an aggregate effective capability of 8.4 MW, bringing wholly owned effective capability to 116.3 MW. The Company also owns 17.9% of the outstanding common stock, and is entitled to 17.265% (90.1 MW) of the capacity of Vermont Yankee, a 1.1% (7.1 MW) joint-ownership share of the Wyman #4 plant located in Maine, a 8.8% (30.2 MW) joint-ownership share of the Stony Brook I intermediate units located in Massachusetts and an 11% (5.8 MW) joint-ownership share of the J. C. McNeil wood-fired steam plant located in Burlington, Vermont. (See "Power Resources" under Item 1 above for plant details and the table hereinafter set forth for generating facilities presently available). TRANSMISSION AND DISTRIBUTION The Company had, at December 31, 1993, approximately 1.5 miles of 115- kV transmission lines, 9.4 miles of 69 kV transmission lines, 5.4 miles of 44-kV and 265.1 miles of 34.5 kV transmission lines. Its distribution system included about 2,336 miles of overhead lines, 2.4 kV to 34.5 kV, and about 392 miles of underground cable of 2.4 kV to 34.5 kV. At such date, the Company owned approximately 433,150 kVa of substation transformer capacity in distribution substations, 156,775 kVa of transformer capacity in transmission substations and 1,207,299 kVa of transformers for stepdown from distribution to customer use. The Company owns 33.8% of the Highgate transmission intertie, a 200-MW converter and transmission line utilized to transmit power from Hydro- Quebec. The Company also owns 29.5% of the common stock and 30% of the preferred stock of VELCO which operates a high-voltage transmission system interconnecting electric utilities in the State of Vermont. PROPERTY OWNERSHIP The principal wholly owned plants of the Company are located on lands owned in fee by the Company. Water power and floodage rights are controlled through ownership of the necessary land in fee or under easements. Transmission and distribution facilities which are not located in or over public highways are, with minor exceptions, located either on land owned in fee or pursuant to easements which, in nearly all cases, are perpetual. Transmission and distribution lines located in or over public highways are so located pursuant to authority conferred on public utilities by statute, subject to regulation by state or municipal authorities. INDENTURE OF FIRST MORTGAGE The Company's interests in substantially all of its properties and franchises are subject to the lien of the mortgage securing its First Mortgage Bonds. GENERATING FACILITIES OWNED The following table gives information with respect to generating facilities presently available in which the Company has an ownership interest. See also "Power Resources" in Item 1. Winter Capability Type Location Name Fuel MW(1) Wholly Owned Hydro Middlesex, VT Middlesex #2 Hydro 3.4 Marshfield, VT Marshfield #6 Hydro 5.0 Vergennes, VT Vergennes #9 Hydro 2.3 W. Danville, VT W. Danville #15 Hydro 1.2 Colchester, VT Gorge #18 Hydro 3.3 Essex Jct., VT Essex #19 Hydro 7.8 Waterbury, VT Waterbury #22 Hydro 5.0 Bolton, VT DeForge #1 Hydro 8.4 Diesel Vergennes, VT Vergennes #9 Oil 4.2 Essex Jct., VT Essex #19 Oil 4.2 Gas Berlin, VT Berlin #5 Oil 56.3 Turbine Colchester, VT Gorge #16 Oil 15.2 Jointly Owned Steam Vernon, VT Vermont Yankee Nuclear 90.1(2) Yarmouth, ME Wyman #4 Oil 7.1 Burlington, VT McNeil Wood 6.6(3) Combined Ludlow, MA Stony Brook #1 Oil/Gas 30.2(2) _____ Total Winter Capability 250.3 (1) Winter capability quantities are used since the Company's peak usage occurs during the winter months. Some units are derated for the summer months. Capability shown includes capacity and associated energy sold to other utilities. (2) For a discussion of the impact of various power supply sales on the availability of generating facilities, see "Long-Term Power Sales." (3) The Company's entitlement in McNeil is 5.8 MW. However, the Company receives up to 6.6 MW as a result of other owners' losses on this system. CORPORATE HEADQUARTERS For a discussion of the Company's operating lease for its Corporate Headquarters building, see Note I-2 of Notes to Consolidated Financial Statements. ITEM 3. ITEM 3. LEGAL PROCEEDINGS See the discussion under "Environmental Matters" in Item 1 concerning a notice received by the Company in 1982, under the Comprehensive Environmental Response, Compensation, and Liability Act of 1980. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. None. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Outstanding shares of the Common Stock are listed and traded on the New York Stock Exchange. The following tabulation shows the high and low sales prices for the Common Stock on the New York Stock Exchange during 1992 and 1993: HIGH LOW 1993 First Quarter 35 5/8 31 3/8 Second Quarter 36 1/2 32 5/8 Third Quarter 36 5/8 34 3/8 Fourth Quarter 35 1/8 30 3/4 1992 First Quarter 31 1/4 29 1/4 Second Quarter 30 3/4 29 Third Quarter 33 5/8 30 Fourth Quarter 33 1/4 30 1/8 The number of common stockholders of record as of March 18, 1994, was 6,693. Quarterly cash dividends were paid as follows for the past two years: First Second Third Fourth Quarter Quarter Quarter Quarter ------- ------- ------- ------- 1993 52 1/2 cents 52 1/2 cents 53 cents 53 cents 1992 51 1/2 cents 51 1/2 cents 52 1/2 cents 52 1/2 cents SELECTED FINANCIAL DATA Results of operations for the years ended December 31 - ----------------------------------------------------- Financial Condition as of December 31 - ------------------------------------- ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS Earnings Summary -- Earnings per average share of common stock in 1993 were $2.20 as compared with $2.54 in 1992 and $2.45 in 1991. The 1993 earnings represent an earned return on average common equity of 10.3 percent. In 1992 and 1991, the earned return on equity was 12.2 and 12.5 percent, respectively. The 1993 decrease in earnings resulted principally from a nearly two- fold increase in purchases of electricity from independent power producers mandated by federal and state law. These purchases are priced at rates set by the Vermont Public Service Board (VPSB) based on the VPSB calculations of the statewide long-term cost of electricity acquisitions avoided by such purchases. In 1993, these rates were substantially higher than the Company's overall cost of electricity. The principal factors contributing to the earnings results in 1992 were higher retail revenues, due primarily to a rate increase of 5.6 percent that took effect in April 1992, and stable energy prices. Operating Revenues and MWH Sales -- Operating revenues and MWH sales for the years 1993, 1992 and 1991 consisted of 1993 1992 1991 ---- ---- ---- (Dollars in Thousands) Operating Revenues: Retail . . . . . . . . . . . . . $ 130,061 $ 126,057 $ 118,021 Sales for Resale . . . . . . . . 14,441 17,258 23,663 Other . . . . . . . . . . . . . 2,751 1,925 1,871 ---------- ---------- ---------- Total Operating Revenues . . . . . $ 147,253 $ 145,240 $ 143,555 ========== ========== ========== Megawatthour Sales: Retail . . . . . . . . . . . . . 1,688,803 1,692,179 1,645,387 Sales for Resale . . . . . . . . 331,875 375,894 545,031 --------- --------- --------- Total Megawatthour Sales . . . . . 2,020,678 2,068,073 2,190,418 ========= ========= ========= Average Number of Customers: Residential . . . . . . . . . . 67,994 67,201 66,406 Commercial & Industrial . . . . 11,472 11,269 11,239 Other . . . . . . . . . . . . . 74 73 71 ------ ------ ------ Total Customers . . . . . . . . . . 79,540 78,543 77,716 ====== ====== ====== Differences in operating revenues were due to changes in the following: 1992 1991 to to 1993 1992 ---- ---- (In Thousands) Operating Revenues: Retail Rates . . . . . . . . . . . . . . . $4,269 $4,499 Retail Sales Volume . . . . . . . . . . . (265) 3,537 Resales and Other Revenues . . . . . . . . (1,991) (6,351) ------- ------- Increase in Operating Revenues . . . . . . . $2,013 $1,685 ======= ======= In 1993, total electricity sales decreased 2.3 percent due principally to a reduction in wholesale sales. Total operating revenues increased 1.4 percent in 1993 due primarily to a 5.6 percent retail rate increase that was effective in April 1992. Wholesale revenues declined 16.3 percent in 1993 due principally to the sluggish economy and the availability of inexpensive, excess power supply in New England. In 1992, total electricity sales decreased 5.6 percent due principally to a reduction in wholesale sales. Total operating revenues increased 1.1 percent in 1992, due primarily to a 5.6 percent rate increase that was effective in April 1992, and to increased sales of electricity to retail customers reflecting colder (but normal) temperatures in 1992 and higher usage by commercial and industrial customers. These factors were principally responsible for the 6.8 percent rise in retail revenues that occurred in 1992. Wholesale revenues declined 27.1 percent in 1992 due principally to the end of a multi-year contract under which the Company sold electricity to another New England utility, the sluggish economy, and the availability of inexpensive, excess power in New England. IBM, the Company's single largest customer, operates manufacturing facilities in Essex Junction. IBM's electricity requirements for its main plant and an adjacent plant accounted for 13.6, 13.8 and 13.0 percent of the Company's operating revenues in 1993, 1992 and 1991, respectively. No other retail customer accounted for more than one percent of the Company's revenue. Power Supply Expenses -- Power supply expenses constituted 59.7 percent, 58.1 percent and 60.7 percent of total operating expenses for the years ended 1993, 1992 and 1991, respectively. These expenses increased by $4.1 million in 1993 (5.5 percent), and decreased by $3.4 million (4.4 percent) in 1992. Power supply expenses increased in 1993 due primarily to a nearly twofold increase in purchases of electricity from independent power producers mandated by federal and state law. The average cost per kilowatthour of such electricity is substantially greater than the Company's embedded cost of electricity. The decrease in power supply expenses in 1992 was principally the result of lower fuel prices, abundant and inexpensive opportunity purchases, reduced levels of wholesale electricity sales and favorable changes in the Company's power purchase contracts with Hydro-Quebec. Other Operating Expenses -- Other operating expenses were virtually unchanged in 1993 from 1992. Higher pension and postretirement health care benefit costs and increased regulatory commission expenses resulted in an 8.2 percent increase in other operating expenses in 1992. Transmission Expenses -- The Company's restructuring of a series of transmission contracts produced a 3.0 percent decrease in transmission expenses in 1993. Transmission expenses decreased 4.8 percent in 1992 for the same reason. Maintenance Expenses -- Maintenance expenses decreased 7.3 percent in 1993 due principally to a scheduled increase in activity in various capital projects that had the effect of reducing activity by Company employees on maintenance projects. Maintenance expenses increased 8.1 percent in 1992 due principally to scheduled increases in tree trimming expenses and hydroelectric generating facilities maintenance. Depreciation and Amortization -- Depreciation and amortization expenses increased 6.3 percent in 1993, reflecting continuing additions to the Company's distribution facilities. Depreciation and amortization expenses increased 14.5 percent in 1992, reflecting continuing additions to the Company's distribution facilities and the amortization of costs of conservation programs. Income Taxes -- The effective federal tax rates for the years 1993, 1992 and 1991 were 28.9 percent, 28.8 percent and 28.5 percent, respectively. The various effects and components of the income tax provisions are detailed in Note G of the Notes to Financial Statements. Other Income -- Other income increased 16.6 percent in 1993 due primarily to an increase in earnings of the Company's wholly owned subsidiary, Mountain Energy, Inc., and to the VPSB's disallowance in the 1992 retail rate case of approximately $400,000 in construction costs. Diminished equity in earnings of affiliates and non-utility operations, primarily attributable to operating losses sustained by the propane subsidiary, was responsible for a 20.9 percent decrease in other income in 1992, compared to the previous year. Interest Charges -- Interest charges were virtually unchanged in 1993 from 1992. A 67.2 percent decrease in short-term debt interest expense, due to both lower interest rates and a reduction in short-term borrowings, was partially offset by an increase in long-term debt expense resulting in an overall decrease of 2.9 percent in interest charges in 1992. Dividends on Preferred Stock -- Dividends on preferred stock decreased 2.4 percent in 1993 due primarily to the repurchase by the Company in 1992 of the following preferred stock: 450 shares of 4.75 percent, Class B; 450 shares of 7 percent, Class C; and 1,600 shares of 9.375 percent, Class D, Series 1. Dividends on preferred stock decreased 2.5 percent in 1992 due primarily to the repurchase of preferred stock by the Company in 1991 of the same class and quantity. Future Outlook -- The Company continues to implement aggressive conservation programs to mitigate the increasing demand for electricity. The Company is reviewing its future conservation plans in light of various factors, including changing avoided electricity costs, its experience and increased effectiveness in delivering conservation programs, and its total resource mix. Even with continued existing conservation programs, the Company anticipates that the demand for electricity in its service territory will grow by approximately 1.0 percent per year over the next five years. Because the Company purchases most of its power supply from other utilities, it does not anticipate that it will incur any material direct cost increases as a result of the recently enacted Federal Clean Air legislation. Furthermore, only one of its power supply purchase contracts, which expires in 1998, relates to a generating plant that is likely to be affected by the acid rain provisions of this legislation. Overall, approximately 10 percent of the Company's committed electricity supply is expected to be affected by federal and State environmental compliance requirements. The Company regularly reviews rates and forecasts costs. As these forecasts change, the Company will seek changes in rates that will enable it to recover operating costs. Financial statements are prepared in accordance with generally accepted accounting principles and report operating results in terms of historic costs. This accounting provides reasonable financial statements but does not always take inflation into consideration. As rate recovery is based on these historical costs and known and measurable changes, the Company is able to receive some rate relief for inflation. It does not receive immediate rate recovery relating to fixed costs associated with Company assets. Such fixed costs are recovered based on historic figures. Any effects of inflation on plant costs are generally offset by the fact that these assets are financed through long-term debt. Diversification -- The Company has a plan of diversification into energy-related businesses intended to complement the Company's basic utility enterprise. The Company plans to limit diversification to 20 percent of the Company's consolidated revenue. Environmental Matters -- In recent years, public concern for the physical environment has brought about increased government regulation of the licensing and operation of electric generation, transmission and distribution facilities. The Company must meet various land, water, air and aesthetic requirements as administered by local, state and federal regulatory agencies. The Company maintains an environmental compliance and monitoring program that includes employee training, regular inspection of Company facilities, research and development projects, waste handling and spill prevention procedures and other activities. Subject to the results of developments discussed in Note I.1 of Notes to Consolidated Financial Statements concerning the Pine Street Marsh site in Burlington, Vermont, the Company believes that it is in substantial compliance with such requirements, and no material complaints concerning compliance by the Company with present environmental protection regulations are outstanding. During 1991, the Company incurred approximately $400,000 in costs associated with the Pine Street Marsh site for technical consultants and legal assistance in connection with the United States Environmental Protection Agency's (EPA) enforcement actions at the site and insurance litigation. In its 1991 rate increase proceeding, the Company, for the first time, sought to recover costs associated with the Pine Street Marsh site in retail rates. The Department of Public Service and the Company entered into an agreement providing that the Company was entitled to recover all such costs incurred in 1991. The agreement provided that such rate recovery is not intended to serve as a precedent for retail ratemaking treatment of future costs incurred by the Company in connection with the Pine Street Marsh site. The Company's rates approved by the VPSB on April 2, 1992, reflected the 1991 Pine Street related expenditures referred to above. From January 1, 1992 through July 31, 1993, the Company incurred approximately $4.2 million in such costs associated with the Pine Street Marsh site and insurance litigation. In its 1993 rate proceeding, the Company sought to recover these costs in retail rates. The Company and the other parties to the rate proceeding entered into an agreement providing that the Company was entitled to recover all such costs incurred in the January 1, 1992 through July 31, 1993 period. The agreement provided that such rate recovery is not intended to serve as a precedent for retail ratemaking of future costs incurred by the Company in connection with the Pine Street Marsh site. This agreement, which is a part of an overall 2.9 percent rate increase settlement reached by the parties, is pending before the VPSB. As of December 31, 1993, the Company has reserved approximately $680,000 for costs attributable to the site, other than those costs that are the subject of the two agreements between the Department and the Company mentioned above. Management expects to seek and receive ratemaking treatment for other costs incurred beyond the amounts that have been reserved. As of December 31, 1993, such other costs are approximately $4,918,000, of which $4.2 million is the subject of the agreement that is a part of the settlement of the Company's 1993 rate proceeding referred to above. As is more fully set forth in Note I.1 of Notes to Consolidated Financial Statements, the Company is unable to predict at this time the magnitude of liability that may be imposed on it resulting from potential claims for the cost of studies undertaken by the EPA or performance of any remedial action in connection with the Pine Street Marsh site. The Company is one of several parties that the EPA has identified as potentially responsible for the cost of studying and remedying the results of releases of allegedly hazardous substances at the site. To the degree that it is held liable for such claims, the Company will pursue claims against other responsible parties seeking to ensure that they contribute appropriately to reimburse the Company for any costs incurred. In December 1991, the Company brought suit against several previous insurers seeking recovery of all past costs and indemnity against future liabilities associated with the environmental problems at the site. The parties to the action are engaged in discovery and motions practice. The Company has reached a confidential settlement with one of the defendants, which provided the Company with second layer excess liability coverage for a seven-month period in 1976. The Company has also reached a confidential agreement in principle with another insurance company defendant that provided the Company with comprehensive general liability insurance between 1976 and 1982, and with environmental impairment liability insurance from 1981 to 1984. These policies were in place in 1982 when EPA first notified the Company that it might be a potentially responsible party at the Pine Street site. LIQUIDITY AND CAPITAL RESOURCES Construction -- The Company's capital requirements result from the need to construct facilities or to invest in programs to meet anticipated customer demand for electric service. The policy of the Company is to increase diversification of its power supply and other resources through various means, including power purchase and sales arrangements and relying on sources that represent relatively small additions to the Company's mix to satisfy customer requirements. This permits the Company to meet its financing needs in a flexible, orderly manner. Planned expenditures over the next five years will be primarily for distribution and conservation projects. Capital expenditures over the past three years and forecasted for the next five years are as follows: Total Net Actual Generation Transmission Distribution Conservation Other Expenditures (Dollars in thousands and net of AFUDC and Customer Advances For Construction) 1991 $2,038 $1,682 $7,628 $2,269 $2,564 $16,181 1992 868 1,766 7,320 3,144 2,925 16,023 1993 1,747 1,605 9,093 8,136 2,937 23,518 Forecasted 1994 $ 709 $ 829 $7,849 $6,975 $3,618 $19,980 1995 7,567 999 7,132 6,776 2,402 24,876 1996 1,978 1,499 7,301 6,497 2,251 19,526 1997 1,579 999 7,386 5,867 2,386 18,217 1998 1,579 999 7,386 5,430 2,386 17,780 Other Cash Requirements -- In its January 1991 rate order, the VPSB required that the Company set up a special trust account for monies currently accrued for postretirement health care benefits. This fund totaled $2.1 million at December 31, 1993, and $3.3 million at January 31, 1994. In 1994, the Company may devote $1 million to $4 million to unregulated investments. Insurance Settlement -- In January 1993, the Company settled a long- disputed claim with a former medical benefits insurance carrier relating to overcharged premiums dating back to 1984, resulting in an agreement under which the carrier paid the Company $360,000. The Company received this payment in the first quarter of 1993. Rates -- On October 1, 1993, the Company filed a request with the VPSB to increase retail rates by 8.6 percent. The increase is needed primarily to cover the cost of buying power from independent power producers, the cost of energy conservation programs, the cost of plant additions made in the past two years, and costs incurred in 1992 and 1993 associated with the Company's response to the EPA's RI/FS and proposed remedy at the Pine Street Marsh site and with the Company's litigation against its previous insurers seeking recovery of past costs incurred and indemnity against future liabilities in connection with the site. On January 28, 1994, the Company and the other parties in the proceeding reached a settlement agreement providing for a 2.9 percent retail rate increase effective June 15, 1994, and a target return on equity for utility operations of 10.5 percent. The settlement agreement also provided for the Company's recovery in rates of $4.2 million in costs associated with the Pine Street Marsh site, as described herein above. The agreement must be reviewed and approved by the VPSB before it can take effect. Financing and Capitalization -- For the period 1991 through 1993, internally generated funds, after payment of dividends, provided approximately 47 percent of total capital requirements for construction, sinking funds and other requirements. The Company anticipates that for the period 1994-1998, internally generated funds will provide approximately 67 percent of total capital requirements. In November of 1993, the Company sold $20 million of its first mortgage bonds in two components -- $15 million that will mature in 2018 and $5 million that will mature in 2000. The 2018 and 2000 bonds will bear interest at the rate of 6.7 percent and 5.71 percent, respectively. The proceeds from the sale were used to refinance existing debt, to finance construction and conservation expenditures, and for other corporate purposes. At December 31, 1993, the Company's capitalization consisted of 51.6 percent common equity, 43.4 percent long-term debt and 5.0 percent preferred equity. The Company has a comprehensive capital plan to maintain approximately this balance of common equity, long-term debt and preferred equity. The Company anticipates issuing additional shares of its common stock in 1994. The Company has not determined the date or the amount of the stock issuance. The Company's first mortgage securities are rated "A-" by Standard & Poor's. This rating was affirmed in November of 1993 by Standard & Poor's following its annual review of the Company. Standard & Poor's changed its "outlook" of the Company from "stable" to "negative," reflecting Standard & Poor's assessment that the electric utility industry is becoming increasingly more competitive. The Company's first mortgage securities are rated "A" by Duff & Phelps. See Note F of Notes to Consolidated Financial Statements for a discussion of bank lines of credit available to the Company. ITEM 8. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA GREEN MOUNTAIN POWER CORPORATION INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULES Page Financial Statements Statements of Consolidated Income For the Years Ended December 31, 1993, 1992 and 1991 39 Consolidated Statements of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991 40 Consolidated Balance Sheets as of December 31, 1993 and 1992 41-42 Consolidated Capitalization data as of December 31, 1993 and 1992 43 Notes to Consolidated Financial Statements 44-63 Report of Independent Public Accountants 64 Schedules For the Years Ended December 31, 1993, 1992 and 1991: V Property, Plant and Equipment 65-67 VI Accumulated Depreciation and Amortization of Property, Plant and Equipment 68 VIII Valuation and Qualifying Accounts and Reserves 69 IX Short-Term Borrowings 70 X Supplementary Income Statement Information 71 All other schedules are omitted as they are either not required, not applicable or the information is otherwise provided. Consents and Reports of Independent Public Accountants KPMG Peat Marwick 109 Arthur Andersen & Co. 110-111 STATEMENTS OF CONSOLIDATED INCOME GREEN MOUNTAIN POWER CORPORATION For the Years Ended December 31 CONSOLIDATED STATEMENTS OF CASH FLOW GREEN MOUNTAIN POWER CORPORATION For the Years Ended December 31 CONSOLIDATED BALANCE SHEETS GREEN MOUNTAIN POWER CORPORATION December 31 GREEN MOUNTAIN POWER CORPORATION December 31 CONSOLIDATED CAPITALIZATION DATA GREEN MOUNTAIN POWER CORPORATION December 31 Notes to Consolidated Financial Statements A. Significant Accounting Policies 1. System of Accounts The Company's accounting records, rates, operations and certain other practices of its electric utility business are subject to the regulatory authority of the Federal Energy Regulatory Commission (FERC) and the Vermont Public Service Board (VPSB). 2. Basis of Presentation Included in equity in earnings of affiliates and non-utility operations in the Other Income section of the Statements of Consolidated Income are the results of operations of the Company's rental water heater program, which is not regulated by the VPSB, and four of the Company's wholly owned subsidiaries, Green Mountain Propane Gas Company, Mountain Energy, Inc., GMP Real Estate Corporation, and Lease-Elec, Inc. (also unregulated). Summarized financial information is as follows: For the years ended December 31 1993 1992 ---- ---- (In thousands) Revenue . . . . . . . . . . . . . . . $11,487 $11,146 Expense. . . . . . . . . . . . . . . . 11,527 11,409 --------- --------- Net Income (Loss) . . . . . . . . . . ($ 40) ($ 263) ========= ========= The Company carries its investments in various associated companies -- Vermont Yankee Nuclear Power Corporation (Vermont Yankee), Vermont Electric Power Company, Inc. (VELCO), New England Hydro-Transmission Corporation, and New England Hydro-Transmission Electric Company -- at equity. 3. Statements of Cash Flows The following amounts of interest (net of amounts capitalized) and income taxes were paid for the years ending December 31: 1993 1992 1991 ---- ---- ---- (In thousands) Interest . . . . . . . . . . . . . . . . $6,206 $7,683 $7,254 Income Taxes (Net of refunds) . . . . . $1,920 $3,511 $3,695 4. Utility Plant The cost of plant additions includes all construction-related direct labor and materials, as well as indirect construction costs including the cost of money (Allowance for Funds Used During Construction or AFUDC). The costs of renewals and betterments of property units are capitalized; the costs of maintenance, repairs and replacements of minor property items are charged to maintenance expense; the costs of units of property removed from service, net of removal costs and salvage, are charged to accumulated depreciation. AFUDC represents the composite interest and equity costs of capital funds used to finance construction. AFUDC, a non-cash item, is recognized as a cost of "Utility Plant" with offsetting credits to "Other Income" and "Interest Charges." This is in accordance with established regulatory ratemaking practice under which a utility is permitted a return on, and the recovery of, these capital costs through their ultimate inclusion in rate base and in the provisions for depreciation. When Construction Work in Progress (CWIP) is included in rate base and the utility is recovering the cost of financing this construction through rates, no AFUDC is included in the cost of such construction. The VPSB generally allows CWIP in rate base for short-term construction projects and projects for which completion is imminent. AFUDC, which is compounded semi-annually, was calculated using weighted average rates of 7.2 percent, 8.9 percent and 7.6 percent for the years 1993, 1992 and 1991, respectively. 5. Depreciation The Company provides for depreciation on the straight-line method based on the cost and estimated remaining service life of the depreciable property outstanding at the beginning of the year. The annual depreciation provision was approximately 3.6 percent, 3.5 percent and 3.5 percent of total depreciable property at the beginning of the year for 1993, 1992 and 1991, respectively. 6. Operating Revenues Operating revenues consist principally of sales of electric energy. The Company records accrued utility revenues, based on estimates of electric service rendered and not billed at the end of an accounting period, in order to match revenues with related costs. 7. Deferred Charges In a manner consistent with authorized or expected ratemaking treatment, the Company defers and amortizes certain replacement power, maintenance and other costs associated with the Vermont Yankee nuclear plant. In addition, the Company accrues other replacement power expenses to reflect more accurately its cost of service to better match revenues and expenses consistent with regulatory treatment. At December 31, 1993 deferred charges totaled $42.3 million, consisting of charges for conservation programs, response and litigation costs attributable to the Pine Street Marsh site discussed in Note I.1, repair costs for and relicensing of the Essex hydroelectric facility, repair costs for the Vergennes hydroelectric facility, Hydro-Quebec power contract negotiations and support charges, regulatory deferrals of storm damages, PCB clean-up, regulatory deferrals of rights-of-way maintenance, costs associated with the 1993 scheduled Vermont Yankee outage, postretirement health care costs, and various other projects and deferrals. 8. Earnings Per Share Earnings per share are based upon the weighted average number of shares of common stock outstanding during each year. 9. Major Customers The Company had one major retail customer, IBM, metered at two locations, that accounted for 13.6, 13.8 and 13.0 percent of operating revenues in 1993, 1992 and 1991, respectively. 10. Pension and Retirement Plans The Company has a defined benefit pension plan covering substantially all of its employees. The retirement benefits are based on the employees' level of compensation and length of service. The Company's policy is to fund all pension costs accrued. The Company records annual expense in accordance with methods approved in the rate-setting process. Net pension costs reflect the following components and assumptions: 1993 1992 1991 ---- ---- ---- (Dollars in thousands) Service cost-benefits earned during the period . $ 748 $ 676 $ 621 Interest cost on projected benefit obligations . 1,593 1,466 1,275 Actual (return) loss on plan assets . . . . . . . (3,107) (1,743) (3,109) Net amortization and deferral . . . . . . . . . . 1,141 (77) 1,440 Adjustment due to actions of regulator . . . . . 337 430 153 ------ ------- ------ Net periodic pension cost funded and recognized . $ 712 $ 752 $ 380 ====== ======= ====== Assumptions used to determine pension costs in 1993, 1992 and 1991 were: Discount rate . . . . . . . . . . . . . . . . 8.0% 8.0% 8.0% Rate of increase in future compensation levels 6.0% 6.0% 6.0% Expected long-term rate of return on assets . 9.0% 9.0% 9.0% The following table sets forth the Plan's funded status as of December 31: 1993 1992 1991 ---- ---- ---- (In thousands) Actuarial present value of benefit obligations: Accumulated benefit obligations, including vested benefits of $16,825, $15,100 and $12,567, respectively . . . . . ($17,105) ($15,262) ($12,704) ========= ========= ========= Projected benefit obligations for service rendered to date . . . . . . . . . ($21,002) ($19,235) ($16,563) Plan assets at fair value . . . . . . . . . . . 23,981 21,167 19,675 ------- ------- ------- Assets in excess of projected benefit obligations . . . . . . . . . . . . . 2,979 1,932 3,112 Unrecognized net loss (gain) from past experience different from that assumed . . . (272) 559 399 Prior service cost not yet recognized in net periodic pension cost . . . . . . . . . . . . 1,885 2,028 842 Unrecognized net asset at transition being recognized over 16.47 years . . . . . . (2,162) (2,391) (2,619) Adjustment due to actions of regulator . . . . . (2,430) (2,128) (1,734) ------ ------ ----- Prepaid pension cost included in other assets . $ --- $ --- $ --- ====== ====== ====== The Company has evaluated the effect of a reduction in the discount rate and compensation trend rate and has concluded that the net effect of such changes is insignificant. The plan assets consist primarily of cash equivalent funds, fixed income securities and listed equity securities. The Company also has a supplemental pension plan for certain employees. Pension costs for the years ended December 31, 1993, 1992 and 1991 were $384,000, $377,000 and $352,000, respectively, under this plan. This plan is supported through insurance contracts. 11. Fair Value of Financial Instruments If the first mortgage bonds, debentures, and preferred stock outstanding at December 31, 1993 were refinanced using new issue debt rates of interest, which are generally lower than the Company's outstanding rates, the present value of those obligations would differ from the amounts outstanding on the December 31, 1993 balance sheet by nine percent. The Company does not anticipate a refinancing; however, if such an event were to occur, there would be no gain or loss, inasmuch as under established regulatory precedent, any such difference would be reflected in rates and have no effect upon income. 12. Postretirement Health Care Benefits The Company provides certain health care benefits for retired employees and their dependents. Employees become eligible for these benefits if they reach normal retirement age while working for the Company. On January 1, 1993, the Company adopted the standard on accounting for postretirement health care and other benefits, SFAS 106, which requires the Company to use accrual accounting for postretirement benefits other than pensions. Prior to 1993, the Company recognized the cost of postretirement health care benefits by recording an amount equivalent to that which had been allowed in rates. The difference between total cost and claims paid was accrued on the balance sheet. In its January 4, 1991 rate order, the VPSB required the Company to establish a fund in which the Company will accumulate monies for postretirement health care expenses. At December 31, 1993, the Company had deposited $2.1 million in the investment fund, which is included in other investments in the accompanying balance sheet. In January 1994, the Company fully funded its accrued postretirement benefit cost of $3.3 million. In order to maximize the tax deductible contributions that are allowed under IRS regulations, the Company has amended its pension plan and established separate VEBA trusts for its union and nonunion employees. The Company will seek and expects to receive rate recovery for all amounts expended for postretirement health care benefits. Net postretirement benefits costs for 1993 reflect the following components and assumptions: (In thousands) Accumulated postretirement benefit obligation: Current retirees . . . . . . . . . . . . . . . . . ($ 3,628) Participants currently eligible . . . . . . . . . (2,288) All others . . . . . . . . . . . . . . . . . . . . (4,789) -------- Total accumulated postretirement benefit obligation . (10,705) Plan assets at fair value . . . . . . . . . . . . . . 0 ------- Accumulated postretirement benefit obligation in excess of plan assets . . . . . . . . . . . . . . . . . . (10,705) Unrecognized transition obligation . . . . . . . . . 6,845 Unrecognized net loss (gain) . . . . . . . . . . . . 538 -------- Accrued postretirement benefit cost . . . . . . . . . $3,322 ======== Net periodic postretirement benefit cost for 1993 includes the following components: (In thousands) Service cost . . . . . . . . . . . . . . . . . . . . $ 438 Interest cost . . . . . . . . . . . . . . . . . . . 940 Amortization and deferral . . . . . . . . . . . . . 380 -------- Total net periodic postretirement benefit cost . . . $ 1,758 ======== For measurement purposes, a 14.25 percent annual rate of increase in the per capita cost of covered benefits was assumed for 1993; the rate was assumed to decrease gradually to 5.5 percent by the year 2000 and remain at that level thereafter. The health care cost trend rate assumption has a significant effect on the amounts reported. For example, increasing the assumed health care cost trend rate by one percentage point would increase the accumulated postretirement benefit obligation as of December 31, 1993 by $1.7 million and the aggregate of the service and interest components of net periodic postretirement benefit cost for the year ended December 31, 1993 by $241,000. The weighted average discount rate used in determining the accumulated postretirement benefit obligation was 8 percent at December 31, 1993. The Company has evaluated the effect of a reduction in the discount rate and medical care trend rate and has concluded that the net effect of such changes is insignificant. 13. Deferred Credits The Company has deferred credits and other long-term liabilities of $22.1 million, consisting of operating lease equalization, general liabilities and damages reserves and accruals for employee benefits. B. Investments in Associated Companies The Company accounts for investments in the following companies by the equity method: Investment in Equity Percent Ownership December 31, at December 31, 1993 1993 1992 -------------------- ---- ---- (In thousands) VELCO - Common . . . . . . . . . 29.5% $ 1,816 $ 1,818 - Preferred . . . . . . . 30.0% 1,572 1,736 ------- ------ Total VELCO . . . . . . . . . . 3,388 3,554 Vermont Yankee - Common . . . . 17.9% 9,745 9,731 New England Hydro-Transmission - Common . . . . . . . . . . 3.18% 1,408 1,489 New England Hydro-Transmission Electric - Common . . . . . 3.18% 2,345 2,396 -------- -------- $16,886 $17,170 ======= ======== Undistributed earnings in associated companies totaled $1,140,000 at December 31, 1993. VELCO VELCO is a corporation engaged in the transmission of electric power within the state of Vermont. VELCO has entered into transmission agreements with the State of Vermont and other electric utilities, and under these agreements bills all costs, including interest on debt and a fixed return on equity, to the State and others using the system. The Company's purchases of transmission services from VELCO were $8.0 million, $7.8 million and $7.8 million for the years 1993, 1992 and 1991, respectively. Pursuant to VELCO's Amended Articles of Association, the Company is entitled to approximately 30 percent of the dividends distributed by VELCO. The Company has recorded its equity in earnings on this basis and also is obligated to provide its proportionate share of the equity capital requirements of VELCO through continuing purchases of its common stock, if necessary. Summarized financial information for VELCO is as follows: December 31, --------------------------- 1993 1992 1991 ---- ---- ---- (In thousands) Company's equity in net income . . . . . . . $ 406 $ 448 $ 466 ======= ======= ====== Total assets . . . . . . . . . . . . . . . . $70,199 $70,821 $69,949 Less: Liabilities and long-term debt . . . . . 58,806 58,889 57,395 ------- ------- ------- Net assets . . . . . . . . . . . . . . . . . $11,393 $11,932 $12,554 ======= ======= ======= Company's equity in net assets . . . . . . . $ 3,388 $ 3,554 $ 3,738 ======= ======= ======= Vermont Yankee The Company is responsible for 17.3 percent of Vermont Yankee's expenses of operations, including costs of equity capital and estimated costs of decommissioning, and is entitled to a similar share of the power output of the nuclear plant, which has a net capacity of 520 megawatts. Vermont Yankee's current estimate of decommissioning is approximately $253 million in 1993 dollars, of which $99 million has been funded. At December 31, 1993, the Company's portion of the net unfunded liability was $27 million, which it expects will be recovered through rates over Vermont Yankee's remaining operating life. As a sponsor of Vermont Yankee, the Company also is obligated to provide 20 percent of capital requirements not obtained by outside sources. During 1993, the Company incurred $27.7 million in Vermont Yankee annual capacity charges, which included $1.6 million for interest charges. The Company's share of Vermont Yankee's long-term debt at December 31, 1993 was $13.8 million. The Price-Anderson Act currently limits public liability from a single incident at a nuclear power plant to $9.4 billion. Any liability beyond $9.4 billion is indemnified under an agreement with the NRC. The first $200 million of liability coverage is the maximum provided by private insurance. The Secondary Financial Protection program is a retrospective insurance plan providing additional coverage up to $9.2 billion per incident by assessing retrospective premiums of $79.3 million against each of the 116 reactor units in the United States that are currently subject to the Program, limited to a maximum assessment of $10 million per incident per nuclear unit in any one year. The maximum assessment is to be adjusted at least every five years to reflect inflationary changes. The above insurance covers all workers employed at nuclear facilities prior to January 1, 1988, for bodily injury claims. Vermont Yankee has purchased a master worker insurance policy with limits of $200 million with one automatic reinstatement of policy limits to cover workers employed on or after January 1, 1988. Vermont Yankee's estimated contingent liability for a retrospective premium on the master worker policy as of December 1993 is $3.1 million. The secondary financial protection program referenced above provides coverage in excess of the Master Worker policy. Insurance has been purchased from Nuclear Electric Insurance Limited (NEIL II) to cover the costs of property damage, decontamination or premature decommissioning resulting from a nuclear incident. All companies insured with NEIL II are subject to retroactive assessments if losses exceed the accumulated funds available to NEIL II. The maximum potential assessment against Vermont Yankee with respect to losses arising during the current policy year is $5.8 million at the time of the first loss and $12.3 million at the time of a subsequent loss. Vermont Yankee's liability for the retrospective premium adjustment for any policy year ceases six years after the end of that policy year unless prior demand has been made. Summarized financial information for Vermont Yankee is as follows: December 31, 1993 1992 1991 ---- ---- ---- (In thousands) Earnings: Operating revenues . . . . . . . . . . . $180,145 $175,919 $151,722 Net income applicable to common stock . 7,793 7,921 8,490 Company's equity in net income . . . . . 1,425 1,415 1,516 Total assets . . . . . . . . . . . . . . . $469,770 $438,208 $417,618 Less: Liabilities and long-term debt . . . . 415,606 383,933 363,354 -------- -------- -------- Net assets . . . . . . . . . . . . . . . . $ 54,164 $ 54,275 $ 54,264 ======== ======== ======== Company's equity in net assets . . . . . . $ 9,745 $ 9,731 $ 9,729 ======== ======== ======== C. Common Stock Equity The Company maintains a Dividend Reinvestment and Stock Purchase Plan (DRIP) under which 394,112 shares were reserved and unissued at December 31, 1993. The Company also funds an Employee Savings and Investment Plan (ESIP). At December 31, 1993, there were 47,067 shares reserved and unissued under the ESIP. In October 1991, the Company issued 429,600 additional shares of common stock at a price of $28.25 per share. The net proceeds were used to reduce the Company's outstanding short-term debt, to finance planned capital additions and to maintain an appropriate capital structure. In May 1993, the Company amended its Articles of Association increasing the number of authorized shares of common stock from 6,000,000 to 10,000,000. Changes in common stock equity for the years ended December 31, 1991, 1992 and 1993 are as follows: Dividend Restrictions Certain restrictions on the payment of cash dividends on common stock are contained in the indentures relating to long-term debt and in the Restated Articles of Association. Under the most restrictive of such provisions, $17.9 million of retained earnings were free of restrictions at December 31, 1993. The properties of the Company include several hydroelectric projects licensed under the Federal Power Act, with license expiration dates ranging from 1993 to 2022. At December 31, 1993, $259,000 of retained earnings had been appropriated as excess earnings on hydroelectric projects as required by Section 10(d) of the Federal Power Act. D. Preferred Stock The holders of the preferred stock are entitled to specific voting rights with respect to the placement of restrictions on certain types of corporate actions. They are also entitled to elect the smallest number of directors necessary to constitute a majority of the Board of Directors in the event of preferred stock dividend arrearages equivalent to or exceeding four quarterly dividends. Similarly, the holders of the preferred stock are entitled to elect two directors in the event of a default in any purchase or sinking fund requirements provided for any class of preferred stock. Certain classes of preferred stock are subject to annual purchase or sinking fund requirements. The sinking fund requirements are mandatory. The purchase fund requirements are mandatory, but holders may elect not to accept the purchase offer. The redemption or purchase price to satisfy these requirements may not exceed $100 per share plus accrued dividends. All shares redeemed or purchased in connection with these requirements must be canceled and may not be reissued. The annual purchase and sinking fund requirements for certain classes of preferred stock are: Purchased and Sinking Fund 4.75%, Class B . . . . . . . . December 1 450 Shares 7%, Class C . . . . . . . . . December 1 450 Shares 9.375%, Class D, Series 1 . . December 1 1,600 Shares The 8.625%, Class D, Series 3, preferred stock issued in September 1990, requires no sinking fund. Under the Restated Articles of Association relating to Redeemable Cumulative Preferred Stock, the annual aggregate amounts of purchase and sinking fund requirements for the next five years are $250,000 for each of the years 1994 and 1995, and $1,650,000 for the years 1996 - 1998. All of the classes of preferred stock are redeemable at the option of the Company or, in the case of voluntary liquidation, at various prices on various dates. The prices include the par value of the issue plus any accrued dividends and a redemption premium. The redemption premium for Class B, C and D, Series 1, is $1.00 per share. The redemption premium for the Class D, Series 3, is $5.751 per share until September 1, 1994; $4.793 per share from September 1, 1994 to September 1, 1995; $3.835 per share from September 1, 1995 to September 1, 1996; $2.877 per share from September 1, 1996 to September 1, 1997; $1.919 per share from September 1, 1997 to September 1, 1998; and $0.916 per share from September 1, 1998 to September 1, 1999, after which there is no redemption premium. In May 1993, the Company amended its Articles of Association authorizing a new class of preferred stock, Class E, which may be divided into and issued in series. No shares of Class E preferred stock were issued as of December 31, 1993. E. Long-term Debt Utility Substantially all of the property and franchises of the Company are subject to the lien of the indenture under which first mortgage bonds have been issued. The annual sinking fund requirements (excluding amounts that may be satisfied by property additions) and long-term debt maturities for the next five years are: Sinking Funds Maturities Total ------- ---------- ----- (In thousands) 1994 . . . . . . . . . . . . . . $1,800 $ --- $1,800 1995 . . . . . . . . . . . . . . 4,833 --- 4,833 1996 . . . . . . . . . . . . . . 4,833 3,000 7,833 1997 . . . . . . . . . . . . . . 3,500 1,334 4,834 1998 . . . . . . . . . . . . . . 3,500 3,000 6,500 Non-Utility At December 31, 1993, Green Mountain Propane Gas Company, the Company's propane subsidiary, had long-term debt of $4,125,000, which was secured by substantially all of the subsidiary's assets. The annual sinking fund requirements and maturities for the next three years are: Sinking Funds Maturities Total (In thousands) 1994 . . . . . . . . . . . . . $1,100 $ --- $1,100 1995 . . . . . . . . . . . . . 1,100 --- 1,100 1996 . . . . . . . . . . . . . 550 1,375 1,925 F. Short-term Debt Utility At December 31, 1993, the Company had lines of credit with five banks totaling $30.5 million, with borrowings outstanding of $19.0 million. Borrowings under these lines of credit are at interest rates ranging from less than prime to the prime rate. The Company has fee arrangements on its lines of credit ranging from 1/4 to 3/8 percent and no compensating balance requirements. These lines of credit are subject to periodic review and renewal during the year by the various banks. Non-Utility At December 31, 1993, Green Mountain Propane Gas Company, the Company's propane subsidiary, had a line of credit with a bank for $2.0 million, with borrowings outstanding of $400,000. G. Income Taxes Utility On January 1, 1993, the Company adopted the standard on accounting for income taxes, SFAS 109, which requires an asset and liability approach for financial accounting and reporting for income taxes. When implementing SFAS 109 the Company created additional deferred tax assets of $4.8 million and deferred tax liabilities of $5.6 million to give recognition to certain temporary differences previously not recognized in the Company's financial statements. These additional deferred taxes will be collected from or returned to ratepayers in future periods and, accordingly, the Company recognized a regulatory liability and regulatory asset related to income taxes of $4.8 million and $5.6 million, respectively. The implementation of SFAS 109 on January 1, 1993, and the application of SFAS 109 had no material impact on the Company's results of operations or cash flows in the twelve months ended December 31, 1993. Additionally, the Company does not believe SFAS 109 will significantly impact future results of operations or cash flows based on current ratemaking policy. The implementation of SFAS 109 also requires the Company to consider now the future utilization of deferred tax assets. If there is doubt that the Company will be able to utilize these future tax benefits, it might be necessary to establish a valuation allowance. The Company has concluded that it is not necessary at this time to establish a valuation allowance. The Company has been in a tax-paying position for approximately ten years and does not foresee future events that will alter the Company's capacity to utilize these deductions when intended. The temporary differences which gave rise to the net deferred tax liability at January 1, 1993 and December 31, 1993, were as follows: At January 1, At December 31, 1993 1993 ------------- --------------- (In thousands) Deferred Tax Assets Contributions in aid of construction. . $ 4,584 $ 5,094 Deferred compensation and postretirement benefits . . . . . . . 3,046 3,387 Alternative minimum tax credit . . . . 305 749 Excess deferred taxes . . . . . . . . . 2,287 2,188 Unamortized investment tax credits . . 2,528 2,402 Other . . . . . . . . . . . . . . . . . 2,077 1,018 ------- ------- $14,827 $14,838 ------- ------- Deferred Tax Liabilities Property-related and other . . . . . . $22,659 $25,090 Demand side management costs . . . . . 2,856 5,841 Unamortized investment tax credit . . . 5,956 5,672 Reversal of previously flowed-through tax depreciation . . . . . . . . . . 4,865 4,182 AFUDC equity basis adjustment . . . . . 771 726 -------- -------- 37,107 41,511 -------- -------- Net accumulated deferred income tax asset (liability) . . . . . . . . . . ($22,280) ($26,673) ========= ========= The following table reconciles the change in the net accumulated deferred income tax liability to the deferred income tax expense included in the income statement for the period: Net change in deferred income tax liability per above table . . . $4,393 Change in income tax related regulatory assets and liabilities. . 503 Other adjustments . . . . . . . . . . . . . . . . . . . . . . . . 849 ------ Deferred income tax expense for the period . . . . . . . . . . . $5,745 ====== The components of the provision for income taxes are: Year Ended December 31, 1993 1992 1991 ---- ---- ---- (In thousands) Current state income taxes . . . . . . . $ 134 $ 796 $ 991 Deferred state income taxes . . . . . . 1,225 716 332 Current federal income taxes . . . . . . 369 3,007 3,730 Deferred federal income taxes . . . . . 4,804 2,678 1,243 Investment tax credits -- net . . . . . (284) (284) (276) ------- ------- -------- Total income taxes . . . . . . . . . . . 6,248 6,913 6,020 Amounts included in "Other income" . . . 1 2 2 ------- ------- ------- Income taxes charged to operations . . . $6,249 $6,915 $6,022 ======= ======= ======= The following table details the components of the provisions for deferred federal income taxes: Year Ended December 31, 1993 1992 1991 ---- ---- ---- (In thousands) Deferred purchase power costs . . . . . $ 904 $ 475 $ (606) Excess tax depreciation . . . . . . . . 1,300 1,512 1,497 Demand side management . . . . . . . . 1,918 733 584 State tax benefit . . . . . . . . . . . (416) (211) (52) Contributions in aid of construction . (404) (746) (293) Supplemental benefit plans . . . . . . (182) (42) (383) Prepaid property taxes . . . . . . . . --- 8 36 Pine Street . . . . . . . . . . . . . . 817 237 152 Other . . . . . . . . . . . . . . . . . 867 712 308 ------- ------- ------- $4,804 $2,678 $1,243 ======= ======= ======= Total federal income taxes differ from the amounts computed by applying the statutory tax rate to income before taxes. The reasons for the differences are: Year Ended December 31, 1993 1992 1991 ---- ---- ---- (In thousands) Income before income tax . . . . . . . $16,880 $18,765 $16,476 Federal statutory rate . . . . . . . . 34% 34% 34% Computed "expected" federal income taxes . . . . . . . . . . . . $ 5,739 $ 6,380 $ 5,602 Increase (decrease) in taxes resulting from: Tax versus book depreciation . . . . 327 357 357 Dividends received and paid credit . (580) (597) (634) AFUDC - equity funds . . . . . . . . (93) (63) (77) Amortization of ITC . . . . . . . . (284) (284) (276) State tax benefit . . . . . . . . . (462) (514) (450) Excess deferred taxes . . . . . . . (60) (60) (60) Other . . . . . . . . . . . . . . . 302 182 235 ------- ------- ------- Total federal income taxes . . . . . . $4,889 $5,401 $4,697 ======= ======= ======= Effective federal income tax rate . . 28.9% 28.8% 28.5% Non-Utility The Company's non-utility subsidiaries had accumulated deferred income taxes of $2.3 million on its balance sheet at December 31, 1993, largely attributable to property-related transactions. The components of the provision for income taxes for the non-utility operations are: Year Ended December 31, 1993 1992 1991 ---- ---- ---- (In thousands) State income taxes . . . . . . . . . . $ (58) $(104) $ (40) Federal income taxes . . . . . . . . . (224) (314) (150) Investment tax credits . . . . . . . . (45) (45) (61) ------ ------ ------ Income taxes charged to operations . . $(327) $(463) $(251) ====== ====== ====== Total federal income taxes differ from the amounts computed by applying the statutory rate to income before taxes, primarily attributable to state tax benefits. The effective federal income tax rates for the non-utility operations were 34.2 percent, 33.3 percent and 43.1 percent for the years ended 1993, 1992 and 1991, respectively. H. Quarterly Financial Information (Unaudited) The following quarterly financial information, in the opinion of management, includes all adjustments necessary to a fair statement of results of operations for such periods. Variations between quarters reflect the seasonal nature of the Company's business and the timing of rate changes. 1993 Quarter Ended March June Sept. Dec. Total ----- ---- ----- ---- ----- (Amounts in thousands, except per share) Operating Revenues . . . . . . $40,751 $33,427 $35,647 $37,428 $147,253 Operating Income . . . . . . . 5,160 2,093 3,075 4,498 14,826 Net Income . . . . . . . . . . 4,302 966 2,051 3,312 10,631 Net Income Applicable to Common Stock . . . . . . . . 4,099 763 1,848 3,110 9,820 Earnings per Average Share of Common Stock . . . . . . . . $0.93 $0.17 $0.41 $0.69 $2.20 Weighted Average Number of Common Shares Outstanding . 4,415 4,442 4,470 4,503 4,457 1992 Quarter Ended March June Sept. Dec. Total ----- ---- ----- ---- ----- (Amounts in thousands, except per share) Operating Revenues . . . . . . $39,476 $33,288 $33,911 $38,565 $145,240 Operating Income . . . . . . . 5,636 2,420 3,888 4,468 16,412 Net Income . . . . . . . . . . 4,060 1,585 2,766 3,441 11,852 Net Income Applicable to Common Stock . . . . . . . . 3,852 1,377 2,558 3,234 11,021 Earnings per Average Share of Common Stock . . . . . . . . $0.89 $0.32 $0.59 $0.74 $2.54 Weighted Average Number of Common Shares Outstanding . 4,305 4,329 4,359 4,386 4,345 I. Commitments and Contingencies 1. Environmental Matters In 1982, the United States Environmental Protection Agency (EPA) notified the Company that the EPA, pursuant to the Comprehensive Environmental Response, Compensation and Liability Act of 1980 (CERCLA), was considering spending public funds to investigate and take corrective action involving claimed releases of allegedly hazardous substances at a site identified as the Pine Street Marsh in Burlington, Vermont. On part of this site was located a manufactured-gas facility owned and operated by a number of separate enterprises, including the Company, from the late 19th century to 1967. In its notice, the EPA stated that the Company may be a "potentially responsible party" (PRP) under CERCLA from which reimbursement of costs of investigation and of corrective action may be sought. On February 23, 1988, the Company received a Special Notice letter from the EPA stating that the letter constituted a formal demand for reimbursement of costs, including interest thereon, that were incurred and were expected to be incurred in response to the environmental problems at the site. On December 5, 1988, the EPA brought suit against the Company, New England Electric System, and Vermont Gas Systems, Inc. in the United States District Court for the District of Vermont seeking reimbursement for costs it incurred in conducting activities in 1985 to remove allegedly hazardous substances from the site, and requested a declaratory judgment that the Company and the other defendants are liable for all costs that have been incurred since the removal and that continue to be incurred in responding to claims of releases or threatened releases from the Maltex Pond Area -- the portion of the site where the removal action occurred. The complaint specifically alleged that the EPA expended at least $741,000 during the 1985 removal action and sought interest on this amount from the date the funds were expended and costs of litigation, including attorneys' fees. The Company entered a cross-claim against New England Electric System and third-party claims against UGI Corporation, Southern Union Corporation, the State of Vermont, and an individual property owner at the site for recovery of its response costs and for contribution. Fourth-party defendants subsequently were joined. In July 1990, the Company and other parties signed a proposed Consent Decree settling the removal action litigation. All 14 settling defendants contributed to the aggregate settlement amount of $945,000. Individual contributions were treated as confidential under the proposed Consent Decree. On December 26, 1990, upon the unopposed motion of the United States, the Consent Decree was entered by the Court. During the summer and fall of 1989, the EPA conducted the initial phase of the Remedial Investigation (RI) and commenced the Feasibility Study (FS) relating to the site. In the fall of 1990 and in 1991, the EPA conducted a second phase of RI work and studied the treatability of soils and groundwater at the site. In the fall of 1991, the EPA responded favorably to a request from the Company and other PRPs to participate in informal discussions on the EPA's ongoing investigation and evaluation of the site, and invited the Company and other interested parties to share technical information and resources with the EPA that might assist it in evaluating remedial options. Thereafter, the Company and other PRPs held several meetings with the EPA to discuss technical issues and received copies of the EPA's Supplemental Remedial Investigation Final Report, and its Baseline Risk Assessment Final Report. On November 6, 1992, the EPA released its final RI/FS and announced a proposed remedy with an estimated total cost of approximately $49.5 million, including 30 years' operation and maintenance costs, with a net present value of approximately $26.4 million. The EPA's preferred remedy called for construction of a Containment/Disposal Facility "CDF" over a portion of the site. The CDF would have consisted of subsurface vertical barriers and a low permeability cap, with collection trenches and hydraulic control system to capture groundwater and prevent its migration outside of the CDF. Collected groundwater would have been treated and discharged or stored and disposed of off-site. The proposed remedy also would have required construction of new wetlands to replace those that would be destroyed by construction of the CDF and a long-term monitoring program. On May 15, 1993, the PRP group in which the Company participated submitted extensive comments to the EPA opposing the proposed remedy. In response to an earlier request from the EPA, the PRP group also submitted a detailed analysis of an alternative remedy anticipated to cost approximately $20 million. In early June, in response to overwhelming negative comment, the EPA withdrew its proposed remedy and announced that it would work with all interested parties in developing a new proposal. Since then, the EPA has established a coordinating council, with representatives of PRPs, environmental groups, and government agencies, and presided over by a neutral mediator. The council is charged with determining what additional studies may be appropriate for the site and may also eventually address additional response activities. The Company is represented on the council. In early 1994, the Company and other PRPs met with the EPA to commence negotiations on an Administration Order of Consent pursuant to which the PRPs would conduct additional studies agreed to by the coordinating council. Although negotiations are not yet complete, it is likely that the EPA will consent to allowing the PRPs to conduct additional studies at the site and that the EPA will not require reimbursement for its past RI/FS study costs as a condition to allowing the PRPs to conduct these additional studies. The EPA has previously advised the Company that ultimately it will seek to hold the Company and the PRPs liable for such costs. In September 1991, the Company, New England Electric System and Vermont Gas Systems, Inc. entered into confidential negotiations with most other PRPs concerning allocation of unresolved liabilities concerning the site. Those negotiations are continuing. In December 1991, the Company brought suit against several previous insurers seeking recovery of unrecovered past costs and indemnity against future liabilities associated with environmental problems at the site. The parties to this action are engaged in discovery and motions practice. The Company has reached a confidential settlement with one of the defendants that provided the Company with second layer excess liability coverage for a seven month period in 1976. The Company has also reached a confidential agreement in principle with another insurance company defendant that provided the Company with comprehensive general liability insurance between 1976 and 1982, and with environmental impairment liability insurance from 1981 to 1984. These policies were in place in 1982 when the EPA first notified the Company that it might be a potentially responsible party at the Pine Street Marsh site. The Company is unable to predict at this time the magnitude of any liability resulting from potential claims for the costs of the RI/FS or the performance of any remedial action, or the likely disposition or magnitude of claims the Company may have against others, including its insurers, except to the extent described above. In its 1991 rate case, the Company, for the first time, sought recovery for expenses associated with the Pine Street Marsh site. Specifically, the Company proposed rate recognition of its estimated, unrecovered 1991 expenditures (approximately $400,000) for technical consultants and legal assistance in connection with the EPA's enforcement actions at the site and insurance litigation. While reserving the right to argue in the future about the appropriateness of rate recovery for Pine Street Marsh related costs, the Company and the Vermont Department of Public Service (Department) reached agreement that the full amount of Pine Street Marsh costs reflected in the Company's 1991 rate case should be recovered in rates. The Company's rates approved by the Vermont Public Service Board (VPSB) on April 2, 1992, reflected the 1991 Pine Street Marsh related expenditures referred to above. In its rate increase request filed on October 1, 1993, the Company proposed rate recognition for its expenditures between January 1, 1992 and July 31, 1993 (approximately $4.2 million) for technical consultants and legal assistance in connection with the EPA's enforcement actions at the site and insurance litigation. The Department and the Company have reached the same agreement regarding recovery of these costs in rates that they reached with respect to the Company's 1991 Pine Street Marsh related expenditures. A comprehensive settlement of the Company's 1993 rate case, including the agreement regarding Pine Street Marsh costs, is currently pending before the VPSB. As of December 31, 1993, the Company had reserved approximately $680,000 for costs attributable to the site, other than those costs that are the subject of the agreement between the Department and the Company mentioned above. Management expects to seek and receive ratemaking treatment for other costs incurred beyond the amounts that have been reserved. As of December 31, 1993, such other costs are approximately $4,918,000, which includes the $4.2 million in costs that are the subject of the rate case settlement agreement referred to above. 2. Operating Leases The Company has an operating lease for its corporate headquarters building and two of its service center buildings, including related real estate. This lease has a base term of 25 years, ending June 30, 2009, with renewal options aggregating another 25 years. The annual lease charges will total $983,000 for each of the years 1994 through 2008 and $574,000 for 2009. The Company has options to purchase the buildings at fair market value at the end of the base term and at the end of each renewal period. 3. Jointly-Owned Facilities The Company had joint-ownership interests in electric generating and transmission facilities at December 31, 1993, as follows: Ownership Share of Utility Accumulated Interest Capacity Plant Depreciation (In %) (In MW) (In thousands) Highgate . . . . . . . . . . 33.8 67.6 $ 9,726 $2,310 McNeil . . . . . . . . . . . 11.0 5.9 $ 8,503 $2,464 Stony Brook (No. 1) . . . . . 8.8 30.2 $10,035 $4,660 Wyman (No. 4) . . . . . . . . 1.1 6.8 $ 2,372 $1,100 Metallic Neutral Return (1) . 59.4 --- $ 1,563 $ 181 (1) Neutral conductor for NEPOOL/Hydro-Quebec Interconnection The Company's share of expenses for these facilities is reflected in the Statements of Consolidated Income. Each participant in these facilities must provide for its own financing. 4. Rate Matters On October 1, 1993, the Company filed a request with the VPSB to increase retail rates by 8.6 percent. The increase is needed primarily to cover the cost of buying power from independent power producers, the cost of energy conservation programs, the cost of plant additions made in the last two years, and costs incurred in 1992 and through July 31, 1993, associated with the proposed remedy at the Pine Street Marsh site and with the Company's litigation against its previous insurers seeking recovery of past costs incurred and indemnity against future liabilities in connection with the site. On January 28, 1994, the parties to the rate proceeding reached an agreement resulting in a 2.9 percent retail rate increase and a return on equity of 10.5 percent, effective June 15, 1994. The agreement must be reviewed and approved by the VPSB. 5. Other Legal Matters The Company is involved in legal and administrative proceedings in the normal course of business and does not believe that the ultimate outcome of these proceedings will have a material effect on the financial position or the results of operations of the Company. J. Obligations Under Transmission Interconnection Support Agreement Agreements executed in 1985 among the Company, VELCO and other NEPOOL members and Hydro-Quebec, provided for the construction of the second phase (Phase II) of the interconnection between the New England electric systems and that of Hydro-Quebec. Phase II expands the Phase I facilities from 690 megawatts to 2,000 megawatts and provides for transmission of Hydro-Quebec power from the Phase I terminal in northern New Hampshire to Sandy Pond, Massachusetts. Construction of Phase II commenced in 1988 and was completed in late 1990. The Company is entitled to 3.2 percent of the Phase II power-supply benefits. Total construction costs for Phase II were approximately $487 million. The New England participants, including the Company, have contracted to pay monthly their proportionate share of the total cost of constructing, owning and operating the Phase II facilities, including capital costs. As a supporting participant, the Company must make support payments under thirty-year agreements. These support agreements meet the capital lease accounting requirements under SFAS 13. At December 31, 1993, the present value of the Company's obligation is $11.0 million. Projected future minimum payments under the Phase II support agreements are as follows: Year ending December 31, 1994 . . . . . . . . . . . $ 501,311 1995 . . . . . . . . . . . 501,311 1996 . . . . . . . . . . . 501,311 1997 . . . . . . . . . . . 501,311 1998 . . . . . . . . . . . 501,311 Total for 1999-2020 . . . 8,522,270 ----------- $11,028,825 =========== The Phase II portion of the project is owned by New England Hydro- Transmission Electric Company and New England Hydro-Transmission Corporation, subsidiaries of New England Electric System, in which certain of the Phase II participating utilities, including the Company, own equity interests. The Company holds approximately 3.2 percent of the equity of the corporations owning the Phase II facilities. K. Long-Term Power Purchases 1. Unit Purchases Under long-term contracts with various electric utilities in the region, the Company is purchasing certain percentages of the electrical output of production plants constructed and financed by those utilities. Such contracts obligate the Company to pay certain minimum annual amounts representing the Company's proportionate share of fixed costs, including debt service requirements (amounts necessary to retire the principal of and to pay the interest on the portion of the related long-term debt ascribed to the Company) whether or not the production plants are operating. The cost of power obtained under such long-term contracts, including payments required to be made when a production plant is not operating, is reflected as "Power Supply Expenses" in the Statements of Consolidated Income. Information (including estimates for the Company's portion of certain minimum costs and ascribed long-term debt) with regard to significant purchased power contracts of this type in effect during 1993 follows: Stony Vermont Merrimack Brook Yankee --------- ----- ------- (Dollars in thousands) Plant capacity . . . . . . . . . . . 320.0 MW 343.0 MW 520.0 MW Company's share of output . . . . . 8.9% 4.4% 17.3% Contract period . . . . . . . . . . 1968-1998 (1) (2) Company's annual share of: Interest . . . . . . . . . . . . . $ 589 $ 307 $ 1,403 Other debt service . . . . . . . . 297 270 --- Other capacity . . . . . . . . . . 1,560 353 26,327 ------ ------ ------- Total annual capacity . . . . . . . $2,446 $ 930 $27,730 ====== ====== ======= Company's share of long-term debt . $ 944 $5,983 $13,749 ====== ====== ======= (1) Life of plant estimated to be 1981 - 2006. (2) License for plant operations expires in 2012. 2. Hydro-Quebec System Power Purchases Under various contracts approved by the VPSB, the details of which are described in the table below, the Company purchases capacity and associated energy produced by the Hydro-Quebec system. Such contracts obligate the Company to pay certain fixed capacity costs whether or not energy purchases above a minimum level set forth in the contracts are made. Such minimum energy purchases must be made whether or not other, less expensive energy sources might be available. These contracts are intended to complement the other components in the Company's power supply to achieve the most economic power-supply mix reasonably available. On October 12, 1990, the VPSB granted conditional approval of the Company's purchases pursuant to the contract with Hydro-Quebec entered into December 4, 1987: (1) Schedule A -- 17 megawatts of firm capacity and associated energy to be delivered at the Highgate interconnection for five years beginning 1990; (2) Schedule B -- 68 megawatts of firm capacity and associated energy to be delivered at the Highgate interconnection for twenty years beginning in September 1995; and (3) Schedule C3 -- 46 megawatts of firm capacity and associated energy to be delivered at interconnections to be determined at a later time for 20 years beginning in November 1995. The opponents to the December 1987 contract appealed the VPSB's October 1990 order to the Vermont Supreme Court. On October 2, 1992, the Vermont Supreme Court affirmed the VPSB's October 1990 order. On February 12, 1992, the VPSB issued an order finding that the Company had complied with substantial conditions imposed by the VPSB in its October 1990 order and approved the Company's purchase under the December 1987 contract. In March 1992, the opponents to the December 1987 contract appealed the VPSB's February 1992 compliance order to the Vermont Supreme Court. On May 7, 1993, the Vermont Supreme Court affirmed the VPSB's compliance order approving the Company's purchases under the December 1987 contract. The Company anticipates that the Schedule C3 purchases will be delivered over its entitlement to the NEPOOL/Hydro-Quebec interconnection (Phase I and Phase II). If such interconnection is utilized, the Company must forego certain savings associated with other energy deliveries and capacity arrangements that would benefit the Company if the interconnection were not utilized for delivery of the Schedule C3 purchases. The Company believes that the benefits of the Schedule C3 purchases, if power is delivered over such interconnection, will offset the value of the foregone savings. In September 1993, the Company negotiated a renewal of a short-term "tertiary energy" contract with Hydro-Quebec under which Hydro-Quebec delivers up to 61 megawatts of capacity and energy to the Company over the NEPOOL/Hydro-Quebec interconnection. The electricity purchased under this tertiary contract is priced at less than 2.5 cents per kilowatthour. The benefits realized by the Company from this favorably priced electricity will be greater than those associated with deliveries foregone by the Company otherwise available over the NEPOOL/Hydro-Quebec interconnection. This tertiary energy contract will expire in August 1994. The Company anticipates that purchases of tertiary energy will extend beyond August 1994, but will end when the Schedule C3 deliveries begin in November 1995. On September 27, 1990, the Canadian National Energy Board (NEB) issued its decision approving the export by Hydro-Quebec pursuant to the December 1987 contract. The NEB, however, imposed a condition on its approval: Hydro-Quebec's export license was to be deemed valid so long as Hydro-Quebec obtained all federal and environmental approvals required for any of its new hydroelectric generating units advanced in order to satisfy Hydro-Quebec's contractual obligations. Hydro-Quebec and the Province of Quebec appealed the imposition of this condition to the Federal Court of Appeal. In a decision handed down on July 9, 1991, the Federal Court of Appeal agreed with Hydro-Quebec's assertion that the NEB has no authority to regulate the construction of hydroelectric generating units -- a matter that lies exclusively within provincial jurisdiction under the Canadian Constitution. The Federal Court of Appeal struck down the challenged NEB license condition and otherwise affirmed the license. The opponents to the December 1987 contract appealed the decision of the Federal Court of Appeal to the Supreme Court of Canada. On February 24, 1994, the Supreme Court of Canada rendered a decision reversing the judgment of the Federal Court of Appeal, and reinstated the NEB decision, including the condition that Hydro-Quebec had objected to. The December 1987 contract, like the July 1984 contract, calls for the delivery of system power and is not related to any particular facilities in the Hydro-Quebec system. Consequently, there are no identifiable debt-service charges associated with any particular Hydro-Quebec facility that can be distinguished from the overall charges paid under the contract. Based on current integrated resource analyses, the Company believes that these contracts for Hydro-Quebec system power compare favorably with alternative long-term resources available to the Company. July 1984 December 1987 Contract Contract Schedule A Schedule B Schedule C3 --------- ---------- ---------- ----------- (Dollars in thousands) Capacity Acquired . . . . 50 MW 17 MW 68 MW 46 MW Contract Period . . . . . 1985-1995 1990-1995 1995-2015 1995-2015 Minimum Energy Purchase (annual load factor) . 50% 50% 75% 75% (1992-1995) Minimum Energy Charge . . $3,881 $2,134 $16,157 $11,060 (1993) (1993) (1995-2015)* (1995-2015)* $3,785 $2,281 (1994-1995)* (1994-1995) Annual Capacity Charge . $3,379 $1,681 $16,633 $11,821 (1993) (1993) (1995-2015)* (1995-2015)* $3,355 $1,691 (1994-1995)* (1994-1995)* Average Cost per KWH . . 2.8 cents 5.5 cents 7.0 cents 7.3 cents (1993) (1993) (1995-2015)** (1995-2015)** 2.7 cents 4.6 cents (1994-1995)* (1994-1995)* *Estimated average. **Estimated average in nominal dollars, levelized over the period indicated. 3. Rochester Gas & Electric Purchase In 1988, the Company entered into a ten-year contract with Rochester Gas and Electric Corporation (RG&E) for the purchase of up to 50 megawatts of firm power and associated energy. This flexible contract allows the Company the discretion of purchasing from 0 megawatts to 50 megawatts on a weekly basis. The Company has no obligation to purchase power in any week. When the Company elects to schedule a purchase, however, it must take and pay for energy at a 75 percent load factor, or pay a penalty, in the week of the purchase. Although the Company has no fixed capacity payments, it must pay to reserve transmission from the Niagra Mohawk Power Corporation for the 50-megawatt maximum purchase. Both RG&E and the Company have the option to terminate the contract effective 1995. Pursuant to an agreement with Connecticut Light and Power Corporation (CL&P) and Bozrah Light and Power (Bozrah) that was finalized in December 1992, the Company exercised the option to terminate the RG&E agreement and the transmission contract with Niagara Mohawk that supports it effective October 31, 1995. The Company also agreed to offer RG&E power to CL&P for purchase on a weekly basis through the remaining term of the RG&E agreement, and to terminate a contract under which the Company supplied all of the electrical requirements of Bozrah, a small electric utility operating in Gilman, Connecticut. In return, CL&P, which will replace the Company as the supplier of electricity to Bozrah, will assume responsibility for approximately 75 percent of the fixed costs of the transmission contract with Niagara Mohawk, and will provide the Company with up to 50 megawatts of system power, to be scheduled on a weekly basis, at a total price expected to be lower than that provided under the existing RG&E contract. In addition, CL&P has offered the Company an option, which may be exercised in yearly increments starting in July 1994, to purchase up to 50 additional megawatts of system power for the period July 1995 through December 2004. The Company expects that the reductions in its purchased power and fixed transmission costs derived from this three-party agreement will more than offset the loss of revenues associated with the termination of its electricity sales contract with Bozrah. The arrangement was approved by FERC effective May 1, 1993. Estimated Charges Annual Transmission Reservations . . . . . . . . . $300,000 Average Cost per KWH . . . . . . . . . . . . . . . (1993)(1) 4.1 cents (1994 - 1995) (1)No power purchases were made under the RG&E or CL&P contracts described above during 1993. REPORT OF INDEPENDENT PUBLIC ACCOUNTS To the Board of Directors of Green Mountain Power Corporation: We have audited the accompanying consolidated balance sheets and capitalization data of Green Mountain Power Corporation (a Vermont corporation) as of December 31, 1993 and 1992, and the related consolidated statements of income and cash flows for each of the three years in the period ended December 31, 1993. 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 Green Mountain Power Corporation as of December 31, 1993 and 1992, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed in Notes A and G to the accompanying financial statements, effective January 1, 1993, the Company changed its method of accounting for post-retirement benefits other than pensions and income taxes. ARTHUR ANDERSEN & CO. Boston, Massachusetts February 1, 1994 Schedule V GREEN MOUNTAIN POWER CORPORATION PROPERTY, PLANT AND EQUIPMENT December 31, 1993 Schedule V GREEN MOUNTAIN POWER CORPORATION PROPERTY, PLANT AND EQUIPMENT December 31, 1992 Schedule V GREEN MOUNTAIN POWER CORPORATION PROPERTY, PLANT AND EQUIPMENT December 31, 1991 Schedule VI GREEN MOUNTAIN POWER CORPORATION ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT For the Years Ended December 31, 1993, 1992 and 1991 Schedule VIII GREEN MOUNTAIN POWER CORPORATION VALUATION AND QUALIFYING ACCOUNTS AND RESERVES For the Years Ended December 31, 1993, 1992 and 1991 Schedule IX GREEN MOUNTAIN POWER CORPORATION Short-term Borrowings For the Years Ended December 31, 1993, 1992 and 1991 Schedule X GREEN MOUNTAIN POWER CORPORATION Supplementary Income Statement Information For the Years Ended December 31, 1993, 1992 and 1991 All other items were not material or were disclosed in the Consolidated Financial Statements or the related notes. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None PART III ITEMS 10, 11, 12 & 13 Certain information regarding executive officers called for by Item 10, "Directors and Executive Officers of the Registrant," is furnished under the caption, "Executive Officers" in Item 1 of Part I of this Report. The other information called for by Item 10, as well as that called for by Items 11, 12, and 13, "Executive Compensation," "Security Ownership of Certain Beneficial Owners and Management" and "Certain Relationships and Related Transactions," will be set forth under the captions "Nominees for Director," "Compliance with the Securities Exchange Act," "Executive Compensation," "Pension Plan Information" and "Security Ownership of Certain Beneficial Owners and Management" in the Company's definitive proxy statement relating to its annual meeting of stockholders to be held on May 19, 1994. Such information is incorporated herein by reference. Such proxy statement pertains to the election of directors and other matters. Definitive proxy materials will be filed with the Securities and Exchange Commission pursuant to Regulation 14A in April 1994. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K Filed Herewith On Page Item 14(a)(1). The financial statements and financial 38 statement schedules of the Company are listed on the Index to financial statements set forth in Item 8 hereof. Item 14(a)(2). The financial statements and financial 84 statement schedules of Vermont Yankee Nuclear Power Corporation, together with report thereon of Arthur Andersen & Co. and KPMG Peat Marwick are bound and filed herewith as Item 14(d). ITEM 14(a)(3). EXHIBITS ____________________ * Filed herewith ITEM 14(b) There were no reports on Form 8-K filed for the quarter ending December 31, 1993. OTHER MATTERS For the purposes of complying with the amendments to the rules governing Form S-8 (effective July 13, 1990) under the Securities Act of 1933, the undersigned registrant hereby undertakes as follows, which undertaking shall be incorporated by reference into registrant's Registration Statement on Form S-8 No. 33-47985 (filed May 14, 1992): Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers and controlling persons of the registrant pursuant to the foregoing provisions, or otherwise, the registrant has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Securities Act of 1933 and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the registrant of expenses incurred or paid by a director, officer or controlling person of the registrant in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, the registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Act and will be governed by the final adjudication of such issue. 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. GREEN MOUNTAIN POWER CORPORATION By: /s/D. G. Hyde Date: March 31, 1994 ---------------------------- (D. G. Hyde, President and Chief Executive Officer) Pursuant to the requriements 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 dates indicated. SIGNATURE TITLE DATE /s/D. G. Hyde Chairman of the Executive Commit- March 31, 1994 (D. G. Hyde) tee, President, Chief Executive Officer and Director /s/E. M. Norse Vice President, Treasurer and March 31, 1994 (E. M. Norse) Chief Financial Officer (Principal Financial Officer) /s/G. J. Purcell Controller March 31, 1994 (G. J. Purcell) (Principal Accounting Officer) /s/T. P. Salmon Chairman of the Board and March 31, 1994 (T. P. Salmon) Director /s/R. E. Boardman Director March 31, 1994 (R. E. Boardman) /s/N. L. Brue Director March 31, 1994 (N. L. Brue) /s/W. H. Bruett Director March 31, 1994 (W. H. Bruett) /s/M. O. Burns Director March 31, 1994 (M. O. Burns) /s/J. V. Cleary Director March 31, 1994 (J. V. Cleary) /s/R. I. Fricke Director March 31, 1994 (R. I. Fricke) /s/E. A. Irving Director March 31, 1994 (E. A. Irving) /s/M. L. Johnson Director March 31, 1994 (M. L. Johnson) /s/R. W. Page Director March 31, 1994 (R. W. Page) ITEM 14(d) FINANCIAL STATEMENTS VERMONT YANKEE NUCLEAR POWER CORPORATION FINANCIAL STATEMENTS December 31, 1993, 1992 and 1991 (WITH INDEPENDENT AUDITOR'S REPORT THEREON) VERMONT YANKEE NUCLEAR POWER CORPORATION Index to Financial Statements and Financial Statement Schedules Financial Statements: Page Balance Sheets, December 31, 1993 and 1992 88-89 Statements of Income and Retained Earnings, years ended December 31, 1993, 1992 and 1991 90 Statements of Cash Flows, years ended December 31, 1993, 1992 and 1991 91 Notes to Financial Statements 92-105 Financial Statements: Schedule I - Marketable Securities and Other Investments at December 31, 1993 106 Schedule V - Property, Plant and Equipment, years ended December 31, 1993, 1992 and 1991 107 Schedule VI - Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment, years ended December 31, 1993, 108 1992 and 1991 All other schedules are omitted as the required information is inapplicable or the required information is included in the financial statements or related notes. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS The Stockholders and Board of Directors of Vermont Yankee Nuclear Power Corporation: We have audited the accompanying balance sheet of Vermont Yankee Nuclear Power Corporation as of December 31, 1993, and the related statements of income and retained earnings and cash flows for the year then ended. 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 audit. The financial statements of Vermont Yankee Nuclear Power Corporation as of December 31, 1992 and 1991, were audited by other auditors whose report, dated February 5, 1993, expressed an unqualified opinion on those statements and included an additional paragraph discussing the Company's 1992 change in accounting for postretirement benefits other than pensions. We conducted our audit 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 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 audit provides a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Vermont Yankee Nuclear Power Corporation as of December 31, 1993, and the results of its operations and its cash flows for the year then ended, in conformity with generally accepted accounting principles. As discussed in Note 10 to the accompanying financial statements, effective January 1, 1993, the Company adopted the provisions of Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes. Our audit was made for the purpose of forming an opinion on the basic financial statements taken as whole. Supplementary schedules I, V and VI are presented for purposes of additional analysis and are not a required part of the basic financial statements. This information has been subjected to the auditing procedures applied in our audit of the basic financial statements and, in our opinion, is fairly stated in, all material respects, in relation to the basic financial statements taken as a whole. Boston, Massachusetts January 27, 1994 ARTHUR ANDERSEN & CO. INDEPENDENT AUDITORS' REPORT The Stockholders and Board of Directors Vermont Yankee Nuclear Power Corporation: We have audited the balance sheet of Vermont Yankee Nuclear Power Corporation as of December 31, 1992, and the related statements of income and retained earnings and cash flows for each of the years in the two-year period ended December 1992. In connection with our audits of the financial statements, we also have audited the financial statement schedules for each of the years in the two-year period ended December 31, 1992. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules 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 financial statements referred to above present fairly, in all material respects, the financial position of Vermont Yankee Nuclear Power Corporation at December 31, 1992 and the results of its operations and cash flows for each of the years in the two-year period ended December 31, 1992, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. As discussed in note 13, the Company adopted the provisions of Statement of Financial Accounting Standards Number 106, Employers' Accounting for Postretirement Benefits Other than Pensions, in 1992. KPMG Peat Marwick Boston, Massachusetts February 5, 1993 Balance Sheets Assets December 31, ------------ 1993 1992 ---- ---- (Dollars in thousands) Utility plant: Electric plant, at cost (note 6) $ 374,736 $ 362,278 Less accumulated depreciation 198,389 185,263 ________ ________ 176,347 177,015 Construction work in progress 597 6,408 ________ ________ Net electric plant 176,944 183,423 ________ ________ Nuclear fuel, at cost (note 6): Assemblies in reactor 69,063 74,025 Fuel in process --- 5,236 Spent fuel 287,700 259,199 ________ ________ 356,763 338,460 Less accumulated amortization of burned nuclear fuel 317,039 302,362 ________ ________ 39,724 36,098 Less accumulated amortization of final core nuclear fuel 7,220 6,487 ________ ________ Net nuclear fuel 32,504 29,611 ________ ________ Net utility plant 209,448 213,034 ________ ________ Current assets: Cash and temporary investments 2,349 1,922 Accounts receivable from sponsors 12,235 15,407 Other accounts receivable 4,522 2,715 Materials and supplies 17,081 16,862 Prepaid expenses 3,949 4,381 ________ ________ Total current assets 40,136 41,287 ________ ________ Deferred charges: Deferred decommissioning costs (note 2) 34,379 34,389 Accumulated deferred income taxes (note 10) 18,231 10,378 Deferred DOE enrichment site decontamination and decommissioning fee (note 4) 18,627 18,143 Net unamortized loss on reacquired debt 2,942 --- Other deferred charges (note 4) 3,643 4,994 ________ ________ Total deferred charges 77,822 67,904 ________ ________ Long-term funds at amortized cost: Decommissioning fund (notes 2, 5, and 7) 98,880 82,091 Disposal fee defeasance fund (notes 5, 7, and 8) 43,484 33,892 ________ ________ Total long-term funds 142,364 115,983 ________ ________ $469,770 $438,208 ======== ======== See accompanying notes to financial statements. Balance Sheets Capitalization and Liabilities December 31, ------------ 1993 1992 ---- ---- (Dollars in thousands) Capitalization: Common stock equity: Common stock, $100 par value; authorized 400,100 shares; issued 400,014 shares of which 7,533 are held in Treasury $ 40,001 $ 40,001 Additional paid-in capital 14,227 14,227 Treasury stock (7,533 shares at cost) (1,131) (1,131) Retained earnings 1,067 1,178 ________ ________ Total common stock equity 54,164 54,275 ________ ________ Long-term obligations, net (notes 6 and 7) 79,636 74,193 ________ ________ Total capitalization 133,800 128,468 ________ ________ Commitments and contingencies (notes 2, 14 and 15) Disposal fee and accrued interest for spent nuclear fuel (notes 7 and 8) 80,688 78,239 ________ ________ Current liabilities: Accrued liabilities 28,063 22,743 Accounts payable 2,117 2,591 Accrued interest 635 974 Accrued taxes 1,206 1,472 ________ ________ Total current liabilities 32,021 27,780 ________ ________ Deferred credits: Accrued decommissioning costs (note 2) 134,614 117,601 Accumulated deferred income taxes 56,478 58,963 Net regulatory tax liability (note 10) 8,351 --- Accumulated deferred investment tax credits 7,013 7,590 Net unamortized gain on reacquired debt --- 1,732 Accrued DOE enrichment site decon- tamination and decommissioning fee (note 4) 15,966 17,220 Other deferred credits 839 615 ________ ________ Total deferred credits 223,261 203,721 ________ ________ $469,770 $438,208 ======== ======== See accompanying notes to financial statements. Statements of Income and Retained Earnings Years ended December 31, ------------------------ 1993 1992 1991 ---- ---- ---- (Dollars in thousands except per share amounts) Operating revenues $180,145 $175,919 $151,722 ________ ________ ________ Operating expenses: Nuclear fuel expense 19,526 21,240 24,864 Other operating expense 74,013 72,967 59,666 Maintenance 31,405 27,878 13,664 Depreciation 13,707 13,253 11,800 Decommissioning expense (note 2) 11,315 10,649 8,065 Taxes on income (note 10) 3,777 3,401 3,485 Property and other taxes 9,961 10,227 10,294 ________ ________ ________ Total operating expenses 163,704 159,615 131,838 ________ ________ ________ Operating income 16,441 16,304 19,884 ________ ________ ________ Other income and (deductions): Net earnings on decommissioning fund (notes 2 and 5) 5,653 5,395 4,423 Decommissioning expense (note 2) (5,653) (5,395) (4,423) Allowance for equity funds used during construction 92 89 124 Interest 1,550 2,046 1,377 Taxes on other income (note 10) (623) (756) (447) Other, net (232) (199) (917) ________ ________ ________ 787 1,180 137 ________ ________ ________ Income before interest expense 17,228 17,484 20,021 ________ ________ ________ Interest expense: Interest on long-term debt 7,281 7,101 7,684 Interest on disposal costs of spent nuclear fuel (note 8) 2,450 2,801 4,312 Allowance for borrowed funds used during construction (297) (339) (465) ________ ________ ________ Total interest expense 9,434 9,563 11,531 ________ ________ ________ Net income 7,794 7,921 8,490 Retained earnings at beginning of year 1,178 1,166 1,982 ________ ________ ________ 8,972 9,087 10,472 Dividends declared 7,905 7,909 9,306 ________ ________ ________ Retained earnings at end of year $ 1,067 $ 1,178 $ 1,166 ======== ======== ======== Average number of shares outstanding in thousands 392 392 394 ======== ======== ======== Net income per average share of common stock outstanding $ 19.86 $ 20.18 $ 21.56 ======== ======== ======== Dividends per average share of common stock outstanding $ 20.14 $ 20.15 $ 23.71 ======== ======== ======== See accompanying notes to financial statements. Statements of Cash Flows Years ended December 31, ------------------------ 1993 1992 1991 ---- ---- ---- (Dollars in thousands) Cash flows from operating activities: Net income $ 7,794 $ 7,921 $ 8,490 ________ ________ ________ Adjustments to reconcile net income to net cash provided by operating activities: Amortization of nuclear fuel 15,410 18,143 21,002 Depreciation 13,707 13,253 11,800 Decommissioning expense 11,315 10,649 8,065 Deferred tax expense (979) (2,169) (801) Amortization of deferred investment tax credit (577) (641) (740) Nuclear fuel disposal fee interest accrual 2,450 2,802 4,312 Interest and dividends on disposal fee defeasance fund (1,402) (1,385) (1,495) (Increase) decrease in accounts receivable 1,365 688 (129) (Increase) decrease in prepaid expenses 432 (1,159) 163 (Increase) in materials and supplies inventory (219) (454) (1,531) Increase (decrease) in accounts payable and accrued liabilities 4,846 (7,453) 5,495 Increase (decrease) in interest and taxes payable (605) 306 (760) Other (1,228) (1,410) (1,665) ________ ________ ________ Total adjustments 44,515 31,170 43,716 ________ ________ ________ Net cash provided by operating activities 52,309 39,091 52,206 ________ ________ ________ Cash flows from investing activities: Electric plant additions (7,229) (10,750) (6,596) Nuclear fuel additions (18,303) (4,707) (18,444) Payments to decommissioning fund (11,250) (10,612) (8,323) Payments to disposal fee defeasance fund (8,190) (5,190) (8,216) ________ ________ ________ Net cash used in investing activities (44,972) (31,259) (41,579) ________ ________ ________ Cash flows from financing activities: Dividend payments (7,905) (7,909) (9,306) Purchase of treasury stock --- --- (1,131) Issuance of Series H first mortgage bonds, net --- --- 10,374 Issuance of Series I first mortgage bonds, net 75,125 --- --- Retirement of first mortgage bonds including redemption costs (74,629) (6,521) (13,178) Payments of long-term obligations (137,911) (107,763) (53,419) Borrowings under long-term agreements 138,410 111,215 53,798 ________ ________ ________ Net cash used in financing activities (6,910) (10,978) (12,862) ________ ________ ________ Net increase (decrease) in cash and temporary investments 427 (3,146) (2,235) Cash and temporary investments at beginning of year 1,922 5,068 7,303 ________ ________ ________ Cash and temporary investments at end of year $ 2,349 $ 1,922 $ 5,068 ======== ======== ======== See accompanying notes to financial statements. Notes to Financial Statements NOTE 1. Summary of Significant Accounting Policies (a) Regulations and Operations Vermont Yankee Nuclear Power Corporation ("the Company") is subject to regulations prescribed by the Federal Energy Regulatory Commission ("FERC"), and the Public Service Board of the State of Vermont with respect to accounting and other matters. The Company is also subject to regulation by the Nuclear Regulatory Commission ("NRC") for nuclear plant licensing and safety, and by federal and state agencies for environmental matters such as air quality, water quality and land use. Prior to November, 1993, the Company was subject to regulation by the Securities and Exchange Commission. As a result of the debt refinancing discussed in note 6, the Company is no longer subject to such regulation. The Company recognizes revenue pursuant to the terms of the Power Contracts and Additional Power Contracts. The Sponsors, a group of nine New England utilities, are severally obligated to pay the Company each month their entitlement percentage of amounts equal to the Company's total fuel costs and operating expenses of its Plant, plus an allowed return on equity (since December 1, 1989, 12.25%). Such contracts also obligate the Sponsors to make decommissioning payments through the end of the Plant's service life and the completion of the decommissioning of the Plant. All Sponsors are committed to such payments regardless of the Plant's operating level or whether the Plant is out of service during the period. Under the terms of the Capital Funds Agreements, the Sponsors are committed, subject to obtaining necessary regulatory authorizations, to make funds available to obtain or maintain licenses necessary to keep the Plant in operation. (b) Depreciation and Maintenance Electric plant is being depreciated on the straight-line method at rates designed to fully depreciate all depreciable properties over the lesser of estimated useful lives or the Plant's remaining NRC license life, which extends to March, 2012. Depreciation expense was equivalent to overall effective rates of 3.74%, 3.56% and 3.23% for the years 1993, 1992 and 1991, respectively. Renewals and betterments constituting retirement units are charged to electric plant. Minor renewals and betterments are charged to maintenance expense. When properties are retired, the original cost, plus cost of removal, less salvage, is charged to the accumulated provision for depreciation. (c) Amortization of Nuclear Fuel The cost of nuclear fuel is amortized to expense based on the rate of burn-up of the individual assemblies comprising the total core. The Company also provides for the costs of disposing of spent nuclear fuel at rates specified by the United States Department of Energy ("DOE") under a contract for disposal between the Company and the DOE. The Company amortizes to expense on a straight-line basis the estimated costs of the final unspent nuclear fuel core, which is expected to be in place at the expiration of the Plant's NRC operating license in conformity with rates authorized by the FERC. (d) Amortization of Materials and Supplies The Company amortizes to expense a formula amount designed to fully amortize the cost of the material and supplies inventory that is expected to be on hand at the expiration of the Plant's NRC operating license. (e) Long-term Funds The Company accounts for its investments in long-term funds at amortized cost since it has both the intent and ability to hold these investments for the foreseeable future. Amortized cost represents the cost to purchase the investment, net of any unamortized premiums or discounts. (f) Amortization of Gain and Loss on Reacquired Debt The difference between the amount paid upon reacquisition of any debt security and the face value thereof, plus any unamortized premium, less any related unamortized debt expense and reacquisition costs, or less any unamortized discount, related unamortized debt expense and reacquisition costs applicable to the debt redeemed, retired and canceled, is deferred by the Company and amortized to expense on a straight-line basis over the remaining life of the applicable security issues. (g) Allowance for Funds Used During Construction Allowance for funds used during construction ("AFUDC") is the estimated cost of funds used to finance the Company's construction work in progress and nuclear fuel in process which is not recovered from the Sponsors through current revenues. The allowance is not realized in cash currently, but under the Power Contracts, the allowance will be recovered in cash over the Plant's service life through higher revenues associated with higher depreciation and amortization expense. AFUDC was capitalized at overall effective rates of 5.92%, 6.82% and 6.98% for 1993, 1992 and 1991, respectively, using the gross rate method. (h) Decommissioning The Company is accruing the estimated costs of decommissioning its Plant over the Plant's remaining NRC license life. Any amendments to these estimated costs are accounted for prospectively. (i) Taxes on Income Effective January 1, 1993, the Company began accounting for taxes on income under the liability method required by Statement of Financial Accounting Standard 109. See Note 10 for a further discussion of this change in accounting. Investment tax credits have been deferred and are being amortized to income over the lives of the related assets. (j) Cash Equivalents For purposes of the Statements of Cash Flows, the Company considers all highly liquid short-term investments with an original maturity of three months or less to be cash equivalents. (k) Reclassifications Certain information in the 1992 and 1991 financial statements has been reclassified to conform with the 1993 presentation. (l) Earnings per Common Share Earnings per common share have been computed by dividing earnings available to common stock by the weighted average number of shares outstanding during the year. NOTE 2. Decommissioning The Company accrues estimated decommissioning costs for its nuclear plant over its remaining NRC licensed life based on studies by an independent engineering firm that assumes that decommissioning will be accomplished by the prompt removal and dismantling method. This method requires that radioactive materials be removed from the plant site and that all buildings and facilities be dismantled immediately after shutdown. Studies estimate that approximately six years would be required to dismantle the Plant at shutdown, remove wastes and restore the site. The Company has implemented rates based on a settlement agreement with the FERC which allowed $190 million, in 1988 dollars, as the estimated decommissioning cost. This allowed amount is used to compute the Company's liability and billings to the Sponsors. Based on an assumed inflation rate of 6% per annum and an expiration of the Plant's NRC operating license in 2012, the estimated current cost of decommissioning is $253 million and, at the end of 2012, is approximately $769 million. The present value of the pro rata portion of decommissioning costs recorded to date is $134.6 million. On December 31, 1993, the balance in the Decommissioning Trust was $98.9 million. Billings to Sponsors for estimated decommissioning costs commenced during 1983, at which time the Company recorded a deferred charge for the present value of decommissioning costs applicable to operations of the Plant for prior periods. Current period decommissioning costs not funded through billings to Sponsors or earnings on decommissioning fund assets are also deferred. These deferred costs will be amortized to expense as they are funded over the remaining life of the NRC operating license. In 1994, the Company must file a revised estimate of decommissioning costs and a revised schedule of future annual decommissioning fund collections reflecting the historical differences between assumed and actual rates of inflation and the historical differences between assumed and actual rates of earnings on decommissioning fund assets. Filings are required to be made within four years of the most recent FERC approval of decommissioning cost estimates and rates. Cash received from Sponsors for plant decommissioning costs is deposited into the Vermont Yankee Decommissioning Trust in either the Qualified Fund (i.e., amounts currently deductible pursuant to the IRS regulations) or the Nonqualified Fund (i.e., excess collections pursuant to FERC authorization which are not currently deductible). Funds held by the Trust are invested in high-grade U.S. government securities and municipal obligations. Interest earned by the Decommissioning Trust assets is recorded in other income and deductions, with an equal and offsetting amount representing the current period decommissioning cost funded by such earnings reflected as decommissioning expense. Decommissioning expense for 1991 included an adjustment of approximately $2.1 million resulting from the Company's rate reduction filing approved by the FERC on February 28, 1991 as discussed in Note 3. NOTE 3. FERC Rate Case Matters On April 27, 1989, Vermont Yankee filed an application with the NRC to extend the term of the operating license from 2007 to 2012 so that the Plant may operate for 40 years after it entered commercial service in 1972. On December 17, 1990, the NRC issued an amendment to the operating license extending its term to March 21, 2012. The Company submitted a rate reduction filing with the FERC to reflect in rates the adjustments to decommissioning, depreciation and amortization resulting from the license extension. The Company proposed to make this reduction effective as of March 1, 1991 and, since the extension was issued in 1990, to reflect the necessary adjustment for the period January 1, 1990 through February 28, 1991. On February 28, 1991, the FERC approved the Company's rate reduction filing. The effects of this ruling were accounted for prospectively in fiscal 1991, producing a net revenue reduction ofapproximately $7.4 million in 1991, which reflected the retroactive treatment to January 1, 1990. This ruling resulted in reduced revenue requirements of approximately $3.5 million for both 1992 and 1993, and similar reductions are expected in future years. On March 26, 1993, the FERC initiated a review of the return on common equity component of the formula rates included in the Company's Power Contracts. On October 22, 1993, the FERC approved a settlement whereby the Company retained its 12.25% authorized rate of return on common equity and agreed to credit monthly power billings by approximately $139,000 beginning in June, 1993. In 1994, the Company will submit a rate filing to the FERC which will include, among other things, a revised estimate of decommissioning costs and a revised schedule of future annual decommissioning fund collections. NOTE 4. Other Deferred Charges and Credits In October, 1992, Congress passed the Energy Policy Act of 1992 which requires, among other things, that certain utilities help pay for the cleanup of the DOE's enrichment facilities over a 15- year period. The Company's annual fee is estimated based on the historical share of enrichment service provided by the DOE and is indexed to inflation. These fees will not be adjusted for future business as the DOE's future cost of sales will include a decontamination and decommissioning component. The Act stipulates that the annual fee shall be fully recoverable in rates in the same manner as other fuel costs. In 1993, the DOE billed and the Company paid the first of the 15 annual fees. As of December 31, 1993, the Company has recognized a current accrued liability of $2.6 million for the two fee payments expected to be made in 1994, a deferred credit of $16.0 million for the 12 annual fee payments that are due subsequent to 1994 and a corresponding regulatory asset of $18.6 million which represents the total amount includable in future billings to the purchasers under the Power Contracts. While these amounts are reflected in these financial statements, the Company is reviewing the DOE's calculation of the annual fee and believes that the annual fee will ultimately be reduced. Approximately $2.1 and $3.3 million of the $3.6 and $5.0 million in other deferred charges at December 31, 1993 and 1992, respectively, relate to payments made to the Vermont Low Level Radioactive Waste Authority ("VLLRWA"), an agency of the State of Vermont for the siting and construction of a low-level waste disposal facility. NOTE 5. Long-term Funds The book value and estimated market value of long-term fund investment securities at December 31, is as follows: At December 31, 1993 and 1992, gross unrealized gains and losses pertaining to the long-term investment securities were as follows: 1993 1992 ---- ---- (Dollars in thousands) Unrealized gains on U.S. Treasury obligations $ 1,431 $ 1,071 ------- ------- Unrealized losses on U.S. Treasury obligations $ (27) $ (4) ------- ------- Unrealized gains on Municipal obligations $ 4,843 $ 1,895 ------- ------- Unrealized losses on Municipal obligations $ (22) $ (27) ------- ------- Unrealized losses on corporate bonds and notes $ (112) $ (170) ------- ------- Maturities of short-term obligations, bonds and notes (face amount) at December 31, 1993 are as follows (dollars in thousands): Within one year $ 42,200 Two to five years 16,977 Five to seven years 19,670 Over seven years 57,860 _______ $136,707 ======= NOTE 6. Long-term Obligations A summary of long-term obligations at December 31, 1993 and 1992 is as follows: 1993 1992 ---- ---- (Dollars in thousands) First mortgage bonds: Series B - 8.50% due 1998 $ --- $ 1,307 Series C - 7.70% due 1998 --- 1,612 Series D - 10.125% due 2007 --- 23,147 Series E - 9.875% due 2007 --- 5,703 Series F - 9.375% due 2007 --- 5,704 Series G - 8.94% due 1995 --- 25,000 Series H - 8.25% due 1996 --- 8,388 Series I - 6.48% due 2009 75,845 --- ______ ______ Total first mortgage bonds 75,845 70,861 Eurodollar Agreement Commercial Paper 3,791 3,292 Unamortized premium on debt --- 40 ______ ______ Total long-term obligations $79,636 $74,193 ====== ====== The first mortgage bonds are issued under, have the terms and provisions set forth in, and are secured by an Indenture of Mortgage dated as of October 1, 1970 between the Company and the Trustee, as modified and supplemented by 13 supplemental indentures. All bonds are secured by a first lien on utility plant, exclusive of nuclear fuel, and a pledge of the Power Contracts and the Additional Power Contracts (except for fuel payments) and the Capital Funds Agreements with Sponsors. On July 1, 1993, the Company retired the outstanding Series B and Series C first mortgage bonds. In November, 1993, the Company issued $75.8 million of Series I, first mortgage bonds stated to mature on November 1, 2009. The Company applied the proceeds of the bond issuance principally to retire the remaining Series D, Series E, Series F, Series G and Series H first mortgage bonds including call premiums totalling $3.7 million based on the early redemption of the bonds. Cash sinking fund requirements for the Series I first mortgage bonds are $5.4 million annually beginning in November, 1999. The Company has a $75.0 million Eurodollar Credit Agreement that expires on December 31, 1995 subject to three optional one-year extensions. The Company issued commercial paper under this agreement with weighted average interest rates of 3.22% for 1993 and 3.95% for 1992. Payment of the commercial paper is supported by the Eurodollar Credit Agreement, which is secured by a second mortgage on the Company's generating facility. NOTE 7. Disclosures About the Fair Value of Financial Instruments The carrying amounts for cash and temporary investments, trade receivables, accounts receivable from sponsors, accounts payable and accrued liabilities approximate their fair values because of the short maturity of these instruments. The fair values of long-term funds are estimated based on quoted market prices for these or similar investments. The fair values of each of the Company's long-term debt instruments are estimated based on the quoted market prices for the same or similar issues, or on the current rates offered to the Company for debt of the same remaining maturities. The estimated fair value of the Company's financial instruments as of December 31 are summarized as follows (dollars in thousands): 1993 1992 ---- ---- Carrying Estimated Carrying Estimated Amount Fair Value Amount Fair Value -------- ---------- -------- ---------- Decommissioning fund $98,880 $105,105 $82,091 $85,026 Disposal fee defeasance fund 43,484 43,372 33,892 33,722 Long-term debt 79,636 77,361 74,193 78,235 Disposal fee and accrued interest 80,688 80,688 78,239 78,239 Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instrument. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates. NOTE 8. Disposal Fee for Spent Nuclear Fuel The Company has a contract with the United States Department of Energy ("DOE") for the permanent disposal of spent nuclear fuel. Under the terms of this contract, in exchange for the one-time fee discussed below and a quarterly fee of 1 mil per kwh of electricity generated and sold, the DOE agrees to provide disposal services when a facility for spent nuclear fuel and other high-level radioactive waste is available, which is required by current statute to be prior to January 31, 1998. The DOE contract obligates the Company to pay a one-time fee of approximately $39.3 million for disposal costs for all spent fuel discharged through April 7, 1983. Although such amount has been collected in rates from the Sponsors, the Company has elected to defer payment of the fee to the DOE as permitted by the DOE contract. The fee must be paid no later than the first delivery of spent nuclear fuel to the DOE. Interest accrues on the unpaid obligation based on the thirteen-week Treasury Bill rate and is compounded quarterly. Through 1993, the Company deposited approximately $37.5 in an irrevocable trust to be used exclusively for defeasing this obligation at some future date, provided the DOE complies with the terms of the aforementioned contract. On December 31, 1991, the DOE issued an amended final rule modifying the Standard Contract for Disposal of Spent Nuclear Fuel and/or High-level Radioactive Waste. The amended final rule conforms with a March 17, 1989 ruling of the U.S. Court of Appeals for the District of Columbia that the 1 mil per kilowatt hour fee in the Standard Contract should be based on net electricity generated and sold. The impact of the amendment on the Company was to reduce the basis for the fee by 6% on an ongoing basis and to establish a receivable from the DOE for previous overbillings and accrued interest. The Company has recognized in its rates the full impact of the amended final rule to the Standard Contract. The DOE is refunding the overpayments, including interest, to utilities over a four-year period ending in 1995 via credits against quarterly payments. Interest is based on the 90-day Treasury Bill Auction Bond Equivalent and will continue to accrue on amounts remaining to be credited. At December 31, 1993 and 1992, respectively, approximately $0.9 and $1.6 million in principal and interest is reflected in other accounts receivable. NOTE 9. Short-term Borrowings The Company had lines of credit from various banks totalling $6.3 million at December 31, 1993 and 1992. The maximum amount of short-term borrowings outstanding at any month-end during 1993, 1992 and 1991 was approximately $0.2 million, $0.6 million and $0.4 million, respectively. The average daily amount of short-term borrowings outstanding was approximately $0.3 million for 1993, and $0.1 million for 1992 and 1991 with weighted average interest rates of 5.75% in 1993, 6.12 % in 1992 and 8.19% in 1991. There were no amounts outstanding under these lines of credit as of December 31, 1993 and 1992. NOTE 10. Taxes on Income In February, 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes", which required the Company to change from the deferred method to the liability method of accounting for income taxes on January 1, 1993. The liability method accounts for deferred income taxes by applying enacted statutory rates in effect at the balance sheet date to differences between the book basis and the tax basis of assets and liabilities ("temporary differences"). This new statement requires recognition of deferred tax liabilities for (a) income tax benefits associated with timing differences previously passed on to customers and (b) the equity component of allowance for funds used during construction, and of a deferred tax asset for the tax effect of the accumulated deferred investment tax credits. It also requires the adjustment of deferred tax liabilities or assets for an enacted change in tax laws or rates, among other things. Although adoption of this new statement has not and is not expected to have a material impact on the Company's cash flow, results of operations or financial position because of the effect of rate regulation, the Company was required to recognize an adjustment to accumulated deferred income taxes and a corresponding regulatory asset or liability to customers (in amounts equal to the required deferred income tax adjustment) to reflect the future revenues or reduction in revenues that will be required when the temporary differences turn around and are recovered or settled in rates. In addition, this new statement required a reclassification of certain deferred income tax liabilities to liabilities to customers in order to reflect the Company's obligation to flow back deferred income taxes provided at rates higher than the current 35% federal tax rate. The Company has applied the provisions of this new statement without restating prior year financial statements. The components of income tax expense for the years ended December 31, 1993, 1992 and 1991 are as follows: 1993 1992 1991 ---- ---- ---- (Dollars in thousands) Taxes on operating income: Current federal income tax $ 4,236 $ 4,926 $ 4,003 Deferred federal income tax (1,059) (1,840) (1,285) Current state income tax 1,097 1,285 1,024 Deferred state income tax 80 (329) 483 Investment tax credit adjustment (577) (641) (740) ______ ______ ______ 3,777 3,401 3,485 ______ ______ ______ Taxes on other income: Current federal income tax 496 598 353 Current state income tax 127 158 94 ______ ______ ______ 623 756 447 ______ ______ ______ Total income taxes $ 4,400 $ 4,157 $ 3,932 ====== ====== ====== A reconciliation of the Company's effective income tax rates with the federal statutory rate is as follows: 1993 1992 1991 ---- ---- ---- Federal statutory rate 35.0% 34.0% 34.0% State income taxes, net of federal income tax benefit 6.9 6.1 6.1 Investment credit (4.7) (5.3) (6.0) Book depreciation in excess of tax basis 2.0 1.9 1.7 AFUDC equity 0.6 0.9 0.9 Flowback of excess deferred taxes (3.6) (3.1) (6.7) Other (0.1) (0.1) 1.7 ____ ____ ____ 36.1% 34.4% 31.7% ==== ==== ==== The items comprising deferred income tax expense are as follows: 1993 1992 1991 ---- ---- ---- (Dollars in thousands) Decommissioning expense not currently deductible $ (351) $ (104) $ 14 Tax depreciation over (under) financial statement depreciation (978) (679) 955 Tax fuel amortization over (under) financial statement amortization (255) (637) (1,389) Tax loss on reacquisition of debt over (under) financial statement expense 1,887 187 178 Pension expense not currently deductible (167) (192) (562) Postemployment benefits deduction over (under) financial statement expense 67 (141) --- Amortization of materials and supplies not currently deductible (335) (343) (239) Low-level waste deduction over (under) financial statement expense (596) 139 825 Flowback of excess deferred taxes (442) (376) (828) Other 191 (23) 245 ______ ______ ______ $ (979) $(2,169) $ (801) ====== ====== ====== The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 1993 and January 1, 1993 are presented below: The net periodic postretirement benefit cost for 1993 and 1992 includes the following components (dollars in thousands): For measurement purposes, a 15% annual rate of increase in the per capita cost of covered benefits (i.e., health care cost trend rate) was assumed for 1993; the rate was assumed to decrease gradually to 6% by the year 2001 and remain at that level thereafter. The health care cost trend rate assumption has a significant effect on the amounts reported. For example, increasing the assumed health care cost trend rates by one percentage point in each year would increase the accumulated postretirement benefit obligation as of December 31, 1993 by $2.2 million and the aggregate of the service and interest cost components of net periodic postretirement benefit cost for the year ended December 31, 1993 by $0.3 million. The weighted-average discount rate used in determining the accumulated postretirement benefit obligation was 7% at December 31, 1993. The change in the accumulated postretirement benefit obligation from $12.5 million in 1992 to $10.0 million in 1993 is the result of adjustments made to reflect a lower actual medical cost increase during 1993 than projected. The reduction in the unrecognized net transition obligation from $10.3 million in 1992 to $7.9 million in 1993 is primarily the result of elimination of Medicare Part B coverage. NOTE 14. Lease Commitments The Company leases equipment and systems under noncancelable operating leases. Charges against income for rentals under these leases were approximately $3.7 million, $2.6 million and $3.7 million in 1993, 1992 and 1991, respectively. Minimum future rentals as of December 31, 1993 are as follows: Fiscal years ended Annual rentals - ------------------ -------------- (Dollars in thousands) 1994 $3,283 1995 3,060 1996 2,878 1997 2,798 1998 and after 5,053 The Company has entered into an agreement with General Electric Capital Corporation to lease certain equipment being constructed by General Electric Corporation valued at approximately $29 million including installation costs. Under the lease agreement, the Company will make 120 monthly payments of $342,358 per month commencing on the later of (1) April 15, 1995 or (2) the commissioning date of the equipment. The lease will also include the sale and leaseback of a $2 million turbine rotor forging previously owned by the Company. The lease will be classified as an operating lease for accounting purposes. The construction contract requires progress payments to be paid by Vermont Yankee prior to installation of the equipment. Just prior to delivery of the equipment, the lessor will reimburse Vermont Yankee for these payments and will continue to make the remaining payments until the commencement date of the lease. During the time period subsequent to equipment delivery before the equipment is commissioned, the Company will pay interim rent to the lessor based on the amount of outstanding progress payments. The final documentation of the lease is currently being negotiated, and if a final agreement cannot be reached, the Company would be responsible for substantial termination payments. NOTE 15. Commitments and Contingencies Low-level Waste In February, 1993, the Vermont Public Service Board issued an order which requires the Company to pay its share of expenses incurred by the Vermont Low Level Radioactive Waste Authority for the period April, 1993 through June, 1994, currently capped at $4.5 million. In addition, in accordance with Vermont Act 296, the order established a fund for the long-term care of any eventual Vermont low-level waste disposal facility. Based on this order, the Company must make annual payments of approximately $0.8 million into the long-term care fund. Payments made to the VLLRWA, not pertaining directly to the siting and construction of a low-level waste disposal facility, are being expensed currently. In parallel with siting a low-level radioactive waste facility in Vermont, there has been a three-state effort between Vermont, Maine, and Texas to form a compact to site such a facility in Texas. The Texas Legislature has approved, and Governor Ann Richards of Texas has signed into law, a bill that would form such a compact. On November 2, 1993, Maine voters ratified the compact. Early during its 1994 session, the Vermont Legislature is scheduled to vote to approve entry into the compact. Following approval by the Vermont Legislature, the compact will require approval of the U.S. Congress. If the compact is successful and proceeds on schedule, Vermont Yankee would begin sending its waste to a Texas facility during 1997. Under the proposed compact, Vermont would pay the State of Texas $25 million ($12.5 million when the U.S. Congress ratifies the compact and $12.5 million when the facility opens). In addition, Vermont must pay $2.5 million ($1.25 million when Congress ratifies the compact and $1.25 million when the facility is licensed) for community assistance projects in Hudspeth County, Texas, where the facility is to be located. Vermont would also pay one-third of the Texas Low-Level Radioactive Waste Disposal Compact Commission's expenses until the facility opens. The Disposal fees for generators in Vermont and Maine would then be set at a level that is the same for generators in Texas. The Company anticipates recovering the costs of the compact from sponsors. Nuclear Fuel The Company has approximately $165 million of "requirements based" purchase contracts for nuclear fuel needs to meet substantially all of its power production requirements through 2002. Under these contracts, any disruption of operating activity would allow the Company to cancel or postpone deliveries until actually needed. Insurance The Price-Anderson Act, as amended, currently limits public liability from a single incident at a nuclear power plant to $9.4 billion. Any damages beyond $9.4 billion are indemnified under an agreement with the NRC, but subject to Congressional approval. The first $200 million of liability coverage is the maximum provided by private insurance. The Secondary Financial Protection program is a retrospective insurance plan providing additional coverage up to $9.2 billion per incident by assessing retrospective premiums of $79.3 million against each of the 116 reactor units that are currently subject to the Program in the United States, limited to a maximum assessment of $10 million per incident per nuclear unit in any one year. The maximum assessment is to be adjusted at least every five years to reflect inflationary changes. The above insurance covers all workers employed at nuclear facilities prior to January 1, 1988, for bodily injury claims. The Company has purchased a Master Worker insurance policy with limits of $200 million with one automatic reinstatement of policy limits to cover workers employed on or after January 1, 1988. Vermont Yankee's estimated contingent liability for a retrospective premium on the Master Workers policy as of December, 1993 is $3.1 million. The Secondary Financial Protection program referenced above provides coverage in excess of the Master Worker policy. Insurance has been purchased from Nuclear Electric Insurance Limited (NEIL II) to cover the costs of property damage, decontamination or premature decommissioning resulting from a nuclear incident. All companies insured with NEIL II are subject to retroactive assessments if losses exceed the accumulated funds available to NEIL II. The maximum potential assessment against the Company with respect to losses arising during the current policy year is $5.8 million at the time of a first loss and $12.3 million at the time of a subsequent loss. The Company's liability for the retrospective premium adjustment for any policy year ceases six years after the end of that policy year unless prior demand has been made. VERMONT YANKEE NUCLEAR POWER CORPORATION Schedule I Marketable Securities - Other Investments VERMONT YANKEE NUCLEAR POWER CORPORATION Schedule V - Property, Plant and Equipment Years Ended December 31, 1993, 1992, and 1991 ($000) 1993 1992 1991 ---- ---- ---- Electric Plant: Land and land rights $ 1,397 $ 1,127 $ 984 Structures and improvements 61,887 61,868 61,515 Reactor, turbogenerator and accessory equipment 304,388 292,561 285,808 Transmission equipment 5,948 5,606 6,141 Other 1,116 1,116 1,116 Construction work in progress 597 6,408 4,188 _______ _______ _______ 375,333 368,686 359,752 _______ _______ _______ Nuclear Fuel: Assemblies in reactor 69,063 74,025 83,213 Fuel in process --- 5,236 637 Fuel in stock --- --- 22,863 Spent fuel 287,700 259,199 227,040 _______ _______ _______ 356,763 338,460 333,753 _______ _______ _______ Total $732,096 $707,146 $693,505 ======= ======= ======= Neither total additions of $25,361,000, $15,167,000 or $25,002,000 nor total retirements of $411,000, $1,526,000, or $0 for the years ended December 31, 1993, 1992 and 1991, respectively, exceeded 10% of the utility plant balance at the end of the year. VERMONT YANKEE NUCLEAR POWER CORPORATION Schedule VI - Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment Years Ended December 31, 1993, 1992 and 1991 (Dollars in Thousands) EXHIBIT 23-a-2 CONSENT OF INDEPENDENT AUDITORS The Board of Directors Green Mountain Nuclear Power Corporation: We consent to the incorporation by reference in the Registration Statement on Form S-3, File No. 3-48882 and in the Registration Statement on Form S-8, File No. 33-47985, of our report dated February 5, 1993, relating to the balance sheet of Vermont Yankee Nuclear Power Corporation as of December 31, 1992 and the related statements of income and retained earnings and cash flows for each of the years in the two- year period ended December 31, 1992, which report is included in the December 31, 1993 Annual Report on Form 10-K of Green Mountain Power Corporation. Boston, Massachusetts March 28, 1994 KPMG Peat Marwick EXHIBIT 23-a-1 CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our reports dated February 1, 1994 included in this Form 10-K, into the Company's previously filed Registration Statement on Form S-3, File No. 33-48882, and into the Company's previously filed Registration Statement on Form S-8, File No. 33-47985. Boston, Massachusetts March 30, 1994 /s/ Arthur Andersen & Co. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Board of Directors of Green Mountain Power Corporation: We have audited, in accordance with generally accepted auditing standards, the consolidated financial statements of Green Mountain Power Corporation included in this Form 10-K and have issued our report thereon dated February 1, 1994. Our audit was made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed in the index on page 38 of this Form 10-K are the responsibility of the Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audit of the basic financial statements, and in our opinion, fairly state, in all material respects, the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. Boston, Massachusetts February 1, 1994 /s/ Arthur Andersen & Co.

1993 Item 1. BUSINESS Fleet Financial Group, Inc. (the "Registrant", "Corporation" or"Fleet") is a diversified financial services company organized under the laws of the State of Rhode Island. Fleet is a legal entity separate and distinct from its subsidiaries, assisting such subsidiaries by providing financial resources and management. By most measures, Fleet is among the 15 largest bank holding companies in the United States, with total assets of $47.9 billion at December 31, 1993. Fleet has approximately 26,000 employees. Fleet reported net income for 1993 of $488 million, or $3.01 per share. This compared to net income of $280 million, or $1.77 per share in 1992. For a more detailed discussion of the Corporation's financial results, refer to "Management's Discussion and Analysis" (pages 9-23) of the accompanying 1993 Annual Report to Shareholders which is hereby incorporated by reference. Banking Subsidiaries Fleet is engaged in a general commercial banking and trust business throughout the states of Rhode Island, New York, Connecticut, Massachusetts, Maine and New Hampshire through its banking subsidiaries, Fleet Bank of New York ("Fleet-Upstate"); Fleet Bank ("Fleet-Long Island"); Fleet National Bank ("Fleet-RI"); Fleet Bank, National Association ("Fleet-CT"); Fleet Bank of Massachusetts, National Association ("Fleet-MA"); Fleet Bank of Maine ("Fleet-Maine") and Fleet Bank-NH ("Fleet-NH"). All of the subsidiary banks are members of the Federal Reserve System, and the deposits of each are insured by the FDIC to the extent provided by law. Nonbanking Subsidiaries Fleet provides, through its nonbanking subsidiaries, a variety of financial services, including mortgage banking, asset-based lending, equipment leasing, consumer finance, real estate financing, credit related life and accident/health insurance, securities brokerage services, investment banking, investment advice and management, data processing, and student loan servicing. The following is a summary of these subsidiaries by line of business: Item 1. BUSINESS - (continued) Mortgage Banking Fleet Mortgage Group, Inc. ("FMG") is a Rhode Island corporation. FMG's mortgage banking business consists primarily of the origination, purchase, sale and servicing of residential first mortgage loans, and the purchase and sale of servicing rights associated with mortgage loans. In 1992, the Corporation sold a 19% interest in FMG, in a public offering of FMG's common stock. FMG currently ranks as the second largest mortgage servicer in the nation. It produces mortgage loans through its 91 retail branch offices located in 37 states and acquires mortgage loans through correspondent lenders, which originate mortgage loans pursuant to guidelines provided by FMG. FMG services a portfolio of approximately $70 billion in mortgage loans. Asset-Based Lending Fleet Credit Corporation ("Fleet Credit") engages primarily in middle market equipment leasing. Fleet Credit had total assets of $1.4 billion as of December 31, 1993, making it one of the largest bank-affiliated commercial finance leasing firms in the U.S. Fleet Credit operates 23 offices in 14 states. Fleet Factors Corporation ("Fleet Factors") is based in New York City, and engages in factoring and commercial finance for various industries, principally textiles, but also including hard goods and electronics. Fleet Factors had total assets of approximately $350 million at December 31, 1993. All of the outstanding common stock of Fleet Factors was sold on February 14, 1994. Consumer Finance Fleet Finance, Inc. ("Fleet Finance") located in Atlanta, Georgia, engages primarily in consumer lending and home equity lending operations through 130 offices in 22 states and underwrites credit life, accident and health insurance. Fleet Finance services a portfolio of approximately $2.3 billion in loans, primarily secured by residential real estate. (Information set forth in Note 16. Commitments, Contingencies, and Other Disclosures (page 47) of the accompanying 1993 Annual Report to Shareholders, which is hereby incorporated by reference, provides a description of certain litigation involving Fleet Finance, Inc.) Securities Brokerage Fleet Securities, Inc. is a full-service municipal securities underwriter and dealer providing services throughout New York and New England. Fleet Brokerage Securities, Inc., is engaged in providing securities brokerage services (including clearing services), related securities credit extension, and other incidental activities through offices in New York City and throughout the country. Fleet Brokerage operates 12 offices in 11 states. Trust and Investment Management Fleet Investment Services Group which has responsibility for overall management of the Corporation's trust activities provides personalized money management and a full range of trust services for individuals, large and small companies, religious and educational endowments and charitable organizations. In total, the Fleet trust operations manage or have under custody approximately $50 billion in assets. Item 1. BUSINESS - (continued) Fleet Investment Advisors Inc. located in Providence, Rhode Island handles investment policy matters and all personal and institutional portfolio management. Data Processing Fleet Services Corporation ("Fleet Services") was formed to consolidate the Corporation's previously existing data processing operations. Fleet Services' principal function is to provide data processing services for the banking and nonbanking subsidiaries of the Corporation. AFSA Data Corporation ("AFSA") provides student loan processing and portfolio management services for Federal Perkins and Federal Family student loans to over 700 colleges, universities, and financial institutions nationwide. AFSA is located in Long Beach, California and operates student loan processing centers in Lombard, IL and Utica, NY. AFSA services a portfolio of approximately $7 billion in student loans. Competition The Corporation's subsidiaries are subject to competition in all aspects of the businesses in which they compete from domestic and foreign banks, equipment leasing companies, finance companies, securities and investment advisory firms, real estate financing companies, mortgage banking companies, and other financial institutions. The Corporation principally competes on interest rates and other terms of financing arrangements, including specialized customer services and various banking arrangements and conveniences to attract depositors, borrowers, and other customers. The Corporation maintains a Products and Services Group to review existing programs and institute new services. Supervision and Regulation Banking is a highly regulated industry, with numerous federal and state laws and regulations governing the organization and operation of banks and their affiliates. As a bank holding company, Fleet is subject to regulation by the Board of Governors of the Federal Reserve Board (the "Federal Reserve Board") under the Bank Holding Company Act of 1956 (as amended) (the "BHCA"). Fleet-Maine, Fleet-NH, Fleet-Upstate and Fleet-Long Island as state-chartered member banks are subject to regulation by the Federal Reserve Board and bank regulators in their respective states. Fleet-CT, Fleet-MA and Fleet-RI are national banks subject to regulation and supervision by the Office of the Comptroller of the Currency (the "OCC"). Each subsidiary bank's deposits are insured by the Federal Deposit Insurance Corporation (FDIC) and each bank subsidiary is a member of the Federal Reserve System. Fleet is also subject to the reporting and other requirements of the Securities Exchange Act of 1934 (the "Exchange Act"). The BHCA requires that Fleet obtain prior approval from the Federal Reserve Board for bank and nonbank acquisitions and restricts the business operations permitted to Fleet. The BHCA also restricts the acquisition of shares of out-of-state banks unless the acquisition is specifically authorized by the laws of the state in which the bank to be acquired is located. In addition, Fleet's bank subsidiaries must obtain prior approval from their respective primary regulators for most acquisitions. Virtually all aspects of the subsidiary banks' businesses are subject to regulation and examination, depending on the charter of the particular banking subsidiary, by the Federal Reserve Board, the OCC, the banking regulatory agency of the state in which they operate, or a combination of the above. Item 1. BUSINESS - (continued) On December 19, 1991, the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") was signed into law. In general, FDICIA subjects banks to significantly increased regulation and supervision. Among other things, FDICIA requires federal bank regulatory authorities to take "prompt corrective action" in respect of banks that do not meet minimum capital requirements. FDICIA establishes five capital tiers: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized. Under the OCC's regulations, a bank is defined to be well capitalized if it maintains a risk-adjusted Tier I capital ratio of at least 6%, a risk-adjusted total capital ratio of at least 10% and a Tier I leverage ratio of at least 5%, and is not otherwise in a "troubled condition" as specified by its appropriate federal regulatory agency. A bank is defined to be adequately capitalized if it maintains a risk-adjusted Tier 1 ratio of at least 4%, a risk-adjusted total capital ratio of at least 8%, and a Tier 1 leverage ratio of at least 4% (3% for certain highly rated institutions), and does not otherwise meet the well capitalized definition. The three undercapitalized categories are based upon the amount by which the bank falls below the ratios applicable to adequately capitalized institutions. A depository institution may be deemed to be in a capitalization category that is lower than is indicated by its actual capital position if it receives an unsatisfactory examination rating. As of December 31, 1993, all of the Registrant's banking subsidiaries met the requirements of a "well capitalized" institution. Under FDICIA, a bank that is not well capitalized is generally prohibited from accepting brokered deposits and offering interest rates on deposits higher than the prevailing rate in its market; in addition, "pass through" deposit insurance coverage may not be available for certain employee benefit accounts. Adequately capitalized institutions may apply to the FDIC for a waiver of the prohibition against accepting brokered deposits. Undercapitalized banks are subject to limitations on growth, on their ability to borrow from the Federal Reserve System and on the payment of dividends and are required to submit a capital restoration plan. If a bank fails to submit an acceptable plan, it is treated as if it is significantly undercapitalized. Significantly undercapitalized banks may be subject to a number of requirements and restrictions, including orders to sell sufficient voting stock to become adequately capitalized, requirements to reduce total assets, and cessation of receipt of deposits from correspondent banks. Critically undercapitalized institutions (which are defined to include institutions which still have a positive net worth) are generally subject to the mandatory appointment of a receiver or conservator. FDICIA directs that each federal banking agency prescribe new safety and soundness standards for depository institutions and depository institution holding companies relating to internal controls, information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth compensation, a maximum rate of classified assets to capital, minimum earnings sufficient to absorb losses, a minimum ratio of market value to book value for publicly traded shares and other standards which the agencies deem appropriate. The federal banking regulators recently issued a joint proposal to implement such standards. In general, the standards are expected to increase the regulatory burden and expense of conducting the banking business. FDICIA also contains a variety of other provisions that may affect Fleet's operations, including new reporting requirements, regulatory standards for real estate lending, "truth in savings" provisions, and the requirements that a depository institution give 90 days' prior notice to customers and regulatory authorities before closing any branch. Fleet does not expect the application of the standards to have a material adverse effect on its business. The OCC and the Federal Reserve Board have each issued guidelines which impose upon national banks and state banks, that are members of the Federal Reserve System, risk-based capital and leverage standards. The risk-based capital ratio guidelines are based on an international agreement developed by the Basle Committee of Banking Regulations and Supervisory Practices, which consists of representatives of central banks and supervisory authorities in 12 countries, including the United States and the United Kingdom. The guidelines establish a systematic analytical framework that makes regulatory capital requirements more sensitive to differences in risk Item 1. BUSINESS - (continued) profiles among banking organizations, takes off-balance sheet exposure into explicit account in assessing adequacy, and minimizes disincentives to holding liquid, low-risk assets. The risk-based ratio is determined by allocating assets and specified off-balance sheet commitments into four weighted categories, with higher levels of capital being required for categories perceived as representing greater risk. Under these guidelines, a bank's capital is divided into two tiers. The first tier includes common equity, non-cumulative perpetual preferred stock (excluding auction rate issues) and minority interests in equity accounts of consolidated subsidiaries less ineligible intangible assets. Supplementary (Tier 2) capital includes, among other items, cumulative and limited life preferred stock, mandatory convertible securities, subordinated debt and the allowance for loan and lease losses, subject to certain limitations. National banks and state-chartered member banks are required to maintain a minimum total risk-based capital ratio of 8%, of which at least half must be Tier I capital. The OCC and the Federal Reserve Board may, however, set higher capital requirements for an individual bank when the bank's particular circumstances warrant. In addition to the risk-based capital standard, national banks and state-chartered member banks are also subject to a leverage capital standard, with a numerator consisting of Tier I capital a denominator consisting of total assets (as defined by the OCC's and the Federal Reserve Board's rules). The OCC and the Federal Reserve Board established a 3% minimum Tier I leverage ratio applicable only to banks meeting certain specified criteria, including excellent asset quality, high liquidity, low interest rate exposure, and the highest regulatory rating. Institutions not meeting these criteria are expected to maintain a ratio which exceeds the 3% minimum by at least 100 to 200 basis points. Failure to meet applicable capital guidelines could subject a bank to a variety of enforcement remedies available to the federal regulatory authorities, including limitations on the ability to pay dividends, the issuance by the appropriate bank regulatory agency of a capital directive to increase capital, the termination of deposit insurance by the FDIC, and (in severe cases) the appointment of a conservator or receiver. In September 1993, the OCC and the Federal Reserve Board, in conjunction with the FDIC, issued proposed revisions to their risk-based capital regulations which provide for consideration of interest rate risk in the overall determination of a bank's minimum capital requirement. The intended effect of the proposal would be to ensure that banking institutions effectively measure and monitor their interest rate risk and that they maintain adequate capital for that risk. Under the proposal, an institution's exposure to interest rate risk would be measured using either a supervisory model, developed by the federal bank regulatory agencies, or the bank's own internal model. An institution that exceeds the threshold level of interest rate risk established by its primary federal regulator would be required to allocate additional capital to cover such exposure. If such additional capital was not available to be allocated, such institution would be required to raise additional capital. Pursuant to certain provisions of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 ("FIRREA"), an insured depository institution which is commonly controlled with another insured depository institution is generally liable for any loss incurred, or reasonably anticipated to be incurred, by the FDIC in connection with the default of such commonly controlled institution, or any assistance provided by the FDIC to such commonly controlled institution, which is in danger of default. The term "default" is defined to mean the appointment of a conservator or receiver for such institution. Thus, each subsidiary bank could incur liability to the FDIC pursuant to this statutory provision in the event of the default of any other subsidiary bank or any of the other insured depository institutions owned or controlled by the Corporation. Such liability is subordinated in right and payment to depository liabilities, secured obligations, any other general or senior liability, and any obligation subordinated to depositors or other general creditors, other than obligations owed to any affiliate of the depository institution (with certain exceptions), and any obligations to shareholders in such capacity. Item 1. BUSINESS - (continued) In its resolution of the problems of an insured depository institution in default or in danger of default, the FDIC is obligated to satisfy its obligations to insured depositors at the least possible cost to the deposit insurance fund. In addition, the FDIC may not take any action that would have the effect of increasing the losses to a deposit insurance fund by protecting depositors for more than the insured portion of deposits (generally $100,000) or creditors other than depositors. FDICIA authorized the FDIC to settle all uninsured and unsecured claims in the insolvency of an insured bank by making a final settlement payment after the declaration of insolvency. Such a payment would constitute full payment and disposition of the FDIC's obligations to claimants. The rate of such final settlement payment is to be a percentage rate determined by the FDIC reflecting an average of the FDIC's receivership recovery experience. On August 10, 1993, the President signed into law legislation which accords the claims of a receiver of an insured depository institution for administrative expenses and the claims of holders of deposit liabilities of such an institution (including the FDIC, as the subrogee of such holders) priority over the claims of general unsecured creditors of such an institution in the event of a liquidation or other resolution of such institution. Under an FDIC interim rule, which became effective August 13, 1993, "administrative expenses" of a receiver are defined as those incurred by a receiver in liquidating or resolving the affairs of a failed insured depository institution. Fleet is a legal entity separate and distinct from its subsidiaries. In addition to those discussed herein, there are various other statutory and regulatory limitations on the extent to which banking subsidiaries of Fleet can finance or otherwise transfer funds to Fleet or its nonbanking subsidiaries, whether in the form of loans, extensions of credit, investments, or asset purchases. Such transfers by any subsidiary bank to Fleet or any nonbanking subsidiary are limited in amount to 10% of the bank's capital and surplus and, with respect to Fleet and all such nonbanking subsidiaries, to an aggregate of 20% of each such bank's capital and surplus. Furthermore, loans and extensions of credit are required to be secured in specified amounts and are required to be on terms and conditions consistent with safe and sound banking practice. In addition, there are regulatory limitations on the payment of dividends directly or indirectly to Fleet from its banking subsidiaries. Under applicable banking statutes, at December 31, 1993, Fleet's banking subsidiaries could have paid additional dividends of approximately $417 million, of which $125 million and $95 million could have been paid by Fleet- MA and Fleet-CT, respectively. Federal and state regulatory agencies have the authority to limit further Fleet's banking subsidiaries' payment of dividends. The payment of dividends by any subsidiary bank may also be affected by other factors, such as the maintenance of adequate capital for such subsidiary bank. Further, holders of Fleet's Dual Convertible Preferred Stock are entitled to dividends equal to one-half of the total dividends declared (after the first $15 million in dividends) to Fleet, if any, on the common stock of Fleet Banking Group, the parent of Fleet-MA and Fleet-CT. Dividends on the Dual Convertible Preferred Stock, if accrued and unpaid, will be cumulative. Under the policies of the Federal Reserve Board, Fleet is expected to act as a source of financial strength to each subsidiary bank and to commit resources to support such subsidiary bank in circumstances where it might not do so absent such policy. In addition, any subordinated loans by Fleet to provide capital to any of the subsidiary banks would also be subordinate in right of payment to deposits and to certain other indebtedness of such subsidiary bank. The ability of holders of debt and equity securities of Fleet to benefit from the distribution of assets of any subsidiary upon the liquidation or reorganization of such subsidiary is subordinate to prior claims of creditors of the subsidiary except to the extent that a claim of Fleet as a creditor may be recognized. The banking industry is also affected by the monetary and fiscal policies of the federal government, including the Federal Reserve, which exerts considerable influence over the cost and availability of funds obtained for lending and investing. In addition, proposals to change the laws and regulations governing the operations and taxation of banks, companies that control banks, and other financial institutions are frequently raised in Congress, in the state legislatures and before various bank regulatory authorities. The likelihood of any major changes and the impact such changes might have on Fleet are impossible to determine. Item 1. BUSINESS - (continued) Reference is made to Note 16 Commitments, Contingencies, and Other Disclosures (pages 47-48) of the Notes to Consolidated Financial Statements and to the "Capital" and "Liquidity" sections of Management's Discussion and Analysis in the accompanying 1993 Annual Report to Shareholders for information concerning restrictions on the banking subsidiaries' ability to pay dividends and other regulatory matters and legal proceedings. Executive Officers of the Corporation The information required by this item is included in Item 10. Directors and Executive Officers of the Registrant on pages 11 through 12 of this Form 10-K. STATISTICAL INFORMATION BY BANK HOLDING COMPANIES The following information set forth in the accompanying 1993 Annual Report to Shareholders is hereby incorporated by reference: Consolidated Average Balances/Interest Earned-Paid/Rates 1989-1993 table (Page 52-53) for average balance sheet amounts, related taxable equivalent interest earned or paid, and related average yields and rates paid. Rate/Volume Analysis table (page 54) for changes in the taxable equivalent interest income and expense for each major category of interest-earning assets and interest-bearing liability. Note 3. Securities Available for Sale and Note 4. Investment Securities of the Notes to Consolidated Financial Statements (pages 32-34) for information regarding book values, market values, maturities and weighted average yields of securities (by category). Note 5. Loans and Leases of the Notes to the Consolidated Financial Statements (page 35) for distribution of loans of the Registrant. Loan and Lease Maturity table and Interest Sensitivity of Loans Over One Year table (page 54) for maturities and sensitivities of loans to changes in interest rates. Note 7. Nonperforming Assets (page 36) and Note 1. Summary of Significant Accounting Policies - Loans and Leases (page 30) of the Notes to Consolidated Financial Statements for information on nonaccrual, past due and restructured loans and the Registrant's policy for placing loans on nonaccrual status. "Loans and Leases" section of Management's Discussion and Analysis (pages 13-15 and 44-45) for information regarding loan concentrations of the Registrant. "Reserve for Credit Losses" section of Management's Discussion and Analysis (pages 17-18) for the analysis of loss experience, the allocation of the reserve for credit losses, and a description of factors which influenced management's judgment in determining the amount of additions to the allowance charged to operating expense. Consolidated Average Balances/Interest Earned-Paid/Rates 1989-1993 table (pages 52-53) and the "Deposits" section of Management's Discussion and Analysis (page 18) for deposit information. Selected Financial Highlights (page 1) for return on assets, return on equity, dividend payout ratio and equity to asset ratio. Item 1. BUSINESS - (continued) Note 8. Short-term Borrowings of the Notes to Consolidated Financial Statements (page 37) for information on short-term borrowings of the Registrant. Item 2. Item 2. PROPERTIES The Registrant maintains its corporate headquarters in Providence, Rhode Island, located in a building in which the Registrant has a partnership interest through a subsidiary. The subsidiary is a partner with certain other parties in the ownership and management of the building. Adjacent to the Providence headquarters building, Fleet-RI owns a building which houses the main branch of Fleet-RI and the offices of many of the Providence-based subsidiaries. Fleet-RI also owns an operations center, located in Providence. The Registrant also owns office buildings in Buffalo, NY and Albany, NY, which house operational facilities of Fleet-Upstate. Fleet-LI owns an office building in Melville, NY, which houses its headquarters. Portions of the Fleet-RI, Fleet-Upstate and Fleet-LI buildings are leased to nonaffiliates. As of December 31, 1993, the Registrant's subsidiaries also operated approximately 1,200 domestic offices, of which approximately 500 are owned and 700 are leased from others. The Registrant also leases office space in London. In general, all leases run from one to ten years and most contain options to renew. Item 3. Item 3. LEGAL PROCEEDINGS Information regarding legal proceedings of the Registrant is hereby incorporated by reference from Note 16. Commitments, Contingencies and Other Disclosures (pages 47-48) of the Registrant's accompanying 1993 Annual Report to Shareholders. Item 4. Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY-HOLDERS There were no matters submitted to a vote of security-holders in the fourth quarter. PART II. Item 5. Item 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS For information regarding the Registrant common stock's principal U.S. market, high and low quarterly sales prices, approximate number of holders, and quarterly dividends declared and paid, see the Common Stock Price and Dividend Information table (page 51) of the Registrant's accompanying 1993 Annual Report to Shareholders, which is hereby incorporated by reference. Item 6. Item 6. SELECTED FINANCIAL DATA The information set forth in Selected Financial Highlights (page 1) of the Registrant's accompanying 1993 Annual Report to Shareholders is hereby incorporated by reference. Item 7. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information set forth in Management's Discussion and Analysis (pages 9-23) of the Registrant's accompanying 1993 Annual Report to Shareholders is hereby incorporated by reference. Item 8. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The following information set forth in the Registrant's accompanying 1993 Annual Report to Shareholders is hereby incorporated by reference. The Consolidated Financial Statements together with the report thereon by KPMG Peat Marwick (pages 25-29); the Notes to the Consolidated Financial Statements (pages 30-50); and the unaudited information presented in the Quarterly Summarized Financial Information table (page 51). Item 9. Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE There were no changes in or disagreements with accountants on accounting and financial disclosure as defined by Item 304 of Regulation S-K. PART III. Item 10. Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information set forth under the caption "Election of Directors" (page 2-7) in the Registrant's Proxy Statement with respect to the name of each nominee or director, his age, his positions and offices with the Registrant, his service on the Registrant's Board, his business experience, his directorships held in other public companies, and certain family relationships is hereby incorporated by reference. The names, positions, ages and business experience during the past five years of the executive officers of the Corporation as of March 25, 1994 are set forth below. The term of office of each executive officer extends until the annual meeting of the Board of Directors, and until a successor is chosen and qualified or until they shall have resigned, retired, or have been removed. Terrence Murray joined Fleet-RI in 1962. After serving in various capacities for Fleet-RI and the Corporation, in April 1978, he was elected President of the Corporation and Fleet-RI. He is a Director of the Corporation, Fleet-RI and FMG. He became Chairman of the Board of Directors of the Corporation and Fleet-RI in May of 1982. Mr. Murray has been a Director of Fleet since 1976, a Director of Fleet-RI since 1977 and a Director of FMG since 1985. Upon the merger of Fleet and Norstar in January 1988, he became President and Chief Operating Officer of Fleet. Mr. Murray was elected Chairman and Chief Executive Officer of Fleet in September 1988. Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT - (continued) Robert J. Higgins joined Fleet-RI in 1971. In March 1984, he was named a Vice President of the Corporation. He was elected President in February 1986. In 1989, he was named an Executive Vice President of the Corporation and Chief Executive Officer of Fleet-RI. In 1991, Mr. Higgins was named President of Fleet-CT. In March 1993, he was named a Vice Chairman of the Corporation in charge of commercial banking. H. Jay Sarles joined Fleet-RI in 1968. In 1980, he was appointed a Vice President of the Corporation. Mr. Sarles was appointed Executive Vice President of the Corporation in February of 1986. In 1991, Mr. Sarles became President and Chief Executive Officer of Fleet Banking Group, the parent company of Fleet-MA and Fleet-CT. In March 1993, he was named a Vice Chairman of the Corporation in charge of investment services and administration. Michael R. Zucchini joined the Corporation in August 1987 as Executive Vice President and Chief Information Officer responsible for all data processing activities of the Corporation and its subsidiaries. Since 1974, Mr. Zucchini had served in various capacities for General RE Corp., Stamford, Connecticut and its subsidiary, General RE Services Corp., which engages in data processing. In March 1993, Mr. Zucchini was named a Vice Chairman of the Corporation in charge of consumer banking and operations. Eugene M. McQuade joined the Corporation in 1992 as Senior Vice President-Finance. From 1980 to 1991, Mr. McQuade served in various capacities with Manufacturers Hanover Corporation and Manufacturers Hanover Trust Company, having served as an Executive Vice President and Controller from 1985 to 1991. In March 1993, Mr. McQuade was named an Executive Vice President of the Corporation and in July 1993 was elected as Chief Financial Officer of the Corporation. James P. Murphy joined the Corporation in 1989 as an Executive Vice President and Director of Public Policy and External Relations. Before joining Fleet, Mr. Murphy had served as Executive Vice President of the New York State Bankers Association since March 1976. John B. Robinson, Jr., became an Executive Vice President of the Corporation in 1988. Mr. Robinson had been associated with Norstar Bank ("Norstar") since 1970 when he joined Hempstead Bank (now Fleet-LI). He served in various capacities with Norstar and in 1987, he became President of Norstar. Mr. Robinson is currently in charge of government banking. Peter C. Fitts joined the Corporation in May, 1991 as Senior Vice President-Credit Administration and is responsible for corporate-wide credit administration. In March 1994, Mr. Fitts was named senior credit officer for the Corporation. From 1965 to 1991, Mr. Fitts served in various capacities with Citibank, N.A., having last served as a Senior Vice President and Head of Credit Policy, North America, from 1985 to 1991. William C. Mutterperl joined Fleet-RI in 1977. In June 1985, Mr. Mutterperl was named Vice President, Secretary, and General Counsel of the Corporation. In 1989, Mr. Mutterperl was named a Senior Vice President of the Corporation. Anne M. Slattery joined the Corporation in January, 1994 as Senior Vice President and head of Consumer and Community Banking. From 1969 through 1993, Ms. Slattery served in various capacities with Citicorp, having last served as a managing director of U.S. Consumer Banking. Item 11. Item 11. EXECUTIVE COMPENSATION Pursuant to Instructions to Form 10-K and Item 402 of Regulation S-K, information set forth in the following sections of the Corporation's Proxy Statement (pages 7-18) are hereby incorporated by reference: "Committees of the Board of Directors", "Compensation Committee Interlocks and Insider Participation", "Compensation Committee Report on Executive Compensation", "Directors' Compensation", "Executive Compensation", "Option/SAR Grants in Last Fiscal Year", "Aggregated Option/SAR Exercises in Last Fiscal Year and FY Option/SAR Values", "Pension Plans", "Change in Control Contracts", and "Stockholder Return Performance Graph". Such incorporation by reference shall not be deemed to specifically incorporate by reference the information required by Item 402(a)(8) of Regulation S-K. Item 12. Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Pursuant to Instructions to Form 10-K and Item 403 of Regulation S-K, information set forth in the "Securities of the Corporation and Fleet Mortgage Group, Inc. Owned by Management" (page 9) of the Corporation's Proxy Statement is hereby incorporated by reference. Item 13. Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Pursuant to Instructions to Form 10-K and Item 404 of Regulation S-K, information set forth in the "Indebtedness and Other Transactions" section (pages 18-20) of the Corporation's Proxy Statement is hereby incorporated by reference. Item 14. Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a)1. The financial statements of Fleet required in response to this Item are listed in response to Item 8 of this Report and are incorporated by reference. (a)2. All schedules to the consolidated financial statements required by Article 9 of Regulation S-X and all other schedules to the financial statements of the Registrant have been omitted because the information is either not required, not applicable, or is included in the financial statements or notes thereto. (b) Two Current Reports on Form 8-K were filed during the fourth quarter of 1993; one dated October 11, 1993 (describing the merger agreement with Sterling Bancshares Corporation), and a second dated December 16, 1993 (announcing a settlement agreement with the Georgia Attorney General and the Governor's Office of Consumer Affairs relative to suits filed against Fleet Finance, Inc.). (c) Exhibit Index Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (continued) Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (continued) [FN] (5) Incorporated by reference to Exhibit 4(a) of Registrant's Registration Statement on Form S-8/S-3 dated June 25, 1992 (No. 33-48818). (6) Incorporated by reference to Exhibit 10(b) of the Registrant's 1992 Form 10-K Annual Report filed March 31, 1993. (7) Incorporated by reference to Exhibit 10(c) of the Registrant's 1992 Form 10-K Annual Report filed March 31, 1993. (8) Incorporated by reference to Exhibit 10 of Registrant's 1989 Form 10-K filed March 31, 1990. (In January 1994, Ms. Slattery entered into a contract in the same form as set forth in such Exhibit 10.) (9) Incorporated by reference to Exhibit 4 of Registrant's Form 8-K Current Report dated July 12, 1991. (10) Incorporated by reference to Exhibit 4(a) of the Registrant's Form 8-K Current Report dated July 14, 1991. (11) Incorporated by reference to Exhibit 10(d) of the Registrant's Form 10-K Annual Report dated December 31, 1991. (12) Incorporated by reference to Exhibit 4(b) of the Registrant's Form 8-K Current Report dated July 14, 1991. (d) Financial Statement Schedules - None SIGNATURES Pursuant to the requirements of Section 13 of 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. FLEET FINANCIAL GROUP, INC. (Registrant) /s/ Eugene M. McQuade ---------------------- Eugene M. McQuade Executive Vice President and Chief Financial Officer Dated March 30, 1994 /s/ Robert C. Lamb, Jr. ----------------------- Robert C. Lamb, Jr. Chief Accounting Officer and Controller Dated March 30, 1994 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 in the capacities indicated. /s/ Raymond C. Kennedy ----------------------- Raymond C. Kennedy, Director

1993 Item 1. BUSINESS GENERAL St. Jude Medical, Inc. (the "Company") develops, manufactures and markets medical devices for cardiovascular applications. Its principal product is a mechanical heart valve prosthesis. Based on market information obtained by Company personnel as well as information provided by various industry sources, the Company believes it is the market share leader in the mechanical segment of the worldwide heart valve replacement market. The Company's products are distributed worldwide through a combination of direct sales personnel and independent manufacturers' representatives. The Company operates through three divisions to focus on the management and growth of its established businesses. The St. Jude Medical Division is responsible for the Company's heart valves (mechanical and tissue) and annuloplasty ring products. The Cardiac Assist Division is responsible for the Company's intra-aortic balloon pump and centrifugal pump systems. The International Division is responsible for marketing, sales and distribution of the Company's products in Europe, Africa and the Middle East. Typically, the Company's net sales are somewhat stronger in the first and second quarters and weaker in the third quarter. This results from a tendency by patients to defer, if possible, heart valve replacements during the summer months and from the seasonality of the Western European market where summer vacation schedules normally result in lower orders. Manufacturer representatives place large orders randomly which can distort the net sales pattern noted above. HEART VALVES General. The Company manufactures and markets a bileaflet pyrolytic carbon coated prosthetic heart valve which it designed and first sold in 1977. The purpose of a heart valve is to facilitate the one-way flow of blood through the arteries and heart and prevent significant back flow of blood into the heart. Though the human heart has four valves, the two that are most commonly replaced by prosthetic valves are the aortic and mitral valves. Heart valve replacement may be required where the heart valve has congenital defects, is diseased or is malfunctioning. To-date, over 500,000 St. Jude Medical(R) mechanical heart valves have been implanted worldwide. The first prosthetic heart valves were used in the 1960s and were mechanical valves made primarily of inert materials, such as plastics and fabrics. Mechanical valves were followed by the development of tissue valves made from the heart valve of a pig or the pericardial tissue of a calf. Mechanical valves, especially those utilizing pyrolytic carbon, offer the advantage of longevity because of the durable nature of pyrolytic carbon. These valves also are less susceptible than tissue valves to calcium build-up which may cause valve malfunctions. The primary advantage of tissue valves is that they generally require little or no patient anticoagulant drug therapy to reduce the possibility of clotting. Such therapy is presently indicated for mechanical valves. Physicians will select either a tissue or a mechanical valve depending upon the patient's requirements and the physician's preference. Physician tendency to prescribe mechanical valves rather than tissue valves has resulted in the mechanical segment becoming a larger percentage of the total market through time. In the early 1980s, the heart valve market was evenly split between mechanical valves and tissue valves. In 1993, the Company estimates that mechanical valves were approximately 70% of the market, which is consistent with the 1992 mechanical heart valve share of the total heart valve market. Mechanical Valves. The Company's mechanical heart valve consists of four basic components: two leaflets; the valve body or orifice; and the sewing cuff. St. Jude Medical(R) mechanical heart valves are sold in sizes ranging from 17mm to 33mm in diameter with nine sizes available for the mitral position and eight for the aortic position. The St. Jude Medical(R) mechanical heart valve was the first mechanical valve to utilize 100% pyrolytic carbon coating in the fabrication of the valve body and leaflets. The two leaflets and the valve body are fabricated from a graphite substrate, coated with pyrolytic carbon and then polished. Pyrolytic carbon is utilized because of its extremely hard and durable nature and excellent compatibility with blood. Until 1986, all pyrolytic carbon components were purchased from CarboMedics, Inc. of Austin, Texas ("CMI"). The Company provides a wide range of mechanical heart valve products. Depending upon physician preference, sewing cuffs are made from either polyester fiber or polytetrafluoroethylene fiber. In November 1992, the Company received Food and Drug Administration ("FDA") approval to market its Hemodynamic Plus mechanical heart valve series which provide optimum hemodynamics in patients with a small valvular annulus. In February 1994, the Company received FDA approval to market its collagen impregnated aortic valved graft which combines its aortic heart valve with a collagen impregnated graft and is utilized to replace the aortic heart valve and reconstruct the ascending aorta. In 1982, the Company commenced research in the field of pyrolytic carbon technology, including an effort to determine whether it could manufacture its own heart valve components. This research was deemed necessary to maintain and improve its technological and competitive position within the heart valve industry and to reduce its dependence on its sole supplier. In 1986, the Company's initial production efforts were successful and the Company began selling mechanical heart valves internationally utilizing self-manufactured pyrolytic carbon coated components. Since then, the Company has sold over 90,000 valves made from its own pyrolytic carbon coated components and has made significant improvements in its manufacturing process. The Company is able to produce its own heart valve components pursuant to a license agreement with CMI. See "Suppliers." In May 1991, the Company received FDA approval to domestically market the St. Jude Medical(R) mechanical heart valve as assembled with self-manufactured pyrolytic carbon coated components. With this approval, the Company believes it is the only mechanical heart valve manufacturer with two sources of pyrolytic carbon components. Tissue Valves. The Company acquired the assets and business of BioImplant Canada, Inc., a Canadian manufacturer of tissue heart valves, in 1986. The tissue valve purchased from BioImplant was first implanted in 1978. The BioImplant tissue valve is available in six aortic sizes (21mm through 28mm) and five mitral sizes (27mm through 34mm). The product incorporates a flexible medical grade plastic stent (frame) to provide tissue support and improve handling characteristics during implantation. It is sold outside the United States and is not approved for commercial marketing in the United States. In late 1992, the Company, together with Dr. Tirone David, introduced in the Canadian and selected Western European markets the Toronto SPV tissue heart valve. This is a stentless heart valve which offers the potential for superior hemodynamic performance and increased durability as compared to the current stented designs. The Company filed an IDE application for this valve in 1993 and received FDA approval to begin clinical trials under an IDE in the United States in February 1994. In 1992, the Company, in a joint venture with Hancock Jaffe Laboratories, initiated a program to develop an advanced stented tissue heart valve. The Company expects the first human implant of this valve to take place in the first half of 1994. The joint venture expects to file an IDE application with the FDA by the end of 1994. The Company cannot presently predict the timing or likelihood of obtaining IDE approval for this product. A pre-market approval application for these tissue valve products is expected to be filed with the FDA approximately two years following receipt of IDE approval. See "Government Regulation." ANNULOPLASTY RINGS Annuloplasty rings are prosthetic devices used to repair diseased or damaged mitral heart valves which are determined by the surgeon to be repairable. The Company received FDA authorization to market this product in early 1991. The BiFlex(tm) annuloplasty ring is made from tubular, knitted polyester fabric. It is available in three sizes, 25mm, 30mm and 35mm. The ring can be adjusted either symmetrically or asymmetrically before, during or after placement to produce the desired valve annulus size and configuration. INTRA-AORTIC BALLOON PUMP In December 1988, the Company acquired the assets and business of Aries Medical, Inc., Woburn, Massachusetts, a manufacturer of an intra-aortic balloon pump ("IABP") system. The IABP is a cardiac assist device used to provide temporary support to a weakened or unstable heart. It is used to stabilize heart function before and after open-heart surgery and certain angioplasty procedures. While there are a variety of cardiac assist devices under development, IABPs are the least invasive and the most widely used, commercially available type of cardiac assist device currently on the market. The Model 700 IABP system consists of a control console and a single-use, balloon-tipped catheter. In IABP therapy, the catheter is inserted percutaneously (through the skin), usually into the femoral artery (the chief artery of the thigh). The physician then threads the catheter through the circulatory system to position the balloon in the descending thoracic aorta. Once the balloon is properly positioned, the control console is used to adjust the function of a pump that synchronizes the balloon's inflation and deflation with the contraction and relaxation of the heart's left ventricle. Properly applied, this therapy increases the heart's output and the supply of oxygen- rich blood to the heart while reducing the heart muscle's workload (thereby decreasing the heart muscle's oxygen demand). Over three quarters of annual expenditures on IAB products are for the single-use balloon catheters used with the control consoles. To take advantage of the higher volume portion of the IAB market, the Company's catheters are adaptable for use on competitive IABP consoles. In 1993, the Company introduced its RediGuard 2.0 catheter which eases the guiding and placement process. CENTRIFUGAL PUMP In April 1989, the Company acquired technology relating to a centrifugal pump system from Symbion, Inc., of Salt Lake City, Utah. Centrifugal pumps are used to replace a patient's cardiac function during open heart surgery. Centrifugal pumps are less traumatic to the blood than conventional roller pumps and centrifugal designs reduce the risk of air and tubing emboli entering the blood stream. The Company's Lifestream centrifugal pump system consists of a single-use pump, a control console, a motor drive, flow transducer and probe used to control blood flow. In 1990, the Company introduced the centrifugal pump system after receiving FDA authorization to market the system domestically under the 510(k) pre-market notification procedure for cardiopulmonary bypass products. The Company entered into a distribution agreement with COBE Cardiovascular Inc. (COBE) late in 1992 which was amended in late 1993. This three-year agreement requires COBE to purchase from the Company specified minimum amounts of pumps and flow probes for the domestic, Canadian and Australian markets. The pumps and flow probes will be made part of COBE's sterile custom packs for use in various surgical procedures. Late in 1993, the Company entered into a non-exclusive distribution agreement with COBE for selected European markets. This agreement allows COBE to include the Company's pumps and flow probes in COBE's custom pack units which are distributed in these markets. SUPPLIERS In April 1990, the Company entered into an agreement with CarboMedics, Inc. ("CMI") which covers the supply of heart valve carbon components from 1991 through 1998. Under the agreement, the Company agreed to purchase at least 70% of its carbon component requirements from CMI in 1991, with lesser requirements ranging downward to 48% of its needs in 1995 and, thereafter, 20% of its needs through 1998. In return for the Company's agreement to increase its minimum purchases from those required under an earlier agreement, CMI agreed to price concessions in the current agreement. Prices are fixed under the agreement and escalate through 1995, whereupon the parties have agreed to negotiate prices for the years 1996 through 1998. Prices are adjusted upward if the Company's purchases are less than 95% of scheduled quantities for each year and downward if purchases are 110% or more than such scheduled quantities. If CMI is unable or fails to perform under the agreement, the license permits the Company to meet its own requirements during the supply interruption. The agreement can be extended for additional one year terms after 1998 and the prices the Company would pay in 1999 and beyond will be adjusted annually by a formula established in the agreement. The formula is based upon certain components of the producer price index for intermediate goods published by the United States Department of Labor. In addition, CMI has agreed that it will not discriminate against the Company in the setting of future prices and terms for its supply of heart valve components. See "Patents and Licenses." The Company and CMI are also parties to a patent license agreement pursuant to which the Company can produce its own heart valve components. The license does not provide for an interchange of carbon technology between the two companies but does grant the Company a non-exclusive worldwide license to make carbon coated heart valve components. Royalties were paid on all Company produced heart valve components manufactured prior to September 1993 after which time the license was fully paid. The Company purchases raw material and other items from numerous suppliers for use in connection with the production of its products. The Company maintains sizeable inventories of up to three years of its projected requirements for certain materials, some of which are available only from single source vendors. In 1992, the Company was advised that certain of such vendors were planning to terminate sales of products to customers that manufacture implantable medical devices in an effort to reduce potential product liability exposure. Some vendors have modified their position and have indicated a willingness to either temporarily continue to provide product until such time as an alternative vendor or product can be qualified or to reconsider the supply relationship. While the Company believes that alternative sources of raw materials are available and that there is sufficient lead time in which to qualify such other sources, any supply interruption could have a material adverse effect on the Company's ability to manufacture its products. MARKETING The Company sells its products directly and through independent manufacturers' representative organizations in the United States and throughout the world. The international representatives purchase products and resell them to hospitals. No representative organization or single customer accounted for more than 10% of 1993 net sales. Early in 1987 in the United States, the Company began a phased conversion from a distributor-based sales organization to a direct employee-based sales organization. The domestic conversion was completed in 1989. The Company initiated a direct sales presence in the United Kingdom in January 1990 and commenced direct sales activities in several other European countries in January 1991. In addition, the Company initiated a direct sales presence in the United States for its Cardiac Assist Division in 1991. Such efforts allow Company personnel to interface directly with customers. In the normal course of its business, claims may be made by former distributors whose agreements are terminated or not renewed. The Company is currently involved in distributor litigation and does not regard such litigation as material to its business. Payment terms, worldwide, are consistent with local practice. Orders are shipped as they are received and, therefore, no material back orders exist. COMPETITION The heart valve business is highly competitive. Presently, there are four significant heart valve manufacturers in addition to the Company: Baxter International, Medtronic, Sorin Biomedica and CarboMedics. All competitors offer both tissue and mechanical valves. See "Patents and Licenses." In the domestic market, the Company competes primarily with Medtronic and Baxter. CarboMedics, Inc. received FDA authorization to market its bileaflet mechanical heart valve in the U.S. in the third quarter 1993. Internationally, the Company competes with the principal competitors as well as other smaller manufacturers. Mechanical heart valves currently being marketed by established companies sell domestically in a price range from $3,000 to $4,300. The Company's mechanical heart valve sells at the high end of the domestic price range. When sold outside the United States, valve prices vary significantly by country depending on the country's economic climate and its government reimbursement policies and, in certain instances, mark-ups by international distributors. The Company does not believe the price of its mechanical valve is a significant disadvantage in the domestic market because the valve price represents a relatively small proportion of the overall cost of heart valve surgery. Health care reform and increased competition in the domestic market is putting downward pressure on pricing. Resistance to valve price increases and price limitations imposed by government funded customers is not uncommon overseas. The Company believes price considerations will continue to be a factor in its ability to compete in certain foreign markets. See "Government Regulation." The Company, Medtronic, Sorin Biomedica and Baxter International are the principal participants in the annuloplasty ring market. The primary competitive factors include product performance and ease of implantation. The Company's fully- flexible BiFlex(tm) annuloplasty ring has two adjustable segments which allow the ring to be easily shaped to the valve annulus. Currently, there are five significant IABP manufacturers: the Company, Datascope, the Mansfield Division of Boston Scientific, C.R. Bard and Kontron Instruments, a division of Arrow International. While Datascope is the leading market competitor, all competitors have significant experience in the manufacture and marketing of intra-aortic balloon pump systems. Product performance, ease of use, price and service are the principal competitive factors. Manufacturers of roller pump systems and centrifugal pumps include the Company, Medtronic, 3M, Pfizer, and Gambro. The principal competitive factors in the blood pump market include product performance, safety and price. While roller pump systems are less expensive, centrifugal pump systems offer superior product performance and higher patient safety levels. RESEARCH AND DEVELOPMENT The Company is focusing on the development of new products and improvements to existing products. In addition, research and development expense reflects the Company's efforts to obtain FDA approval of certain products and processes and to maintain the highest quality standards of existing products. The Company's expenditures for research and development were $10,972,000 (4.3% of net sales), $11,478,000 (4.8%) and $8,110,000 (3.9%) in 1993, 1992 and 1991, respectively. GOVERNMENT REGULATION The medical devices manufactured and marketed by the Company are subject to regulation by the FDA and, in some instances, by state and foreign governmental authorities. Under the Federal Food, Drug and Cosmetic Act (the "Act"), and regulations thereunder, manufacturers of medical devices must comply with certain policies and procedures that regulate the composition, labeling, testing, manufacturing, packaging and distribution of medical devices. Medical devices are subject to different levels of government approval requirements, the most comprehensive of which requires the completion of an FDA approved clinical evaluation program and submission and approval of a pre-market approval ("PMA") application before a device may be commercially marketed. The Company's mechanical heart valve was subject to this level of approval. Tissue valves are also subject to this level of approval. The annuloplasty ring, IABP and the centrifugal pump are currently marketed under the 510(k) pre- market notification procedure of the Act. The FDA has advised that companies marketing IABPs will be required to make PMA filings in the future. The Company is preparing to make such a filing and cannot predict when the FDA will call for PMA submission. The FDA has called for a PMA submission for centrifugal pumps. The Company has petitioned the FDA to downclass centrifugal pumps to Class II which, if successful, would eliminate the need to file a PMA. If unsuccessful, the Company is prepared to make a PMA filing. Diagnostic-related groups ("DRG") reimbursement schedules regulate the amount the United States government will reimburse hospitals for the inpatient care of persons covered by Medicare. While the Company has not been aware of significant domestic price resistance directly as a result of DRG reimbursement policies, changes in current DRG reimbursement levels could have an adverse effect on its domestic pricing flexibility. Various proposals to adjust the health care delivery system in the United States are under consideration by the United States Government. Certain specific areas under review include the uninsured population, the rate of growth of health care expenses and the overall size of the health care portion of the total budget consumed by health care costs. It is possible that changes to the existing health care system will be proposed and implemented in 1994. The Company cannot predict the effect, if any, such changes will have on the Company's operating results. PATENTS AND LICENSES The Company's policy is to protect the intellectual property rights in its work on heart valves and other biomedical devices. Where appropriate, the Company applies for United States and foreign patents. In those instances where the Company has acquired technology from third parties, it has sought to obtain rights of ownership to the technology through the acquisition of underlying patents or exclusive licenses. While the Company believes design, development, regulatory and marketing aspects of the medical device business represent the principal barriers to entry into such business, it also recognizes that its patents and license rights may make it more difficult for its competitors to market products similar to those produced by the Company. The Company can give no assurance that any of its patent rights, whether issued, subject to license or in process, will not be circumvented or invalidated. Further, there are numerous existing and pending patents on medical products and biomaterials. Although the Company is unaware of any violation by it of the patent or proprietary rights of others, there can be no assurance that the Company's existing or planned products do not or will not infringe such rights or that others will not claim such infringement. The Company believes it would be able to maintain, against future challenges, the validity of its mechanical heart valve patents and its right thereto. No assurance can be given that the Company will be able to prevent competitors with designs similar to its mechanical heart valve from challenging the Company's patents or from entry into the marketplace. The Company is aware that certain companies, including CMI, have developed mechanical heart valves which have designs similar to the Company's mechanical heart valve design. In 1990, the Company granted CMI a non-exclusive worldwide license to manufacture and sell the CMI mechanical heart valve in return for the payment of royalties in the period from 1991 through July 1998 for those CMI valves sold in the ten countries where the Company has patent protection. The license limits through 1995 the number of valves CMI may sell in the United States. Sorin Biomedica S.p.A. ("Sorin") has also developed a bileaflet heart valve which has a design similar to the Company's mechanical heart valve design and has entered selected international markets with its valve. The Company has commenced litigation against Sorin in France and Germany alleging that the design of the Sorin heart valve infringes the Company's heart valve patents in those countries. Sorin has challenged the validity of the Company's French and German patents. PRODUCT LIABILITY The Company carries insurance coverage for both domestic and international products liability occurrences in amounts which it believes are adequate. In 1986 and 1987, the Company was unable to obtain suitable insurance coverage in amounts it deemed adequate and, therefore, adopted a self-insurance program and established reserves to cover products liability claims pertaining to those years. The Company would be financially responsible for any uninsured claims or claims which exceed its insurance coverage. The Company's products are not marketed with any express warranty provisions. CMI has made no warranty on the valve components it manufactures on behalf of the Company and the Company has agreed to hold CMI harmless in the event claims are made or damages are assessed against CMI as a result of any valve-related litigation. From time to time, the Company receives communications from persons who have received heart valve implants concerning various claims which are generally surgery related. Also, claims relating to the Company's other products have been received. On occasion, these claims evolve into litigation and, in some instances, plaintiffs have sought punitive damages in addition to compensatory damages. In many states, the courts have held that in certain circumstances corporations may not receive insurance proceeds to pay punitive damages awarded in the course of litigation. While the Company believes the likelihood of an award of punitive damages in product liability litigation is remote, any uninsured award of such damages could have an adverse impact on the Company. EMPLOYEES As of December 31, 1993, the Company had 722 full-time employees. It has never experienced a work stoppage as a result of labor disputes and none of its employees is represented by a labor organization. INDUSTRY SEGMENT AND INTERNATIONAL OPERATIONS The medical products and service industry is the single industry segment in which the Company operates. The Company's domestic and foreign net sales, operating profit and identifiable assets, and its export sales to customers are described in Note 6 to the consolidated financial statements on page 28 of the 1993 Annual Report to Shareholders and are incorporated by reference herein. The Company's foreign business is subject to such special risks as exchange controls, currency devaluation, dividend restrictions, the imposition or increase of import or export duties and surtaxes, and international credit or financial problems. Since its international operations require the Company to hold assets in foreign countries denominated in local currencies, many assets are dependent for their U.S. dollar valuation on the values of a number of foreign currencies in relation to the U.S. dollar. The Company may from time to time enter into purchase and sales contracts in the forward markets for various foreign currencies with the objective of protecting U.S. dollar values of assets and commitments denominated in foreign currencies. Item 2. Item 2. PROPERTIES The Company's principal plant and executive offices are located in St. Paul, Minnesota. Its facilities are as follows: OWNED LEASED LOCATION SQUARE FEET LOCATION SQUARE FEET Domestic Domestic St. Paul, MN 119,000 Caguas, PR 22,000 St. Paul, MN 30,000 Chelmsford, MA 34,000 St. Paul, MN 80,000 St. Paul, MN 9,100 Foreign Foreign Quebec, Canada 8,000 Vienna, Austria 150 Brussels, Belgium 11,000 Paris, France 3,100 Dusseldorf, Germany 4,000 Tokyo, Japan 350 Breda, Netherlands 400 Madrid, Spain 3,000 Basel,Switzerland 250 Coventry, U.K. 2,400 In management's opinion, all buildings and machinery and equipment are in good condition and suitable for their purposes and are maintained and repaired on a basis consistent with sound operations. Management believes that adequate property and casualty insurance is in force with respect to all property. Item 3. Item 3. LEGAL PROCEEDINGS The Company is a named defendant in a purported class action captioned Weisburgh, et al. v. St. Jude Medical, Inc. et al. filed July 2, 1992 in the United States District Court for the District of Minnesota, and later amended. The second amended complaint also names as defendants certain officers and directors alleged to control the Company. The plaintiff purports to represent a class consisting of all persons who purchased common stock of the Company during the period from December 17, 1991 through July 2, 1992. The second amended complaint alleges that the defendants deceived the investing public regarding the Company's finances, financial condition and present and future prospects and induced the plaintiff class to purchase the Company's common stock during the period prior to July 2, 1992 at inflated prices. The second amended complaint asserts claims for federal securities fraud, common law fraud and negligent misrepresentation. The second amended complaint seeks damages (including punitive damages) in an unspecified amount, attorney's fees, costs and expenses. On March 2, 1993, the Company and the other defendants moved to dismiss all claims for failure to state a claim for relief and failure to plead fraud with particularity. In its Order dated May 28, 1993, the court denied the defendant's motion at that time, but directed the plaintiffs to file a second amended complaint, with more particularized allegations of fraud. The plaintiffs have filed a second amended complaint, and on June 28, 1993, the Company and the other defendants moved to dismiss the second amended complaint for failure to state a claim for relief and failure to plead fraud with particularity. The plaintiff has moved for a class certification. Both motions are under advisement. The Company believes that the second amended complaint is without merit and intends to pursue a vigorous defense of the action. The Company is unaware of any other pending legal proceedings which it regards as likely to have a material adverse effect on its business. Item 4. Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. Item 4A. EXECUTIVE OFFICERS OF THE COMPANY NAME AGE POSITION* Ronald A. Matricaria 51 President and Chief Executive Officer (1993) Lawrence A. Lehmkuhl 56 Former President and Chief Executive Officer (1985) Eric W. Sivertson 43 President, St. Jude Medical Division (1992) Todd F. Davenport 43 President, St. Jude Medical International Division (1992) Stephen L. Wilson 41 Vice President, Finance and Chief Financial Officer (1990) Robert S. Elgin 46 Vice President, Operations St. Jude Medical Division (1990) *Dates in brackets indicate period during which officers began serving in such capacity. Executive officers serve at the pleasure of the Board of Directors and are elected annually for one year terms. Mr. Matricaria is a director of the Company and his business experience is set forth in the Company's definitive Proxy Statement dated March 28, 1994 under the Section "Election of Directors." The information is incorporated herein by reference. Mr. Lehmkuhl is a director of the Company and his business experience is set forth in the Company's definitive Proxy Statement dated March 28, 1994 under the section "Election of Directors." The information is incorporated herein by reference. Mr. Sivertson joined the Company in June 1985 as Director of Marketing. In 1986 he became Director of International Sales and held that post until April 1988. He was appointed Vice President of Sales and Marketing in May 1988 and held that position until he was appointed as President of the International Division in February 1990. In August 1992, Mr. Sivertson was appointed President of the St. Jude Medical Division. Prior to joining the Company, Mr. Sivertson spent eight years with American Hospital Supply Corporation in various management positions, including Vice President of Marketing for the Converters Division. Mr. Davenport joined the Company in August 1992 as President, St. Jude Medical International Division. Prior to joining the Company, Mr. Davenport served for two years as Vice President Marketing and Sales for the Edwards Critical-Care Division of Baxter International, Inc., a manufacturer, marketer and distributor of various hospital supply products. From 1986 to 1990, Mr. Davenport was employed by Abiomed, Inc., a cardiac assist device manufacturer and marketer, and most recently was that company's Vice President and General Manager. Prior to joining Abiomed, he spent eleven years in various management positions with Cordis Corporation, a catheter device manufacturer. Mr. Wilson joined the Company in May 1990 as Vice President, Finance and Chief Financial Officer. Prior to joining the Company, Mr. Wilson was Vice President and Controller of The Foxboro Company, a manufacturer and marketer of products for the automation of industrial processes, where he had been employed for five years. Prior to that, he was the Controller of Brown & Sharpe Manufacturing Company, a manufacturer and marketer of metrology products and machine tools, and previously was with Coopers & Lybrand. Mr. Elgin joined the Company in January 1990 as Vice President, Operations of the St. Jude Medical Division. Prior to joining the Company, Mr. Elgin served as the Vice President of Manufacturing for the V. Mueller Division of Baxter International, Inc. From 1982 to 1990, Mr. Elgin held various management positions with American Hospital Supply Corporation and Baxter International, Inc. Mr. Elgin spent nine years in various management capacities with Colt Industries Inc. prior to joining American Hospital Supply Corporation. PART II Item 5. Item 5. MARKET FOR THE COMPANY'S COMMON STOCK AND RELATED SECURITY HOLDER MATTERS The information set forth under the captions "Supplemental Market Price Data" and "Cash Dividends" on page 33 of the Company's 1993 Annual Report to Shareholders is incorporated herein by reference. Item 6. Item 6. SELECTED FINANCIAL DATA The information set forth under the caption "Ten Year Summary of Selected Financial Data" on pages 30 and 31 of the Company's 1993 Annual Report to Shareholders is incorporated herein by reference. Item 7. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION The information set forth under the caption "Management's Discussion and Analysis of Results of Operations and Financial Condition" on pages 17, 18, 19 and 20 of the Company's 1993 Annual Report to Shareholders is incorporated herein by reference. Item 8. Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The following consolidated financial statements of the Company and Report of Independent Auditors set forth on pages 21 through 29 of the Company's 1993 Annual Report to Shareholders are incorporated herein by reference: Consolidated Statements of Income - Years ended December 31, 1993, December 31, 1992 and December 31, 1991 Consolidated Balance Sheets - December 31, 1993 and December 31, 1992 Consolidated Statements of Shareholders' Equity - Years ended December 31, 1993, December 31, 1992 and December 31, Consolidated Statements of Cash Flows - Years ended December 31, 1993, December 31, 1992 and December 31, 1991 Notes to Consolidated Financial Statements Item 9. Item 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III Item 10. Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY The information set forth under the caption "Election of Directors" in the Company's definitive Proxy Statement dated March 28, 1994, is incorporated herein by reference. Information on executive officers is set forth in Part I, Item 4A hereto. Item 11. Item 11. EXECUTIVE COMPENSATION The information set forth under the caption "Executive Compensation and Other Information" and "Election of Directors" in the Company's definitive Proxy Statement dated March 28, 1994, is incorporated herein by reference. Item 12. Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information set forth under the caption "Security Ownership of Certain Beneficial Owners and Management" and "Election of Directors" in the Company's definitive Proxy Statement dated March 28, 1994, is incorporated herein by reference. Item 13. Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information set forth under the caption "Election of Directors" in the Company's definitive Proxy Statement dated March 28, 1994, is incorporated herein by reference. PART IV Item 14. Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) List of documents filed as part of this Report (1) Financial Statements The following consolidated financial statements of the Company and Report of Independent Auditors as set forth on pages 21 through 29 of the Company's 1993 Annual Report to Shareholders are incorporated herein by reference: Consolidated Statements of Income - Years ended December 31, 1993, December 31, 1992 and December 31, 1991 Consolidated Balance Sheets - December 31, 1993 and December 31, Consolidated Statements of Shareholders' Equity - Years ended December 31, 1993, December 31, 1992 and December 31, 1991 Consolidated Statements of Cash Flows - Years ended December 31, 1993, December 31, 1992 and December 31, 1991 Notes to Consolidated Financial Statements (2) Financial Statement Schedules The following financial statement schedules are filed as part of this Form 1O-K Report: Schedule Number Description Page Number I Marketable Securities - Other Investments 24 VIII Valuation and Qualifying Accounts 25 X Supplementary Income Statement Information 26 The report of the Company's Independent Auditors with respect to the above-listed financial statements and financial statement schedules appears on page 23 of this Report. All other financial statements and schedules not listed have been omitted because the required information is included in the Consolidated Financial Statements or the Notes thereto, or is not applicable. (3) Exhibits Exhibit Index Page Number 3.1 Articles of Incorporation are incorporated by --- reference to Exhibit 3(a) of the Company's Form 8 filed on August 20, 1987 amending the Company's quarterly report on Form 1O-Q for the quarter ended June 30, 1987 3.2 Bylaws are incorporated by reference to --- Exhibit 3B of the Company's Form S-3 Registration Statement dated September 25, 1986 (Commission File No. 33-8308) 4.1 Amended and Restated Rights Agreement dated as --- of June 26, 1990 between the Company and Norwest Bank Minneapolis, N.A., as Rights Agent including the Certificate of Designation, Preferences and Rights of Series A Junior Participating Preferred Stock is incorporated by reference to Exhibit 1 of the Company's Form 8 Amendment 2 to Form 8-A dated July 6, 1990 10.1 Employment letter dated as of March 9, 1993, 28 between the Company and Ronald A. Matricaria* 10.2 Supplemental Executive Retirement Plan and 36 Trust agreement dated April 12, 1993, between the Company and Ronald A. Matricaria* 10.3 Supply Contract and Patent License Agreement --- dated September 6, 1985 between the Company and CarboMedics, Inc. is incorporated by reference to the Company's 8-K Report dated September 20, 1985 10.4 Form of Indemnification Agreement that the --- Company has entered into with officers and directors. Such agreement recites the provisions of Minnesota Statutes Section 302A.521 and the Company's Bylaw provisions (which are substantially identical to the Statute) and is incorporated by reference to Exhibit 1O(d) of the Company's Form 1O-K Annual Report for the year ended December 31, 1986* 10.5 Form of Employment Agreement that the Company --- has entered into with officers relating to severance matters in connection with a change in control is incorporated by reference to the Company's Form 10-K Annual Report for the year ended December 31, 1988* 10.6 Retirement Plan for members of the Board of --- Directors, as amended, is incorporated by reference to exhibit 10.5 of the Company's Form 10-K Annual Report for the year ended December 31, 1992* 10.7 Deferred Compensation Plan dated December 2, --- 1986 is incorporated by reference to the Company's Form 10-K Annual Report for the year ended December 31, 1987* 10.8 Supplemental Executive Retirement Plan 75 agreement dated September 30, 1988, and as restated on April 9, 1993, between the Company and Lawrence A. Lehmkuhl* 10.9 1989 Restricted Stock Plan is incorporated by --- reference to the Company's Form S-8 Registration Statement dated June 6, 1989 (Commission File No. 33-29085)* 10.10 Management Incentive Compensation Plan* 81 10.11 Supply Contract dated April 17, 1990 between --- the Company and CarboMedics, Inc. (portions of this exhibit have been deleted and filed separately with the Securities and Exchange Commission pursuant to Rule 24b-2) is incorporated by reference to the Company's Form 8 filed on April 19, 1990 amending the Company's Form 10-K Annual Report for the year ended December 31, 1989 11 Computation of Earnings Per Share 90 13 1993 Annual Report to Shareholders. Except 91 for those portions of such report expressly incorporated by reference in this Form 1O-K Report, the Annual Report is not deemed to be "filed" with the Securities and Exchange Commission 21 Subsidiaries of the Company 127 23 Consent of Independent Auditors 128 *Management contract or compensatory plan or arrangement. (b) Reports on Form 8-K during the quarter ended December 31, 1993 Reports on Form 8-K filed by the Company during the fourth quarter 1993: Form 8-K dated December 1993 Item 2. Acquisition or Disposition of Assets - Acquisition of Electromedics, Inc. (c) Exhibits: Reference is made to Item 14(a)(3). (d) Schedules: Reference is made to Item 14(a)(2). For the purposes of complying with the amendments to the rules governing Form S-8 under the Securities Act of 1933, the undersigned Company hereby undertakes as follows, which undertaking shall be incorporated by reference into Company's Registration Statements on Form S-8 Nos. 33-9262 (filed October 3, 1986), 33-29085 (filed June 6, 1989), 33-41459 (filed June 28, 1991) and 33-48502 (filed June 10, 1992): Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers and controlling persons of the Company pursuant to the foregoing provisions, or otherwise, the Company has been advised that, in the opinion of the Securities and Exchange Commission, such indemnification is against public policy as expressed in the Securities Act of 1933 and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the Company of expenses incurred or paid by a director, officer or controlling person of the Company in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, the Company will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Act and will be governed by the final adjudication of such issue. SIGNATURES Pursuant to the requirements of Sections 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. ST. JUDE MEDICAL, INC. Date: March 24, 1994 By /s/ Ronald A. Matricaria Ronald A. Matricaria President and Chief Executive Officer (Principal Executive Officer) By /s/ Stephen L. Wilson Stephen L. Wilson Vice President, Finance and Chief Financial Officer (Principal Financial and Accounting 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. /s/ Lawrence A. Lehmkuhl Chairman of the March 24, 1994 Lawrence A. Lehmkuhl Board of Directors /s/ Ronald A. Matricaria Director March 24, 1994 Ronald A. Matricaria /s/ Frank A. Ehmann Director March 24, 1994 Frank A. Ehmann /s/ Thomas H. Garrett III Director March 24, 1994 Thomas H. Garrett III /s/ Charles V. Owens, Jr. Director March 24, 1994 Charles V. Owens, Jr. /s/ James S. Womack Director March 24, 1994 James S. Womack /s/ William R. Miller Director March 24, 1994 William R. Miller /s/ Roger G. Stoll Director March 24, 1994 Roger G. Stoll - ----------------------------------------------------------------------------- SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 OF ST. JUDE MEDICAL, INC. FOR CALENDAR YEAR ENDED DECEMBER 31, 1993 - ------------------------------------- FINANCIAL STATEMENT SCHEDULES - ----------------------------------------------------------------------------- Report of Independent Auditors We have audited the consolidated financial statements of St. Jude Medical, Inc. as of December 31, 1993 and 1992, and for each of the three years in the period ended December 31, 1993, and have issued our report thereon dated February 4, 1994. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These schedules are the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. [signature] Ernst & Young February 4, 1994 ST. JUDE MEDICAL, INC. AND SUBSIDIARIES YEAR ENDED DECEMBER 31, 1993 SCHEDULE I - MARKETABLE SECURITIES AND OTHER INVESTMENTS (1) Reserve adjustments or uncollectible accounts written off, net of recoveries. (2) Settlements paid. (3) Deducted from accounts receivable on the balance sheet. (4) Included in accrued expenses on the balance sheet. ST. JUDE MEDICAL, INC. AND SUBSIDIARIES YEAR ENDED DECEMBER 31, 1993 SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION (Dollars in Thousands) COL. A COL. B Charged to Costs Item and Expenses Year Ended December 31 1993 1992 1991 Royalties $6,754 $7,203 $5,607 Amortization of intangible assets $4,458 $4,202 $4,237 Each of the following items are less than 1% of net sales and are not required to be reported: *Maintenance and repairs *Taxes, other than payroll and income taxes *Advertising costs - ----------------------------------------------------------------------------- SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 OF ST. JUDE MEDICAL, INC. FOR CALENDAR YEAR ENDED DECEMBER 31, 1993 - ------------------------------------- EXHIBITS - ----------------------------------------------------------------------------- March 9, 1993 Mr. Ronald A. Matricaria 840 Wedgewood Lane Carmel, IN 46032 Dear Mr. Matricaria: We write to set forth our agreement with respect to your employment as the President and Chief Executive Officer of St. Jude Medical, Inc. (the "Company"). This letter shall be effective and shall bind the Company from and after the date hereof, but shall be operative only upon your acceptance by executing this letter and upon your actual commencement of employment with the Company on or before April 12, 1993. 1. Employment. The Company hereby agrees to employ you, and you agree to be employed by the Company, on the terms and conditions hereinafter set forth. You will serve as the Company's President and Chief Executive Officer and, in addition, at no additional compensation, be elected as a member of the Board of Directors, and in such other directorships, Board committee memberships and offices of the Company and its subsidiaries to which you may from time to time be elected or appointed by the Chairman of the Board. You agree to serve the Company faithfully and, to the best of your ability, to promote the Company's interest, and to devote your full working time, energy and skill to the Company's business. You will assume all of the duties and responsibilities as President and Chief Executive Officer immediately upon your employment. As President, you will report directly to the Board of Directors although you will normally work with the Chairman of the Board as its representative. You will be solely responsible for determining job description, compensation and promotion of all employees other than corporate officers in accordance with any salary and personnel policies established from time to time by the Board of Directors. You shall recommend to the Board, after consultation with the Chairman, job descriptions, compensation and promotion of all corporate officers. You will discharge your duties at all times in accordance with any and all policies established by the Board of Directors and will report to, and be subject to the direction of, the Board of Directors. I will, upon your commencement of employment, assume the sole duties of Chairman of the Board, but will be available for a period of up to 60 days to assist you in your assuming the position of President and Chief Executive Officer. It is the spirit of our agreement that I will not be involved in day to day management and that I will move off- site after a reasonable transition time. 2. Compensation. (a) As full compensation for all of your services (including services as director, Board committee member or officer of the Company and its subsidiaries) during your term of employment hereunder, you shall, beginning with the 1993 calendar year, receive a base salary at the rate of Four Hundred Thousand Dollars ($400,000) per annum, payable in bi-weekly installments. (b) Nothing in this agreement shall prevent the Company's Board of Directors from at any time increasing the compensation to be paid to you, if the Board shall deem it advisable to do so in order to compensate you fairly for services to be rendered. It is the parties' contemplation that the Board of Directors will effect such increases from time to time, to the extent justified by all the circumstances, including increases in the cost of living, the value of your services, and the Company's results of operations and financial position. 3. Bonus. (a) You shall be eligible to earn bonus compensation for each fiscal year of the Company during your term of employment hereunder in an amount to be determined in accordance with an incentive compensation plan for you as established by the Company's Board of Directors. Under the plan, you will have an opportunity to earn bonus compensation of up to 100% of your base compensation each fiscal year upon achievement of various established targets based on personal and corporate performance to be mutually agreed upon by you and the Board of Directors. Bonus compensation payable to you will be paid following approval of the fiscal year results by the Audit Committee of the Board. (b) Notwithstanding the foregoing, unless you voluntarily resign from or are terminated for good cause by the Company before December 31, 1993, the Company will pay you a bonus for 1993 equal to $358,250, representing 3/12ths of the bonus target you would have earned from your previous employer for 1993 and 9/12ths of the $400,000 bonus target for 1993 under the incentive compensation plan described above. Such bonus shall be paid at the same time as other corporate officer bonuses for 1993 are paid or payable. 4. Fringe Benefits. (a) You will be included in the Company's Executive Officer Perquisite Plan (PERK) during the term of your employment hereunder and the value of such perquisites shall be at least $24,000 during 1993. You shall also be eligible to participate in any and all Company sponsored insurance (including medical, dental, life and disability insurance), profit sharing and other fringe benefit programs that it maintains for any of its executive officers, subject to the terms of each such plan or program. Notwithstanding this, you will be entitled to three weeks of vacation in 1993 upon completion of six months of employment and four weeks of vacation in each calendar year thereafter. (b) The Company will provide for your relocation to Minneapolis-St. Paul in accordance with the terms of a relocation plan comparable to your current employer's plan including, but not limited to home purchase, temporary living and relocation of your family and household goods. 5. Expenses. During the term of your employment hereunder, the Company will reimburse you for your reasonable travel and other expenses incident to your rendering of services hereunder, in conformity with its regular policies regarding reimbursement of expenses as in effect from time to time. Payments to you under this paragraph will be made upon presentation of expense vouchers in such detail as the Company may from time to time require. 6. Term. (a) The term of your employment hereunder shall continue until the earliest of the following dates: (i) December 31, 1997; (ii) the last day of any month in which you die; (iii) if you shall be unable to substantially perform under this agreement by reason of physical or mental disability for a period of six consecutive months, on the last day of any month in which the Company shall have elected to terminate your employment hereunder by notice to you; and (iv) the date on which the Company terminates your employment hereunder for "good cause." (v) the date on which you voluntarily terminate your employment. (b) For purposes of this agreement, the Company shall have "good cause" if you have acted in bad faith or with dishonesty, you have willfully violated any law of any domestic or international government to which the Company is bound, or willfully failed to follow instructions of the Company's Board of Directors, you have performed duties with gross negligence or you have otherwise materially breached this agreement; provided, however, that in the case of your willful failure to follow instructions or other material breach hereof not involving bad faith, dishonesty or willful violation of law, the Company shall give you written notice of such failure or other breach and you shall have 21 days to correct same. (c) For purposes of this agreement, "good reason" shall mean the Company, without your express written consent, (i) substantially and materially reducing the principal duties, responsibilities and reporting obligations of your position as President and CEO, (ii) reducing your annual compensation as described in Paragraph 2 (including any increases given under Paragraph 2(b) or reducing your bonus described in Paragraph 3 or (iii) failing to provide you with benefits at least as favorable to those enjoyed by you under any of the Company's pension, life insurance, medical, health and accident, disability, deferred compensation, incentive awards, incentive stock options, savings plans or vacation plans in which you were eligible to participate at the beginning of your term of employment with the Company, provided, however, that nothing herein will restrict the Company from altering, amending or terminating any benefit plan so long as any such change applies to executive officers generally. 7. Payments Due Upon Termination. If prior to such scheduled expiration of your employment as provided in Paragraph 6(a), your employment is terminated by the Company before December 31, 1997 for any reason other than your death, disability or because your employment has been terminated for "good cause," then and in such event the Company shall pay you as severance, in monthly installments, at the rate of your base compensation then in effect and the actual bonus paid for the immediately preceding fiscal year. Such payments shall continue until the earlier of: (a) 24 months following the date of your termination, or (b) December 31, 1997. You shall continue to be obligated under Paragraph 12 hereunder for as long as you receive payments under this paragraph and for a period of one year thereafter. 8. Change in Control. You and the Company agree to enter into a separate "Employment Agreement" in substantially the form previously presented to you pursuant to which you will be entitled to receive severance pay and benefits as provided therein in the event of a "change in control" as defined therein. Your rights under such Employment Agreement are in lieu of your rights under Paragraph 7. Accordingly, if you elect to receive the benefits afforded you under such Employment Agreement, you may not receive compensation under Paragraph 7 hereof. 9. Stock Option. You will receive two non-qualified options to purchase up to 400,000 shares of Company common stock in the following manner: (a) 200,000 shares shall be exercisable at a rate of 20% per year on each anniversary of your date of employment, with the final 20% exercisable on December 31, 1997. In addition, all or any of the 200,000 shares will be exercisable immediately if you die or become disabled while employed by the Company. This option shall be governed by the terms of a "Non-Qualified Stock Option Agreement" substantially in the form previously presented to you. If, prior to the third anniversary of your date of employment, your employment is terminated by the Board of Directors other than for "good cause" as defined in Paragraph 6(b) above or by you for "good reason" as defined in Paragraph 6(c) above, death or disability, any shares of stock under the option above that are not then exercisable shall become exercisable immediately upon your termination. In that event, if the share price on the date of exercise is not less than the purchase price in the option agreement, you agree to immediately exercise the option for the number of shares that vest solely as a result of your termination under this paragraph and to sell to the Company such shares at the closing price on the date of exercise. The Company shall pay you for such shares within 10 days of the date of your exercise. (b) 200,000 shares shall be contingent on achievement of annual increases in market valuation of the Company for the five calendar years commencing in 1993 as follows: (i) The number of whole Shares that the Optionee shall earn and that shall become exercisable immediately following the determination of Actual Market Value for any year shall be equal to one percent (1%) of the excess of the Actual Market Value of the Company over the Target Market Value for the immediately prior calendar year divided by the Purchase Price contained in the Option Agreement. (ii) Actual Market Value shall equal the number of shares issued and outstanding as reported on the Company's year end balance sheet, multiplied by the closing price of the Company's Common Stock as reported on NASDAQ-NMS for the last trading day of the calendar year; provided, however, that if there is any change in the financial results of the Company by the Audit Committee of the Board of Directors, the Actual Market Value shall be determined based upon the average of the closing price for the first five trading days in the month following the date the Company's annual audited financial results are released to the public. (iii) The Target Market Value for each year shall be as follows: $1,900,511,770 as of December 31, 1993 2,181,787,511 as of December 31, 1994 2,463,238,101 as of December 31, 1995 2,827,797,340 as of December 31, 1996 3,266,105,928 as of December 31, 1997 Provided, however, that the Target Market Value shall never be less than the highest Actual Market Value for any prior year during the performance period. This Option shall be governed by a "Non-Qualified Stock Option Agreement" substantially in the form previously presented to you. 10. Pension Benefit. (a) In addition to the compensation to be provided in Paragraph 2 above, the Company shall deposit in an irrevocable "vesting trust" an amount of $2,500,000 representing the actuarial present value of a monthly benefit of $16,800, beginning October 1, 1996, during your life and, upon your death, 50% to your surviving spouse, such payments adjusted every fourth year at a rate equal to 50% of the cumulative four year CPI-U, less any payments you will receive from your previously employer's retirement plan. This amount represents the value of the benefit you would have received from your previous employer's plan had you remained in its employment until October 1, 1996. (b) The Company shall within 30 days of the date of your employment, deposit this amount in the vesting trust, it being the intent of the Company that such trust shall afford a measure of security for the payment of these retirement benefits and to provide for the additional net tax liability you will incur upon the vesting of the trust. Under the terms of the trust, the amount of the tax liability will be distributed to you in 1996 necessary to pay any taxes then due, and the remainder to be paid to you in monthly installments equal to the after tax benefit described above. The trust will vest on October 1, 1996, but will not vest in the event that you voluntarily terminate your employment before September 30, 1996 other than for "good reason" defined above or the Company terminates your employment for "good cause" as defined above. With the consent of the Company and you, the trust may purchase an noncancellable annuity contract after October 1, 1996, to provide for such payments to you. 11. Retiree Benefits. On your first day of employment, shall receive an award of 10,000 shares of restricted Company stock that will vest at a rate of 25% per year on each anniversary date of issue. This is intended to compensate you for giving up the health coverage for you and your spouse during your life and your spouse's life, offered by your current employer to its retirees as of the date of the agreement. 12. Non-Compete and Confidentiality. (a) During the term of your employment hereunder and for a period of one year thereafter (or such later date as specified in Paragraph 7), you will not, directly or indirectly, engage in or be interested in any business which is then manufacturing or developing products either marketed by the Company or under development by the Company during the term of your employment, including but not limited to cardiac valve prostheses, vascular grafts, oxygenators, centrifugal blood pump and intra-aortic balloon pump. For the purposes of this paragraph, you will be considered to have been engaged or interested in a business if you engage or are interested in such business as a stockholder, director, officer, employee, agent, broker, partner, individual proprietor, lender, consultant or in any other capacity, except that nothing herein contained will prevent you from owning less than 3% of any class of equity or debt securities listed on a national securities exchange or traded in any established over-the- counter securities market. (b) During the term of your employment hereunder and thereafter, you shall not disclose any confidential information or take any other action proscribed in the "Confidentiality Agreement" substantially in the form previously presented to you. 13. General Provisions. (a) This agreement may not be amended or modified except by written agreement of the parties. (b) In the event that any provision or portion of this agreement shall be determined to be invalid or unenforceable for any reason, the remaining provisions of this agreement shall remain in full force and effect to the fullest extent permitted by law. (c) This agreement shall bind and benefit the parties hereto and their respective successors and assigns, but no right or obligation of Executive hereunder may be assigned without the Company's written consent. (d) This agreement has been made in and shall be governed and construed in accordance with the laws of the State of Minnesota. ____________________________________ If the foregoing correctly sets forth your understanding of our agreement, please so indicate by signing and returning to us a copy of this letter. Very truly yours, ST. JUDE MEDICAL, INC. [signature] Lawrence A. Lehmkuhl Chairman Accepted and agreed to: [signature] Ronald A. Matricaria ST. JUDE MEDICAL, INC. SUPPLEMENTAL EXECUTIVE RETIREMENT PLAN AND TRUST April 12, 1993 TABLE OF CONTENTS Page ARTICLE 1 NAME AND PURPOSE . . . . . . . . . . . . . . . . . . . . . . . . . . 1 1.1 Name . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 1.2 Purpose. . . . . . . . . . . . . . . . . . . . . . . . . . 1 ARTICLE 2 DEFINITIONS AND INTERPRETATIONS. . . . . . . . . . . . . . . . . . . 2 2.1 General Definitions. . . . . . . . . . . . . . . . . . . . 2 ARTICLE 3 PARTICIPATION IN THE PLAN. . . . . . . . . . . . . . . . . . . . . . 7 3.1 Eligibility. . . . . . . . . . . . . . . . . . . . . . . . 7 3.2 Designation of Beneficiary . . . . . . . . . . . . . . . . 7 ARTICLE 4 CONTRIBUTIONS. . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 4.1 St. Jude Contributions . . . . . . . . . . . . . . . . . . 8 4.2 Reversion to St. Jude. . . . . . . . . . . . . . . . . . . 9 4.3 Contribution Does Not Vest . . . . . . . . . . . . . . . . 9 4.4 Valuation of the Trust Fund. . . . . . . . . . . . . . . . 9 ARTICLE 5 INVESTMENT OF CONTRIBUTIONS. . . . . . . . . . . . . . . . . . . . . 9 5.1 Investment Powers. . . . . . . . . . . . . . . . . . . . . 9 5.2 Written Investment Policy. . . . . . . . . . . . . . . . . 10 5.3 Appointment of Investment Manager. . . . . . . . . . . . . 10 5.4 Executive's Right to Direct Investments. . . . . . . . . . 11 ARTICLE 6 VESTING. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 6.1 Vesting of Executive in Trust Fund . . . . . . . . . . . . 12 6.2 Executive's Forfeiture of Interest in Trust Fund . . . . . 12 6.3 Notice and Dispute Resolution. . . . . . . . . . . . . . . 12 ARTICLE 7 PAYMENTS OF BENEFITS . . . . . . . . . . . . . . . . . . . . . . . . 13 7.1 Notice . . . . . . . . . . . . . . . . . . . . . . . . . . 13 7.2 Amount of Benefits and Valuation . . . . . . . . . . . . . 14 7.3 Notice of Benefit Commencement . . . . . . . . . . . . . . 14 7.4 Modes of Payment to Executive After Full Vesting . . . . . 14 7.5 Time for Payment . . . . . . . . . . . . . . . . . . . . . 16 7.9 Medium of Payment. . . . . . . . . . . . . . . . . . . . . 16 7.7 Payment to Executive to Satisfy Taxes. . . . . . . . . . . 16 7.8 Facility of Payment. . . . . . . . . . . . . . . . . . . . 17 ARTICLE 8 CLAIMS PROCEDURE . . . . . . . . . . . . . . . . . . . . . . . . . . 17 8.1 Claims for Benefits. . . . . . . . . . . . . . . . . . . . 17 8.2 Dispute of Benefits. . . . . . . . . . . . . . . . . . . . 17 8.3 Arbitration or Judicial Review of Dispute. . . . . . . . . 18 ARTICLE 9 COMMITTEE. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 9.1 Appointment. . . . . . . . . . . . . . . . . . . . . . . . 19 9.2 Action of the Committee. . . . . . . . . . . . . . . . . . 19 9.3 Meetings . . . . . . . . . . . . . . . . . . . . . . . . . 19 9.4 Records. . . . . . . . . . . . . . . . . . . . . . . . . . 19 9.5 Powers . . . . . . . . . . . . . . . . . . . . . . . . . . 20 9.6 Compensation . . . . . . . . . . . . . . . . . . . . . . . 21 9.7 Indemnity. . . . . . . . . . . . . . . . . . . . . . . . . 21 9.8 Powers Denied. . . . . . . . . . . . . . . . . . . . . . . 21 9.9 Action When There is a Vacancy . . . . . . . . . . . . . . 21 9.10 Settlement of Claims. . . . . . . . . . . . . . . . . 21 9.11 Discretionary Powers . . . . . . . . . . . . . . . . . . . 21 9.12 Employment of Professionals and Assistants . . . . . . . . 22 9.13 Bond . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 ARTICLE 10 TRUSTEE. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 10.1 Duty and Liability of Trustee. . . . . . . . . . . . . . . 22 10.2 General Scope of Powers. . . . . . . . . . . . . . . . . . 23 10.3 Powers Discretionary . . . . . . . . . . . . . . . . . . . 26 10.4 Annual Account . . . . . . . . . . . . . . . . . . . . . . 26 10.5 Person Dealing with Trustee. . . . . . . . . . . . . . . . 26 10.6 Prohibited Transactions. . . . . . . . . . . . . . . . . . 26 10.7 Indemnity. . . . . . . . . . . . . . . . . . . . . . . . . 27 10.8 Resignation and Appointment. . . . . . . . . . . . . . . . 27 10.9 Removal of Trustee . . . . . . . . . . . . . . . . . . . . 27 10.10 Continuation of the Trust . . . . . . . . . . . . . . 28 ARTICLE 11 CLAIMS AGAINST THE TRUST FUND. . . . . . . . . . . . . . . . . . . . 28 11.1 Anti-Alienation of Benefits. . . . . . . . . . . . . . . . 28 11.2 Qualified Domestic Relations Orders. . . . . . . . . . . . 28 11.3 Independent Fund . . . . . . . . . . . . . . . . . . . . . 30 ARTICLE 12 RIGHTS OF ST. JUDE TO AMEND, DISCONTINUE OR TERMINATE. . . . . . . . 30 12.1 Amendment. . . . . . . . . . . . . . . . . . . . . . . . . 30 12.2 Termination of Plan. . . . . . . . . . . . . . . . . . . . 31 12.3 Termination of Trust . . . . . . . . . . . . . . . . . . . 31 ARTICLE 13 SUCCESSOR EMPLOYER AND MERGER OR CONSOLIDATION OF PLANS. . . . . . . 31 13.1 Successor Employer . . . . . . . . . . . . . . . . . . . . 31 13.2 Merger and Consolidation . . . . . . . . . . . . . . . . . 32 ARTICLE 14 MISCELLANEOUS. . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 14.1 Liability of St. Jude. . . . . . . . . . . . . . . . . . . 32 14.2 Indemnification. . . . . . . . . . . . . . . . . . . . . . 32 14.3 No Guarantee of Employment . . . . . . . . . . . . . . . . 33 14.4 Governing Law. . . . . . . . . . . . . . . . . . . . . . . 33 14.5 Binding Effect . . . . . . . . . . . . . . . . . . . . . . 33 ST. JUDE MEDICAL, INC. SUPPLEMENTAL EXECUTIVE RETIREMENT PLAN AND TRUST This Agreement, establishing the St. Jude Medical, Inc. Supplemental Executive Retirement Plan and Trust, is adopted by St. Jude Medical, Inc., a Minnesota corporation, ("St. Jude"), and Norwest Bank Minnesota, N.A. (the "Trustee") and is effective as of April 12, 1993. W I T N E S S E T H : WHEREAS, St. Jude desires to establish a retirement plan (the "Plan") for the benefit of Ronald A. Matricaria ("the Executive"); WHEREAS, Norwest Bank Minnesota, N.A. has agreed to serve as Trustee of the Trust established hereunder; NOW, THEREFORE, the St. Jude Medical, Inc. Supplemental Executive Retirement Plan and Trust is established to read as follows: ARTICLE 1 NAME AND PURPOSE 1.1 Name. The name of the Plan set forth in this instrument is the St. Jude Medical, Inc. Supplemental Executive Retirement Plan, and the name of the trust which is part of that Plan and the terms of which are set forth in this instrument is the St. Jude Medical, Inc. Supplemental Executive Retirement Trust. 1.2 Purpose. The purpose of the Plan is to provide retirement income to the Executive and his family. The purpose of the Trust is to facilitate the administration of the Plan for the exclusive benefit of the Executive and his Beneficiaries. ARTICLE 2 DEFINITIONS AND INTERPRETATIONS 2.1 General Definitions. (1) "Alternate Payee" shall mean a: (a) spouse; (b) former spouse; (c) child; or (d) other dependent of the Executive who is recognized by a Qualified Domestic Relations Order as having a right to receive all, or a portion of, the Executive's Beneficial Interest under the Plan. An Alternate Payee is treated as a Beneficiary for all purposes under the Plan. (2) "Anniversary Date" shall mean each December 31, beginning December 31, 1993. (3) "Beneficial Interest" shall mean all of the assets of the Trust Fund which are distributable to the Executive or his Beneficiary in accordance with the terms of the Plan. (4) "Beneficiary" shall mean the Executive's spouse and his natural or adopted children, or a trust established by the Executive solely for their benefit, who are entitled to receive benefits that may be payable upon or after the Executive's death. (5) "Board of Directors" shall mean the elected Board of Directors of St. Jude Medical, Inc. (6) "Change in Control" shall mean a Change in Control as defined in that certain Employment Agreement between the Executive and St. Jude dated as of April 12, 1993. (7) "Code" shall mean the Internal Revenue Code of 1986, and amendments thereto. (8) "Committee" shall mean the Compensation Committee of the Board of Directors of St. Jude, or its successor, the members of which are named fiduciaries of the Plan within the meaning of Section 402 of the Employee Retirement Income Security Act of 1974. In no event shall the Executive be a member of such Committee at any time prior to the date the Executive becomes fully vested in the Plan as provided in Article 6. (9) "Disability" shall mean a physical or mental condition of the Executive resulting from a bodily injury or disease or mental disorder which renders him incapable of continuing employment with St. Jude. Disability of the Executive shall be determined by the Committee in accordance with uniform principles consistently applied, upon the basis of such medical and other evidence which the Committee deems necessary and desirable. (10) "Earliest Retirement Age" shall mean, for purposes of a Qualified Domestic Relations Order, the earlier of: (a) the date on which the Executive is entitled to a distribution under the Plan; or (b) the later of the day the Executive attains age 50, or the earliest date on which the Executive could begin receiving his Beneficial Interest under the Plan if the Executive separated from service. Earliest Retirement Age shall also mean a date earlier than (i) or (ii) if such date is specified in the Qualified Domestic Relations Order. (11) "Effective Date" shall mean April 12, 1993. (12) "ERISA" shall mean the Employee Retirement Income Security Act of 1974, as amended, and any successor thereto, and any regulations promulgated thereunder. (13) "Good Cause," as grounds for the termination of the Executive's employment by St. Jude, shall mean: (a) prior to a Change in Control, any act by which the Executive in bad faith or with dishonesty, willfully violates any law of any domestic or international government to which St. Jude is bound, willfully fails to follow instructions of the Company's Board of Directors, performs duties with gross negligence or otherwise materially breaches the employment agreement between the Executive and St. Jude; provided, however, that in the case of the Executive's willful failure to follow instructions or other material breach of said employment agreement not involving bad faith, dishonesty or willful violation of law, St. Jude shall give the Executive written notice of such failure or other breach and the Executive shall have 21 days to correct same. (b) after a Change in Control, the conviction of the Executive by a court of competent jurisdiction for felony criminal conduct. (14) "Good Reason", as grounds for the voluntary termination of employment by the Executive, shall mean: (a) prior to a Change in Control, any act by which St. Jude, without the express written consent of the Executive: (i) substantially and materially reduces the principal duties, responsibilities and reporting obligations of the Executive in his position as President and CEO; (ii) reduces the Executive's annual compensation as described in the written employment agreement between St. Jude and the Executive or (iii) fails to provide the Executive with benefits at least as favorable to those enjoyed by the Executive under any of St. Jude's pension, life insurance, medical, health and accident, disability, deferred compensation, incentive awards, incentive stock options, savings plans or vacation plans in which the Executive was eligible to participate in the beginning of his term of employment with St. Jude, provided, however, that nothing herein will restrict St. Jude from altering, amending or terminating any benefit plan so long as any such change applies to executive officers generally. (b) after a Change in Control, without Executive's express written consent, any of the following acts by St. Jude: (i) the assignment to Executive of any duties inconsistent with Executive's status or position with St. Jude, or a substantial alteration in the nature or status of Executive's responsibilities from those in effect immediately prior to the Change in Control; (ii) a reduction by St. Jude in Executive's annual compensation in effect immediately prior to a Change in Control; (iii) the relocation of St. Jude's principal executive offices to a location more than fifty miles from St. Paul, Minnesota or St. Jude requiring Executive to be based anywhere other than St. Jude's principal executive offices except for required travel on St. Jude's business to an extent substantially consistent with Executive's business travel obligations immediately prior to the Change in Control; (iv) the failure by St. Jude to continue to provide Executive with benefits at least as favorable to those enjoyed by Executive under any of St. Jude's pension, life insurance, medical, health and accident, disability, deferred compensation, incentive awards, incentive stock options, or savings plans in which Executive was partici- pating immediately prior to the Change in Control, the taking of any action by St. Jude which would directly or indirectly materially reduce any of such benefits or deprive Executive of any material fringe benefit enjoyed at the time of the Change in Control, or the failure by St. Jude to provide Executive with the number of paid vacation days to which Executive is entitled immediately prior to the Change in Control, provided, however, that St. Jude may amend any such plan or programs as long as such amendments do not reduce any benefits to which Executive would be entitled upon termination; (v) the failure of St. Jude to obtain a satisfactory agreement from any successor to assume and agree to perform that certain Employment Agreement between the Executive and St. Jude dated as of April 12, 1993; or (vi) any purported termination of Executive's employment which is not made pursuant to a Notice of Termination satisfying the requirements of the Employment Agreement described in paragraph (v) above. (15) "Plan" shall mean the St. Jude Medical, Inc. Supplemental Executive Retirement Plan for Ronald A. Matricaria. (16) "Plan Year" shall mean the 12 consecutive months ending on December 31 of each year. (17) "Qualification Procedures" shall mean written procedures adopted by the Committee to: (a) determine whether domestic relations orders meet the requirements for Qualified Domestic Relations Orders; and (b) to administer distributions under such orders. The procedures shall be implemented within a reasonable time after receipt of a domestic relations order by the Committee. Qualification Procedures must permit an Alternate Payee to designate a representative for receipt of copies of notices sent to the Alternate Payee with respect to a Qualified Domestic Relations Order. (18) "Qualified Domestic Relations Order" shall mean a judgment, decree or order, including approval of a property settlement agreement, that relates to provision of child support, alimony payments, or marital property rights to an Alternate Payee, is made pursuant to state domestic relations law (including a state community property law) and creates an Alternate Payee's right to all or a portion of the benefits payable to the Executive under the Plan. A Qualified Domestic Relations Order must satisfy all of the requirements of Section 414(p) of the Code and must specify: (a) the name and last known mailing address of each Alternate Payee; (b) the amount or percentage of the Executive's benefits to be paid to the Alternate Payee or the manner in which the amount is to be determined; (c) the number of payments or period for which payments are required; and (d) each plan to which the order relates. An order does not qualify under this definition if it requires the Committee to provide a benefit or option not available under the Plan, requires the Plan to provide increased benefits or requires payment of benefits to an Alternate Payee that are required to be paid to another Alternate Payee under a previously existing Qualified Domestic Relations Order. (19) "Qualified Joint and Survivor Annuity" shall mean if the Executive has a Spouse at the time of the commencement of benefits, an annuity for the life of the Executive with a survivor annuity for the life of his Spouse which can be purchased with the Executive's Beneficial Interest. A Qualified Joint and Survivor Annuity for the Executive if he is unmarried at the time of the commencement of benefits shall mean an annuity for the life of such Executive and which can be purchased with his Beneficial Interest. (20) "Qualified Preretirement Survivor Annuity" shall mean an annuity for the life of the Executive's surviving Spouse, purchased with the Executive's Beneficial Interest as of the date of the Executive's death. (21) "St. Jude" shall mean St. Jude Medical, Inc., a Minnesota corporation, and its successors and assigns. (22) "Spouse" shall mean the person to whom the Executive is married on the date payments actually commence under the Plan. (23) "Termination of Employment" of the Executive shall mean complete severance from the service of St. Jude. (24) "Trust" shall mean the St. Jude Medical, Inc. Supplemental Executive Retirement Trust. (25) "Trust Fund" or "Fund" shall mean the total of contributions made hereunder, or the investments purchased, increased by profits, income, refunds and recoveries received, and decreased by investment losses and expenses incurred in the administration of the Trust and by benefits released or paid. (26) "Trustee" shall mean the undersigned Trustee or Trustees or any duly appointed successor Trustee. ARTICLE 3 PARTICIPATION IN THE PLAN 3.1 Eligibility. The Executive is the sole employee of St. Jude eligible to participate in the Plan. 3.2 Designation of Beneficiary. Upon commencement of participation in the Plan, the Executive shall complete, sign and file with the Committee a designation of Beneficiary on a form to be provided by the Committee. On said form, the Executive shall designate a Beneficiary (or Beneficiaries), which may be an individual or a trust established solely for the individual, to whom shall be paid any sum which may be payable on account of the Executive's death after the Executive becomes fully vested in the Plan as provided in Article 6 (reserving, however, to the Executive the power to change the designation of Beneficiary from time to time) and where applicable, a particular form of benefit. The Executive's Spouse shall be the Beneficiary of the entire vested and nonforfeitable benefit payable upon the death of the Executive unless the Executive's Spouse irrevocably consents in writing to the designation of another Beneficiary. Such spousal consent shall identify the specific alternate Beneficiary, and where applicable, a particular form of benefit, acknowledge the effect of such designation, and be witnessed by a Plan representative or a notary public. Any subsequent change by the Executive in the designation of a Beneficiary shall require specific written consent by the Executive's Spouse unless the Spouse has previously consented in writing to voluntarily waive the right to consent to subsequent Beneficiary changes, and such consent acknowledges the Spouse's right to otherwise limit consent to a specific Beneficiary. However, the designation of a Beneficiary other than the Executive's Spouse shall be effective if the Committee determines that the foregoing consent may not be obtained because there is no Spouse, because the Spouse cannot be located, or because of other circumstances described in regulations issued by the Secretary of the Treasury. A divorce before the payment commencement date shall terminate all rights of the Executive's ex-spouse to any benefits under this Plan, unless the Executive expressly designates or redesignates the ex- spouse as Beneficiary or as otherwise provided under a Qualified Domestic Relations Order. If the Executive shall fail to validly designate a Beneficiary, or if no designated Beneficiary survives the Executive, the following designated persons shall be the Beneficiaries in the order named: (a) the Executive's spouse, if living; or (b) the Executive's lawful children, if living, including any lawfully adopted children. In the event the last survivor of the Executive, his Spouse, and his children dies prior to the date all assets are distributed from this Plan and Trust, any amount then remaining in the Trust shall revert to St. Jude. Notwithstanding anything herein to the contrary, in the event St. Jude, directly or through insurance, provides a death benefit payment to Executive's Beneficiaries pursuant to that certain Supplement to his employment letter agreement, dated May 5, 1993, no benefits shall be due or paid under this Plan. ARTICLE 4 CONTRIBUTIONS 4.1 St. Jude Contributions. St. Jude shall contribute to the Trust the sum of Two Million Five Hundred Thousand Dollars ($2,500,000.00) within 30 days of the Effective Date of the Plan. In addition, until such time as the Executive becomes fully vested in the Plan as provided in Article 6, St. Jude shall pay any and all reasonable Trustee fees and any additional expenses, including but not limited to, any taxes on the income of the Trust, incurred in connection with the administration of the Plan and Trust. St. Jude shall reimburse the Trust, as an additional contribution, any amount which the Trust is required to pay in federal, state and local income or other taxes imposed upon the Trust during the period prior to the date the Executive becomes fully vested in the Plan as provided in Article 6. From and after the date the Executive becomes fully vested in the Plan as provided in Article 6, St. Jude shall have no further responsibility or obligation to pay any expenses of the Trust or the Trustee. 4.2 Reversion to St. Jude. Except as provided for in Section 3.2 or 6.2, principal or income of this Trust shall not be paid or revert to St. Jude or be used for any purpose whatsoever other than the exclusive benefit of the Executive or his Beneficiaries. 4.3 Contribution Does Not Vest. The fact that a contribution has been made as hereinbefore provided will not of itself operate to vest in the Executive any right, title or interest in the Trust. Vesting will be accomplished only at the times and on the contingencies hereinafter set forth. 4.4 Valuation of the Trust Fund. The Trustee shall determine the fair market value of the Trust Fund as of the Anniversary Date of each Plan Year. All accounts, books and records maintained pursuant to this Section 4.4 shall be opened to inspection and audit at all reasonable times by St. Jude and by the Executive. ARTICLE 5 INVESTMENT OF CONTRIBUTIONS 5.1 Investment Powers. Except as otherwise provided in this Article, during the term of the Trust, the Trustee shall have the exclusive authority and discretion to invest and reinvest the principal and income of the Trust in real and personal property of any kind. The Trustee shall not be limited by the laws of any state proscribing or limiting the investment of trust funds by trustees, either as to types of investments or as to diversification of investments. Notwithstanding the foregoing, until such time as the Executive becomes fully vested in the Plan as provided in Article 6, the Trustee shall invest the Trust Funds only in one or more of the following investments: (a) obligations of or guaranteed by the United States of America; (b) securities traded on a national securities exchange or the NASDAQ national market; (c) commercial paper obligations receiving the highest rating from either Moody's Investors Services, Inc. or Standard & Poor's Corporation or a similar rating service; (d) certificates of deposit, bank repurchase agreements or bankers acceptances (including those of the trustee or of its affiliates) of commercial banks the securities of which or the securities of the holding company of which are rated in the highest category by a nationally- recognized credit agency; (e) an annuity or insurance policy of a company licensed to do business in Minnesota; (f) registered investment funds, including such funds of an affiliate of the Trustee; or (g) a commingled common money-market, stock or bond fund operated by the Trustee. 5.2 Written Investment Policy. The Trustee shall invest the Trust Fund in accordance with the written investment policy set forth as Exhibit A attached hereto and incorporated herein. Except as otherwise provided in Section 5.3, the Committee shall have no further power or authority with respect to the investment of the Trust assets. 5.3 Appointment of Investment Manager. Prior to the date the Executive becomes fully vested in the Plan as provided in Article 6, the Committee may, with the consent of the Executive, appoint one or more parties that are investment managers as defined in ERISA, to have power to manage, acquire, or dispose of all or part of the Trust Fund, and thereafter, the Committee may, with the consent of the Executive, remove such investment manager and appoint a successor. The appointment of any such investment manager and investment of the Trust Fund pursuant to such appointment shall be subject to the following: (a) Written notice of each such appointment shall be given to the Trustee a reasonable time in advance of the date that the investment manager first exercises the power granted to it. Such notice shall state what portion of the Trust Fund is to be invested by the manager and shall direct the Trustee to segregate such portion of the Trust Fund into a separate account for such investment manager. (b) The Trustee shall not act on any direction or instruction of the investment manager until the Trustee has been furnished with an acknowledgment in writing by the investment manager that it is a fiduciary with respect to the Plan. (c) There shall be a written agreement between St. Jude and each investment manager. The Trustee shall receive a copy of each agreement and all amendments thereto and shall give written acknowledgment of receipt of same. 5.4 Executive's Right to Direct Investments. The Executive shall not be permitted to direct the investment of the Trust Fund prior to the date the Executive becomes fully vested in the Plan as provided in Article 6. From and after the date the Executive becomes fully vested in the Plan as provided in Article 6, the Executive shall have the sole authority to instruct the Trustee as to investments (including the acquisition, sale or retention of specific assets), disbursements or any other matter which comes within the investment powers granted to the Trustee under this Plan, provided, however, that the Executive shall not direct the investment of the Trust Fund in any investment in which the Executive, any family member or any affiliate of the Executive has an interest. When the Executive does instruct the Trustee, the Trustee shall have no responsibility or accountability for making any investment, for retaining any investment or for doing any other act directed by the Executive other than to comply with the instructions of the Executive. From and after the date the Executive becomes fully vested in the Plan as provided in Article 6, the Trustee may rely upon any instruction from the Executive given to it in writing and shall be under no duty to inquire as to the action taken. ARTICLE 6 VESTING 6.1 Vesting of Executive in Trust Fund. The Executive shall have a fully vested and nonforfeitable interest in the assets of the Trust Fund and earnings thereon, upon the occurrence of any one of the following events: (a) involuntary Termination of Employment of the Executive by St. Jude for reasons other than Good Cause; (b) voluntary Termination of Employment from St. Jude by the Executive for Good Reason; (c) the Executive's continued employment with St. Jude until October 1, 1996; or (d) October 1, 1996 if, prior to October 1, 1996, the Executive is rendered incapable of continuing his employment with St. Jude due to a Disability and the Executive survives to October 1, 1996. 6.2 Executive's Forfeiture of Interest in Trust Fund. The Executive shall forfeit any and all right, title and interest in and to the Trust Fund upon the occurrence of any one of the following events prior to October 1, 1996: (a) involuntary Termination of Employment of the Executive by St. Jude for Good Cause; (b) voluntary Termination of Employment from St. Jude by the Executive for reasons other than Good Reason; or (c) the Executive dies prior to October 1, 1996. If at any time the Executive's rights to the Trust Fund are forfeited, the purpose of the Trust will be deemed to have been accomplished and all liabilities of the Trust shall be deemed satisfied, the Trust shall terminate and all the assets in the Trust shall revert to St. Jude. 6.3 Notice and Dispute Resolution. Within 30 days after the occurrence of an event specified in this Article resulting in either the full vesting of Executive in accordance with Section 6.1 or the forfeiture by Executive in accordance with Section 6.2, St. Jude and the Executive shall jointly notify the Trustee of such occurrence in writing. If either St. Jude or the Executive disagree as to the occurrence of an event or the consequences of such event, each party shall immediately notify the Trustee that a dispute as to the Executive's rights under the Plan exists. Upon such notice, the Trustee shall not make any payment to the Executive, his Beneficiaries or to St. Jude until such time as the parties resolve such dispute or until the Trustee is ordered to pay or begin payments to one or the other of the parties or by a court of competent jurisdiction. Any such dispute between St. Jude and the Executive as to the occurrence of an event giving rise to full vesting or forfeiture under this Article (including, but not limited to, any determination with respect to Executive's Disability) shall be resolved by the parties in accordance with Article 8. ARTICLE 7 PAYMENTS OF BENEFITS 7.1 Notice. The Trustee shall furnish the Executive or Beneficiary with a written statement of the terms, conditions and forms of payment from the Trust available to him no less than 30 nor more than 90 days prior to the first day of the first period for which an amount is paid as an annuity or any other form under Section 7.5 of the Plan. The statement shall explain: (a) the terms and conditions of the Qualified Joint and Survivor Annuity; (b) the Executive's right to make, and the effect of, an election to waive the Qualified Joint and Survivor Annuity form of benefit; (c) if the Executive is married at the time, the right of the Executive's Spouse to consent to the above election; and (d) the right to make, and the effect of, a revocation of a previous election to waive the Qualified Joint and Survivor Annuity. The Trustee shall furnish the Executive and his Spouse, if any, with a statement explaining the Qualified Preretirement Survivor Annuity in a form similar to the form described above. 7.2 Amount of Benefits and Valuation. Benefits under the Plan shall be paid solely from the Trust Fund and the amount payable to the Executive shall be based on the fair market value of the assets of the Trust as of the time for distribution. 7.3 Notice of Benefit Commencement. Upon receipt of a notice of benefit commencement, the Trustee shall, within 10 days of receipt of such notice, provide notice to St. Jude of such commencement, and the terms thereof and St. Jude shall, within 30 days after receipt of such notice, inform the Trustee whether or not St. Jude disputes such benefit commencement. If St. Jude disputes such commencement, the Trustee shall not pay any amount to the Executive except in accordance with Section 6.3. It shall be the responsibility of the Trustee to verify that the Executive's Beneficial Interest from the Trust shall be due and payable in accordance with the terms of the Plan and Trust. 7.4 Modes of Payment to Executive After Full Vesting. (a) The Executive's Beneficial Interest shall be paid at the time specified in Section 7.5 in the form of a Qualified Joint and Survivor Annuity unless the Executive elects subject to the provisions of this Subsection to waive the Qualified Joint Survivor Annuity or to receive another form of benefit as provided under paragraph (b). An election to waive the Qualified Joint and Survivor Annuity shall be made (or revoked) within 90 days prior to the date on which payment of his Beneficial Interest begins, and shall be effective only if: (i) the Executive's Spouse consents in writing to such election, and the Spouse's consent acknowledges the effect of such election and the consent is witnessed by a Plan representative or a notary public; or (ii) it is established to the satisfaction of the Trustee that the Spouse's consent may not be obtained because there is no Spouse, because the Spouse cannot be located, or because of such other circumstances that the Secretary of the Treasury may prescribe by regulation. Any consent by the Spouse under paragraph (i) above (or establishment that the consent of the Spouse cannot be obtained under paragraph (ii) above) shall be effective only with respect to such Spouse. If the Executive dies before payment of his Beneficial Interest has commenced and has a surviving Spouse, payment of benefits shall take place as provided in Subsection (c) below. (b) If the Executive is unmarried on the date on which payment of his Beneficial Interest begins, as specified in Section 7.5, or if the Executive has elected to waive the Qualified Joint and Survivor Annuity as provided above, the Executive's Beneficial Interest in the Plan shall be paid under one or more of the following modes of settlement selected by the Executive, or by the Executive's designated Beneficiary if the Executive dies before commencement of benefits: (i) by payment of nonperiodic lump sum amounts; provided, however, that the cumulative payments during the first 12 month period commencing on the date on which the Executive becomes fully vested as provided in Article 6 shall not exceed 1/10th of the value of the Trust Fund as of the most recent Anniversary Date (excluding any amount payable under Section 7.7(a)) and thereafter, a fraction of the value of the Trust Fund as of the most recent Anniversary Date, the denominator of which is reduced by one for each subsequent 12 month period, and further provided that any amount not distributed in any year shall be available for distribution in any later year; (ii) by payment in the form of annual or more frequent installments of as nearly equal amounts as may be conveniently determined over a period of not less than 10 years; or (iii) by payment in any other form of annuity over the life of the Executive, the joint lives of the Executive and his Beneficiary or over a period certain of not less than 10 years. (c) If the Executive dies before commencement of his Beneficial Interest and leaves a surviving Spouse, the Executive's Beneficial Interest shall be paid to his surviving Spouse in the form of a Qualified Preretirement Survivor Annuity, unless the Executive had otherwise elected as provided herein, subject to the following rules: (i) Payment of such benefit shall commence within 60 days after the Executive's death, unless the surviving Spouse elects a later date in accordance with this Article, but in no event later than the date the Executive would have reached age 70.5. (ii) The Executive's surviving Spouse may elect in writing to receive such benefit in any of the forms permitted under Subsection (b). (iii) The Executive may elect to waive the Qualified Preretirement Survivor Annuity. Designation under Section 3.2 of a Beneficiary or Beneficiaries other than the Executive's Spouse shall be deemed a waiver of the Qualified Preretirement Survivor Annuity, subject to the Spouse's consent in accordance with that Section. (iv) The Trustee shall provide the Executive with a written explanation of the Qualified Preretirement Survivor Annuity containing comparable information to that required in regard to the Qualified Joint and Survivor Annuity under Section 8.1. The decision of the Executive as to the mode of settlement shall be final and the Trustee shall not be liable to the recipient (or to any heir, Beneficiary, or representative of the Executive, or of the recipient if other than the Executive) for such decision notwithstanding the fact that another mode of settlement would have resulted in a greater benefit. Any distribution to a Beneficiary shall be in accordance with this Article and shall be determined as if the Beneficiary were the Executive. 7.5 Time for Payment. Except as otherwise set forth below, payment of the Executive's Beneficial Interest in the Plan to the Executive, or his Beneficiary, to be made or begin as soon as administratively feasible following the date the Executive becomes fully vested in the Plan as provided in Article 6, or on such later date as elected by the Executive. 7.9 Medium of Payment. Any payment of benefits from the Plan to the Executive or his Beneficiary shall be made in cash, except that, with the consent of the Executive or his Beneficiary, such a payment may be in the form of a nontransferable, noncancellable annuity contract upon termination of the Plan and Trust. 7.7 Payment to Executive to Satisfy Taxes. Notwithstanding anything in this Article to the contrary: (a) The Trustee shall, upon request of the Executive, distribute to the Executive such amount of the Trust Fund as the Executive represents as necessary to pay any and all federal, state and local taxes which are assessed against the Executive as a result of the Executive's becoming fully vested in the Plan in accordance with Article 6. The Trustee may request reasonable proof of the amount requested by the Executive. The Trustee shall make payment to the Executive as soon as administratively feasible following verification of such amount, but in no event later than the date such taxes are otherwise due from Executive. Such distribution shall not be credited against or reduce any amount otherwise payable under Section 7.4. (b) In addition to any amounts payable under the preceding paragraph, following the Executive's becoming fully vested in the Plan in accordance with Article 6, the Trustee shall, upon request of the Executive, pay to the Executive part or all of any interest, gains or earning on the Trust Fund for the Plan Year. Such distribution shall be credited against, and reduce, any amount otherwise payable under Section 7.4. 7.8 Facility of Payment. In case of incompetency of the Executive or Beneficiary entitled to receive any distribution under the Plan, and if the Trustee shall be advised of the existence of such condition, the Trustee shall direct distribution to any one of the following: (a) to the duly appointed guardian, conservator, or other legal representative of the Executive or Beneficiary; or (b) to a person or institution entrusted with the care or maintenance of the incompetent Executive or Beneficiary, provided such person or institution has satisfied the Trustee that the payment will be used for the best interest and assist in the care of the Executive or Beneficiary and; provided further, that no prior claim for said payment has been made by a duly appointed guardian, conservator, or other legal representative of the Executive or Beneficiary. Any payment made in accordance with the foregoing provisions of this Section shall constitute a complete discharge of any liability or obligation of St. Jude, the Trustee, and the Trust Fund. ARTICLE 8 CLAIMS PROCEDURE 8.1 Claims for Benefits. At any time after the Executive becomes fully vested in the Plan as provided in Article 6, the Executive or, if the Executive is deceased, his Beneficiary may make a claim for Plan benefits, by filing a written request with the Trustee on a form to be furnished to him for such purpose. The Executive or Beneficiary shall also furnish such additional information as may be reasonably necessary to pay the Executive's Beneficial Interest in accordance with the terms of the Plan and Trust. 8.2 Dispute of Benefits. Any dispute between the Executive and St. Jude as to the occurrence of an event described in Article 6 and the effect of such event or any other dispute under the Plan shall be resolved first by the Board of Directors of St. Jude. The Board of Directors shall furnish to the Executive a notice of its decision, meeting the requirements stated below within 30 days after receipt of a notice of dispute from the Executive. If special circumstances require more than 30 days to process the claim, this period may be extended for up to an additional 30 days by giving written notice to the Executive before the end of the initial 30-day period, stating the special circumstances requiring the extension and the date by which a decision is expected. Failure to provide a notice of decision in the time specified shall constitute a denial of the claim, and the Executive shall be entitled to the rights specified in Section 8.3. The notice to be provided to the Executive in the event the claim for benefits is denied, shall be in writing and shall set forth the following: (a) the specified reason or reasons for the denial of a benefit; (b) specific reference to pertinent Plan provisions on which the denial is based. 8.3 Arbitration or Judicial Review of Dispute. If the Executive is dissatisfied with the decision of the Board of Directors of St. Jude under Section 8.2, the Executive shall have the right, in addition to all other rights and remedies provided by law, at his election, either to seek arbitration in St. Paul, Minnesota, under the rules of the American Arbitration Association, by serving a notice to arbitrate upon St. Jude or to institute a judicial proceeding, in either case within 60 days after having received notice of denial of benefits under this Plan, or within such longer period as may reasonably be necessary for the Executive to take action in the event of his Disability during such 60 day period. If arbitration is elected, each party shall select one arbitrator and a third arbitrator shall be selected by St. Jude from a list submitted to it by the Executive. Each party shall bear its own costs and expenses, including attorney and expert witness fees, in any arbitration or judicial proceeding. All decisions of the Committee or the Board of Directors with respect to Executive's rights to his Beneficial Interest under the Plan shall be subject to review de novo by the court or arbitrators. ARTICLE 9 COMMITTEE 9.1 Appointment. The Compensation Committee of the Board of Directors of St. Jude is designated as the administrator of the Plan and its members are "named fiduciaries." Such Committee shall be responsible for the administration of the Plan prior to and until such time as the Executive shall become fully vested in the Plan as provided in Article 6, at which time the authority and control of the Committee otherwise provided in this Plan shall cease. The Executive shall not be a member of this committee at any time prior to the date on which he becomes fully vested in the Plan as provided in Article 6. 9.2 Action of the Committee. The Committee may authorize one or more of its members or any agent to execute or deliver any instrument on behalf of the Committee. 9.3 Meetings. The Committee shall hold such meetings upon such notice and at such place or places and at such time or times as it may from time to time determine. A majority of members then serving on the Committee shall constitute a quorum for the conduct of business and the affirmative vote of a majority of the members present at any meeting shall be necessary to approve action taken at the meeting. Action by the Committee may be taken without a formal meeting by the written authorization of all the members thereof. 9.4 Records. The Committee shall keep all records appropriate for the performance of its powers and duties under the Plan and may keep appropriate written records of its meetings. 9.5 Powers. Prior to the date the Executive becomes fully vested in the Plan, the Committee shall have full power and authority to do each and every act and thing which it is specifically required or permitted to do under the provisions of the Plan and in addition thereto shall have the following discretionary powers and duties in connection with the administration of the Plan: (a) to adopt from time to time such bylaws, procedures and forms as the Committee considers appropriate in the operation and administration of the Plan and Trust; (b) to determine that an event giving rise to full vesting by the Executive as provided in Article 6 shall have occurred; (c) to establish rules and procedures needed for its administration of the Plan; (d) to receive information and review copies of all Trust accountings; (e) to exercise general administration of the Plan except to the extent responsibilities are expressly conferred on others; (f) to be the designated agent of the Plan for the service of legal process; (g) to determine conclusively for all parties all questions arising in the interpretation or administration of the Plan; (h) to employ a qualified investment manager to manage all or part of the Plan assets; (i) to allocate fiduciary duties and responsibilities (other than Trustee responsibilities) among members of the Committee or other named fiduciaries appointed by the Committee to act in such capacity and to designate persons other than named fiduciaries to carry out fiduciary responsibilities (other than Trustee responsibilities) under the Plan to the extent that it is deemed advisable by the Committee. For purposes of this subparagraph, Trustee responsibility shall mean any responsibility provided in the Trust to manage or control the assets of the Plan, other than power of the Committee to appoint an investment manager in accordance with Section 402(c)(3) of ERISA. Before the Committee delegates any duties or responsibilities as provided herein, it must first obtain approval for such delegation from the Board of Directors of St. Jude. The Committee shall periodically review the performance of any person to whom it has delegated such responsibilities. In no event shall the Committee delegate any authority to the Executive prior to the date he becomes fully vested in the Plan as provided in Article 6. It is intended under this Plan and Trust that each fiduciary shall be responsible for the proper exercise of its own powers, duties, responsibilities and obligations under this Plan and the Trust, and shall not be responsible for any act or failure to act of another fiduciary. 9.6 Compensation. No member of the Committee shall receive any compensation from the Trust for his services. 9.7 Indemnity. St. Jude shall indemnify each member of the Committee against any and all claims, loss, damages, expenses (including counsel fees approved by the Committee), and liability (including any amounts paid in settlement with the Committee's approval) arising from any loss or damage or depreciation which may result in connection with the execution of his duties or the exercise of his discretion or from any other action or failure to act hereunder, except when the same is judicially determined to be due to gross negligence or willful misconduct of such member. 9.8 Powers Denied. No action of the Committee shall: (a) alter the amount of the contribution otherwise payable to the Plan; (b) increase the duties or liabilities of the Trustee without its written consent; or (c) cause the funds contributed to this Trust or the assets of this Trust to ever revert to or be used or enjoyed by St. Jude, except as provided in this Plan. 9.9 Action When There is a Vacancy. If at any time there should be a vacancy on the Committee, then pending the appointment of a successor to fill such vacancy, the remaining members shall have the power to act on behalf of the Committee. 9.10 Settlement of Claims. The Committee shall have the power to accept, compromise, arbitrate, or otherwise settle any obligation, liability or claim, but it shall not be obligated to do so unless, in its sole judgment, it is in the interest of the Plan or Trust to do so. 9.11 Discretionary Powers. Whenever in this Plan and Trust discretionary powers are given to the Committee, it shall have absolute discretion, and its decision shall be binding upon all persons affected thereby. 9.12 Employment of Professionals and Assistants. The Committee shall have the power: (a) to secure such legal, medical, and actuarial advice or assistance as it deems necessary or desirable in carrying out the provisions of the Plan; (b) to appoint or employ such other advisors or assistants as it deems necessary or desirable to carry out its duties. The Committee shall have full discretion to employ any person or firm that it deems qualified to supply any of the required services set forth above; provided, however, that the person or firm so employed shall be independent of the control of St. Jude and, where required, shall have all necessary licenses to practice his profession. 9.13 Bond. Until such time as the Executive becomes fully vested in the Plan as provided in Article 6, St. Jude shall obtain and maintain a fidelity bond that shall cover every fiduciary of the Plan and every person who handles funds or other property of the Plan ("Plan official"). Each fiduciary and Plan official shall be bonded in an amount which is not less than 10% of the assets of the Plan. Said bond will insure the Plan against loss by reason of acts of fraud or dishonesty on the part of every fiduciary and Plan official, directly or through connivance with others. ARTICLE 10 TRUSTEE 10.1 Duty and Liability of Trustee. The Trustee shall discharge its duties with respect to this Plan solely in the interests of the Executive and his Beneficiaries and for the exclusive purpose of providing benefits to the Executive and his Beneficiaries and defraying reasonable expenses of administering the Plan. The Trustee shall have generally all of the powers of owners with respect to securities or properties held in the Trust Fund, but shall not be liable for any losses incurred upon investments, except to the extent such Trustee failed to diversify the investments of the Plan so as to minimize the risk of large losses (unless under the circumstances it is clearly prudent not to do so), or failed to manage the investments of the Plan with the care, skill, prudence and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims. Except to the extent such duties may be expressly allocated to the Trustee, the Trustee in its capacity as such shall have no authority or responsibility with respect to the operation and administration of the Plan. 10.2 General Scope of Powers. Except as otherwise provided in Article 5, the Trustee shall have all powers necessary for the performance of its duties. In extension, but not in limitation of the rights, powers and discretion conferred upon the Trustee by virtue of any statute or rule of law, or conferred upon the Trustee by other provisions of this Plan and Trust, the Trustee shall have and may exercise from time to time in the administration of the Trust herein created and for the purpose of distribution after the termination thereof and for the purpose of distributing the Executive's Beneficial Interest after vesting thereof, and without order or license of any court, any one or more of the following rights, powers and discretion: (a) To Determine Executive's Beneficial Interests. To compute and determine the interest of the Executive and Beneficiaries in the Trust Fund, and any such computation or determination made in good faith shall be binding and conclusive upon all parties to this Plan and Trust and upon all persons interested or who may become interested in the Trust Fund. (b) To Carry Securities in Nominee Form. To purchase, hold and carry investments for the Trust Fund in the name of the Trustee, or in the name of any nominee or nominees selected by the Trustee, without Trust designation in any said case, and to invest funds of the Trust in deposits, including savings accounts, savings certificates, and similar interest-bearing instruments or accounts, in itself or its affiliates, provided that such deposits bear a reasonable rate of interest. (c) To Exercise Powers of Owners in Cases of Reorganization, Merger and the Like. To institute, participate and join in any plan of reorganization or readjustment or merger or consolidation of any corporation, the securities of which are held by the Trust Fund, or to use any other means of protecting or dealing with any investments of the Trust Fund, and in general, to exercise each and every other power or right with respect to each investment of the Trust Fund as individuals generally have and enjoy with respect to their own investments and securities, including the power to give proxies, with or without power of substitution or revocation, and to deposit securities with any protective committee or with a trustee or with depositories designated by any such committee or by any such trustee or by any court. (d) To Segregate Funds for Proper Purposes. To segregate any parts or portion of the Trust Fund for the purposes of administration thereof, or for purposes of distribution, or for any other purpose deemed proper by the Trustee. (e) To Sue and Defend and be Indemnified on that Account. To institute or defend any proceedings at law or in equity concerning the Trust Fund or the assets thereof at the sole cost and expense of the Trust Fund, and of the several Beneficial Interests involved or concerned therein, but the Trustee shall be under no duty or obligation to institute, maintain, or defend any suit, action or other legal proceedings except and unless the Trustee shall have been indemnified to the Trustee's satisfaction against all expenses and liabilities which the Trustee may sustain or anticipate by reason thereof. (f) To Sell or Otherwise Dispose of Assets. To sell, exchange, or otherwise dispose of any investment of the Trust Fund for such price and on such terms as the Trustee in the Trustee's absolute discretion shall elect, without regard to whether the time of payment provided in any said sale shall be greater than the probable or actual duration of the Trust herein created or not. (g) To Employ Agents, Servants and Attorneys. To select and employ or retain such agents, servants, or attorneys as the Trustee from time to time may deem necessary or advisable in connection with the management and operation of the Trust herein created, and to pay the fees, commissions, or salaries incurred on account thereof as an expense of administration of the Trust. (h) To Value Assets and the Trust Fund. To fix and determine, at the current fair market value thereof, the value of the Trust Fund annually and from time to time as may be necessary or advisable, in the Trustee's opinion, for any of the purposes of this Plan and Trust, including power to fix and determine the then fair market value of each and every item constituting the Trust, the items composing the same, and any such computation, determination, or action of the Trustee made in good faith shall be binding and conclusive upon all parties to this Plan and Trust and upon St. Jude, and the Executive and his Beneficiary. (i) To Determine Complex Questions of Income and Principal. To determine, in accordance with sound business or accounting practices, with respect to any receipt of the Trust Fund and without regard to statutes or rules of law that otherwise would be controlling, the part or portion thereof which is income and the part or portion thereof which is principal, and to charge or credit to principal or income, as the Trustee may from time to time elect (without duty or obligation to exercise this power uniformly in all cases) any premiums paid or received or discounts received or allowed in connection with, or any gain or loss resulting from the purchase, sale, call, redemption or payment of any security or investment acquired, held, or disposed of by the Trust Fund. (j) To Require Settlement and Allowance of Accounts Before Making Distribution. In making distribution of any Beneficial Interest, to demand and receive from the Executive or Beneficiary such verification as the Trustee in its sole discretion shall require before the Trustee shall be obligated to pay, distribute, or make available any part thereof to the Executive or Beneficiary. (k) Form and Method of Accounting. To select and determine the appropriate forms, methods and books of account for use by the Trustee in the management and administration of the Trust herein created and for the purpose of accounting for the same. (l) Compensation. To receive reasonable compensation for the Trustee's services as Trustee hereunder, and to pay from out of the Trust Fund all costs, fees, expenses, taxes, and other charges and expenses of administration and distribution of the Trust Fund to the extent that they are not paid directly by St. Jude as provided in Section 4.1, and the Trustee shall further be entitled to reimburse itself for or on account of any said item of disbursement from and out of the Trust Fund from time to time held by the Trustee. From and after the date the Executive becomes fully vested in the Plan as provided in Article 6, all compensation and other expenses of the Trustee shall be paid solely from the Trust Fund. (m) To Pay any Taxes on the Trust Fund. To pay when due any taxes of any kind levied or assessed against the Trust Fund under the existing or future laws of the United States and any state or local taxing authority. To the extent required by law, the Trustee shall withhold from any payment to the Executive or Beneficiary any amount of taxes required by law, or such larger amounts as may be requested by the Executive or Beneficiary. The Trustee shall cooperate with St. Jude or the Executive who shall be primarily responsible for filing any return required by any tax authority in connection with the operation of the Plan. (n) To Hold and Deposit Funds. To hold uninvested such cash funds as may appear reasonably necessary to meet the anticipated cash requirements of the Plan from time to time, and to deposit such funds or any part thereof, either separately or together with other trust funds under the control of the Trustee, in its own deposit department or to deposit the same in its name as Trustee in such other depositories as he may select. 10.3 Powers Discretionary. Each of the foregoing rights, powers and discretion conferred upon the Trustee and each and every power possessed by trustees generally by virtue of any statute or rule of law or other provisions of this Plan and Trust shall be discretionary powers exercisable by the Trustee, and the Trustee shall in no event be or become liable to anyone on account of the exercise of any said power by him in good faith. 10.4 Annual Account. The Trustee shall account annually for the Trust Fund and for its various transactions in connection therewith to the Committee. 10.5 Person Dealing with Trustee. No purchaser at any sale made by the Trustee hereunder, and no person, firm, or corporation dealing with the Trustee shall be obligated to see to the application of any money or property paid or delivered to the Trustee. All persons dealing with the Trustee may act in reliance upon the signature of the Trustee and shall not be bound to inquire as to whether or not said signature represents valid action by the Trustee. 10.6 Prohibited Transactions. Except as may be expressly permitted by law, no Trustee or other fiduciary hereunder shall permit the Plan to engage, directly or indirectly, in any of the following transactions with a disqualified person (as defined in Section 4975 of the Code): (a) sale or exchange, or leasing, of any property between the Plan and a disqualified person; (b) lending of money or other extension of credit between the Plan and a disqualified person; (c) furnishing of goods, services or facilities between the Plan and a disqualified person; (d) transfer to, or use by or for the benefit of, a disqualified person of the income or assets of the Plan; (e) act by a disqualified person who is a fiduciary whereby he deals with the income or assets of the Plan in his own interest or for his own account; or (f) receipt of any consideration for his own personal account by any disqualified person who is a fiduciary from any party dealing with the Plan in connection with a transaction involving the income or assets of the Plan. 10.7 Indemnity. St. Jude shall indemnify, save and hold harmless, the Trustee from any and all loss, damage and liability which the Trustee may incur or sustain, arising out of the performance of its nondiscretionary duties under the Plan to the extent directed by the Committee, except to the extent that they result from the willful misconduct or gross negligence or lack of good faith of the Trustee, or such actions are otherwise contrary to the terms of the Plan or ERISA. Except to the extent otherwise required under ERISA or other applicable law, the Trustee shall not be liable for the acts or omissions of third parties. 10.8 Resignation and Appointment. The Trustee, or any successor Trustee, must accept its appointment in writing. The Trustee, or any successor Trustee, may resign as Trustee of this Trust at any time by giving 30 days' notice of resignation by registered mail to St. Jude, or if the Executive has become fully vested in the Plan, the Executive, or such shorter notice as may be agreed to by St. Jude or the Executive, as appropriate. Upon such resignation becoming effective, the resigning Trustee shall render to St. Jude an account of its administration of the Trust during the period following that covered by the most recent account, and shall perform all acts necessary to transfer the assets of the Trust to its successor Trustee. In the event of the resignation of the original or any successor Trustee, St. Jude, or if the Executive has become fully vested in the Plan, the Executive, shall have the power to appoint a successor Trustee. Any successor Trustee shall be a corporate Trustee with the authority to operate in the State of Minnesota and with assets under trust of at least $500,000,000. No successor Trustee shall be or become liable for any action or default of a prior Trustee. 10.9 Removal of Trustee. St. Jude, or if the Executive has become fully vested in the Plan, the Executive may remove a Trustee or any successor Trustee upon 30 days' notice of removal by registered mail to the Trustee, or such shorter notice as may be agreed to by the Trustee in the event the Trustee has breached its duties under this Plan. In case of such removal, the Trustee shall be under the same duty to account for and transfer assets of the Trust to a successor as hereinabove provided in the case of the resignation of a Trustee; and St. Jude or if the Executive has become fully vested in the Plan, the Executive shall have the same power to appoint a successor Trustee as provided in Section 10.8. 10.10 Continuation of the Trust. Resignation, disqualification, liability or removal of a Trustee shall not terminate the Trust; and any successor Trustee shall have all powers, duties and discretion herein conferred upon the original Trustee. ARTICLE 11 CLAIMS AGAINST THE TRUST FUND 11.1 Anti-Alienation of Benefits. Except as otherwise provided herein, neither the Executive nor any Beneficiary shall have any transmissible interest in the Trust Fund or in his Beneficial Interest therein, either before or after the vesting thereof, or in any of the assets comprising the same prior to actual payment and distribution thereof to him, nor shall such person have any power to alienate, dispose of, pledge or encumber the same, while in the possession or control of the Trustee, nor shall the Trustee recognize any assignment thereof, either in whole or in part, nor shall the interest of the Executive or Beneficiary be subject to attachment, garnishment, execution or other legal process while in the hands of the Trustee. 11.2 Qualified Domestic Relations Orders. Notwithstanding any provision to the contrary herein, the Committee may assign the interest of the Executive in the Plan to an Alternate Payee pursuant to a Qualified Domestic Relations Order if such order is received prior to the date the Executive becomes fully vested in the Plan as provided in Article 6. In the event the Plan receives a Qualified Domestic Relations Order with respect to the Executive's interest in the Trust Fund, the following provisions shall apply: (a) The Committee shall promptly give written notification to the Executive and to the Alternate Payee of receipt of a domestic relations order and of Plan Qualification Procedures. The Committee shall then proceed with Qualification Procedures to determine whether the order is a Qualified Domestic Relations Order and shall notify the Executive and Alternate Payee (or the Alternate Payee's designated representative) of its determination. (b) Disputed funds shall be disposed of as follows: (i) During the period in which the Qualification Procedures are in progress, the Committee shall separately account for any amounts which would be payable to an Alternate Payee if the domestic relations order is determined to be a Qualified Domestic Relations Order. (ii) If the order is determined to be a Qualified Domestic Relations Order within the 18-month period beginning on the date on which the first payment would be required to be made under the order, the Committee shall pay the amounts designated in the Order, together with earnings or losses, if required, to the Alternate Payee. (iii) If the Committee determines that the order is not a Qualified Domestic Relations Order, or if the 18-month period described in paragraph (i) above elapses and the qualification dispute has not been resolved, the Committee shall pay such amounts, together with earnings or losses, if required, to the persons who would have received the amounts if the order had not been issued. (iv) If an order is qualified after expiration of the 18-month period described in paragraph (i) above, payment of benefits to an Alternate Payee shall proceed prospectively and the Plan shall not be liable to an Alternate Payee for benefits attributable to the period prior to qualification. (c) The Committee shall obey a Qualified Domestic Relations Order requiring that benefits be paid to an Alternate Payee beginning on a date on or after the Executive's Earliest Retirement Age, even though the Executive does not have a Termination of Employment on that date. (d) Payment of benefits pursuant to a Qualified Domestic Relations Order shall be made only as permitted under the Plan. (e) To the extent permitted by law and except as otherwise provided under a Qualified Domestic Relations Order, the Committee may, on a uniform basis, charge the reasonable and necessary expenses associated with the review of a domestic relations order and the implementation of a Qualified Domestic Relations Order as an expense of the Trust. 11.3 Independent Fund. In the event St. Jude shall at any time go out of business, cease to exist, be dissolved, either voluntarily or involuntarily, or have a receiver or trustee in bankruptcy appointed for it, or be merged or consolidated into or with another company, no part of the Trust Fund created hereunder or the Executive's Beneficial Interest shall in any manner whatsoever be or become subject to the rights or claims of any of its creditors, but the Trust herein created from its inception shall be a separate entity, aside and apart from St. Jude and its assets, and except as provided in Section 6.2, St. Jude shall have no claim or right to repossess any part of the funds or properties of the Trust or of the income derived therefrom. ARTICLE 12 RIGHTS OF ST. JUDE TO AMEND, DISCONTINUE OR TERMINATE 12.1 Amendment. Except as herein limited, prior to the date the Executive becomes fully vested in the Plan as provided in Article 6, the Board of Directors of St. Jude shall have the right to amend this Plan and Trust at any time to the extent necessary to satisfy the requirements of ERISA. Such amendment will be stated in an instrument in writing executed by St. Jude. Upon delivery of such instrument to the Trustee, this Plan and Trust shall be deemed to have been amended in the manner therein set forth, and the Executive shall be bound thereby; provided, however: (a) that no amendment shall increase the duties or liabilities of the Trustee without its written consent; (b) that no amendment shall have the effect of vesting in St. Jude any interest in or control over any of the funds or properties subject to the terms of the Trust; (c) that no amendment shall modify the vesting requirements hereunder; and (d) that no amendment shall reduce the Executive's Beneficial Interest. From and after the date the Executive becomes fully vested in the Plan as provided in Article 6, the Plan and Trust shall not be amended except upon written agreement of both the Executive and the Board of Directors of St. Jude. 12.2 Termination of Plan. This Plan shall continue indefinitely as a contractual obligation of St. Jude until such time as the purposes herein are accomplished, at which time the Plan shall terminate. From and after the date Executive becomes fully vested in the Plan as provided in Article 6, the Plan and Trust shall not be terminated except by written agreement of both the Executive and the Board of Directors of St. Jude. 12.3 Termination of Trust. The term of the Trust herein created shall be for such time as may be necessary to accomplish the purposes set forth herein and in no event shall the term exceed the limits prescribed by the laws of the jurisdiction to which the Trust is subject. In the event such limit should be reached at any time, or for any reason, prior to the accomplishment of the purposes for which the Trust is created, the Trust shall be deemed to have terminated upon the attainment of such limit. The Board of Directors of St. Jude reserves the right to terminate the Trust at any time after the Executive's rights in the Plan are fully vested with the consent of the Executive, provided that all assets in the Trust Fund are distributed to the Executive and his Beneficiaries in the form of a nontransferable, noncancellable annuity contract. ARTICLE 13 SUCCESSOR EMPLOYER AND MERGER OR CONSOLIDATION OF PLANS 13.1 Successor Employer. In the event of the dissolution, merger, consolidation or reorganization of St. Jude, provision may be made by which the Plan and Trust will be continued by the successor; and, in that event, such successor shall be substituted for St. Jude under the Plan. The substitution of the successor shall constitute an assumption of Plan liabilities by the successor and the successor shall have all of the powers, duties and responsibilities of St. Jude under the Plan. 13.2 Merger and Consolidation. This Plan shall not be merged into or consolidated with, or the assets and liabilities of the Trust Fund transferred in whole or in part to another trust fund held under any other plan or deferred compensation plan maintained or to be established for the benefit of and other employees of St. Jude. ARTICLE 14 MISCELLANEOUS 14.1 Liability of St. Jude. All benefits payable under the Plan shall be paid or provided for solely from the Trust. Upon the deposit of funds into the Trust as provided in Section 4.1, St. Jude shall have no further responsibility for contributions or otherwise to provide for the Beneficial Interest of the Executive under this Plan and Trust. From and after the date the Executive becomes fully vested in the Plan in accordance with Article 6, St. Jude's authority under this Plan and Trust shall be limited to the enforcement of the limitations on distributions set forth in Article 7 and to approving the termination of the Plan and Trust upon satisfaction of all of its liabilities to Executive. 14.2 Indemnification. St. Jude shall be responsible to comply with any and all applicable requirements of ERISA, including, but not limited to, all reporting and disclosure imposed upon the Employer during the term of the Plan and Trust, and St. Jude shall indemnify and hold harmless the Executive from any liability resulting from any act or omission by St. Jude as Employer in connection with the Plan and Trust. Executive shall indemnify and hold harmless St. Jude from any loss or liability arising out of ERISA or otherwise resulting from any act or omission of Executive required or permitted hereunder. 14.3 No Guarantee of Employment. Nothing contained in this Plan and Trust shall be deemed to give the Executive the right to be retained in the employ of St. Jude or to interfere with the right of the Executive to terminate his employment with St. Jude at any time. 14.4 Governing Law. This Plan and Trust shall be construed, administered, and governed in all respects under the laws of the State of Minnesota to the extent not preempted by federal law. 14.5 Binding Effect. This Plan and Trust shall be binding upon and inure to the benefit of the heirs, personal representatives, successors and assigns of any and all of the parties hereto. IN WITNESS WHEREOF, St. Jude Medical, Inc. has caused the St. Jude Medical, Inc. Supplemental Executive Retirement Plan and Trust to be executed by its officer, who has been duly authorized by its Board of Directors; Norwest Bank Minnesota, N.A. has executed this Plan and Trust and hereby accepts its appointment as Trustee; and Executive has executed this Plan and Trust, as of the Effective Date. ST. JUDE MEDICAL, INC. [signature] By: Lawrence A. Lehmkuhl Its Chairman of the Board NORWEST BANK MINNESOTA, N.A. [signature] By Jeanne M. Whitehill Its Assistant Vice President [signature] By Christine Kaehler Its Vice President EXECUTIVE: Ronald A. Matricaria EXHIBIT A WRITTEN INVESTMENT POLICY PURSUANT TO SECTION 5.2 The general investment objectives for the Plan are: 1. To outperform inflation and to equal or exceed the total return of the Standard & Poor's 500 Index. 2. To establish a diversified investment portfolio consisting of equities, fixed income and cash investments that are diversified among securities and industries and are of acceptable quality and diversification. 3. To maximize the pretax return for the total portfolio within reasonable and prudent levels of risk. The general philosophy for the investment program follows: A. The investment program should achieve performance results over a full market cycle that compare favorably to major market indices. B. A particular security class may underperform appropriate market indices in strong markets because of the need to maintain a moderate risk posture in both equity and fixed income investments. C. The Plan should have better than average performance in a weak or declining market by outperforming appropriate market indices because it expects to avoid significant exposure to market declines. D. There should be consistency of results allowing negative returns for both equities and fixed income assets so long as the appropriate market indices are also negative; provided, however, that the Plan in the aggregate should outperform appropriate market indices during periods of negative market results. SUPPLEMENTARY EXECUTIVE RETIREMENT PLAN AGREEMENT THIS AGREEMENT, between St. Jude Medical, Inc., a Minnesota corporation ("St. Jude") and Lawrence A. Lehmkuhl of St. Paul, Minnesota ("Mr. Lehmkuhl"), restating and superseding that certain Supplementary Executive Retirement Plan Agreement dated September 30, 1988, is made and entered into as of the 9th day of April, 1993. WHEREAS, St. Jude and Mr. Lehmkuhl entered into a Supplementary Executive Retirement Plan Agreement effective September 30, 1988 (the "1988 Agreement") to provide Mr. Lehmkuhl with a meaningful pension benefit upon his retirement, taking into account the benefits to which Mr. Lehmkuhl is otherwise due under St. Jude's qualified pension plan and other sources; and WHEREAS, Mr. Lehmkuhl intends to resign as an employee of St. Jude and assume the duties as Chairman of the Board of Directors of St. Jude, whereupon he would forfeit any benefits under the 1988 Agreement, unless St. Jude terminates the Agreement before such termination of employment or otherwise agrees to provide such benefit to Mr. Lehmkuhl; and WHEREAS, paragraph 12 of the 1988 Agreement reserved to St. Jude the power to amend or terminate the Agreement at any time by action of its Board of Directors; and WHEREAS, St. Jude desires to continue to provide Mr. Lehmkuhl the benefits otherwise accrued under the 1988 Agreement at the time of his termination of employment and to restate and modify the 1988 Agreement as set forth herein. THEREFORE, pursuant to the authority reserved to St. Jude in paragraph 12 of the 1988 Agreement, the 1988 Agreement is hereby restated in it entirety to read as follows: 1. Purpose. The purpose of this Agreement is to provide an unfunded deferred compensation for Mr. Lehmkuhl, who is a member of a select group of management employees of St. Jude as that term is used in the Employee Retirement Income Security Act of 1974, as amended in accordance with the terms of the 1988 Agreement. 2. Definitions. The following capitalized terms shall have the meanings specified in this section: a. "Accrued Benefit" shall mean the amount payable to Mr. Lehmkuhl or his named beneficiaries, which represents the present value of Mr. Lehmkuhl's Pension Benefit less his Benefit Offset described in Section 3 discounted at an annual rate of 6% from his Normal Retirement Date to the date of the determination, as set forth on the attached Exhibit A. b. "Actuarial Equivalent" shall mean a lump sum amount payable as of Mr. Lehmkuhl's Normal Retirement Date based on reasonable mortality tables and interest rate consistently applied. c. "Benefit Offset" shall mean the sum of the following retirement benefits (including any death benefit payable upon the death of Mr. Lehmkuhl) expressed as: (i) $3,000, representing the accrued benefit under the American Hospital Supply Corporation Employee Pension Plan and any other deferred compensation plan of American Hospital Supply Corporation or its affiliates to which Mr. Lehmkuhl may be entitled; (ii) $3,476, representing the assumed life annuity value of the account balance under the St. Jude Medical, Inc. Retirement Savings Plan and Trust attributable to contributions other than Mr. Lehmkuhl's cash or deferred contributions or rollover contributions; and (iii) $1,806, representing the assumed Social Security benefits to which Mr. Lehmkuhl is entitled, whether or not Mr. Lehmkuhl is or has been receiving such benefits prior to age 65. d. "Normal Retirement Date" shall mean the date on which Mr. Lehmkuhl attains age 65. e. "Pension Benefit" shall mean $13,225, payable monthly during Mr. Lehmkuhl's life, beginning with the month Mr. Lehmkuhl attains his Normal Retirement Date, which amount represents 50% of Mr. Lehmkuhl's average monthly base salary for the 12 months prior to July 1, 1993. 3. Retirement Pension Benefit. If Mr. Lehmkuhl attains his Normal Retirement Date, St. Jude shall pay to Mr. Lehmkuhl the Actuarial Equivalent of the Pension Benefit, less Mr. Lehmkuhl's Benefit Offset and less the cash surrender value owned by or transferred to Mr. Lehmkuhl (including any policy loans taken by Mr. Lehmkuhl) of any Policy maintained pursuant to that certain Split-Dollar Agreement dated September 30, 1988, as restated April 9, 1993, together with the amount provided in Section 6. Such amount shall be payable in a single lump sum within 60 days following Mr. Lehmkuhl's attainment of his Normal Retirement Date. In the event the cash surrender value of such policy exceeds the Actuarial Equivalent of the Pension Benefit less the Benefit Offset, no payment shall be due hereunder. 4. Pre-Retirement Death Benefit. In the event Mr. Lehmkuhl dies prior to his Normal Retirement Date, St. Jude shall pay to Mr. Lehmkuhl's named beneficiary or beneficiaries his Accrued Benefit as of the date of his death, less the cash surrender value owed by or transferred to Mr. Lehmkuhl (including any policy loans taken by Mr. Lehmkuhl) of any Policy maintained pursuant to that certain Split Dollar Agreement dated September 30, 1988, as restated April 9, 1993. The Pre-Retirement Death Benefit shall be payable in a single lump sum within 60 days following Mr. Lehmkuhl's date of death. 5. Designation of Beneficiary. Mr. Lehmkuhl may designate a beneficiary or beneficiaries and may change such designation at any time by written notice to St. Jude in the form attached hereto, which shall be effective only upon receipt by St. Jude. In the event Mr. Lehmkuhl fails to name a beneficiary, or if any and all designated beneficiaries have predeceased Mr. Lehmkuhl, payment of any benefits shall be made to Mr. Lehmkuhl's spouse, if living, otherwise to Mr. Lehmkuhl's surviving children in equal shares, and if no spouse or children survive Mr. Lehmkuhl, to the executor or administrator of Mr. Lehmkuhl's estate. 6. Additional Payment for Taxes. In addition to the amount payable under Sections 3 or 7 of this Agreement, St. Jude shall pay to Mr. Lehmkuhl such additional compensation as is necessary, after taking into account all federal, state and local taxes payable by Mr. Lehmkuhl as a result of the receipt of such additional compensation, such that the payment received under Sections 3 or 7 represents an after tax amount. 7. Merger, Consolidation or Sale of Assets. In the event of a merger, consolidation or sale of substantially all of the assets of St. Jude where St. Jude is not the surviving corporation, Mr. Lehmkuhl's Accrued Benefit shall be immediately payable to Mr. Lehmkuhl in a lump sum within 60 days of the effective date of such merger, consolidation or sale of assets, together with the amount provided in Section 6; provided that such tax payment shall never exceed the tax otherwise payable at Normal Retirement Age as if this Agreement had continued in effect until such date. 8. Assignment of Benefits. Neither Mr. Lehmkuhl, nor his spouse or beneficiary may assign or alienate the benefits payable under this Agreement, whether voluntary or involuntary, or directly or indirectly. 9. No Funding. This Agreement shall not be funded by St. Jude and neither Mr. Lehmkuhl, his spouse nor beneficiaries shall have any right, title, or interest in any of St. Jude's assets or have any greater rights than an unsecured general creditor of St. Jude in any respect with regard to benefits payable under this Agreement. 10. Claims and Arbitration Procedure. The Board of Directors of St. Jude shall make all determinations concerning rights to benefits under this Agreement; provided that the Chairman shall not participate in any matter before the Board regarding this Agreement. Any decision by the Board of Directors of St. Jude denying a claim by Mr. Lehmkuhl for benefits under this Agreement shall be stated in writing and delivered or mailed to Mr. Lehmkuhl (or beneficiary). Such decision shall set forth the specific reasons for the denial, as well as specific reference to the provisions of this Agreement upon which denial is based. In addition, St. Jude shall afford a reasonable opportunity to Mr. Lehmkuhl (or his beneficiary) for a full and fair review of the decision denying such claim, provided that such request for a review is received by St. Jude within 60 days of the date of receipt of such denial. If any claim arising under this Agreement is not resolved under the preceding paragraph or any other dispute arises under the terms of this Agreement, the Board of Directors of St. Jude and Mr. Lehmkuhl agree to submit the claim or dispute to arbitration proceedings held in accordance with the rules of the American Arbitration Association. Judgment upon the award rendered by the arbitrators may be entered in any court having jurisdiction thereof. Pending final resolution of the dispute, St. Jude and Mr. Lehmkuhl shall continue to comply with the provisions of this Agreement not in dispute. The expenses of the arbitration shall be borne equally by the parties to the arbitration, provided that each party shall pay for and bear the costs of its own experts, evidence and legal counsel. Such arbitration shall be held in Minneapolis, Minnesota. 11. Amendment and Termination. St. Jude may amend and may terminate this Agreement at any time by the action of its Board of Directors in the event of a change in the laws providing for the deferral of income taxes on amounts deferred under this Agreement. Any amendment to or termination of this Agreement shall not decrease the obligations of St. Jude to pay a benefit equal to the benefit that would have been provided to Mr. Lehmkuhl upon his Normal Retirement Date, and further provided that upon termination of this Agreement, the Board of Directors of St. Jude may, in its sole discretion, pay to Mr. Lehmkuhl his Accrued Benefit at time of the termination of this Agreement. 12. Construction of Agreement. This Agreement shall be construed according to the laws of the State of Minnesota. IN WITNESS WHEREOF, St. Jude has caused this Agreement, which restates and supersedes the 1988 Agreement, to be executed on behalf of the corporation and Mr. Lehmkuhl has executed this Agreement as of the day and date first above written. ST. JUDE MEDICAL, INC. By Thomas H. Garrett III Its Secretary ___________________________ Lawrence A. Lehmkuhl CALCULATION OF ACCRUED BENEFIT AND DEATH BENEFIT UNDER SERP Calendar Year Accrued Benefit Under SERP Agreement 1993 $371,275 1994 393,552 1995 417,165 1996 442,194 1997 468,726 1998 496,850 1999 526,661 2000 558,260 2001 591,756 2002 627,261 ST. JUDE MEDICAL, INC. DESIGNATION OF BENEFICIARY Pursuant to the terms of an Executive Supplemental Retirement Agreement, dated April 9, 1993, between St. Jude Medical and Lawrence A. Lehmkuhl, I hereby designate the following beneficiary(ies) to receive any payments which may be due under such Agreement after my death: Primary Beneficiary 1. [ ] My spouse, ______________________________________, if my spouse survives me. 2. [ ] My descendants, per stirpes, who survive me. (The share of a deceased child will be distributed to the deceased child's children.) 3. [ ] My children who survive me in equal shares. (The children of a deceased child will not be entitled to their parent's share.) 4. [ ] Other: _______________________________________________________________ Name Relationship Contingent Beneficiary(ies) --------------------------------------------------------------- Name Relationship --------------------------------------------------------------- Name Relationship The Primary Beneficiary named above shall be the designated beneficiary referred to in Article 4 of said Agreement if he or she is living at the time a death benefit payment thereunder becomes due and payable, and the Contingent Beneficiary named above shall be the designated beneficiary referred to in Article 4 of said Agreement only if he or she is living at the time a death or retirement benefit payment becomes payable and the Primary Beneficiary is not then living. Upon acknowledgement by St. Jude this designation hereby revokes any prior designation which may have been in effect. Date:______________________________ _______________________________ ______________________________ (Witness) Lawrence A. Lehmkuhl Acknowledged By: ______________________________ Title Received By (Company Use Only): ______________________________ ST. JUDE MEDICAL, INC. MANAGEMENT INCENTIVE COMPENSATION PLAN MANAGEMENT INCENTIVE COMPENSATION PLAN The Management Incentive Compensation Plan (MICP) is designed to reward management for achieving annual performance goals. MICP intents include: Reinforce strategically important operational objectives Establish stretch goals related to profitability, and Provide additional compensation based on achieving significant company, division, organizational unit and individual goals The Plan serves St. Jude's interests by motivating its management and providing annual compensation opportunities which are comparable to those found among similar organizations within the industry. 1994 CHANGES The MICP contains several changes for 1994 which are detailed in later sections of this document. These changes include: Incorporating the Technical Incentive Compensation Plan (TICP) into the MICP Establishing the lowest level of Plan eligibility at grade levels A15 and E15 Assigning performance measures which are most directly within participants' control Calculating MICP awards by adding results from each performance measure rather than multiplying results across performance measures For 1994, setting 10% of payout aside subject to president/ CEO discretion Redefining base salary as annual base compensation paid during the Plan year, excluding commissions, special awards, bonuses, and perquisites. PLAN SUMMARY Individual MICP awards for division participants are based on achievement of corporate earnings per share (EPS), division income before taxes (IBT), and local/individual performance objectives (MBO). Individual MICP awards for corporate participants are based on achievement of corporate EPS and individual performance objectives. Awards are calculated and distributed during the first quarter of the subsequent year following Audit Committee approval of year end results and subject to approval by the president/CEO, the Compensation Committee of the Board and the Board of Directors. Funding for the Plan is based on percent of corporate EPS goal achieved. The president/CEO and the Compensation Committee of the Board set the corporate EPS target annually based on the Company's operating plan, subject to approval by the Board of Directors. TARGET AWARD LEVELS Target award levels vary by participant grade level. Award levels range from 20% of base salary at the A15/E15 level to 50% of base salary at the A24 level, and 100% for the president/CEO. MANAGEMENT INCENTIVE COMPENSATION PLAN TARGET AWARD LEVELS Grade Level Management Group Percent of Base ----------------------------------------------------- A26 President/CEO 100% A24 Officers 50% A20-A22 Officers 40% A18-A19 Officers/Directors 30% E/A16-E/A17 Directors/Managers 25% E/A15 Managers 20% In the event that performance measures are exceeded, awards may exceed the above-stated target award levels. Such overachievement awards will be based on a percentage of the participants' bonus to a maximum of 25% of the bonus. PERFORMANCE MEASURES The Plan uses three performance measures to determine MICP awards: corporate EPS, division IBT, and local/individual performance objectives. The Plan assigns performance measures which are most directly within participants' ability to influence them. For example, division presidents directly impact division performance which in turn impacts the consolidated results of the Company. Division presidents, therefore, have been assigned MICP performance measures which are exclusively tied to corporate and division results. Corporate participants directly impact overall corporate results and, therefore, have performance measures largely based on corporate EPS. Performance measures for division participants, including country managers, are largely based on division and local/individual performance objectives. PERFORMANCE MEASURES & WEIGHTS BY ORGANIZATIONAL LEVEL CORPORATE DIVISION LOCAL/INDIVIDUAL Earnings Per Income Before Performance Levels: Share (EPS) Taxes (IBT) Objectives - ----------------------------------------------------------------- CEO 100% - - Division Presidents 50% 50% Corporate Participants 70% - 30% Division Participants 30% 40% 30% Country Managers 20% 30% 50% INDIVIDUAL OBJECTIVES Corporate EPS and division IBT goals are established prior to the start of each Plan year by the president/CEO, the Compensation Committee of the Board, and the Board of Directors. The process for setting participants' local/individual performance objectives begins with the operating plan as approved by the Board of Directors. Based on the operating plan, the president/CEO provides direct staff with annual objectives for application within their specific functional area. All MICP participants will incorporate these objectives to the extent they apply in their functional area. The six-to-seven most essential individual performance objectives are listed on the 1994 Local/Individual Performance Objectives form (see Appendix A) and submitted for approval to the division president and/or the president/CEO. Once approved, objectives are reviewed quarterly to ensure milestones are met and any changes are reviewed by the president/CEO. The year-end achievement level for local/individual performance objectives must be approved by the division president or corporate vice presidents, with final approval by the president/CEO. ELIGIBILITY Employees in grade level 15 and above positions as of January 1 of the Plan year are eligible to participate in MICP, subject to president/CEO approval. New employees hired into grade level 15 and above positions after January 1 but before October 1 of the Plan year are eligible to participate on a pro rata basis. Current employees promoted into grade level 15 and above positions between January 1 and October 1 of the Plan year will be eligible to participate, or participate at a higher level, on a pro rata basis. Individuals hired or promoted into grade level 15 and above positions after October 1 of the Plan year will be ineligible for participation during the remainder of the Plan year. FURTHER INFORMATION This information summarizes the Management Incentive Compensation Plan. It is not intended to be an all inclusive document. The Compensation Committee of the Board and the Board of Directors has final discretion on all employee incentive programs. If you have any questions regarding this Plan, please contact the division human resource manager or Corporate Compensation. DEFINITION OF TERMS The following terms as used in the Plan shall have the meaning as set forth below: PERFORMANCE MEASURES - Performance measures for corporate EPS, division IBT and local/individual performance objectives are based on the operating plan. The Board may amend the performance measures to reflect material adjustments in or changes to the Company's accounting policies; to reflect changes due to foreign currency translations, to reflect material corporate changes such as mergers, acquisitions, or divestitures; and to reflect such other events having a material impact on the performance measures. BASE SALARY - Annual base compensation paid during the Plan year, excluding commissions, special awards, bonuses, and perquisites. PARTICIPANT - Any employee or position which shall have been designated by the Board as a participant in the Plan for the year or during the year. ELIGIBILITY - If a management position is qualified to participate in the MICP, individuals will be eligible on January 1 of the Plan year. Any individuals hired or promoted into an MICP position on or before October 1 of the Plan year shall be eligible to participate on a pro rata basis effective with the date in which the individual is hired or promoted. Individuals hired or promoted into an MICP position after October 1 will not be eligible to participate in the Plan until the following year. PLAN YEAR - Shall mean the fiscal year of the corporation. FUNDING - Funding levels are determined by percent of corporate EPS goal achieved. AWARDS - The actual amount to be paid to a participant based upon achievement of corporate, division and local/individual performance objectives (as applied). TARGET AWARD LEVELS - The percent of base salary for which a participant is eligible, based on grade level. For instance, an A15 participant is eligible for a 20% target award. OVERACHIEVEMENT AWARDS - Achievement in excess of 100% of Corporate EPS and division IBT performance measures may qualify the participant for an additional award based on a percentage of the normal award. DESIGNATION OF PARTICIPANTS - The minimum level of MICP eligibility is at grade level A15 or E15. Each eligible employee at grade 15 or above shall be furnished with a copy of the Plan as it applies to him/her and shall be notified of the level of incentive for which he/she is eligible. PAYMENT OF AWARDS - Individual awards will not be paid until the president/CEO and Compensation Committee of the Board of Directors approve each participant's individual award and the Audit Committee approves year-end results. PROMOTIONS - Awards for individuals promoted to either a higher level MICP position or from a non-MICP position to an MICP position prior to October 1 of the Plan year will be pro- rated effective the day in which the individual is promoted into the new position. DEMOTIONS - For individuals demoted from one MICP level position to another, the lower MICP level will be effective the day in which the demotion occurs. For individuals demoted into a non-MICP position, MICP award will be pro- rated based on the length of time in the MICP position. TERMINATION OF EMPLOYMENT - In the event that any participant shall cease to be a full-time employee during any year in which s/he is participating in the Plan, such participant shall be entitled to receive no incentive compensation for such Plan year. If s/he terminates after the Plan year, but prior to the award payment, payment is at the discretion of the president/CEO. AMENDMENT OF THE PLAN - The Board, may, from time to time, make amendments to the Plan as it believes appropriate and may terminate the Plan at any time, provided that no such amendment or termination will affect the right of any participant to receive incentive compensation in accordance with the terms of the Plan for the portion of any year up to the date of the amendment or termination. MISCELLANEOUS - Nothing contained in the Plan shall be construed to confer upon any employee any right to continue in the employ of the Company or the Company's right to terminate his/her employment at any time. 1994 MICP PERFORMANCE MEASURES CORPORATE Corporate performance funds MICP awards. The award level for the president/CEO is 100% based on Corporate performance. Corporate performance impacts MICP awards for other participants as follows: division presidents (50%), division participants (30%), corporate participants (70%), and country managers (20%). 1994 CORPORATE PERFORMANCE (YEAR-END EARNINGS PER SHARE) Percent of Funding Goal Achieved Percentage - ------------- ---------- 110% 115% 108% 110% 106% 105% 104% 100% 103% 95% 102% 90% 101% 85% 100% 80% 99% 79% 98% 75% 97% 70% 96% 60% 95% 55% 94% 50% 0% Under the 1994 program, payment of 10% of a participant's target award will be subject to the president/CEO discretion. LOCAL/INDIVIDUAL PERFORMANCE OBJECTIVES Division and corporate participant MICP awards are 30% based on local/individual performance. Country managers MICP award is 50% based on local country performance. 1994 LOCAL/INDIVIDUAL PERFORMANCE LOCAL/INDIVIDUAL PERFORMANCE OBJECTIVES Percent of Award Measure Achieved Percentage - ---------------- ---------- 100% 100% 99% 99% 98% 98% 97% 97% 96% 96% 95% 95% 94% 94% 93% 93% 92% 92% 91% 91% 90% 90% 85%-89% 85% 80%-84% 80% <80% 0% DIVISION GOALS Division performance directly impacts corporate EPS. Division presidents have 50% of their MICP award based on division performance, other division participants have 40% of their MICP award based on division performance, and country managers have 30% of their MICP award based on division performance. 1994 ST. JUDE MEDICAL DIVISION INCOME BEFORE TAXES (IN THOUSANDS) Percent of Award Measure Achieved Percentage - ---------------- ---------- 110% 115% 108% 110% 106% 105% 104% 100% 103% 95% 102% 90% 101% 85% 100% 80% 99% 79% 98% 75% 97% 70% 96% 60% 91-95% 55% 85-90% 50% Under 85% 0% 1994 CARDIAC ASSIST DIVISION INCOME/LOSS BEFORE TAXES (IN THOUSANDS) Percent Measure Award Achieved Percentage - ---------------- ---------- 307% 115% 276% 110% 245% 105% 215% 100% 184% 95% 153% 90% 123% 85% 100% 80% 50% 75% 0% 70% -150% 65% -200% 60% Under -200% 0% 1994 ST. JUDE MEDICAL INTERNATIONAL DIVISION INCOME BEFORE TAXES (IN THOUSANDS) Percent of Award Measure Achieved Percentage - ---------------- ---------- 110% 115% 108% 110% 106% 105% 104% 100% 103% 95% 102% 90% 101% 85% 100% 80% 99% 79% 98% 75% 97% 70% 96% 60% 91-95% 55% 85-90% 50% Under 85% 0% ESTABLISHMENT OF 1994 INDIVIDUAL PERFORMANCE OBJECTIVES In establishing individual performance objectives, the following guidelines should be used: Each objective should be concise, clear and measurable (based on time, cost, and task accomplishment) Each objective should be a precise, written statement which is discussed and agreed upon by the individual and manager Individual objectives should measure accomplishment and not effort Individuals should normally have 6-to-7 objectives in total Before receiving an MICP award, it will be necessary for immediate managers to: Submit written measurable objectives using the attached format prior to commencement of the Plan year (or two weeks after receipt of this material) to the division president and/or the president/chief executive officer for review and approval Submit a documented quarterly evaluation of results against established objectives to the division president and/or the president /chief executive officer by the second Monday following each calendar quarter closes Any modifications or adjustments to the original objectives must be reviewed by the participant and his/her manager and then submitted to the division president or the president/chief executive officer for their respective approvals Submit the final year-end results against objectives by January 9, 1995, to the division president and the president/chief executive officer for their respective approvals All proposed MICP awards will be reviewed for approval by the Compensation Committee of the Board of Directors ACKNOWLEDGEMENT 1994 MANAGEMENT INCENTIVE COMPENSATION PLAN This is to acknowledge that I have read and understand the terms and conditions of the attached Management Incentive Compensation Plan for the 1994 Plan year. NAME: __________________________________ DATE: ___________________________________ EXHIBIT 11 ST. JUDE MEDICAL, INC. AND SUBSIDIARIES YEAR ENDED DECEMBER 31, 1993 EXHIBIT 11 - COMPUTATION OF EARNINGS PER SHARE ST. JUDE MEDICAL, INC. Annual Report Leader in Quality Products for Tomorrow's Health Care [photo] Financial Highlights 1 Letter to Shareholders 2 Q&A with the CEO 4 Review of Operations 6 Mission Statement 16 Management's Discussion and Analysis 17 Report of Management 21 Report of Independent Auditors 21 Consolidated Financial Statements 22 Notes to Consolidated Financial Statements 26 Ten-Year Summary of Selected Financial Data 30 Directors and Officers 32 Investor Information 33 ABOUT THE COMPANY St. Jude Medical, Inc. is a multinational manufacturer and marketer of the world's leading mechanical heart valve. The Company serves physicians worldwide with the highest quality medical devices for cardiovascular applications. Since the introduction of the St. Jude Medical(R) mechanical heart valve in 1977, more than 500,000 have been successfully implanted. St. Jude Medical is headquartered in St. Paul, Minnesota, and has operations in Chelmsford, Massachusetts; St. Hyacinthe, Canada; Caguas, Puerto Rico; and Brussels, Belgium; as well as sales and service offices throughout the United States, Japan and Europe. The Company's products are sold in more than 75 countries and its customers include more than 1,500 open heart centers worldwide. At December 31, 1993, St. Jude Medical employed 722 people in 11 countries. St. Jude Medical, Inc. common stock is traded on the over-the-counter market's National Market System under the symbol STJM. Listed options are traded on the Chicago Board Options Exchange under the symbol SJQ. OUR PRODUCTS *St. Jude Medical(R) mechanical heart valve. *St. Jude Medical(R) mechanical heart valve Hemodynamic Plus series. *BioImplant(R) tissue heart valve. *Toronto SPVtm tissue heart valve. *BiFlex(tm)annuloplasty ring. *Collagen-impregnated aortic valved graft. *Model 700 intra-aortic balloon pump system. *RediFurl(R), RediGuardtm and TaperSeal(R) intra-aortic balloon catheters. *Lifestream(R) centrifugal pump system. *Isoflow(R) centrifugal pump. THE COVER: JUDI GAVIN OF PRINCETON, NEW JERSEY What difference has a St. Jude Medical(R) mechanical heart valve made in the life of Judi Gavin, 41-year-old competitive A level tennis player, certified scuba diver and skier? "I now feel like I have a Maserati engine in a Yugo body," Gavin says. She was born with congenital aortic stenosis, a narrowing of the aortic valve. When she was a child, her condition was discovered by her father, Angelo Migliori, M.D., now a retired cardiologist -- and his daughter's frequent tennis partner. Despite shortness of breath, Gavin developed an extremely active lifestyle. But her condition progressively worsened, forcing her to have surgery to replace her aortic valve at age 35. Gavin recalls: "I was concerned about the effects a St. Jude valve would have on my life. But knowing what I know now, I'd have had the surgery years before I did. I feel better than I ever have. Four months after my surgery, I won the tennis tournament at my club for the third consecutive year. I can still scuba dive to depths of 90 feet. And I love to ski from the top of a mountain to the bottom without stopping, which I could never do before. I've also taken up aerobic exercises." Gavin works full time as a manager in IBM's Latin America organization. She volunteers with the Women's Heart Research Foundation, from whom she received the 1993 Ambassador Award. She has written and plans to publish a book for children with serious illnesses. FINANCIAL HIGHLIGHTS (Dollars in thousands, except per share amounts) Year ended December 31 1993 1992 % Change INCOME STATEMENT Net sales $252,642 $239,547 5 Operating profit 131,288 122,258 7 Net income 109,643 101,658 8 Earnings per share 2.32 2.12 9 PROFIT MARGINS Gross 75.7% 74.8% Operating 52.0 51.0 Net 43.4 42.4 BALANCE SHEET Cash and marketable securities $368,991 $338,690 9 Property, plant and equipment, net 47,185 35,433 33 Total assets 526,817 469,750 12 Shareholders' equity 484,241 429,039 13 FINANCIAL CONDITION Current ratio 11.0/1 10.8/1 Shareholders' equity to total liabilities 11.4/1 10.5/1 Return on average net operating assets 68.2% 75.0% [photo] Ronald A. Matricaria President and Chief Executive Officer [caption]: "We have an ambitious but achievable vision for St. Jude Medical to become a globally significant medical device company built on several major technology platforms, including our heart valve business." TO OUR SHAREHOLDERS St. Jude Medical accomplished a great deal in 1993's tumultuous health care environment. Most significantly, we moved decisively to set the stage for diversification so that we can achieve improved future growth and maximize long-term shareholder value. Through diversification, we can mitigate risks associated with reliance on a single product line and fuel our growth. After many months of work, we have developed St. Jude Medical's first comprehensive diversification strategy, which will guide us to swift and intelligent action with regard to appropriate opportunities. During 1993, we also strengthened our world leadership position in the mechanical heart valve business and achieved record financial performance. We are continuously improving and strengthening our core business to become the most innovative and efficient company in all facets of the heart valve market. RECORD FINANCIAL PERFORMANCE During 1993, sales grew to $252.6 million, up 5.5 percent from $239.5 million in 1992. Net income reached $109.6 million, an increase from the year-earlier level of $101.7 million. Earnings per share totaled $2.32 versus $2.12 for 1992, an increase of 9.4 percent. Our 1993 first half year-over-year income statement comparisons were very favorable. However, during the third and fourth quarters, sales and earnings felt the impact of foreign currency exchange rate changes, increasing worldwide competition and reduced domestic market demand. Our gross margin continued to improve, moving from 74.8 percent in 1992 to 75.7 percent in 1993, as we increased manufacturing efficiency in both our St. Jude Medical and Cardiac Assist divisions. Net after-tax margin reached 43.4 percent, up from 42.4 percent in 1992. Our vertical integration strategy continued to unfold as we reduced reliance on our major outside supplier and completed construction of a new, highly efficient manufacturing plant. Under the contract with our supplier, we will have the opportunity by 1999 to be completely self-sufficient in producing the main components for the St. Jude Medical(R) mechanical heart valve. St. Jude Medical's strong balance sheet offers us considerable opportunity and financial flexibility to achieve our diversification objectives. At the end of 1993, cash totaled $369.0 million, or 70 percent of total assets of $526.8 million. We have no debt. During the year, we repurchased 1.2 million shares of the Company's stock for a total of 1.4 million shares repurchased since 1992. We continued to pay a $.10 per share quarterly cash dividend. CORE BUSINESS ACHIEVEMENTS During 1993, we were pleased with strong market acceptance of our new Hemodynamic Plus (HP) mechanical heart valve. We made significant progress in tissue valve products -- our single greatest opportunity to accelerate growth in the heart valve business. The initial human implants of the tissue valve developed by The Heart Valve Company, our 50-50 joint venture with Hancock Jaffe Laboratories, are planned for the first half of 1994 in Europe. We continue to make excellent progress in international marketing of the Toronto SPVtm (Stentless Porcine Valve) and we recently received Food and Drug Administration (FDA) approval to enter clinical trials in the United States with this product. St. Jude Medical's Cardiac Assist Division is investing in new products to increase worldwide market share. In 1993, we introduced a new intra-aortic balloon catheter, the RediGuardtm 2.0, which we believe is the best on the market today. 1994 GOALS During 1994, we will continue to build our core heart valve business and effectively deal with increased competition. We are thoroughly prepared, from both product superiority and marketing perspectives, to meet our biggest competitive challenge this year -- the U.S. market entry of mechanical valve manufacturer, CarboMedics, Inc. We will become more efficient, focusing in 1994 on bringing our new heart valve component manufacturing facility on line and beginning the FDA qualification process. We will continue to research, develop and introduce new products and would expect to achieve international market share gains. We plan a 1994 international introduction of a new rotatable mechanical heart valve, which surgeons prefer in certain cases. We also will move forward aggressively to implement our diversification strategy. THE FUTURE We have an ambitious but achievable vision for St. Jude Medical to become a globally significant medical device company built on several major technology platforms, including our heart valve business. In the near term, we seek one technology platform with a fully developed world leadership capability, and another representing an emerging technology with potential for eventual market leadership. Over the next several years, we will create shareholder value through diversification and by investing in research and development, vertical integration and new service and distribution capabilities. Much of our future growth will come from acquisitions, joint ventures, research and development partnerships, and investments in technology-based companies. During 1993, we invested in InControl, Inc. of Redmond, Washington, which is developing a product to treat atrial fibrillation. We also signed a license and supply agreement with California-based Telios Pharmaceuticals, Inc., which has developed biocompatible product coatings designed to improve tissue ingrowth. We recently made an investment in Advanced Tissue Sciences, Inc. of La Jolla, California, and separately signed an agreement to pursue the joint development of tissue engineered heart valves. A WORD OF THANKS We would like to extend our sincere thanks to William G. Hendrickson, who retired from our Board of Directors in July 1993 after 12 years as chairman. Dr. Hendrickson provided us with strong leadership and insight during a period of tremendous growth and profitability. The gold standard we carry into the future is our core heart valve business, which has lengthened and improved the lives of more than 500,000 people. We look forward, with you, to an exciting future of growth and change for St. Jude Medical. Sincerely, [signature] RONALD A. MATRICARIA President and Chief Executive Officer [signature] LAWRENCE A. LEHMKUHL Chairman of the Board March 15, 1994 [photo] [caption]: Lawrence A. Lehmkuhl Chairman of the Board [photo] [caption]: "I support the concept of managed competition and the idea that competitive forces should be allowed to work freely. However, I do not believe that the government should be the nation's health care manager." HEALTH CARE REVOLUTION: Q&A WITH RON MATRICARIA In March 1993, St. Jude Medical's Board of Directors named Ronald A. Matricaria to the position of president and chief executive officer, assigning him the responsibility for leading the Company to a new level of growth and prosperity. Prior to joining St. Jude Medical, Mr. Matricaria spent 23 years with Eli Lilly and Company. He most recently was executive vice president of the Pharmaceutical Division and president of North American Operations. He brings significant medical device and international marketing experience through his previous positions as president of the company's Medical Device Division and president of Lilly International. Under his leadership, Eli Lilly's medical device sales grew from several hundred million dollars to more than $1 billion. Previously, Mr. Matricaria was president and CEO of Cardiac Pacemakers, Inc., a wholly owned Eli Lilly subsidiary. Q: What are the major changes taking place in the health care industry, and how will they affect investors? A: First, it is important to realize that we are in the midst of a revolution in the way health care products and services are delivered and purchased. These changes are taking place not only here in the United States but in a number of major countries around the world. Change is underway, and no investor should believe that we will return to business as usual. In the United States, health care reform is a major political issue as well as a budgetary one. While we continue to have the best health care system in the world, it does need some constructive reform. Health care inflation clearly has started to slow, but the overall expenditure level is still too high as a percentage of our country's gross domestic product. As a health care consumer, I have concerns about whether the best quality care will be available to my family in a few years. And I am concerned that we retain incentives that encourage our best and brightest young people to continue to become health care professionals. Q: Specifically, what are your views on the Clinton Administration's health care reform plan? A: As a citizen, taxpayer and medical company CEO, I support the concept of managed competition and the idea that competitive forces should be allowed to work freely. However, I do not believe that the government should be the nation's health care manager. Details of the Clinton proposal indicate that more than 10 percent of the budget would be used to pay for additional bureaucracy -- a national health care board, health care alliances, approved health planning, regional health care committees and more. I clearly think the administration is on the wrong track in terms of the specific legislation they are recommending. Having said that, I think our elected representatives are having a significant impact on changes that are underway simply by continuing to talk about reform. [photo] [photo] Q: What trends and changes do you anticipate for your specific segment of the market -- medical devices for cardiovascular applications? A: Among the changes already in process are shifts in buying patterns, industry consolidation, increased competition and pricing pressures worldwide and a changing regulatory environment that requires new partnership efforts between medical device companies and the FDA. Perhaps the single most important change is a greater demand for data that will prove our products are cost-effective. St. Jude Medical's pricing philosophy is in line with these trends, and we are holding our price increases well below many measures of health care inflation. We are working on many fronts to build value for our shareholders within the context of these changes. It is important to note that medical devices account for only a few cents of every health care dollar. We are not one of the health care system's problems; we are part of the solution in that we provide proven medical devices which save and enhance lives in a cost-effective manner. Q: How is St. Jude Medical positioned to succeed in this environment? A: For several reasons, I believe we are well-positioned for any post-reform environment. First, all of our products are life sustaining or life enhancing. Second, our heart valve product line is recognized as the standard of excellence in the industry. We are the cardiovascular surgeon's first, and many times only, choice. Third, the valve itself represents just a small percentage of the total cost of a heart valve replacement procedure; over the next several years, we will continue to improve our cost competitiveness. Fourth, the number of cardiovascular procedures will continue to increase because the worldwide population is aging and cardiovascular disease remains the leading cause of death in the United States and Europe. In addition, universal coverage may soon provide all consumers with insurance to cover such procedures. These reasons are connected to our markets and our products. Looking inside the Company, we are confident because we have assembled an experienced, talented and dedicated team of employees and have developed a sound strategic framework for diversification and future growth. We have tremendous financial strength and are recognized for our unparalleled product quality and clinical documentation, which will be increasingly important in the future. The bottom line is that we have the ability and commitment to diversify and continuously improve to stay ahead and take advantage of change. [photo] [caption]: "We are working on many fronts to build value for our shareholders within the context of these changes. . . we provide proven medical devices which save and enhance lives in a cost-effective manner." REVIEW OF OPERATIONS [photo] [caption]: St. Jude Medical(R) mechanical heart valve Hemodynamic Plus series [photo] [caption]: Collagen-impregnated aortic valved graft Strengthening Leadership in Our Core Heart Valve Business In 1977, we began marketing the St. Jude Medical(R) mechanical heart valve to cardiac surgeons who treat patients needing valve replacement for a wide range of heart conditions. For more than 16 years, our original bileafet pyrolytic carbon coated valve has set the industry standard and is the cardiovascular surgeon's first choice in mechanical heart valves. Today's worldwide market for prosthetic heart valves is approximately $500 million, with 4 to 5 percent annual unit growth. We feel we have the superior product in the market and through product additions and enhancements, as well as increasing distribution through a direct sales force, St. Jude Medical has steadily increased its market share to the current level of 48 percent of the worldwide heart valve market. During 1993, we were pleased to achieve excellent acceptance of our Hemodynamic Plus (HP) series of mechanical heart valves. Compared with other mechanical heart valves, the HP series offers superior blood flow and reduces the heart's workload for patients with small valvular openings. On January 20, 1994, we celebrated the 500,000th implant of our mechanical heart valve product. Also, we recently received FDA approval for U.S. marketing of our new collagen-impregnated aortic valved graft (CAVG), which is used to replace the aortic heart valve and reconstruct the ascending aorta. Recipients of the St. Jude Medical(R) mechanical heart valve often can resume all the activities they enjoyed prior to any valve deficiency. WORLD'S MOST INNOVATIVE HEART VALVE COMPANY Our long-term goal is to be known as the world's most innovative company in all sectors of the heart valve market, and specifically to: *Increase worldwide market share; *Further reduce our manufacturing costs for the future's demanding health care environment; *Provide a full line of mechanical and tissue valve products; *Participate in new heart valve developments involving synthetics and recellularization technology; *Strengthen our internal research and development capability; and *Continue to expand our heart valve line to provide products that offer the best fit, durability and hemodynamics for all valve replacement patients. NEW CARBON COMPONENT MANUFACTURING CAPABILITIES Our new carbon component manufacturing facility near our St. Paul, Minnesota, headquarters will increase St. Jude Medical's ability to control our own destiny, increasing our manufacturing capacity and self-sufficiency and enhancing our future mechanical heart valve cost advantage. Training of personnel and the FDA qualification process for the new facility are top 1994 priorities, with full on-line FDA approval expected in 1995. This facility will produce top quality components at higher volumes and a lower cost than our current facility. The new, 65,000-square-foot plant is designed for cellular manufacturing, with smaller batch sizes and shorter lead times. Space utilization is twice as efficient as in the existing plant. Special features include state-of-the-art equipment, paperless record keeping and immediate feedback to equipment operators for superior quality control. [photo] [caption]: Our new, world-class manufacturing plant will enable us to become totally self-sufficient in the production of the St. Jude Medical(R) mechanical heart valve's carbon components. We will become the lowest cost manufacturer of mechanical heart valves, while enhancing product quality and customer service levels. Monitoring progress at the new facility are, from left: Robert Eno, Operations Manager; Robert Elgin, Vice President, Operations; and Michael Serie, Plant Manager. Woodridge Carbon Technology Center [photo] [caption]: Linda Stack, 46, became the 500,000th St. Jude Medical(R) mechanical heart valve recipient on January 20, 1994. The St. Paul, Minnesota, resident is a materials control analyst for 3M. Her recovery program includes daily walks with her dog Max. "I had rheumatic fever as a child, but did well until I started experiencing fatigue and respiratory problems four years ago. Since then, Dr. Arom has replaced two of my heart valves with St. Jude mechanical heart valves and I feel great. In fact, I have a trip to Glacier National Park planned for next summer." [photo] [caption]: "Linda's aortic stenosis progressed faster than we thought. She needed both a mitral valve and an aortic valve replacement in what was a relatively short time period, especially for someone so young. In both cases, I was happy that I was able to give her the best mechanical heart valve available today." Dr. Kit V. Arom performed Linda Stack's surgery, implanting the 500,000th St. Jude mechanical heart valve. He participated in initial clinical testing of the St. Jude valve and currently is conducting a 15-year patient follow-up study. His surgical group has implanted nearly 3,000 St. Jude valves. [photo] [caption]: "Receiving a St. Jude Medical heart valve has extended my life. With my wife expecting our second child, I feel great about the future. And I continue to run five miles a day, lift weights and play pick-up basketball." Bill Gurtin, 33, pictured with wife, Kay, and 3-year-old son, Grant. An investment advisor in Chicago, Bill received his implant on February 22, 1993. REVIEW OF OPERATIONS GROWTH OPPORTUNITIES IN TISSUE VALVES The single greatest opportunity to accelerate core business growth is to become a significant player in the tissue valve market, today estimated at $150 million. Mechanical valves currently comprise 70 percent of all implants, primarily because of their superior durability. Because tissue valves normally do not require anticoagulant medication, the market will grow as new technology improves their durability. St. Jude Medical's goal is to reach the U.S. market with approved tissue products within the next several years. In addition to our long-term, next generation heart valve project, we have a joint venture with Hancock Jaffe Laboratories, under the direction of Warren Hancock and Norman Jaffe, Ph.D., two of the world's leading tissue valve experts. The first human implants of this valve are planned for the first half of 1994 in Europe. We expect very favorable results regarding valve implantability and performance. St. Jude Medical also is collaborating with Canadian cardiac surgeon Dr. Tirone David on the U.S. approval of a new stentless aortic tissue valve, the Toronto SPVtm. Stentless valves, which do not have frames, require demanding surgical techniques but are designed to offer potentially superior hemodynamic performance in the aortic position. We received an Investigational Device Exemption (IDE) from the FDA in February 1994, and will begin our U.S. clinical trials of the Toronto SPV before the end of April. INTERNATIONAL EXPANSION Today, our customers include more than 1,500 open heart centers worldwide. While we sell our products in more than 75 countries, approximately 80 percent of our revenues currently come from the United States and eight European countries where we have direct sales forces. However, non-direct foreign market sales will be increasingly important to our future growth as markets such as China, the Pacifc Rim, Latin America, the Middle East, Africa and Eastern Europe continue to develop. We are working to expand our international presence by building relationships with top cardiovascular surgeons and supporting clinical studies in overseas markets. Key accomplishments for St. Jude Medical International in 1993 included: *The launch of an important new randomized multicenter clinical study in Germany. This research, involving 4,500 patients over the course of five years, is designed to confirm that lower doses of anticoagulant medication are sufficient for use with the St. Jude Medical(R) mechanical heart valve. *Significant progress towards achieving our Total Quality Management goals, which will result in exceeding ISO 9000 standards and obtaining the CE mark necessary to market our products in Europe by 1998. *Significant market share gains in the Middle East and Africa. *Strategic alliances in Germany and Spain with well-established companies marketing a full line of cardiovascular devices, which enable us to respond quickly to market changes. During 1994, we anticipate international revenue gains from increasing our mechanical heart valve market share, from increased sales of the Toronto SPV, from our first human implants of the tissue heart valve developed by Hancock Jaffe Laboratories and from the introduction of additional cardiac assist products. We will continue to pursue strategic alliances in the increasingly competitive European market, tailoring approaches to each country's changing reimbursement and regulatory environment. [photo] [caption]: Tissue heart valve developed by Hancock Jaffe Laboratories [photo] [caption]: Toronto SPVtm tissue heart valve [photo] [caption]: Model 700 intra-aortic balloon pump system [photo] [caption]: RediFurl(R), RediGuardTM and TaperSeal(R) intra-aortic balloon catheters [photo] [caption]: Lifestream(R) centrifugal pump system and Isoflow(R) centrifugal pump We also will conduct intensive sales training and clinical symposia in our non-direct markets where distributors will work with us to launch new cardiac assist products, together with new mechanical and tissue heart valve devices. NEW CARDIAC ASSIST PRODUCTS Our Cardiac Assist Division markets two major categories of products associated with open heart surgery to cardiologists and perfusionists. Intra-aortic balloon pump (IABP) systems, which include balloon-tipped catheters and electro-mechanical control consoles, take on part of the heart's workload before and after open heart surgery and complicated coronary balloon angioplasty. Centrifugal pump systems, comprising electro-mechanical control consoles, motor drives and pumps through which the blood circulates, completely take over for the heart during open heart procedures. To increase our market share worldwide, we are introducing new products and building our reputation for superior customer service. During 1993, we successfully introduced a refined IAB catheter product, the RediGuardtm 2.0, which eases the process of guiding and correctly placing the catheter. We also significantly expanded our direct sales force in the United States in 1993 and increased our worldwide cardiac assist presence through our distribution agreement with COBE(R) Cardiovascular Inc., which supplies customized packages of products to perfusionists. Goals for 1994 include introducing our new ArmorGlidetm coating for catheters which will allow for easier insertion, and launching our new Model 800 IABP console. DIVERSIFICATION PLANNING At St. Jude Medical, we understand the importance of knowing our destination. For that reason, before making any major diversification moves, we thoroughly analyzed our business and opportunities for creating shareholder value. The strategic diversification planning process sets the stage for us to achieve our vision of becoming a globally significant medical device company with several major technology platforms, including our heart valve business. It has four phases: 1) An extensive survey, or shareholder profile, told us about shareholder and investment community attitudes toward diversification, various types of acquisitions and growth versus profitability. 2) A core competency assessment identified what we do well, what we can do to improve our existing businesses and what strengths we can transfer or leverage in alliances with other companies. Our management team and consultant advisors identified 191 primary capabilities, which were narrowed to 48 critical cross-functional capabilities. We zeroed in on 15 potential core competencies, then on eight true core competency opportunities for St. Jude Medical which were identified based on passing tests regarding value to customers, barriers to competition and leverageability to other markets. Our true core competency opportunities focus primarily on blood handling and processing, device development and manufacturing, clinical trials and regulatory approval processes. [photo] [caption]: "I like the St. Jude Medical(R) mechanical heart valve's overall design, which resists blood clot formation, its low profile, and rapid opening and closing action, which resemble the human heart valve. Japanese follow-up studies achieve excellent compliance and are very thorough, so Japan is the ideal country to evaluate the valve; we've seen absolutely no structural deterioration in 14 years of implants." Dr. Hitoshi Koyanagi, professor and chairman of the Department of Cardiovascular Surgery at Tokyo Women's Medical College in Japan, has implanted more than 1,800 St. Jude Medical(R) mechanical heart valves since the product's Japanese introduction in 1978. [photo] [caption]: St. Jude Medical's diversification efforts are moving forward from a solid strategy that grew out of a four-part planning process, including a shareholder profile, core competency assessment, therapeutic class review and specific opportunity analysis. [caption]: Members of St. Jude Medical's senior management team conduct a strategic planning session (from left:) Stephen Wilson, Vice President, Finance and Chief Financial Officer; John Berdusco, Vice President, Administration; John Alexander, Vice President, Corporate Development; and Diane Johnson, Vice President and General Counsel. REVIEW OF OPERATIONS 3) A therapeutic class review of the medical devices and supplies market identifies the companies, technologies and products within the markets that show the most promise. This ongoing process analyzes the relative size, growth rates and competition within various segments of the medical devices and supplies market. 4) A specific opportunity analysis continually evaluates the best companies, products and technologies within the most attractive therapeutic classes and within the context of the shareholder profile and core competency assessment, so that our focus is on diversifying in a manner that creates long-term value for our shareholders. SPECIFIC OPPORTUNITIES During 1993 and early 1994, four situations demonstrated our ability to quickly respond to new opportunities. First, we announced an equity investment in InControl, Inc. of Redmond, Washington, which is working with leading medical researchers on a product that would be the first device to diagnose and treat atrial fibrillation, automatically restoring normal rhythm to an improperly beating atrium of the heart. We believe that InControl's promising technology represents an important market opportunity. Second, we signed an exclusive license and supply agreement with Telios Pharmaceuticals, Inc. of San Diego, California, to utilize Telios' proprietary cell adhesion technology. Its PepTite-2000tm biocompatible coating is expected to promote human tissue ingrowth on the sewing cuffs of heart valves, aortic valved grafts and annuloplasty rings. Third, in December we made a fully valued offer to purchase Colorado-based Electromedics, Inc. However, while the company's open heart surgery products fit with our existing Cardiac Assist Division business, we did not choose to participate in a controlled auction process. The agreement was terminated because it did not make sense from a shareholder value point of view for St. Jude Medical to pay what would have been required to make the acquisition. Finally, in January 1994, we announced an investment in Advanced Tissue Sciences, Inc. and a separate agreement to pursue tissue engineered heart valves. As part of this agreement, St. Jude Medical obtained exclusive rights to license technology resulting from this alliance. As we pursue specific diversification transactions, we are focused on building our reputation and competencies in cardiovascular products -- an area we know and where we have an established customer base. We relate each opportunity to our planning process to ensure it has the potential to create shareholder value and truly makes sense for our long-term success. [photo] [caption]: Diversification Planning Shareholder Profile Core Competency Assessment Therapeutic Class Review Specific Opportunity Analysis OUR MISSION MISSION STATEMENT ST. JUDE MEDICAL, INC. IS COMMITTED TO HELPING OUR CUSTOMERS WORLD-WIDE SAVE LIVES, RESTORE HEALTH, AND IMPROVE THE QUALITY OF LIFE IN THEIR PATIENTS THROUGH THE DESIGN, MANUFACTURE, AND MARKETING OF THE HIGHEST QUALITY CARDIOVASCULAR MEDICAL DEVICES AND SERVICES. WE WILL ACCOMPLISH OUR MISSION BY: * PROVIDING THE MOST INNOVATIVE AND HIGHEST VALUE-ADDED PRODUCTS WHICH CREATE A CLINICAL BENEFIT; * EMPHASIZING QUALITY AND INNOVATION IN THE DESIGN, MANUFACTURE, AND DISTRIBUTION OF OUR PRODUCTS; * DEVELOPING AND MAINTAINING SUPERIOR RELATIONSHIPS WITH OUR CUSTOMERS AND THE COMMUNITY; * PROVIDING A CHALLENGING AND REWARDING WORK ENVIRONMENT WHICH ENABLES OUR EMPLOYEES TO REACH THEIR FULLEST POTENTIAL. BY ACHIEVING OUR MISSION WE WILL CREATE ADDITIONAL VALUE IN THE COMPANY AND GREATER REWARDS FOR OUR SHAREHOLDERS. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION (Dollars in thousands, except per share amounts) INTRODUCTION St. Jude Medical, Inc. designs, manufactures and markets medical devices for cardiovascular applications. The Company is the world's leading supplier of mechanical heart valves which account for more than 90% of the Company's net sales. Other products manufactured and sold by the Company include two types of tissue heart valves, annuloplasty rings, intra-aortic balloon pump systems and centrifugal pump systems. The Company's fiscal year is the 52 or 53 week period ending the Saturday nearest to December 31. Fiscal years 1993 and 1991 included 52 weeks and fiscal 1992 included 53 weeks. RESULTS OF OPERATIONS The Company posted record net sales and net income for the eighth consecutive year in 1993 as net sales increased 5% to $252,642 and net income increased 8% to $109,643. Shown below for the periods indicated are the percentage relationships of certain items in the consolidated statements of income to net sales and the percentage change of the dollar amounts of such items as compared with the prior period. NET SALES: Net sales totalled $252,642 in 1993, a 5% increase over 1992 net sales. The increase principally resulted from higher mechanical heart valve unit sales in the Company's international markets which were partially offset by lower domestic unit sales. The decrease in domestic unit sales was attributable to one less operating week in 1993 as compared to 1992 as well as to hospital inventory reductions and fewer procedures caused by managed care and the anticipation of health care reform. Domestic mechanical heart valve net sales increased slightly in 1993 despite the lower unit sales as prices increased due to the introduction of an expanded product line and general price increases. International mechanical heart valve net sales in 1993 increased substantially, particularly in the emerging country markets where selling prices are lower than in the developed country markets. Therefore, the higher revenue resulting from increased unit sales was somewhat offset by lower average selling prices. In addition, net sales in 1993 were negatively impacted by the appreciation of the U.S. dollar from 1992 levels in relation to the eight foreign currencies in which the Company directly markets its products. This foreign currency exchange situation decreased 1993 net sales by $4,670 relative to 1992. [graph] [description]: Net Sales (in millions) International and United States sales compared over the years 1991, 1992 and 1993. Cardiac assist device and tissue heart valve net sales in 1993 increased over 1992 levels. These increases were partially offset by decreased biological vascular graft net sales as a result of the discontinuance of the product line in mid-1992. In 1993, net sales in the international markets increased to 43% of total net sales from 42% in 1992 despite the unfavorable impact of foreign currency exchange rates. The increase was attributable to higher growth rates within these markets and the Company's ability to further penetrate these markets. Net sales in 1992 of $239,547 were 14% higher than 1991 levels. The increase primarily resulted from higher mechanical heart valve unit sales in all geographic markets as well as price increases implemented at the beginning of 1992. In addition, net sales of all other Company products, except the biological vascular graft, increased over 1991 levels. COST OF SALES: Cost of sales as a percentage of net sales decreased in 1993 to 24.3% from 25.2% in 1992. The improvement was principally attributable to higher levels of lower cost self-manufactured pyrolytic carbon components for the mechanical heart valve. In addition, cessation of royalty payments associated with the acquisition of the intra-aortic balloon pump system and increased manufacturing efficiencies associated with higher levels of cardiac assist device production, reduced cost of sales in 1993. These improvements were partially offset by a lower 1993 mechanical heart valve average selling price as compared to 1992 which resulted from unfavorable foreign currency translation and from a higher level of lower margin sales into the emerging country markets. In 1992, cost of sales as a percentage of net sales decreased 3.8 percentage points from the 1991 level. The improvement resulted from reduced costs of mechanical heart valve components purchased from the Company's supplier, higher levels of lower cost self-manufactured mechanical heart valve components, favorable foreign currency translation effects and higher pricing. The margin improvements were partially offset by higher sales levels of lower margin non-mechanical heart valve products. The Company expects cost of sales as a percentage of net sales to increase in 1994 from the 1993 level as a result of a larger increase in international sales versus domestic sales, particularly into lesser developed countries. Selling prices in these faster growth markets are significantly lower than in the markets served by the Company's direct sales forces because sales are made through distributors rather than directly to hospitals and because lesser developed countries are typically more price sensitive due to their economic condition. In addition, the cost of mechanical heart valve components purchased from the Company's supplier will increase in 1994. Also, the Company anticipates its sales of lower margin non-mechanical heart valve products will increase in 1994. Increased competition together with governmental and third-party payor pressures to reduce health care costs may limit the Company's pricing flexibility. SELLING, GENERAL AND ADMINISTRATIVE: Selling, general and administrative expense in 1993 increased $3,479, or 8%, over 1992. The Company expanded its domestic sales force and marketing department during 1993 in order to better serve its customers and to better compete against a new mechanical heart valve competitor in the domestic market. In addition, the Company increased its support of clinical studies to further document the advantages of the Company's products. The Company is aggressively pursuing ISO 9000 certification which raised the 1993 expense level as compared to 1992. The appreciation of the U.S. dollar partially offset the increases noted above. During 1992, selling, general and administrative expense increased $5,275, or 13%, over 1991. The increase mainly resulted from higher commissions associated with higher sales levels, expenses associated with several new product introductions, and increased support of symposia, research papers and follow-up clinical studies. RESEARCH AND DEVELOPMENT: Research and development expense decreased $506, or 4%, in 1993. Expenditures in 1993 were primarily associated with mechanical heart valve product line expansion, tissue heart valve development programs, a new intra-aortic balloon pump console and intra-aortic balloon catheter product improvements. During 1993, funding of the Hancock Jaffe Laboratories joint venture development of a tissue heart valve decreased from the 1992 level due to the completion of certain phases of the project. In 1992, research and development expense increased $3,368, or 42%, over 1991. The increase was principally associated with new product development for mechanical heart valves, tissue heart valves and cardiac assist products. Significant product development efforts included the Hemodynamic Plus (HP) series of mechanical heart valves, the tissue valve developed by Hancock Jaffe Laboratories and the Toronto SPVtm. [graph] [description]: Increase in cash and marketable securities (in millions) shown over the course of 1991, 1992 and 1993. OTHER INCOME: Other income decreased $262, or 2%, from 1992. While cash and marketable securities increased $30,301 during 1993, the additional interest received on the higher investment balances was significantly reduced by the lower average investment rates of return. The additional week of operations in 1992 added approximately $280 to 1992 investment income. Due to a significant shift in the relationship between European currencies in 1993, the loss associated with foreign currency transactions increased to $526 from $43 in 1992. In addition, losses relating to joint ventures and partnerships were $243 higher in 1993 than 1992. INCOME TAX PROVISION: The Company's 1993 effective income tax rate of 24.5% was one percentage point below the 1992 and 1991 rate of 25.5%. The decrease was attributable to the derivation of a higher percentage of the Company's income from the Company's Puerto Rican operations. The relatively low rate as compared to the U.S. statutory rate stems from the reduced taxes on profits generated by the Company's Puerto Rican operations as well as from other income generated by the Company's tax advantaged investments. [graph] [description]: Increase in cash flow from operations (in millions) shown over the course of 1991, 1992 and 1993. NET INCOME: Net income in 1993 of $109,643, or $2.32 per share, increased 8% over the $101,658, or $2.12 per share, reported in 1992 which had risen 21% over 1991 net income. The appreciation of the U.S. dollar against foreign currencies in 1993 as compared to 1992 decreased net income in 1993 by $2,488, or $.05 per share. During 1993, the Company repurchased 1,177,700 shares of its common stock for $35,239. This repurchase reduced 1993 interest income by approximately $650 and average shares outstanding by approximately 600,000 shares. The net effect of the repurchase was an increase in 1993 earnings per share of $.02. OUTLOOK: The Company's core mechanical heart valve business remains strong as the Company has maintained or slightly increased its market share in the developed country markets and has continued to penetrate the emerging country markets. The Company estimates it held a 48% share of the worldwide heart valve market for 1993. The health care industry is in the midst of dramatic change worldwide. Business consolidations and alliances are expected to increase industry efficiencies and strengthen the bargaining position of large providers of health care services. Specifically, domestic health care reform is putting downward pressure on pricing and appears presently to be having the effect of reducing the number of open heart procedures. In addition, during 1993 hospital consolidations and inventory reduction programs reduced the demand for the Company's products. During the third quarter 1993, a competitor received Food and Drug Administration (FDA) approval to market its bileafet mechanical heart valve in the United States. The Company cannot predict the impact that this new competitor may have on its domestic market position. Internationally, the Company has successfully competed against many competitors for many years. The Company expects these international markets to grow at rates which exceed the domestic market rate of growth and the Company anticipates it will continue to gain share in these highly competitive markets. The Omnibus Budget Tax Reconciliation Act of 1993 (the "Act") significantly reduces the tax benefits which were previously available from income generated by the Company's Puerto Rican operations under Internal Revenue Code (IRC) Section 936. Under the new legislation, the Puerto Rican tax benefit will be reduced by 40% in 1994 and an additional 5% per year in years 1995 through 1998 at which time the benefit will have been reduced by 60% from current levels. The Company's 1994 tax provision may increase by as much as five percentage points as a result of this legislation. The impact on 1994 earnings is expected to be approximately $.15 per share. Also, the Act increased domestic corporate income tax rates effective January 1, 1993, by 1% which will increase future tax provisions. There are additional changes to IRC Section 936 regulations being proposed by the Internal Revenue Service which, if enacted, would further negatively impact the Company's effective income tax rate. The Company continues to seek diversification opportunities in the form of acquisitions, joint ventures, partnerships and investments in emerging technology companies, as well as through internal research and development. The Company cannot predict the size or timing of such diversification activities. FINANCIAL CONDITION SUMMARY: The Company's financial condition at December 31, 1993, was strong. Cash and marketable securities totalled $368,991, or 70% of total assets. The Company had no outstanding debt. Working capital, the difference between current assets and current liabilities, continued to increase. The following key measurements are indicative of the excellent liquidity and strong financial position maintained by the Company. LIQUIDITY: Cash flow from operations in 1993 continued to provide sufficient funds to meet working capital and investment needs. Cash and marketable securities increased in 1993 by $30,301 to the level of $368,991 at December 31, 1993. Accounts receivable decreased $2,535 during the year. At December 31, 1993, days sales outstanding (the number of days worth of sales that are in accounts receivable) decreased to 58 days from 65 days at the end of 1992. The decrease was principally attributable to focused collection efforts in several European countries. In particular, Spanish accounts receivable decreased $965 during 1993 and totalled $5,397 at the end of 1993. Inventories increased $5,407 during 1993. The increase was primarily attributable to the extension of the mechanical heart valve product line as well as to the purchase of raw materials considered essential to the Company's operations. Purchases of property, plant and equipment in 1993 of $16,422 were principally associated with building a new manufacturing facility for the production of mechanical heart valve components. This building was completed in 1993; therefore, property, plant and equipment expenditures are anticipated to decrease substantially in 1994. Other assets of $29,722 increased by $11,043 in 1993 as investments were made in several entities including InControl, Inc., an emerging technology cardiac rhythm management company; The Heart Valve Company, a joint venture with Hancock Jaffe Laboratories; and two health care limited partnerships. The Company expects future working capital and capital spending to be financed by funds provided by operations. CAPITAL: During 1993, the Company used $35,239 of its cash flow to repurchase 1,177,700 shares of its common stock. The Company may repurchase approximately 1,000,000 additional shares under the current authorization from the Board of Directors. Future repurchases will depend upon diversification objectives, market conditions, cash position and other factors. Although the Company has no debt or outside credit lines, the Company is prepared to utilize debt to finance its diversification program. The Company's strong cash flow generating capabilities will enable the Company to acquire sufficient capital to finance anticipated acquisitions. Cash dividends paid to shareholders were $18,786 in 1993, an increase of $4,516 from 1992. The Company initiated the cash dividend in the second quarter 1992 and maintained a $.10 per share quarterly cash dividend through 1993. [graph] [description]: Increase in shareholders' equity over the course of 1991, 1992 and 1993. OTHER MATTERS: As a medical device manufacturer, the Company is exposed to product liability claims. Such product liability claims may be asserted against the Company in the future which are presently unknown to management. The Company believes its insurance coverage will be adequate to protect the Company against any material loss. In the United States, several proposals to "reform" health care are under consideration. The Company has already experienced some change, as noted above, as a result of the discussion of reform. Any legislated health care reform could have a material impact on the Company's operations. REPORT OF MANAGEMENT The management of St. Jude Medical, Inc. is responsible for the preparation, integrity and objectivity of the accompanying financial statements. The financial statements have been prepared in accordance with generally accepted accounting principles and include amounts which reflect management's best estimates based on its informed judgement. Management is also responsible for the accuracy of the related data in the annual report and its consistency with the financial statements. In the opinion of management, the Company's accounting systems and procedures, and related internal controls, provide reasonable assurance that transactions are executed in accordance with management's intention and authorization, that financial statements are prepared in accordance with generally accepted accounting principles, and that assets are properly accounted for and safeguarded. The concept of reasonable assurance is based on the recognition that there are inherent limitations in all systems of internal control, and that the cost of such systems should not exceed the benefits to be derived therefrom. These systems are periodically reviewed and modified in response to changed conditions. St. Jude Medical, Inc. also recognizes its responsibility for fostering a strong ethical climate so that the Company's affairs are conducted according to the highest standards of personal and business conduct. This responsibility is reflected in the Company's business ethics policy which is publicized throughout the organization. The adequacy of the Company's internal accounting controls, the accounting principles employed in its financial reporting and the scope of independent and internal audits are reviewed by the Audit Committee of the Board of Directors, consisting solely of outside directors. The independent certified public accountants and internal auditors meet with, and have confidential access to, the Audit Committee to discuss the results of their audit work. [signature] Ronald A. Matricaria President and Chief Executive Officer [signature] Stephen L. Wilson Vice President, Finance and Chief Financial Officer REPORT OF INDEPENDENT AUDITORS Board of Directors St. Jude Medical, Inc. St. Paul, Minnesota We have audited the accompanying consolidated balance sheets of St. Jude Medical, Inc. and subsidiaries as of December 31, 1993 and 1992 and the related consolidated statements of income, shareholders' equity and cash flows for each of the three years in the period ended December 31, 1993. 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 financial statements referred to above present fairly, in all material respects, the consolidated financial position of St. Jude Medical, Inc. and subsidiaries at December 31, 1993 and 1992 and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. [signature] Ernst & Young Minneapolis, Minnesota February 4, 1994 CONSOLIDATED STATEMENTS OF INCOME (Dollars in thousands, except per share amounts) See notes to consolidated financial statements. CONSOLIDATED BALANCE SHEETS (Dollars in thousands, except per share amounts) See notes to consolidated financial statements. CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (Dollars in thousands, except per share amounts) See notes to consolidated financial statements. CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollars in thousands) See notes to consolidated financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in thousands, except per share amounts) NOTE 1 - SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION: The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. Significant intercompany transactions and balances have been eliminated in consolidation. Certain reclassifcations of previously reported amounts have been made to conform with the current year presentation. ACCOUNTING PERIOD: The Company's fiscal year is the 52 or 53 week period ending the Saturday nearest December 31. Fiscal years 1991 and 1993 included 52 weeks and fiscal year 1992 included 53 weeks. TRANSLATION OF FOREIGN CURRENCIES: All assets and liabilities of the Company's foreign subsidiaries are translated at exchange rates in effect on reporting dates and differences due to changing translation rates are charged or credited to "cumulative translation adjustment" in shareholders' equity. Income and expenses are translated at rates which approximate those in effect on transaction dates. CASH EQUIVALENTS: Cash equivalents, consisting of liquid investments with a maturity of three months or less when purchased, are stated at cost which approximates market. MARKETABLE SECURITIES: Marketable securities, consisting of investment grade municipal debt instruments, bank certificates of deposit and Puerto Rico industrial development bonds, are stated at cost which approximates market. In May 1993, the Financial Accounting Standards Board issued Statement of Financial Accounting Standard No. 115, "Accounting for Certain Investments in Debt and Equity Securities," effective for fiscal years beginning after December 15, 1993. Under this pronouncement, debt securities that the Company has both the positive intent and ability to hold to maturity are carried at amortized cost. Debt securities that the Company does not have the positive intent and ability to hold to maturity and all marketable equity securities are classified as either available-for-sale or trading and are carried at fair value. Unrealized holding gains and losses on securities classified as available-for-sale are carried as a separate component of shareholders' equity. Unrealized holding gains and losses on securities classified as trading are reported in earnings. Presently, the Company classifies its marketable securities as available-for-sale and carries them at amortized cost. The Company will apply the new pronouncement starting in the first quarter 1994. The Company anticipates that the majority of its marketable security holdings will be classified as available-for-sale and that any shareholders' equity adjustments will be immaterial. INVENTORIES: Inventories are stated at the lower of cost or market. Cost is determined under the first-in, first-out method. Allowances are made for slow-moving, obsolete, unsalable or unusable inventories. PROPERTY, PLANT AND EQUIPMENT AND DEPRECIATION: Property, plant and equipment are stated at cost and are depreciated on the straight line method over their estimated useful lives ranging from three to 32 years. Accelerated depreciation is used by the Company for tax accounting purposes only. REVENUE RECOGNITION: The Company's general practice is to recognize revenues from sales of products as shipped and services as performed. RESEARCH AND DEVELOPMENT: Research and development expense includes all expenditures for general research into scientific phenomena, development of useful ideas into merchantable products and continuing support and upgrading of various products. All such expense is charged to operations as incurred. EARNINGS PER SHARE: Primary and fully diluted earnings per share are computed by dividing net income for the year by the weighted average number of shares of common stock and common stock equivalents outstanding. NOTE 2 - INCOME TAXES During 1993, the Company adopted Statement of Financial Accounting Standard No. 109, "Accounting for Income Taxes." The statement requires use of the asset and liability approach for financial accounting and reporting for income taxes. The cumulative effect of the accounting change was not material. The components of income before taxes were as follows: 1993 1992 1991 Domestic $140,303 $133,477 $102,143 Foreign 4,919 2,977 10,566 Income before taxes $145,222 $136,454 $112,709 The components of the income tax provision were as follows: 1993 1992 1991 Current: Federal $21,682 $21,892 $15,030 State and Puerto Rico 12,400 11,272 8,896 Foreign 1,953 1,907 4,138 Total current 36,035 35,071 28,064 Deferred: Prepaid 274 (807) 404 Deferred (730) 532 273 Total deferred (456) (275) 677 Income tax provision $35,579 $34,796 $28,741 Deferred tax assets (liabilities) were comprised of the following at December 31, 1993: Net deferred income tax asset: Accruals not currently deductible $ 2,557 Other 287 Deferred income tax asset $ 2,844 Net deferred income tax liability: Depreciation and amortization $(2,925) Other 1,261 Deferred income tax liability $(1,664) The Company's effective income tax rate varied from the statutory U.S. federal income tax rate of 35% in 1993 and 34% in prior years as follows: The Company's effective income tax rate is favorably affected by Puerto Rican tax exemption grants which result in Puerto Rican earnings being partially tax exempt through the year 2003. Consolidated U.S. federal income tax returns fled by the Company have been examined by the Internal Revenue Service through the year 1989. The Company's 1990 and 1991 federal income tax returns are presently under audit. The Company has not recorded deferred income taxes applicable to undistributed earnings of foreign subsidiaries ($4,190 at December 31, 1993) because distribution of these earnings generally would not require additional taxes due to available foreign tax credits. The Company made income tax payments of $28,385, $22,709 and $21,872 in 1993, 1992 and 1991, respectively. NOTE 3 - STOCK PLANS Under the terms of the Company's various stock plans, 1,801,118 shares of common stock have been reserved for issuance to directors, officers and employees upon the grant of restricted stock or the exercise of stock options. The stock options are exercisable over periods up to 10 years from date of grant and may be "incentive stock options" or "non-qualified stock options" and may have stock appreciation rights attached. At December 31, 1993, there were a maximum of 514,000 shares available for grant and 1,287,118 options outstanding, of which 498,831 were exercisable. Stock option activity was as follows: Options Price Outstanding Per Share Balance at December 31, 1991 1,077,297 $ 1.31-50.25 Granted 242,000 28.81-48.25 Cancelled (60,000) 4.59-48.25 Exercised (436,654) 1.31-27.69 Balance at December 31, 1992 822,643 4.59-50.25 Granted 602,250 27.25-35.63 Cancelled (88,050) 21.94-50.25 Exercised (49,725) 4.59-22.63 Balance at December 31, 1993 1,287,118 4.59-49.63 Pursuant to the terms of the Company's various stock plans, optionees can use cash, previously owned shares or a combination of cash and previously owned shares to reimburse the Company for the cost of exercising the option. Shares are acquired from the optionee at the fair market value of the stock on the transaction date. All options have been granted at not less than fair market value at dates of grant. When stock options are exercised, the par value of the shares issued is credited to common stock and the excess of the proceeds over the par value is credited to additional paid-in capital. When non-qualified options are exercised, the Company realizes income tax benefits based on the difference between the fair value of the common stock on the date of exercise and the stock option exercise price. These tax benefits do not affect the income tax provision, but rather are credited directly to additional paid-in capital. Under the terms of the Company's shareholder rights agreement, upon the occurrence of certain events which result in a change in control as defined by the agreement, registered holders of common shares are entitled to purchase one-tenth of a share of Series A Junior Participating Preferred Stock at a stated price, or to purchase either the Company's shares or shares of the acquiring entity at half their market value. NOTE 4 - RETIREMENT PLANS The Company has a defined contribution profit sharing plan, including features under Section 401(k) of the Internal Revenue Code, which provides retirement benefits to substantially all full-time U.S. employees. Under the 401(k) portion of the plan, eligible employees may contribute a maximum of 10% of their annual compensation with the Company matching the first 3%. The Company's level of contribution to the profit sharing portion of the plan is determined based on its earnings per share. The Company has additional defined contribution pension plans for employees outside the United States. The benefits under these plans are based primarily on compensation levels. Total retirement plan expense was $1,265, $1,487 and $1,177 in 1993, 1992 and 1991, respectively. NOTE 5 - SUPPLY OF HEART VALVE COMPONENTS The Company has a long-term contract for supply of pyrolytic carbon components used in its mechanical heart valve prosthesis. Under the terms of the contract, the Company has agreed to purchase decreasing percentages of its component requirements from the supplier through 1998. After 1995, provisions of the contract retain the supplier as a back-up component source, whereby the Company will purchase a minimum of 20% of its needs through 1998. The contract specifies an increasing, but annually fixed pricing structure in effect through 1995, whereupon the parties have agreed to negotiate prices for the years 1996 through 1998. Subsequent to 1998, annual renewal clauses may take effect as appropriate. As part of this contract, the Company has granted the supplier a license to produce and sell the supplier's bileafet mechanical heart valve in countries where patents have been issued covering the St. Jude Medical(R) mechanical heart valve. Under this portion of the contract, the supplier will pay royalties to the Company through 1998. Under a separate agreement, the Company paid a royalty to the supplier based on the number of mechanical heart valves the Company produced from its self-manufactured carbon components through August 1993. NOTE 6 - GEOGRAPHIC AREA The Company operates in the medical products industry and is segmented into two geographic areas--the United States and Canada (including all export sales to unaffiliated customers except to customers in Europe, the Middle East and Africa) and Europe (including export sales to unaffiliated customers in the Middle East and Africa). Sales between geographic areas are made at transfer prices which approximate prices to unaffiliated third parties. Export sales from the United States and Canada to unaffiliated customers were $29,926, $25,748 and $21,643 for 1993, 1992 and 1991, respectively. Net sales by geographic area were as follows: United States and Canada Europe Eliminations Net Sales Customer sales $172,713 $79,929 $ -- $252,642 Intercompany sales 59,908 -- (59,908) -- $232,621 $79,929 $(59,908) $252,642 Customer sales $165,551 $73,996 $ -- $239,547 Intercompany sales 55,893 -- (55,893) -- $221,444 $73,996 $(55,893) $239,547 Customer sales $148,792 $61,045 $ -- $209,837 Intercompany sales 48,772 -- (48,772) -- $197,564 $61,045 $(48,772) $209,837 Operating profit by geographic area was as follows: United States and Canada Europe Corporate Total 1993 $99,092 $41,046 $(8,850) $131,288 1992 $92,613 $38,341 $(8,696) $122,258 1991 $77,937 $32,066 $(9,356) $100,647 Identifiable assets by geographic area were as follows: United States and Canada Europe Corporate Total 1993 $92,083 $40,947 $393,787 $526,817 1992 $73,333 $46,669 $349,748 $469,750 1991 $70,608 $31,794 $272,691 $375,093 Corporate expenses consist principally of non-allocable general and administrative expenses. Corporate identifiable assets consist principally of cash and cash equivalents and marketable securities. NOTE 7 - OTHER INCOME Other income consisted of the following: 1993 1992 1991 Interest income $14,635 $13,840 $11,359 Dividend income 14 49 313 Gain on sale of investments 54 350 456 Joint venture and partnership losses (243) -- -- Foreign exchange losses (526) (43) (66) Other income $13,934 $14,196 $12,062 NOTE 8 - OTHER ASSETS Other assets as of December 31, 1993 and 1992, net of accumulated amortization of $17,422 and $12,964, respectively, consisted of the following: 1993 1992 Investments in companies, joint ventures and partnerships $15,259 $ 3,092 Payments made to former distributors 4,237 6,371 Intangibles and other assets 10,226 9,216 Other assets $29,722 $18,679 Investments in companies, joint ventures and partnerships are stated at cost. Pursuant to various transition agreements, payments made to former distributors are being amortized over their benefit periods of from four to five years. Intangibles and other assets, which consist principally of the excess of cost over net assets of certain acquired businesses and technology purchased in connection with the acquisition of certain businesses, are being amortized over periods ranging from five to 15 years. NOTE 9 - QUARTERLY FINANCIAL DATA (UNAUDITED) Quarterly data for 1993 and 1992 was as follows: Quarter First Second Third Fourth Year Ended December 31, 1993: Net sales $68,154 $66,944 $58,946 $58,598 Gross profit $51,225 $50,617 $44,948 $44,510 Net income $29,189 $28,843 $25,972 $25,639 Earnings per share $ .61 $ .61 $ .55 $ .55 Year Ended December 31, 1992: Net sales $60,055 $57,008 $58,281 $64,203 Gross profit $44,173 $42,796 $44,044 $48,284 Net income $25,054 $24,891 $25,292 $26,421 Earnings per share $ .52 $ .52 $ .53 $ .55 Primary and fully diluted per share results are the same for all quarters in 1993 and 1992. TEN-YEAR SUMMARY OF SELECTED FINANCIAL DATA (Dollars in thousands, except per share amounts) *$.39 on a fully diluted basis. Earnings per share and share data have been adjusted for 100% stock dividends paid in 1990, 1989 and 1986. [graph] Description: Gross Margin (as a percentage of sales) over the years 1984 - 1993. [graph] Description: Operating Margin (as a percentage of sales) over the years 1984 - - 1993. [graph] Description: Net Sales Per Employee (dollars in thousands) over the years 1984 - 1993. [graph] Description: Net Income Per Employee (dollars in thousands) over the years 1984 - 1993. DIRECTORS Lawrence A. Lehmkuhl (3) Chairman St. Jude Medical, Inc. St. Paul, Minnesota Ronald A. Matricaria President and Chief Executive Officer St. Jude Medical, Inc. St. Paul, Minnesota Frank A. Ehmann (1) (3) Consultant RCS Health Care Partners, L.P. San Francisco, California Thomas H. Garrett, III (1) Attorney Lindquist & Vennum Minneapolis, Minnesota William R. Miller (2) Director of Various Companies New York, New York Charles V. Owens (1) Chairman Genesis Labs, Inc. Minneapolis, Minnesota Roger G. Stoll, Ph.D. (2) (3) Chief Executive Officer and President Ohmeda, Inc. Liberty Corner, New Jersey James S. Womack (2) Chairman Sheldahl, Inc. Northfeld, Minnesota (1) Denotes members of the Audit Committee (2) Denotes members of the Compensation Committee (3) Denotes members of the Technology Committee OFFICERS Ronald A. Matricaria President and Chief Executive Officer Todd F. Davenport President, International Division Robert J. Helbling President, Cardiac Assist Division Eric W. Sivertson President, St. Jude Medical Division John J. Alexander Vice President, Corporate Development Andrew K. Balo Vice President, Regulatory Affairs and Quality Assurance St. Jude Medical Division John P. Berdusco Vice President, Administration Robert S. Elgin Vice President, Operations St. Jude Medical Division Diane M. Johnson Vice President and General Counsel J. Gary Jordan Vice President, Sales and Marketing St. Jude Medical Division Stephen L. Wilson Vice President, Finance and Chief Financial Officer INVESTOR INFORMATION TRANSFER AGENT American Stock Transfer & Trust Company 6201 15th Avenue Brooklyn, NY 11219 718-921-8293 800-937-5449 Correspondence regarding stock holdings, dividend checks and changes of address should be directed to the transfer agent. LEGAL COUNSEL Lindquist & Vennum Minneapolis, Minnesota INDEPENDENT AUDITORS Ernst & Young Minneapolis, Minnesota INVESTOR INFORMATION Investors, shareholders and security analysts seeking additional information about the Company should call Investor Relations at (612) 481-7555. A copy of the Company's annual report to the Securities and Exchange Commission on Form 10-K or other financial reports will be provided free of charge to any shareholder upon written request to Investor Relations, St. Jude Medical, Inc., One Lillehei Plaza, St. Paul, Minnesota 55117-9983 ANNUAL MEETING OF SHAREHOLDERS The annual meeting of shareholders will be held at 8:15 a.m. on Wednesday, May 4, 1994, at the Lutheran Brotherhood Auditorium, Lutheran Brotherhood Building, 625 Fourth Avenue South, Minneapolis, Minnesota. SHAREHOLDER MAILINGS When shares owned by one shareholder are held in different forms of the same name (e.g., John Doe, J. Doe) or when new accounts are established for shares purchased at different times, duplicate mailings of shareholder information results. The Company, by law, is required to mail to each name on the shareholder list unless the shareholder requests that duplicate mailings be eliminated or consolidates all accounts into one. Such requests should be directed, in writing, to American Stock Transfer, 6201 15th Avenue, Brooklyn, New York, 11219. St. Jude Medical, Inc. mails quarterly reports only to registered shareholders. Shareholders can obtain the Company's results each quarter by calling a toll-free number (800- 552-7664) and listening to a recorded message. RESEARCH COVERAGE The following firms currently provide research coverage of St. Jude Medical, Inc.: Bear, Stearns & Co., New York, New York Dain Bosworth Incorporated, Minneapolis, Minnesota Goldman Sachs & Co., New York, New York Hambrecht & Quist Incorporated, New York, New York Kemper Securities Group, Inc., Chicago, Illinois Lehman Brothers, New York, New York Mabon Securities Corp., New York, New York Merrill Lynch & Co., New York, New York Morgan Keegan & Company, Inc., Memphis, Tennessee Morgan Stanley & Co. Incorporated, New York, New York Olde Discount, Detroit, Michigan PaineWebber Incorporated, New York, New York Piper, Jaffray Incorporated, Minneapolis, Minnesota Raymond James & Associates, Inc., St. Petersburg, Florida Robert W. Baird Co., Incorporated, Milwaukee, Wisconsin 13D Research Services, Brewster, New York Value Line Inc., New York, New York Vector Securities International, Inc., Deerfeld, Illinois Wertheim Schroder, New York, New York Wessels, Arnold & Henderson, Minneapolis, Minnesota SUPPLEMENTAL MARKET PRICE DATA The common stock of St. Jude Medical, Inc. is traded on the NASDAQ National Market System under the symbol STJM. The range of high and low prices per share for the Company's common stock for 1993 and 1992 are set forth below. As of February 9, 1994, the Company had 5,391 shareholders of record. Year Ended December 31 1993 1992 Quarter High Low High Low First $42.50 $28.75 $55.50 $42.50 Second $39.00 $27.25 $50.75 $34.00 Third $39.50 $25.50 $38.25 $27.50 Fourth $29.75 $25.00 $43.25 $30.25 Price data reflect actual transactions. In all cases, prices shown are inter-dealer prices and do not reflect mark-ups, markdowns or commissions. CASH DIVIDENDS St. Jude Medical, Inc. initiated a cash dividend in the second quarter 1992 and maintained a $.10 per share quarterly cash dividend through 1993. TRADEMARKS St. Jude Medical(R), BiFlex(R), BioImplant(R), Toronto SPVtm, RediFurl(R), RediGuardtm, TaperSeal(R), SureGuidetm, Lifestream(R), and Isoflow(R) are trademarks of St. Jude Medical, Inc. [logo] St. Jude Medical, Inc. One Lillehei Plaza St. Paul, MN 55117 612/483-2000 Telex 298453 Fax 612/490-4333

1993 Item 1. Business. Anuhco, Inc. ("Anuhco"), through its subsidiary, Crouse Cartage Company ("Crouse Cartage"), operates a diversified motor freight transportation system primarily serving the upper central and midwest portion of the United States. Crouse Cartage, acquired by Anuhco as of September 1, 1991, is a regular-route motor common carrier of general commodities in less-than- truckload ("LTL") quantities with a ten state service area, and also offers irregular-route motor common carrier service for truckload quantities of general and perishable commodities throughout the 48 contiguous United States. Crouse Cartage operates as an autonomous company with the same management and operations as before its acquisition by Anuhco. Anuhco, with two employees, performs those functions required of a public holding company and monitors the operations of Crouse Cartage. Crouse Cartage Company The following table sets forth certain financial and operating data with respect to Crouse Cartage prior to the effects of acquisition related adjustments for the years 1993 through 1991. [FN] Notes: (1) Operating ratio is the percent of operating expenses to operating revenue. (2) Less-than-truckload refers to shipments weighing less than 10,000 pounds. (3) Includes company-owned, company leased, agent and other operating locations. Crouse Cartage, an Iowa Corporation headquartered in Carroll, Iowa, is engaged in the transportation of general commodities which include all types of freight other than personal household goods, commodities of exceptionally high value, explosives and commodities in bulk or requiring special equipment. During 1993, LTL shipments (less than 10,000 pounds) comprised 77% of revenue and truckload shipments (10,000 pounds or greater) comprised 23% of revenue. Crouse Cartage is an LTL regular route common carrier with LTL service in the 10 states of Illinois, Indiana, Iowa, Minnesota, Missouri, Nebraska, South Dakota, Wisconsin, Kansas and Michigan. Crouse Cartage also has a truckload general commodities and special commodities division which operates in all 48 contiguous states. More than 90% of Crouse Cartage's business originates or terminates within 400 miles of its headquarters. Crouse Cartage with over 12,000 customers has a broad customer base, with no one customer comprising 5% of its total revenue. LTL shipments must be handled rapidly and carefully in several coordinated stages. Shipments are first picked up from customers by local drivers operating from the Crouse Cartage network of 48 service locations, each of which services a particular territory. The freight is then transported to a terminal, loaded into intercity trailers, carried by linehaul drivers to the terminal which services the delivery area, transferred to trucks or trailers and then delivered to the consignee by local drivers. Much of Crouse Cartage's LTL freight is handled and/or transferred through one of three centrally located "break bulk" terminals between the origin and destination service areas. Competition for LTL freight is primarily based upon service and freight rates. LTL operations require substantial equipment capabilities and an extensive network of terminal facilities. Accordingly, LTL operations, compared to truckload shipments and operations, command higher rates per weight shipped and have tended historically to be less vulnerable to competition from other forms of transportation such as railroads. Crouse Cartage's concentrated and efficient operations typically allow it to provide overnight service (delivery on the day after pickup) on over 90% of the LTL freight it handles; providing Crouse Cartage with a competitive advantage and the ability to maintain compensatory rates. Seasonality Crouse Cartage's quarterly operating results, as well as those of the motor carrier industry in general, fluctuate with the seasonal changes in tonnage levels and with changes in weather-related operating conditions. Tonnage levels are generally highest from September through November. A smaller peak also generally occurs in April through June. Inclement weather conditions during the winter months adversely affect the number of freight shipments and increase operating costs. Historically, Crouse Cartage has achieved its best operating results in the second and third quarters when adverse weather conditions do not affect its operations and seasonal peaks occur in the freight shipped via public transportation. Insurance and Safety Crouse Cartage is largely self-insured with respect to public liability, property damage, workers' compensation, cargo loss or damage, fire, general liability and other risks. In addition, Crouse Cartage maintains excess liability coverage for risks over and above the self-insured retention limits. All claims pending against Crouse Cartage are fully covered by outside insurance or, in the opinion of management, are adequately reserved under Crouse Cartage's self-insurance program. Because most risks are largely self-insured, Crouse Cartage's insurance costs are primarily a function of the success of its safety programs and less subject to the large increases in insurance premiums experienced in recent years by the motor carrier industry. Crouse Cartage conducts a comprehensive safety program to meet its specific needs. Crouse Cartage's drivers have good driving records and have won the Iowa State Truck Driving Championship 13 times in the past 15 years. Auto liability and workers' compensation claims consistently are below industry average in number of claims and amounts paid for such claims (approximately 2.1% of revenue in 1993). Competition Crouse Cartage's operations are subject to intense competition with other motor common carriers and, to a lesser degree, with contract and private carriage. The enactment of the Motor Carrier Act of 1980 substantially deregulated the trucking industry, eased entry requirements into the transportation industry and increased competition among motor carriers. Intense competition for freight has resulted in a proliferation of discount programs among competing carriers. Crouse Cartage competes in such price discounting on an account by account basis, taking into consideration the cost of services relative to the net revenue to be obtained, the competing carriers and the need for freight in specific traffic lanes. Crouse Cartage's main competition over its shorter routes is with Con-Way Central Express, Ann Arbor, Michigan; Central Transport, Sterling Heights, Michigan; H&W Motor Express, Dubuque, Iowa; Hyman Freightways, St. Paul, Minnesota; and Midland Transportation, Marshalltown, Iowa. For freight moving over greater distances, Crouse Cartage must compete with national and large inter-regional carriers. Crouse Cartage's reliable overnight service on key lanes, very low level of freight loss and damage claims and general shipper satisfaction have allowed it to maintain steady growth with a compensatory level of rates. Regulation The interstate operations of Crouse Cartage are subject to regulation by the Interstate Commerce Commission ("ICC") and the Department of Transportation ("DOT"). Crouse Cartage is also subject to state public utilities commissions and similar state regulatory agencies with respect to its intrastate operations. The ICC regulates entry into motor carrier operations, rates and charges, tariffs, accounting systems and certain mergers and consolidations. The DOT generally regulates driver qualifications and safety and equipment standards. Crouse Cartage is also subject to safety regulations of the states in which it operates, as well as regulations governing the weight and dimensions of equipment. Passage of the Motor Carrier Act of 1980 represented, among other things, an effort to increase competition among motor carriers and substantially reduce industry regulation. Entry into the motor carrier market has been facilitated by making ICC operating authority more readily available. Carriers have been given the opportunity to greatly expand the scope of their operations. (See "Competition".) In addition, the Motor Carrier Act of 1980 limited the immunity from the antitrust laws previously applicable to the trucking industry in setting prices for transportation services. After July 1, 1984, collective discussions by motor carriers may only involve general rate increases or tariff restructuring relating to average costs for the industry as a whole. Such discussions may not relate to individual single-line rates or specific markets. In addition, the Motor Carrier Rate-Making Study Commission, established by the Motor Carrier Act of 1980, has, by majority vote, recommended to the Congress that antitrust immunity for all motor carrier collective ratemaking be eliminated. The DOT also has recommended an end to collective ratemaking. Employees Crouse Cartage employs approximately 806 persons, of whom approximately 664 are drivers, mechanics, dockworkers or terminal office clerks. The remainder are engaged in managerial, sales and administrative functions. Labor costs represent the largest single component of Crouse Cartage's operating expenses, totaling 54.4% of consolidated revenue for 1993. In the opinion of its management, Crouse Cartage has a good working relationship with its employees. Approximately 72% of Crouse Cartage employees, including primarily drivers, dockworkers and mechanics, are represented by the International Brotherhood of Teamsters, Chauffeurs, Warehousemen and Helpers of America ("Teamsters Union"). Crouse Cartage and the Teamsters Union are parties to the National Master Freight Agreement ("NMFA") which expires on March 31, 1994. Negotiations by and between Crouse Cartage and the Teamsters Union for the next contract period are ongoing. Crouse Cartage believes the final impact of such negotiations will not significantly affect the results of operations or financial position of the Company. As an employer signatory to the agreement, Crouse Cartage must contribute to certain pension plans established for the benefit of employees belonging to the Teamsters Union. Under provisions of the NMFA, Crouse Cartage has maintained a profit sharing program for all employees since 1988 ("Profit Sharing"). Profit Sharing was implemented after 76% of the union employees and 84% of its non- union employees voted for approval in 1988. In 1991, Profit Sharing was extended for at least another 3 years after 90% of the union employees and 97% of the non-union employees voted for such extension. Although the outcome is uncertain, Crouse Cartage believes the Profit Sharing will be further extended coincident with the conclusion of the NMFA contract negotiations. Profit Sharing is structured to allow all Crouse Cartage employees to ratably share 50% of Crouse Cartage's income before income taxes (excluding extraordinary items and gains and losses on the sale of assets) in return for a 15% reduction in wages. Profit Sharing distributions, made quarterly, totalled $3.3 million in 1993. American Freight System, Inc. Anuhco was a public holding company with several operating motor carrier subsidiaries from 1983 through 1988, under the name American Carriers, Inc. ("ACI"). Following ACI's 1987 acquisition of a large motor carrier, and the merger of its operations into American Freight System, Inc. ("AFS"), ACI's largest LTL subsidiary, substantial operating losses were incurred in the last half of 1987 and the first half of 1988. As a result of the heavy operating losses and cancellation of ACI's bank credit, following ACI's inability to obtain credit from other sources, AFS and ACI's other LTL subsidiary, USA Western, Inc. ("USAW"), ceased operations and filed petitions for protection under Chapter 11 of the Bankruptcy Code (Title 11 of the United States Code) and later in 1988 other subsidiaries of ACI also filed under Chapter 11 ("Debtor Companies"). By the end of 1988 ACI was also under the protection of Chapter 11 of the Bankruptcy Code; as a result of a petition filed by multiemployer pension plans who were creditors of AFS and who also asserted claims against ACI under the Multiemployer Pension Plan Amendments Act of 1980. On July 11, 1991, ACI and the Debtor Companies were discharged from bankruptcy under a reorganization plan confirmed by the U. S. Bankruptcy Court, District of Kansas ("Joint Plan"). ACI's name was changed to Anuhco, Inc., its authorized common stock was increased to 13 million shares and it may only issue voting capital stock. Shareholders retained their shares of ACI's common stock and no new securities were issued by ACI. The other Debtor Companies were merged into AFS and AFS assumed all liabilities of the bankruptcy estates and gained control of all assets of ACI and its other subsidiaries; except for $3.8 million in cash and the capital stock of AFS retained by ACI. AFS was discharged from bankruptcy with an obligation to administer the provisions of the Joint Plan under the control of a reconstituted AFS Board of Directors, which currently consists of three individuals who formerly served on creditors' committees of ACI and AFS, and two additional persons selected by Anuhco. AFS is to sell its remaining non-cash assets and distribute its assets as provided in the Joint Plan. AFS is to resolve creditor claims against the estates of ACI and the Debtor Companies and make distributions to holders of allowed claims as cash is available. The Joint Plan also provides for certain distributions from AFS to Anuhco as unsecured creditor distributions occur in excess of 50% of allowed claims, as shown in the following table: Anuhco receives the full benefit of any remaining assets through its ownership of the capital stock of AFS if unsecured creditors receive distributions equivalent to 130% of their allowed claims. Anuhco and unsecured creditors have received distributions from AFS during 1993 and 1992 as follows: AFS currently projects that cumulative unsecured creditor distributions will equal or exceed 110% of allowed claims and that additional distributions to Anuhco will approximate $4 million, excluding any effects of the judgment held against Westinghouse Credit Corporation. AFS had 14 remaining employees and $37 million of assets as of December 31, 1993. As the Joint Plan provides that liabilities of AFS will be settled solely with the assets of AFS, the liabilities have been set equal to assets in the accompanying financial statements in which AFS is treated as a discontinued operation in conformity with generally accepted accounting principles. (See Note 12 to the consolidated financial statements - Discontinued Operations for further discussion.) Item 2. Item 2. Properties. Anuhco owns property through Crouse Cartage which operates a modern intercity fleet and maintains a network of terminals to support the intercity movement of freight. Crouse Cartage owns most of its fleet but leases some equipment from owner-operators to supplement the owned equipment and to provide flexibility in meeting seasonal and cyclical business fluctuations. As of December 31, 1993 Crouse Cartage owned 446 tractors and 37 trucks. During 1993 Crouse Cartage leased 173 tractors and 30 flatbed trailers from owner-operators. On December 31, 1993, it also owned 248 temperature controlled trailers, 594 volume vans (including 176 53-foot high-cube van trailers), and 27 flatbed trailers. The table below sets forth the number of operating locations at year end for the last three years: Effective January 1, 1994, Crouse Cartage exercised its purchase options under certain operating leases to purchase eleven (11) of the "Leased Terminals", above (See Note 11 to the consolidated financial statements for further discussion). The depreciated net book value of Crouse Cartage's property and equipment at December 31 was: Item 3. Item 3. Legal Proceedings. On February 5, 1991, ACI and the Debtor Subsidiaries filed a Joint Plan of Reorganization ("Joint Plan") and a related Disclosure Statement with the United States Bankruptcy Court, District of Kansas, Topeka Division ("Bankruptcy Court"). After approval by each class of creditors entitled to vote and the equity security holders, on June 10, 1991, following the confirmation hearing, the Bankruptcy Court confirmed the Joint Plan with an Effective Date of July 11, 1991. The Joint Plan provided for the reorganization of ACI with $3.8 million in cash, no debt and the expressed intent of acquiring one or more operating companies; and the administration of the Joint Plan by AFS. (See Item 1, American Freight System, Inc. for further discussion.) On January 12, 1994 a complaint was filed in the District Court of Johnson County, Kansas, against Anuhco, AFS and certain employees of those companies by a former employee of AFS. Such complaint alleges breach of contract, promissory estoppel, tortious interference, and misrepresentation and fraud, as it relates to an alleged incentive compensation arrangement between the former employee and AFS. The suit claims, from Anuhco and others, actual damages in excess of $2 million and punitive damages of $5 million. Management believes such claims will not likely have a material adverse effect on Anuhco's financial position or business. Anuhco's subsidiaries are parties to routine litigation, other than litigation being conducted pursuant to the Joint Plan, primarily involving claims for personal injury and property damage incurred in the transportation of freight and the collection of receivables. Anuhco and its subsidiaries maintain insurance programs and accrue for expected losses in amounts designed to cover liability resulting from personal injury and property damage claims. In the opinion of management, the outcome of such claims and litigation will not materially affect the Company's financial position. Item 4. Item 4. Submission of Matters to a Vote of Security Holders. No matters were submitted to a vote of the security holders during the fourth quarter of 1993. Included herein, pursuant to General Instruction G, is the information regarding executive officers required by Item 401 (b) and (e) of Regulation S-K, as of March 31, 1994. John P. Bigger, a member of the Company's Board from July 19, 1988 to March 22, 1991, has been President and Chief Executive Officer of the Company since September 23, 1988. On July 8, 1991 he was elected to the additional office of Treasurer and designated as Chief Financial Officer. He previously served as Executive Vice President, Senior Vice President-Administration and Corporate Secretary, and Vice President-Administration of ACI at various times from 1982. From 1978 to 1982, he held positions as Vice President- Administration of AFS and Assistant to the Chairman of AFS. From 1972 to 1978 he was Dean of Admissions and Registrar of Georgia State University and from 1960 through 1969 was employed by Arthur Andersen & Co. in their consulting division. Mr. Bigger has sole voting and investment power with respect to 17,863 shares of Anuhco Common Stock. Lawrence D. ("Larry") Crouse has been a member of the Company's Board and Vice President of the Company since September 5, 1991. He has served as Chairman and Chief Executive Officer of CC Investment Corporation (former parent of Crouse Cartage and now a subsidiary of Anuhco) since 1987 and has been Chief Executive Officer of Crouse Cartage since 1987. He has been owner and President of K. P. Enterprises, a personal investment and holding company with a truckload common carrier division doing business as Corrugated Carriers, since 1966. K. P. Enterprises, then named Nebraska Iowa Xpress, Inc., operated as a common motor carrier from 1966 to 1983. Mr. Crouse has sole voting and investment power with respect to 168,036 shares of Anuhco Common Stock. Barbara J. Wackly has been Corporate Secretary of Anuhco since November, 1988. From 1988 to 1992 she served as Vice President of ACI Services, Inc., a wholly-owned subsidiary of the Company. From 1983 to 1988 she was the Executive Assistant to the Chairman of the Board of ACI. Ms. Wackly has sole voting and investment power with respect to 773 shares of Anuhco Common Stock. PART II Item 5. Item 5. Market for Registrant's Common Equity and Related Shareholder Matters. (a) Market Information. Anuhco's Common Stock is and has been traded on the American Stock Exchange under the symbol ANU since its listing on June 21, 1993. From November 12, 1991 to June 21, 1993 Anuhco's Common Stock was traded over-the- counter under the symbol ANUH on the Nasdaq Small-Cap Market. The following table shows the sales price information for each full quarterly period after June 30, 1992, and the bid prices for each full quarterly period from January 1, 1992 through June 30, 1992. (b) Holders. (c) Dividends. No cash dividends were paid during 1993 or 1992 on Anuhco's Common Stock. Anuhco currently intends to retain earnings to finance expansion and does not anticipate paying cash dividends on its Common Stock in the near future. Anuhco's future policy with respect to the payment of cash dividends will depend on several factors including, among others, any acquisitions, earnings, capital requirements and financial and operating conditions. Item 6. Item 6. Selected Financial Data. [FN] 1 See Note 12 of the Notes to Consolidated Financial Statements. 2 Including current maturities of $0 for 1993, $297,000 for 1992 and $315,000 for 1991 (See Note 5 of the Notes to Consolidated Financial Statements). Item 7. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operation. The following table sets forth the percentage relationship of revenue and expense items to operating revenue for the registrant for the years ended December 31: RESULTS OF OPERATIONS The 1993 and 1992 consolidated financial statements for the registrant include both Anuhco and Crouse Cartage for the full year. The 1991 results include Anuhco from July 11, 1991, the effective date of the Joint Plan and the operations of Crouse Cartage from September 1, 1991, the date it was acquired by Anuhco. The 1991 operations were affected by a recession which continued to have some impact on operations in 1992. Anuhco, through its subsidiary Crouse Cartage, was able to continue its growth in total revenue and number of LTL shipments in 1993. In 1993 total tonnage of shipments increased by 3.8% over 1992; with LTL tonnage increasing 9.7% and truckload tonnage decreasing by 0.3%. The decrease in truckload tonnage resulted in a 0.1% increase in truckload revenue per hundredweight due to the retention of the more profitable traffic. In spite of a January 1993 rate increase, LTL revenue per hundredweight only increased 0.1% due to the continued effects of rate discounting. In 1992 total tonnage of shipments increased by 4.9% over 1991; with LTL tonnage increasing 19.0% and truckload tonnage decreasing by 2.8%. The decrease in truckload tonnage resulted in a 3.7% increase in truckload revenue per hundredweight due to the retention of more profitable traffic. In spite of a 3.0% rate increase, LTL revenue per hundredweight decreased 2.3% largely as a result of industry freight rate discounting; fueled by the continued softness of the economy and excess capacity in the motor carrier industry. Led by a 1.3% increase in salaries and wages in 1992 under the labor contract effective April 1, 1991, and with a 3.9% increase in number of employees, operating expenses increased 12.1% over 1991, while revenue increased by 12.3%; resulting in a 22.3% increase in Anuhco's operating income. Crouse Cartage increased its total revenue and number of LTL shipments in the full year 1991 from the full year 1990, albeit at a lower rate of growth and with a lower level of profitability than in the previous year, while truckload shipments dropped. In 1991 total tonnage of shipments decreased by 8.5% from 1990; with LTL tonnage increasing 10.3% and truckload tonnage decreasing by 16.3%. The reduction in truckload tonnage resulted in a 9.9% increase in truckload revenue per hundredweight due to the retention of the more profitable traffic. In spite of a 5.5% rate increase, LTL revenue per hundredweight decreased 1.3% largely as a result of industry freight rate discounting; fueled by the soft economy, excess capacity in the motor carrier industry and lower fuel prices. Led by a 7.3% increase in salaries and wages in 1991, under the new labor contract effective April 1, 1991 and with a 2% increase in number of employees, operating expenses increased 4.4% over 1990, while revenue only increased by 3.7%; resulting in a 7.4% decrease in Crouse Cartage's operating income, excluding any expenses resulting from its acquisition by Anuhco. As a result of inflationary cost increases and in anticipation of labor and other cost increases in 1994, freight rate increases were made effective January 1, 1994 which could favorably impact revenues, if the economy improves and industry wide discounting does not accelerate. Indications are that expenses will increase generally in line with increases experienced in 1993. FINANCIAL CONDITION Anuhco continued to strengthen its financial position during 1993 and 1992. At the beginning of 1992 assets totaled $18.2 million while shareholders' equity amounted to $6.1 million. By the end of 1993 total assets had increased to $24.5 million and shareholders' equity had increased to $17.1 million. During this period long-term debt was reduced from $6.9 million to $1.9 million, while the Company's cash position increased from $2.8 million to $4.7 million. Major factors contributing to these improvements were successful operations creating $2.7 million and $2.3 million of net income and discontinued operations which generated $3.75 million and $2.25 million of net income for 1993 and 1992, respectively. The increased capital is being utilized to further upgrade the company's equipment and for additions and enhancement of terminal facilities. Capital expenditures totaled $2.7 million and $4.3 million in 1993 and 1992, respectively; including $2.0 million to acquire and improve a Chicago area freight terminal and over $4.8 million in equipment upgrades. Anuhco expects available cash and cash generated from 1994 operations to be sufficient to fund its operations, service its debt and to meet other cash needs for 1994. Should additional cash be required, Crouse Cartage has a $2.5 million secured revolving credit agreement with Bankers Trust Company of Des Moines, Iowa, with no balance outstanding on December 31, 1993, which is available to meet short term operational needs and long-term requirements. In addition to principal payments on long-term debt, the $1.9 million of long term debt bears interest at the prime rate plus 1% per annum. At December 31, 1993, Crouse Cartage owns or leases 28 parcels of real property which are utilized in their operations. Because many of these facilities maintain underground or other fuel storage tanks, some ongoing environmental liability exists; however, management is not aware of any material contamination. The Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 112 which will become effective in 1994. This statement requires the recording of certain post employment benefit obligations over the service life of such employees. This statement will not have a material impact on financial position or results of operations. AFS is accounted for as a discontinued operation in the financial statements with a net asset value of zero; due to provisions of the Joint Plan which provide that all assets of AFS are dedicated to payments of obligations under the Joint Plan and that AFS' liabilities, including administrative costs, will be paid out of its net assets. Item 8. Item 8. Financial Statements and Supplementary Data REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Shareholders of Anuhco, Inc.: We have audited the accompanying consolidated balance sheet of Anuhco, Inc. (a Delaware corporation) and Subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, shareholders' equity and cash flows for each of the three years in the period ended December 31, 1993. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated 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 consolidated 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 Anuhco, Inc. and Subsidiaries as of December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. Schedules IV, V, VI, VIII and X are presented for the purpose of complying with the Securities and Exchange Commission rules and are not a required part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, are fairly stated in all material respects in relation to the basic financial statements taken as a whole. /s/ Arthur Andersen & Co. ARTHUR ANDERSEN & CO. Kansas City, Missouri February 16, 1994 [FN] The accompanying notes to consolidated financial statements are an integral part of this statement. [FN] The accompanying notes to consolidated financial statements are an integral part of these statements. ANUHCO, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS (/FN> The accompanying notes to consolidated financial statements are an integral part of these statements. ANUHCO, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY [FN] The accompanying notes to consolidated financial statements are an integral part of these statements. ANUHCO, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 1993 and 1992 1. Acquisition and Plan of Reorganization On August 2, 1991, Anuhco, Inc. ("Anuhco") entered into an agreement for the acquisition of Crouse Cartage Company ("Crouse Cartage"), a regional less-than-truckload motor carrier. The acquisition was consummated effective September 1, 1991 with the final purchase price composed of $5.5 million cash, a $4.0 million convertible note and 1,342,524 shares of common stock in exchange for the outstanding shares of Crouse Cartage. This transaction has been accounted for as a purchase and the operating results of Crouse Cartage have been consolidated with Anuhco beginning September 1, 1991. On June 10, 1991, the Joint Plan of Reorganization ("Joint Plan") was confirmed by the Bankruptcy Court resulting in the formal discharge of American Carriers, Inc. ("ACI"), American Freight System, Inc. ("AFS"), and other subsidiaries from Chapter 11 Bankruptcy proceedings. ACI filed with the Secretary of the State of Delaware an amended and restated certificate of incorporation changing its name to Anuhco, Inc., prohibiting the issuance of non-voting capital stock and increasing the authorized common stock to 13 million shares. 2. Summary of Significant Accounting Policies Principles of Consolidation - The consolidated financial statements include Anuhco and all of its subsidiary companies ("the Company"), all of which are wholly-owned. All significant intercompany accounts and transactions have been eliminated in consolidation. Depreciation and Maintenance - Depreciation is computed using the straight- line method and the following useful lives for new equipment: Upon sale or retirement of operating property, the cost and accumulated depreciation are removed from the accounts and any gain or loss is reflected in non-operating income. The Company expenses costs related to repairs and overhauls of equipment as incurred. Cost of Tires - The cost of tires, including those purchased with new equipment, is expensed when the tires are placed in service. Recognition of Revenues - Operating revenues, and related direct expenses, are recognized when freight is delivered. Other operating expenses are recognized as incurred. Income Taxes - The Company accounts for income taxes in accordance with the liability method as specified in the Financial Accounting Standards Board's Statement No. 109, Accounting for Income Taxes. Deferred income taxes are determined based upon the difference between the book and the tax basis of the Company's assets and liabilities. Deferred taxes are provided at the enacted tax rates expected to be in effect when these differences reverse. Discontinued Operations - American Freight System, Inc. has been accounted for as a "discontinued operation" with only the "net assets" of this operation reflected on the Anuhco financial statements. Anuhco recognizes income from discontinued operations upon receipt of a distribution in accordance with the Joint Plan (See Note 12). Statements of Cash Flows - For purposes of the consolidated statement of cash flows, the Company considers all highly liquid debt instruments purchased with an original maturity of three months or less to be cash equivalents. 3. Employee Benefits Multiemployer Plans Crouse Cartage contributed $2,780,082, $2,573,270 and $805,164 to the multiemployer pension plans for 1993, 1992 and 1991, respectively. Crouse Cartage contributed $3,600,635, $3,128,312 and $1,005,485 to the multiemployer health and welfare plans for 1993, 1992 and 1991, respectively. Contribution amounts for 1991 relate only to the post-acquisition period of September 1 through December 31. Non-Union Pension Plan Crouse Cartage has a defined contribution profit sharing (as defined by the Internal Revenue Code) plan ("the Non-union Plan") providing for a mandatory Company contribution of 5% of annual earned compensation of the non-union employees. Additional discretionary contributions can be made by Crouse Cartage depending upon profitability of Crouse Cartage. Any discretionary funds contributed to the Non-union Plan will be invested 100% in Anuhco Common Stock. Crouse Cartage had a defined benefit pension plan covering employees not covered under collective bargaining agreements. Crouse Cartage terminated this plan effective December 31, 1992, at which time all benefit accruals ceased. Benefits under the plan were based on years of service and the employees' compensation during the last three years of employment. All par- ticipants who had met this plan's requirements, who had been entered into this plan and who were actively employed by Crouse Cartage as of the termination date, are 100% vested in their accrued plan benefits. Crouse Cartage has purchased an annuity contract to satisfy the individual accrued plan benefits as of the termination date. Crouse Cartage intends to distribute any excess plan assets to plan participants as additional annuities or through rolling them into the Non-union Plan. The Company believes the plan assets will be sufficient to settle all termination obligations and expenses, including the participants' accrued plan benefits. Final settlement of the terminated plan is expected in 1994. Pension expense, exclusive of the multi-employer pension plans, was $80,000, $0 and $184,845 for the years 1993, 1992 and 1991, respectively. The accompanying consolidated balance sheet includes a pension liability of $152,158 and $375,000 as of December 31, 1993 and 1992, respectively. Profit Sharing In September, 1988, the employees of Crouse Cartage approved the establishment of a profit sharing plan ("the Plan"). The Plan is structured to allow all employees (union and non-union) to ratably share 50% of Crouse Cartage's income before income taxes (excluding extraordinary items and gains or losses on the sale of assets) in return for a 15% reduction in their wages. The Plan calls for profit sharing distributions to be made on a quarterly basis. The Plan was recertified in 1991, and shall continue in effect through March 31, 1994, or until a replacement Collective Bargaining Agreement is reached between the parties, whichever is the later. Although the outcome is uncertain, Crouse Cartage believes the Plan will be further extended coincident with the conclusion of the overall union contract negotiations. The accompanying consolidated balance sheet includes profit sharing accruals of $986,583 and $742,408 for 1993 and 1992, respectively. The accompanying consolidated statement of income includes profit sharing expense of $3,307,862, $3,071,057 and $874,268 for 1993, 1992 and 1991, respectively. 401(k) Plan Effective January 1, 1990, Crouse Cartage established a salary deferral program under Section 401(k) of the Internal Revenue Code ("the Code"). To date, participant contributions to the 401(k) plan have not been matched with Company contributions. All employees of the Company are eligible to participate in the 401(k) plan after they attain age 21 and complete one year of qualifying employment. 4. Insurance Coverage Claims and insurance accruals reflect accrued insurance premiums and the estimated cost of incurred claims for cargo loss and damage, bodily injury and property damage and workers' compensation not covered by insurance. Workers' compensation expense is included in "Salaries, wages and fringe benefits" in the accompanying statement of income. The Company's public liability and property damage, cargo and workers' compensation premiums are subject to retrospective adjustments based on actual incurred losses. The actual adjustments normally are not known for at least one year; however, based upon a review of the preliminary compilation of losses incurred through December 31, 1993, management does not believe any material adjustment will be made to the premiums paid or accrued at that date. In connection with its public liability and property damage, cargo and workers' compensation insurance coverage, the Company has an irrevocable standby letter of credit ("LOC"), which at December 31, 1993, was $850,000. The LOC, required by the Company's insurance provider, is deemed to be automatically extended unless notice of termination is given. The fee for the LOC is 1% of the LOC amount. 5. Long-Term Debt Long-term debt was as follows, as of December 31: The Convertible Note is payable to sellers of Crouse Cartage, including certain employees, Crouse Cartage officers, and a director and officer of Anuhco. If such note remains unpaid for 15 days after maturity, October 15, 1995, the holders of the note, may at their option, elect to convert the unpaid principal and interest thereunder into 11% cumulative $100 par value preferred stock. The number of such shares is to be determined by dividing the aggregate dollar amount of the unpaid principal and interest by 100. Under certain conditions and upon 30 days prior written notice to the Company, all but not less than all of the preferred stock may be converted to common stock. There are no required payments of existing long-term debt during 1994 through 1998. However, it is the Company's intent to repay the Convertible Note prior to the option date or otherwise prevent its conversion. At December 31, 1993, substantially all net property, equipment and accounts receivable was subject to liens under various debt instruments. 6. Revolving Credit Agreement In September, 1988, Crouse Cartage entered into a five-year credit agreement with a commercial bank which provided for maximum borrowings equaling the lesser of $2,500,000 or the borrowing base, as defined in such agreement. Based on the value of its revenue equipment, such borrowing base exceeds $2,500,000 at December 31, 1993. This agreement was amended and superseded on September 30, 1991, and Anuhco was added as a guarantor. In May, 1993 the term was extended to July 31, 1995. There was no outstanding balance on this revolving line of credit at December 31, 1993 or 1992. On the last day of each calendar month through the term of the agreement, Crouse Cartage is required to pay to the bank equal payments of principal, each in an amount equal to one forty-eighth (1/48) of the highest unpaid principal balance of the previous 12-month period. The agreement provides for interest on borrowings at the bank's prime rate. The effective rate at December 31, 1993, was 6%. The agreement can be terminated by the bank on six months notice or by Crouse Cartage on 30 days notice after full payment of any debt to the bank. The terms of the agreement require the maintenance of a minimum shareholder's equity and contain restrictions on declaration and payment of dividends, acquisition of Crouse Cartage stock, loans to officers or employees, type of investments and annual capital expenditures. The Company was in compliance with all such restrictions at December 31, 1993. 7. Common Stock In accordance with a resolution to amend Anuhco's Certificate of Incorporation, duly prepared and adopted at the Company's 1993 Annual Shareholders' Meeting, the capital stock of Anuhco was changed from stock without par value to $0.01 par value per share effective June 1, 1993. Such change has no impact on total shareholders' equity but does require a reclassification of a portion of capital stock to paid-in capital. This amendment will provide a cost savings on certain franchise taxes. An Incentive Stock Option Plan was adopted in 1983 which provides that options for shares of Anuhco Common Stock may be granted to officers and key employees at fair market value of the stock at the time such options are granted. This plan terminated under its provisions in May, 1993 and no further options may be granted. At December 31, 1993 options for 30,000 shares were outstanding at an average option price of $2.36 per share and options for 10,000 were exercisable. The remaining outstanding options will become exercisable over a period through 1997. An Incentive Stock Plan was adopted in 1992 which provides that options for shares of Anuhco Common Stock shall be granted to directors, and may be granted to officers and key employees at fair market value of the stock at the time such options are granted. At December 31, 1993 options for 73,000 shares were outstanding at an average option price of $4.00 per share and options for 14,500 shares were exercisable. The remaining outstanding options will become exercisable over a period through 2003. 8. Income Taxes The Company accounts for income taxes in accordance with the liability method as required in the Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes". The impact of significant temporary differences and carryforwards representing deferred tax assets and liabilities is determined utilizing the enacted tax rates expected to be in effect when such differences reverse. Deferred tax liabilities (assets) are comprised of the following at December 31: At December 31, 1992 the Company had $25 million of net operating loss carryforwards and $1 million of tax credit carryforwards which will be available for Federal income tax purposes. In addition, the Company generated net operating loss carryforwards in 1993. The amount of these additional carryforwards is estimated to be in excess of $10 million. The net operating loss carryforwards will expire over a period from 2005 to 2008. The tax credit carryforwards expire over a period from 1998 to 2001. The following is a reconciliation of the statutory Federal income tax rate to the effective income tax rate. No net provision for income tax has been made for the years ended December 31, 1993, 1992 or 1991 and no asset related to the Company's net operating loss carryforwards has been recognized due to significant tax losses from the discontinued operations during those years and projected future tax losses. 9. Union Contract During 1991, Crouse Cartage negotiated with its unions for a new contract and in June, 1991, the unions approved a three-year National Master Freight Agreement ("the Agreement") with wage rate increases of $0.50 per hour in 1991 and $0.45 per hour in 1992 and 1993. The Agreement included a profit sharing program provided that such program was ratified by at least 75% of the Company's bargaining unit employees (see Note 3). Negotiations by and between Crouse Cartage and the Teamsters Union for the next contract period are ongoing. Crouse Cartage believes the final impact of such negotiations will not significantly affect the results of operations or financial position of the Company. 10. Long-Term Obligation Receivable In connection with the sale of its terminal in Hodgkins, Illinois, Crouse Cartage received a $1,000,000 Subordinated Tax Incremental General Obligation Bond, Series 1991 ("the Bond"), issued by the Village of Hodgkins, Illinois. The Bond has a face value of $1,000,000, accrues interest at a rate of 14% and is due in December, 2009. Interest at 10% is payable semi-annually on June 1 and December 1, and interest at 4% is due on the December 20th immediately following the date that the principal amount is paid in full. Payments of interest and the repayment of the Bond principal will be funded by future tax revenues from the commercial development of the acquired property and no payments have been made, to date. Based upon the Village of Hodgkins' current cash flow projections and the timing of interest and principal payments, the effective interest rate on the Bond is estimated to be approximately 9%. Accrued interest, during 1993 and 1992 of $90,000, has been recorded as an addition to the carrying value of this bond. 11. Contingencies and Commitments The Company is party to certain other claims and litigation arising in the ordinary course of business. In the opinion of management, the outcome of such claims and litigation will not materially affect the Company's financial position. Crouse Cartage leases buildings and office equipment under various leases which expire from 1994 to 2001. The majority of these building leases are with a former owner of Crouse Cartage. Effective January 1, 1994, Crouse Cartage exercised its purchase options under certain operating leases. Such options covered the purchase of twelve (12) facilities (11 terminals and a salvage store operation) from P&R Realty, a sole proprietorship and related party, for approximately $2.6 million. The option prices were based on the market value of each property, as established by an independent real estate appraiser, and were each equal to or less than the appraised values. Crouse Cartage financed these purchases through currently available operating funds, which included borrowing of $0.5 million on its $2.5 million revolving credit agreement. Crouse Cartage has utilized these facilities for its operations for numerous years and currently anticipates their continued use without change. The exercise of these options will, among other things, have the effect of reducing rental expense by approximately $314,000 annually. Rental expense for 1993, 1992 and 1991 was $492,262, $576,066 and $597,822, respectively. At December 31, 1993, there are no future minimum lease payments under noncancellable operating leases having initial or remaining lease terms of more than one year. Payments are made to tractor owner-operators under various short-term lease agreements for the use of revenue equipment. These lease payments, which totaled $9,554,580, $9,416,968 and $9,275,336 for 1993, 1992 and 1991, respectively, are primarily based on miles traveled or on a percent of revenue generated through the use of the equipment. Future commitments for the purchase of operating property totaled approximately $2.6 million at December 31, 1993, including the aforementioned exercise of options on real property. The total amount of this commitment was paid in January, 1994 and was funded by current operations and a $500,000 draw on the revolving credit agreement. 12. Discontinued Operations Under the provisions of the Joint Plan, American Freight System, Inc. ("AFS") is responsible for the continued resolution of pre-July 12, 1991 creditor claims and conversion of assets owned before that date. As claims are allowed and cash is available, distributions to the creditors will occur. The Joint Plan also provides for distributions to Anuhco as unsecured creditor distributions occur in excess of 50% of allowed claims in accordance with the following table. Such distributions are recognized as "Income from Discontinued Operations" by Anuhco at the time they are received. Anuhco also receives the full benefit of any remaining assets through its ownership of AFS stock, if unsecured creditors receive distributions, including interest, equivalent to 130% of their claims. The preceding and the following information does not disclose all the financial impacts of the Joint Plan. For a more in-depth analysis, the complete Joint Plan and related Disclosure Statement, incorporated in this 10-K by reference, should be reviewed. AMERICAN FREIGHT SYSTEM, INC. STATEMENT OF NET ASSETS Assets and Liabilities - Assets, including property and equipment remaining at December 31, 1993 and 1992, are stated at estimated net realizable value. Certain contingent assets have been identified and are described in the Disclosure Statement. Among these contingent assets is a judgment against Westinghouse Credit Corporation ("WCC"). On February 23, 1993, a judgment in favor of Anuhco and AFS was entered in the Circuit Court of Jackson County, Missouri, at Kansas City, Missouri ("the Court"). This judgment was entered in a case filed by Anuhco and AFS against WCC seeking damages as a result of WCC's failure to provide financing pursuant to a loan commitment issued on June 3, 1988. The judgment awarded $70 million in actual damages to be paid to Anuhco and AFS. WCC filed motions with the Court to have this judgment set aside or to have a new trial granted. On April 8, 1993 WCC's motions were overruled. WCC filed a notice of appeal of this judgment with the Western District Court of Appeals of Missouri and posted a $76.35 million surety bond in support of such judgment, accrued interest (9% simple interest) and other costs. Oral arguments before the appellate court were made on November 4, 1993, with an order expected during the first half of 1994. The Appellate Court could (i) reverse the Court's decision, thereby eliminating the judgment; (ii) remand the case to the Court for retrial; or (iii) affirm the Court's decision. Even with the affirmation of the Appellate Court, WCC could request a rehearing before the Appellate Court and/or a transfer to the Missouri Supreme Court. Any damages paid, net of trial expenses, will be remitted to AFS and AFS will distribute such proceeds under the Joint Plan. Under the Joint Plan, if the judgment is affirmed and/or is otherwise substantially collected and the other assets of the discontinued operations are liquidated, Anuhco could receive net proceeds of $29 million to $37 million, including the additional $4 million described under "Distributions" below. This represents $4 to $5 per share based on Anuhco's 7.5 million currently outstanding shares. Anuhco and AFS are unable to predict when or how this matter or other contingent asset issues will ultimately be resolved and, therefore, they have not been included in the above assets. AFS has provided notice to all known creditors and the deadline for filing claims to be resolved under the Joint Plan has expired. Creditors are barred from submitting claims after the deadline. Claims filed by the creditors are significantly in excess of recorded liabilities. In addition, unliquidated and/or contingent claims were filed; the potentially significant claims are described in the Disclosure Statement. Although some of these claims may result in an increase in liabilities, the amount and timing of such liabilities are unknown. AFS is in the process of investigating these claims, however until this process is completed the amount of liabilities to be settled cannot be ascertained. The ultimate resolution of the amounts, validity and priority of recorded liabilities and other claims is uncertain at this time. Accordingly, liabilities are reflected at estimated amounts due or are based on claims filed with the debtor and modified to reflect AFS assets available to distribute on such liabilities. Future Administrative Costs and Investment Income - AFS will continue to incur professional fees and other administrative costs in connection with the sale of its assets, collection of receivables and settlement of its liabilities. In addition, investment income will be realized on funds invested pending disbursements to creditors. The amount of such costs and income will depend on many factors including the length of time the close- down process continues. An accrual of $3.4 million for future administrative costs net of investment income has been reflected in the 1993 consolidated financial statements. The estimated costs and/or income and any deviations therefrom are absorbed by AFS and only impact Anuhco as a result of the aforementioned participation arrangement. Distributions - On February 18, 1992, September 11, 1992, April 15, 1993 and October 13, 1993 AFS made interim distributions under the Joint Plan at the rate of 20%, 20%, 10% and 5%, respectively, of each allowed unsecured claim. Anuhco's participation in these distributions were $1 million, $1.25 million, $2.5 million and $1.25 million, respectively. A portion of these distributions was applied as payment of a note payable to AFS. To date AFS has distributed a total of 95% on allowed claims which is a more favorable result than was assumed in the March 21, 1991 Disclosure Statement relating to the Joint Plan. Such result is due to favorable (i) settlements of certain claims, (ii) court decisions, and (iii) asset realizations. A revised projection, excluding any impact of the WCC judgment, is that total distributions to Anuhco (including the $6 million previously distributed) may exceed $10 million. This revised projection continues to include the assumptions enumerated in the Disclosure Statement regarding conditions and contingencies. Due to the number and value of claims to be resolved and assets to be converted to cash, the timing and amount of additional interim distributions and the timing of the final distribution have not been included in the revised projection. SUPPLEMENTAL FINANCIAL INFORMATION Summary of Quarterly Financial Information (Unaudited) Anuhco's quarterly operating results, as well as those of the motor carrier industry in general, fluctuate with the seasonal changes in tonnage levels and with changes in weather related operating conditions. Inclement weather conditions during the winter months adversely affect freight shipments and increase operating costs. Historically, Anuhco has achieved its best operating results in the second and third quarters when adverse weather conditions have a lessor effect on operating efficiency. Discontinued operations reflects the continuing winddown of the AFS and related estates. The amounts and timing of future distributions/income are not known (see Note 12 to the consolidated financial statements). The following table sets forth selected unaudited financial information for each quarter of 1993 and 1992 (in thousands, except per share amounts). Item 9. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosures This Item 9 is not applicable. PART III Item 10. Item 10. Directors and Executive Officers of the Registrant Pursuant to General Instruction G(3), the information required by this Item 10 is hereby incorporated by reference from the Anuhco, Inc. Proxy Statement for Annual Meeting of Shareholders to be held on May , 1994, which the Registrant will file pursuant to Regulation 14-A. (See Item 4, included elsewhere herein, for a listing of Executive Officers of the Registrant). Item 11. Item 11. Executive Compensation Pursuant to General Instruction G(3), the information required by this Item 11 is hereby incorporated by reference from the Anuhco, Inc. Proxy Statement for Annual Meeting of Shareholders to be held on May , 1994, which the Registrant will file pursuant to Regulation 14-A. Item 12. Item 12. Security Ownership of Certain Beneficial Owners and Management Pursuant to General Instruction G(3), the information required by this Item 12 is hereby incorporated by reference from the Anuhco, Inc. Proxy Statement for Annual Meeting of Shareholders to be held on May , 1994, which the Registrant will file pursuant to Regulation 14-A. Item 13. Item 13. Certain Relationships and Related Transactions Pursuant to General Instruction G(3), the information required by this Item 13 is hereby incorporated by reference from the Anuhco, Inc. Proxy Statement for Annual Meeting of Shareholders to be held on May , 1994, which the Registrant will file pursuant to Regulation 14-A. PART IV Item 14. Item 14. Exhibits, Financial Statement Schedules and Reports (a)1. Financial Statements Included in Item 8, Part II of this Report - Consolidated Balance Sheet at December 31, 1993 and 1992 Consolidated Statement of Income for the years ended December 31, 1993, 1992 and 1991 Consolidated Statement of Cash Flows for the years ended December 31, 1993, 1992 and 1991 Consolidated Statement of Shareholders' Equity for the years ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements Supplemental Financial Information (Unaudited) - Summary of Quarterly Financial Information for 1993 and (a)2. Financial Statement Schedules Included in Item 14, Part IV of this Report - Financial Statement Schedules for the three years ended December 31, 1993: Schedule IV - Indebtedness of and to Related Parties Schedule V - Property and Equipment Schedule VI - Accumulated Depreciation of Property and Equipment Section VIII - Valuation and Qualifying Accounts Section X - Supplemental Income Statement Information Other financial statement schedules are omitted either because of the absence of the conditions under which they are required or because the required information is contained in the consolidated financial statements or notes thereto. (a)3. Exhibits 2(a) - Fifth Amended Joint Plan of Reorganization of the Registrant and others and Registrant's Disclosure Statement Relating to the Fifth Amended Joint Plan of Reorganization. Filed as Exhibit 28(a) and 28(b) to the Registrant's Form 8-K dated March 21, 1991. 2(b) - United States Bankruptcy Court order confirming the Fifth Amended Joint Plan of Reorganization of the Registrant and others. Filed as Exhibit 28(c) to Registrant's Form 8-K dated June 11, 1991. 3(a) - 1993 Restated Certificate of Incorporation of the Registrant. Filed as Exhibit 3 to Registrant's Form 10-Q dated August 4, 1993. 3(b) - By-Laws of the Registrant. Filed as Exhibit 3(b) to Registrant's Annual Report on Form 10-K for the year ended December 31, 1991 by Amendment No. 1 dated July 30, 1992. 4 - Specimen Certificate of the Common Stock, no par value, of the Registrant. Filed as Exhibit 4 to Registrant's Annual Report on Form 10-K for the year ended December 31, 1991 by Amendment No. 1 dated July 30, 1992. 10(a) - Registrant's 1983 Incentive Stock Option Plan. Filed as Exhibit 10(a) to Registrant's Registration Statement No. 2- 83536, effective May 22, 1986. 10(b) - Form of Indemnification Agreement with Directors and Executive Officers. Filed as Exhibit 10(k) to Registrant's Annual Report on Form 10-K for the year ended December 31, 1986. 10(c) - Trust and Security Agreement by and between American Freight System, Inc. (Grantor) and The Merchants Bank (Trustee), dated July 11, 1991. Filed as Exhibit 10(c) to Registrant's Annual Report on Form 10-K for the year ended December 31, 1991 by Amendment No. 1 dated July 30, 1992. 10(d) - Agreement by and between Registrant (Buyer) and owners of the outstanding capital stock of CC Investment Corporation (Sellers). Filed as Exhibit 10 to Registrant's Form 8-K dated August 9, 1991. 10(e) - Convertible Note for the principal sum of $3,620,000 issued by Registrant (Maker) to Bankers Trust of Des Moines, Iowa, as agent for the owners of the outstanding capital stock of CC Investment Corporation, dated November 1, 1992. Filed as Exhibit 10(e) to Registrant's Annual Report on Form 10-K for the year ended December 31, 1992. 10(f) - Incentive Compensation Agreement by and between Registrant and Lawrence D. Crouse, and Employment Agreement by and between Crouse Cartage Company and Lawrence D. Crouse. Filed as Appendices F. and G. to Exhibit 28(a) to Registrant's Form 8-K dated September 19, 1991. 10(g) - Promissory Note for the principal sum of $2,800,000 by and between Registrant and American Freight System, Inc., dated October 1, 1991. Filed as Exhibit 10(g) to Registrant's Annual Report on Form 10-K for the year ended December 31, 1991 by Amendment No. 1 dated July 30, 1992. 10(h) - Stock Sale Agreement for shares of common stock of Crouse Cartage Company by and between Registrant and American Freight System, Inc., dated October 1, 1991 and supplement thereto dated September 25, 1991. Filed as Exhibit 10(h) to Registrant's Annual Report on Form 10-K for the year ended December 31, 1991 by Amendment No. 1 dated July 30, 1992. 10(i) - Secured Revolving Credit Agreement for a revolving credit facility in the amount of $2,500,000 by and between Crouse Cartage Company and Bankers Trust Company of Des Moines, Iowa. Filed as Exhibit 10(i) to Registrant's Annual Report on Form 10-K for the year ended December 31, 1991 by Amendment No. 1 dated July 30, 1992. 10(j) - Registrant's 1992 Incentive Stock Plan. Filed as Exhibit 10(j) to Registrant's Annual Report on Form 10-K for the year ended December 31, 1992. 22* - List of all subsidiaries of Anuhco, Inc., the state of incorporation of each such subsidiary, and the names under which such subsidiaries do business. 24* - Consent of Independent Public Accountant. (b) Reports on Form 8-K No reports on Form 8-K were filed during the quarter ended December 31, 1993. * Filed herewith. [FN] 1 As mandated by the Joint Plan, AFS loaned $2.8 million to Anuhco which was utilized in the purchase of Crouse Cartage. 2 The indebtedness was incurred as a portion of the purchase price for the acquisition of Crouse Cartage. [FN] 1 Property and equipment acquired in connection with the acquisition of Crouse Cartage Company. [FN] 1 Accumulated depreciation at the date of acquisition of Crouse Cartage Company. [FN] 1 Deduction for purposes for which reserve was created. 2 Reserve balance at the time of the acquisition of Crouse Cartage Company. [FN] NOTE: Depreciation and amortization of intangible assets, royalties and advertising costs were each less than 1% of operating revenue during the years 1993, 1992 and 1991. 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. Date: March 2, 1994 By /s/ John P. Bigger John P. Bigger, 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 dates indicated. /s/ John P. Bigger President and Chief Executive Officer John P. Bigger (Principal Executive Officer) /s/ John P. Bigger Treasurer and Chief Financial Officer John P. Bigger (Principal Financial and Accounting Officer) /s/ Joe J. Brown /s/ Roy R. Laborde Joe J. Brown, Director Roy R. Laborde, Chairman of the Board of Directors /s/ William D. Cox /s/ Eleanor B. Schwartz William D. Cox, Director Eleanor B. Schwartz, Director /s/ Lawrence D. Crouse /s/ Walter P. Walker Lawrence D. Crouse, Director Walter P. Walker, Director /s/ Donald M. Gamet Donald M. Gamet, Director March 2, 1994 Date of all signatures Registrant's Proxy Statement for Annual Meeting of Shareholders to be held in 1994 and Annual Report will be mailed to security holders at a later date. Copies of such material will be furnished to the Securities and Exchange Commission when it is sent to security holders. (All companies do business under same name unless otherwise indicated). Exhibit 24 CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our report included in this Form 10-K into the Company's previously filed Registration Statements for the Anuhco, Inc. 1992 Incentive Stock Plan, File No. 33-51494 and the American Carriers, Inc. 1983 Incentive Stock Option Plan, File No. 2-86915. /s/ Arthur Andersen & Co. ARTHUR ANDERSEN & CO. Kansas City, Missouri March 2, 1994

1993 ITEM 1. BUSINESS. GENERAL Office Depot, Inc. (the "Company") operates the largest chain of high-volume retail office supply stores in the United States, with 344 stores in 33 states and the District of Columbia and 18 stores in 5 Canadian provinces. The Company sells high-quality, brand-name office products at significant discounts primarily to small- and medium-sized businesses. The Company's stores utilize a "warehouse" format and carry a wide selection of merchandise, including general office supplies, business machines and computers, office furniture and other business-related products. The Company also operates five delivery centers and a full-service contract stationer business serving medium- and large-sized businesses in the United States through twelve contract stationer warehouses. The Company is one of the leading full service contract stationers and office furniture dealers in the western United States and Texas through its contract stationer division. The Company, through this division, sells its products primarily to medium- and large-sized businesses (generally, organizations with over 75 white-collar employees), schools and other educational institutions and governmental agencies. The Company provides its customers access to a broad selection of office supplies and office furniture, as well as specialized resources and services designed to aid its customers in achieving improved efficiencies and significant reduction in their overall office supplies and office furniture costs, including electronic ordering, stockless office procurement and business forms management services (which reduce customer needs for office supplies storage facilities), desktop delivery programs (which reduce customer personnel requirements) and comprehensive product utilization reports. The Company's business strategy is to enhance the sales and profitability of its existing stores, to add new stores in locations where the Company can achieve a significant market presence and to expand its contract stationer business. Through expansion, the Company seeks to increase efficiencies in operations, purchasing, marketing and management. During 1993, the Company added 67 new stores. The Company intends to open approximately 60 to 70 stores and additional delivery centers during 1994. The Company's merchandising strategy is to offer customers a wide selection of brand-name office products at everyday low prices. The Company believes that its prices are significantly lower than those typically offered to small- and medium-sized businesses by their traditional sources of supply. The Company is able to maintain its low competitive price policy primarily as a result of the significant cost efficiencies achieved through its operating format and purchasing power. The Company buys substantially all of its inventory directly from manufacturers in large quantities. It does not utilize a central warehouse and maintains its inventory on the sales floors of its "no frills" stores. The Company operates in a highly competitive environment and the Company believes that in the future it will face increased competition from other high-volume office supply and wholesale club chains as the Company and these chains expand their operations. The Company recently has expanded its business into the full-service contract stationer portion of the office supply industry. On May 17, 1993, the Company acquired the office supply business of Wilson Stationery & Printing Company ("Wilson") from Steelcase Inc. for approximately $15 million of Common Stock and the assumption of certain liabilities. The Company and Steelcase Inc. were not, at the time of the acquisition, and are not currently, affiliated. Wilson is a full service contract stationer with operations in Texas and North Carolina. On September 13, 1993, the Company acquired all of the outstanding common stock of Eastman Office Products Corporation ("Eastman"), a full service contract stationer and office furniture dealer headquartered in California that operates primarily in the western United States. The Company acquired the Eastman common stock for approximately $80 million of Common Stock and $20 million in cash. The - 1 - Company also acquired the outstanding preferred stock of Eastman for approximately $13 million in cash, acquired pursuant to a tender offer approximately $82 million aggregate principal amount of Eastman, Inc.'s 13% Series B Subordinated Notes due 2002 for approximately $103 million in cash and paid approximately $19 million in cash to pay off the outstanding balance of Eastman, Inc.'s revolving credit facility. No affiliation existed between the Company and Eastman prior to this transaction. Additionally, in February 1994, the Company acquired all of the outstanding common stock of L.E. Muran Co., a Boston-based contract stationer, and Yorkship Press Inc., a New Jersey-based contract stationer serving Philadelphia and southern New Jersey. No affiliation existed between the Company and either of L.E. Muran Co. or Yorkship Press Inc. prior to these transactions. OFFICE PRODUCTS INDUSTRY The office products industry is comprised of three broad categories of merchandise: office supplies, office machines and microcomputers, and office furniture. These products are distributed through different and sometimes overlapping channels of distribution, including manufacturers, distributors, dealers, retailers and catalog companies. The retail office products industry, through which smaller businesses have traditionally purchased office products, is highly fragmented with few regional or national chains and is typified by stores that do not stock a full range of office products. Retail sales of office products in the United States are made primarily through office product dealers, which generally operate one or more retail stores and utilize a central warehouse facility. Dealers purchase a significant portion of their merchandise from national or regional office supply distributors who in turn purchase merchandise from manufacturers. Dealers often employ a commissioned sales force that utilizes the distributor's catalog, showing products at retail list prices, for selection and price negotiation with the customer. Contract bids are typically available to large businesses that are offered discounts equivalent to or greater than those offered by the Company. The Company believes that small- and medium-sized businesses, however, have typically been able to obtain from dealers discounts on manufacturers' suggested retail list prices of only 20% or less. In addition, those businesses whose volume usage does not justify a dealer's one-to-one selling effort generally have been treated as retail customers and charged prices close to full retail list prices. In the past few years, high-volume office products retailers employing various formats have emerged in several geographic markets of the United States targeting the smaller businesses that traditionally purchased from dealers by offering significantly lower prices. These price advantages result primarily from direct, high-volume purchasing from manufacturers and warehouse retailing, thereby avoiding the distributor's mark-up and eliminating the need for a commissioned sales force and a central distribution facility. High-volume office products retailers typically offer substantial price savings to individuals and small- and medium-sized businesses, which traditionally have had limited opportunities to buy at significant discounts off the retail list prices. Larger customers have been, and continue to be, serviced primarily by full service contract stationers. These stationers traditionally serve larger businesses through commissioned sales forces, purchase in large quantities primarily from manufacturers and offer competitive pricing and customized services to their customers. MERCHANDISING AND PRODUCT STRATEGY The Company's merchandising strategy is to offer a broad selection of brand-name office products at everyday low prices. Each of the Company's stores offer a comprehensive selection of paper and paper products, filing supplies, computer hardware and software, calculators, copiers, typewriters, telephones, facsimile and other business machines, office furniture, art and engineering supplies and virtually every other type of office supply. Each of the Company's stores carries approximately 5,600 stock-keeping units (including variations in color and size). In the Contract Stationer Division, in order to be able to respond satisfactorily to its customers' orders, certain of the contract stationer warehouses currently carry up to 18,000 stock-keeping - 2 - units in inventory. Although the Company has not determined the number of stock-keeping units in inventory its contract stationer warehouses will carry in the future, the Company expects such number to be less than 18,000. The table below shows sales of each major product group as a percentage of total merchandise sales for the 1993, 1992 and 1991 fiscal years: (1) Includes paper, filing supplies, organizers, writing instruments, mailing supplies, desktop accessories, calendars, business forms, binders, tape, art supplies, books, engineering and janitorial supplies and revenues from the business services center located in each store. (2) Includes calculators, adding machines, typewriters, telephones, cash registers, copiers, facsimile machines, safes, tape recorders, computers, computer diskettes, computer paper and related accessories. (3) Includes, chairs, desks, tables, partitions and filing and storage cabinets. The Company buys approximately 95% of its merchandise directly from manufacturers and other primary source suppliers. Products are generally delivered from manufacturers directly to the stores or warehouses. The Company is currently expanding its cross-dock operations that utilize independent distributors' facilities to receive bulk deliveries from vendors and sort and deliver merchandise to the Company's stores. These operations use the Company's computer system and the distributors' existing facilities and trucks, which, when fully implemented, should enable the Company to realize savings from freight and handling charges and reduce store inventory levels. No single customer accounts for more than one percent of the Company's sales. The Company has no material long-term contracts or commitments with any vendor or customer. The Company has not experienced any difficulty in obtaining desired quantities of merchandise for sale and does not foresee any such difficulty in the future. Initial purchasing decisions are made at the corporate headquarters level by buyers who are responsible for selecting and pricing merchandise. Inventory levels are monitored and reorders for products are prepared by central replenishment buyers or "rebuyers" with the assistance of a computerized automatic replenishment system. This system allows buyers to devote more time to selecting products, developing new product lines, analyzing competitive developments and negotiating with vendors in order to obtain more favorable prices and product availability. Purchase orders to approximately 250 vendors are currently transmitted by electronic data interchange (EDI), which expedites orders and promotes accuracy and efficiency. During 1993, the Company started to receive Advance Ship Notices (ASN) and invoicing via EDI from selected vendors. The Company plans to expand this program in 1994. MARKETING AND SALES Retail. The Company's marketing programs are designed to attract new customers to visit its stores for the first time and to provide information to existing customers. The Company places advertisements with the major local newspapers in each of its markets. These newspaper advertisements are supplemented with local radio and television advertising and direct marketing efforts. During 1992, the Company launched a major national television advertising campaign utilizing the "Taking Care of Business" theme. The current series of television commercials is running on three national television networks and on 11 national cable stations. All print advertisements, as well as catalog layouts, are created by the Company's in-house - 3 - graphics department. The Company periodically issues catalogs featuring merchandise offered in its stores. The catalogs compare the manufacturer's suggested retail list price and the Company's price to illustrate the savings offered. The catalogs are distributed through direct mail programs and are available in each store. Upon entering a new market, the Company purchases a list of businesses for an initial mailing of catalogs. This list is continually refined and updated by incorporating the names of private label credit card holders, guarantee card holders and check paying customers and forms the basis of a highly targeted proprietary mailing list for updated catalogs and other promotional mailings. The Company has a low price guarantee policy. Under this policy, the Company will match any competitor's lower price and give the customer 50% (up to $50) of the difference towards the customer's purchase. This program assures customers of always receiving the lowest price from the Company's stores even during periodic sales promotions by competitors. Monthly competitive pricing analyses are performed to monitor each market and prices are adjusted as necessary to adhere to this pricing philosophy and ensure competitive positioning. Contract Stationer. The Company acquires and maintains its customers primarily through its direct sales force. The Company's sales force is divided between its office supplies and contract furniture divisions. All members of the Company's sales force are employees of the Company. SERVICES Retail. The Company provides three key services to its customers -- credit, telephone and facsimile ordering and delivery. The Company offers revolving credit terms to its customers through the use of private label credit cards. Every business customer can apply for one of these credit cards, which are issued without charge. Sales transactions using the private label credit cards are transmitted by computer to financial services companies, which credit the Company's bank account with the net proceeds the following day. The Company's customers nationwide can place orders by telephone or facsimile using toll-free telephone numbers through the Company's order departments in south Florida and the San Francisco area. Orders received by the order departments are transmitted electronically to the store or delivery center nearest the customer for pick-up or delivery at a nominal delivery fee or free delivery with a minimum order size. Orders are packaged, invoiced and shipped for next-day delivery. The Company opened two regional delivery warehouses in 1990 (in south Florida and northern California) and three regional delivery facilities in 1992 (in the Atlanta, Baltimore/Washington and Los Angeles markets). All delivery orders received from customers in these areas, whether through the Company's telephone centers or at its stores, are handled through these facilities. The Company believes that these facilities enable it to provide improved delivery services on a more cost effective basis and intends to open additional regional delivery warehouses during 1994. No new delivery centers were opened during 1993 pending the Company's entry into the contract stationer portion of the business and the determination of the optimal configuration of a facility which would support deliveries to both retail and contract customers. The Company's stores each have a business services center, which offers self-service and high-volume photocopying as well as facsimile, printing, binding, typesetting and other business services. Contract Stationer. The Company provides the office supplies purchasing departments of its customers with a wide range of services designed to improve efficiencies and reduce costs, including electronic ordering, stockless office procurement and business forms management services, desktop delivery programs and comprehensive product utilization reports. For contract stationer customers, the Company will typically sell on credit through an open account. - 4 - The Company services its contract stationer customers from warehouses located in Arizona, California, Colorado, Massachusetts, New Jersey, North Carolina, Texas, Utah and Washington. STORE DESIGN AND OPERATIONS The Company's stores average approximately 25,000 square feet of space and conform to a model designed to achieve cost efficiency by minimizing rent and eliminating the need for a central warehouse. Each store displays virtually all of its inventory on the sales floor according to a plan-o-gram that designates the location of each item in the store. The plan-o-gram is intended to ensure that merchandise is effectively displayed and to promote economy and efficiency in the use of merchandising space. On the sales floor, merchandise is displayed on pallets or in bins on 10 to 12 foot high industrial steel shelving that permits the bulk stacking of inventory and quick and efficient restocking. The shelving is positioned to form aisles large enough to comfortably accommodate customer traffic and merchandise movement. Additional efficiencies are gained by selling merchandise in multiple quantity packaging, which significantly reduces duplicate handling and stock costs. In all of the Company's stores, inventory that has not been bar coded by the manufacturer is bar coded in the receiving area and moved directly to the sales floor. Sales are processed through centralized check-out facilities, which transmit sales and inventory information on a stock-keeping unit basis to the Company's central computer system where this information is updated daily. Rather than individually price marking each product, merchandise is identified by its stock-keeping unit number with a master sign for each product displaying the product's price. As price changes occur, a new master sign is automatically generated for the product display and the new price is reflected in the check-out register, allowing the Company to avoid labor costs associated with price remarking. MANAGEMENT INFORMATION SYSTEMS The Company employs an IBM ES9000 mainframe and multiple IBM System AS/400 computers to aid in controlling its merchandising and operations. The system includes advanced software packages that have been customized for the Company's specific business operations. The Company is currently implementing a multi-year strategy to upgrade and convert its systems to operate in an "open system" mainframe environment. Inventory data is entered into the computer system upon its receipt by the store and sales data is entered through the use of a point-of-sale or telemarketing system. The point-of-sale system permits the entry of sales data through the use of bar code scanning laser guns and also has a price "look-up" capability that permits immediate price checking and efficient movement of customers through the check-out process. Information is centrally processed at the end of each day, permitting a perpetual daily inventory and the calculation of average unit cost by stock-keeping unit for each store or warehouse. Daily compilation of sales and margin data permits the monitoring of sales, gross margin and inventory by item and product line, as well as the results of sales promotions. For all stock-keeping units, management has immediate access to on-hand daily unit inventory, units on order, current and past rates of sale, the number of weeks' sales for which quantities are on-hand and a recommended unit purchase reorder. Data from all the Company's stores (other than those in Florida) are transmitted by satellite to the Company's headquarters, which provides faster response and is more cost efficient than traditional telephonic transmission. EXPANSION PROGRAM The Company's business strategy is to enhance the sales and profitability of its existing stores, to add new stores in locations where the Company can achieve a significant market presence and to expand its contract stationer business. Through expansion, the Company seeks to increase efficiencies in operations, - 5 - purchasing, marketing and management. The Company added 67 new stores in 1993, and plans to open approximately 60 to 70 stores and additional delivery centers during 1994. Prior to selecting a new store site, the Company obtains detailed demographic information indicating business concentrations, traffic counts, population, income levels and future growth prospects. The Company's existing and scheduled new stores are located primarily in suburban strip shopping centers on major commercial thoroughfares where the cost of space is generally lower than at urban locations. Suburban locations are generally more accessible to the Company's primary customers, have convenient parking and facilitate delivery to customers and receipt of inventory from manufacturers. The Company expands by leasing existing space and renovating it according to its specifications or by constructing new space according to its specifications. Accomplishing the Company's expansion goals will depend on a number of factors, including the Company's ability to locate and obtain acceptable sites, open new stores in a timely manner, hire and train competent managers, integrate new stores into its operations, generate funds from operations and continue to access external sources of capital. No assurances can be given that these expansion plans will be accomplished. Through its acquisitions in 1993, the Company is expanding its presence in the contract stationer portion of the office products industry. The Company's business strategy includes continued expansion in this portion of the industry, although no assurances can be given that it will be able to do so. EMPLOYEES, STORE MANAGEMENT AND TRAINING As of March 11, 1994, the Company employed approximately 20,400 persons. Additional personnel will be added as needed to implement the Company's expansion program. The Company's goal is to promote as many existing employees into management positions as possible. Due to the rate of its expansion, however, for the foreseeable future the Company will continue to hire a portion of its management personnel from outside the Company. The Company's policy is to hire and train additional personnel in advance of new store openings. In general, store managers have extensive experience in retailing, particularly with warehouse store chains or discount stores that generate high sales volumes. Each new store manager usually spends two to four months in an apprenticeship position at an existing store prior to being assigned to a new store. The Company's sales employees are required to view product knowledge videos and complete written training programs relating to certain products. The Company creates some of these videos and training programs while the remainder are supplied by manufacturers. The Company grants stock options to certain of its employees as an incentive to attract and retain such employees. The Company has never experienced a strike or any work stoppage and management believes that its relations with its employees are good. There are no collective bargaining agreements covering any of the Company's employees. COMPETITION The Company operates in a highly competitive environment. Its markets are presently served primarily by traditional office products dealers that typically operate a central warehouse and one or more retail stores. The Company believes it competes favorably against these dealers, who purchase their products from distributors and generally sell their products at prices higher than those offered by the Company, because they generally offer small- and medium-sized businesses discounts on manufacturer's suggested retail list prices of only 20% or less as compared to the Company's 30% to 60% discount to all customers. The Company also competes with wholesale clubs selling general merchandise, discount stores, mass merchandisers, conventional retail stores, catalog showrooms and direct mail companies. While these competitors generally charge small - 6 - business customers lower prices than traditional office products dealers, they typically have a more limited in-stock product selection than the Company's stores and do not provide many of the services provided by the Company. Several high-volume office supply chains that are similar in concept to the Company in terms of store format, pricing strategy and product selection and availability also operate in the United States. The Company competes with these chains and wholesale club chains in substantially all of its current and prospective markets. The Company believes that in the future it will face increased competition from these chains as the Company and these chains expand their operations. Some of the entities against which the Company competes, or may compete, are larger and have substantially greater financial resources than the Company. No assurance can be given that increased competition will not have an adverse effect on the Company. The Company believes it competes based on product price, selection, availability and service. In the contract stationer portion of the industry, principal competitors are national and regional full service contract stationers, national and regional office furniture dealers, independent office product distributors, discount superstores and to a lesser extent, direct mail order houses and stationery retail outlets. Certain discount superstores also appear to be attempting to develop a presence in the contract stationer portion of the business. - 7 - ITEM 2. ITEM 2. PROPERTIES. As of March 21, 1994, the Company operated 344 stores in 33 states and the District of Columbia and 18 stores in 5 Canadian provinces. The Company also operates five delivery centers and a full service contract stationer business through 12 contract stationer warehouses. The following table sets forth the locations of the Company's facilities. All the Company's facilities are leased or subleased by the Company with lease terms (excluding renewal options exercisable by the Company at escalated rents) expiring between 1994 and 2015, except for two Oklahoma stores, three Florida stores, four Texas stores and one California store that are owned by the Company. The Company operates its stores under the names Office Depot and The Office Place in Ontario, Canada. The Company operates its contract stationer warehouses under the names Eastman Office Products, Wilson Business Products, L.E. Muran and Yorkship Business Supply. The Company's corporate offices in Delray Beach, Florida, containing approximately 350,000 square feet in two adjacent buildings, were purchased in February 1994 for approximately $16 million. The Company had previously occupied one of the buildings under a lease covering approximately 150,000 square feet. - 8 - ITEM 3. ITEM 3. LEGAL PROCEEDINGS. The Company is involved in litigation arising in the normal course of its business. The Company believes that these matters will not materially affect its financial position or operations. ITEM 4. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. None. PART II ITEM 5. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SECURITY HOLDER MATTERS. The Common Stock of the Company is listed on the New York Stock Exchange ("NYSE") under the symbol "ODP." At March 18, 1994, there were 3,354 holders of record of Common Stock. The last reported sales price of the Common Stock on the NYSE on March 18, 1994 was $39-1/4. The following table sets forth, for the periods indicated, the high and low sale prices of the Common Stock quoted on the NYSE Composite Tape. These prices do not include retail mark-ups, mark-downs or commissions, and have been adjusted to reflect a two-for-one stock split in May 1992 and a three-for-two stock split in May 1993. The Company has never declared or paid cash dividends on its Common Stock and does not currently intend to pay cash dividends in the foreseeable future. Earnings and other cash resources of the Company will be used to continue the expansion of the Company's business. In addition, the Company is limited in the amount of cash dividends it can pay under the terms of its credit facility. ITEM 6. ITEM 6. SELECTED FINANCIAL DATA. The selected financial data as of and for the 52 weeks ended December 28, 1991, December 26, 1992 and December 25, 1993 set forth in the Company's Annual Report to Stockholders for the fiscal year ended December 25, 1993 (on the inside front cover) is incorporated herein by reference and made a part of this report. ITEM 7. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. Management's Discussion and Analysis of Financial Condition and Results of Operations set forth in the Company's Annual Report to Stockholders for the fiscal year ended December 25, 1993 (on pages 17-20) is incorporated herein by reference and made a part of this report. - 9 - ITEM 8. ITEM 8. FINANCIAL STATEMENTS. The financial statements of the Company for the 52 weeks ended December 28, 1991, December 26, 1992 and December 25, 1993 set forth in the Company's Annual Report to Stockholders for the fiscal year ended December 25, 1993 (on pages 21- 36) are incorporated herein by reference and made a part of this report. ITEM 9. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. Not Applicable. PART III ITEM 10. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. Information with respect to directors and executive officers of the Company is incorporated herein by reference to the information under the caption "Management--Directors and Executive Officers" in the Company's Proxy Statement for the 1994 Annual Meeting of Stockholders. ITEM 11. ITEM 11. EXECUTIVE COMPENSATION. Information with respect to executive compensation is incorporated herein by reference to the information under the caption "Management--Compensation" in the Company's Proxy Statement for the 1994 Annual Meeting of Stockholders. ITEM 12. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. Information with respect to security ownership of certain beneficial owners and management is incorporated herein by reference to the tabulation under the caption "Security Ownership" in the Company's Proxy Statement for the 1994 Annual Meeting of Stockholders. ITEM 13. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Information with respect to certain relationships and related transactions is incorporated herein by reference to the information under the caption "Certain Transactions" in the Company's Proxy Statement for the 1994 Annual Meeting of Stockholders. PART IV ITEM 14. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a) The following documents are filed as a part of this report: 1. The financial statements listed in the "Index to Financial Statements." 2. The financial statement schedules listed in "Index to Financial Statement Schedules." 3. The exhibits listed in the "Index to Exhibits." - 10 - (b) Reports on Form 8-K. None. - 11 - 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 on March 23, 1994. OFFICE DEPOT, INC. By /s/ David I. Fuente David I. Fuente, Chairman and Chief Executive 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 in the capacities indicated on March 23, 1994. All other statements have been omitted because they are inapplicable, not required or the information is included elsewhere herein. ______________________________ * Incorporated herein by reference to the respective information in the Company's Annual Report to Stockholders for the fiscal year ended December 25, 1993. F - 1 INDEPENDENT AUDITORS' REPORT ON SCHEDULES To the Board of Directors of Office Depot, Inc.: We have audited the consolidated financial statements of Office Depot, Inc. and subsidiaries as of December 25, 1993 and December 26, 1992 and for each of the three years in the period ended December 25, 1993, and have issued our report thereon dated February 8, 1994; such consolidated financial statements and report are included in your 1994 Annual Report to Stockholders and are incorporated herein by reference. Our audits also included the financial statement schedules of Office Depot, Inc. and subsidiaries referred to in Item 14(a)(2) and listed in the Index to Financial Statement Schedules. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. DELOITTE & TOUCHE Certified Public Accountants Fort Lauderdale, Florida February 8, 1994 F - 2 INDEX TO FINANCIAL STATEMENT SCHEDULES F - 3 SCHEDULE V OFFICE DEPOT, INC. AND SUBSIDIARIES PROPERTY, PLANT AND EQUIPMENT (IN THOUSANDS) F - 4 SCHEDULE VI OFFICE DEPOT, INC. AND SUBSIDIARIES ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (IN THOUSANDS) F - 5 SCHEDULE VIII OFFICE DEPOT, INC. AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS AND RESERVES (In thousands) (1) Allowance for doubtful accounts of Eastman and Wilson at the respective dates of acquisition. F - 6 SCHEDULE X OFFICE DEPOT, INC. AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION (In thousands) F - 7 INDEX TO EXHIBITS + This information appears only in the manually signed original copies of this report. * Management contract or compensatory plan or arrangement. (1) Incorporated by reference to the respective exhibit to the Company's Registration Statement No. 33-66642. (2) Incorporated by reference to the respective exhibit to the Company's Registration Statement No. 33-39473. (3) Incorporated by reference to the respective exhibit to the Company's Registration Statement No. 33-54574. (4) Incorporated by reference to the respective exhibit to the Company's Registration Statement No. 33-70378. (5) Incorporated by reference to the respective exhibit to the Company's Quarterly Report on Form 10-Q for the quarterly period ended June 29, 1991. (6) Incorporated by reference to the respective exhibit to the Company's Current Report on Form 8-K filed October 14, 1993. (7) Incorporated by reference to the respective exhibit to the Company's Proxy Statement for the 1993 Annual Meeting of Stockholders (8) Incorporated by reference to the respective exhibit to the Company's Annual Report on Form 10-K for the year ended December 26, 1992. (9) Incorporated by reference to the respective exhibit to the Company's Registration Statement No. 33-51409. Upon request, the Company will furnish a copy of any exhibit to this report upon the payment of reasonable copying and mailing expenses.